At 27% rates, tax evasion will remain high; indeed, the governments may even end up losing on tax collection
With alcohol and petroleum out of GST, and states allowed to keep a band in tax rates, the scope for tax arbitrage remains, so tax barriers at each state border will remain -- the big benefit of a borderless India will remain a pipe dream
Given how GST has been touted as one of the biggest reforms in India’s tax history in terms of how it will slash rates for both central and state taxes—from around 25% right now to around 12-14%—as well as create a borderless market with no trucks lined up for hours outside inter-state check posts, it is difficult to recommend giving up the dream. Yet, given the 27% revenue-neutral-rate (RNR) that the Empowered Committee of State Finance Ministers is now talking of, this may be a good idea. Indeed, carrying on with a GST at 27% may even cause more losses as, faced with high tax levels, more people may be induced to avoid paying taxes—low tax rates are the sine qua non of any efficient tax system.
One view popular among the political class is to get the states on board with, if need be, a 27% RNR, and then lower the rates as you go along. In other words, as compliance increases and as states start getting more money from the GST, they may be better inclined to accept a lower RNR.
Most important, according to this argument, is the efficiency gain—if truckers don’t spend 60-70% of their time waiting at state borders, and they won’t once there is a GST, think of the benefits. As The Economist’s headline put it so evocatively, ‘the truck stops here’.
In order to understand why all of this is in danger with a 27% RNR, it is important to understand how GST works. If Producer A sells a good to Producer B that costs R100 and the GST is 10%, the good is sold at R110 and R10 is deposited in the treasury as tax. If Producer B does a value addition of R10, he then sells the good to Trader C at R120+tax which equals R132, and so on. But if Producer B is doing a value addition of R10 and paying a tax of R12, there’s a clear problem. Which is why, Producer B gets a tax credit of R10.
Now increase the rate of tax to 27%. Immediately, there’s a major aversion to paying such a huge rate, and that’s why as tax levels are reduced, tax compliance rises. So, with a 27% rate, compliance rates will likely fall.
So how does compliance rise in low VAT/GST regimes? Take the case of polyester chips and the fabric and readymade garments produced from it. One way to tax is to charge Reliance Industries Limited, a polyester producer, a high rate and forget about the hundreds of firms who create garments from this. That’s what typically happens today—there is obviously a large potential revenue loss, but we live with it. According to Satya Poddar, Tax and Regulatory Services Partner at EY, the VAT tax base is probably 50% of what it should be due to this.
The other way is to charge a lower rate all along the chain. Reliance pays a low rate of tax; the firm that buys from Reliance also pays a tax but it gets a refund of the tax Reliance paid, and so on. Over a period, you have hundreds of small producers paying a tax. It doesn’t require a nuclear scientist to figure out which is a more efficient way. In other words, if the RNR is as high as 27%, there will be no chain of producers, and there will be no database on them.
What’s happening at the level of the states is even more interesting since, the way things are evolving in the empowered committee, states want to have the power to tax firms with a turnover of more than R10 lakh per annum. In Uttar Pradesh, with the government machinery unable to tackle VAT, a circular was issued last month saying that if firms sold good, say Coca Cola, to state government undertakings/bodies, no tax would be charged on this; the state government undertaking/body would deposit the tax itself. In other words, UP is not confident of being able to monitor those collecting taxes.
It gets better in Punjab where, last year, the state came out with a list of products—TVs, washing machines, refrigerators, juicers, deodorants, soaps … the list is a long one—where it simply eliminated the VAT ‘provided that tax has already been paid at the first point of sale, i.e. manufacturer or first importer’s stage’. In other words, bye-bye value chain. Yet, these are the very states that want to control the GST chain—if the chain is going to be discarded at the drop of a hat, how is GST going to work?
What of the trucks, will they still have to stop at the interstate borders once GST is introduced? Ironically, there will be no change here. Take alcohol and petroleum, two products where the states are adamant GST will not apply. If these are kept out of GST, and rates differ across states, as they will, each state will fear goods are either being smuggled in or out. How do you ensure this doesn’t happen? By strengthening the check posts, that’s how! Indeed, given how the GST structure being talked of right now allows a band of 2 percentage points on various items across states, the check posts just have to stay.
But why is the RNR so high? Poddar argues it all has to do with the way the tax base is calculated. The Finance Commission used income tax data and then arrived at a 12% RNR. Others, he says, used the VAT and service tax returns which probably don’t capture more than half the potential taxpaying base.
There is then the complication about real estate. Most states argue this shouldn’t be brought into GST, though it is a separate matter that, legally speaking—Poddar argues—anything other than a good is a service and so can be brought under GST. Including land in the tax base can reduce the RNR by around 2-3 percentage points.
But leave that aside. When you buy a flat, Poddar points out, there is a cost of land, there are materials used and there are services involved. Since it is difficult to decompose them, states such as Maharashtra levy a 1% composite tax on flats. In which case, the base that should be taken into account while calculating RNR should be 100 times the tax collected. But if the VAT rate is 12.5%, many would take the base to be just 8 times (1/12.5) the tax collected. How you calculate the tax base makes all the difference.
Until both the central and state finance ministers take a long and hard look at these issues, there seems little to be gained by wasting any more time on bringing in GST.