OPINION | GST Reform: Promise, pitfalls and the road ahead

The ideal GST structure is straightforward: no exemption for any good or taxpayer; single rate for all goods and minimum hurdles for registration and refunds.

All the major economies of the world, except the US, have a value added tax. India introduced national-level Goods and Services Tax (GST) in 2017 which has been amended significantly last week in terms of rate structure and administrative procedures.

GST-style taxes are popular because they promise higher production efficiency and higher revenue collection per rupee spent on enforcement.  If these are the only objectives of the government, the ideal GST structure is straightforward: no exemption for any good or taxpayer; single rate for all goods and minimum hurdles for registration and refunds.

Balancing multiple goals

In practice, however, the Indian policymaker has had to balance efficiency with competing objectives of equity and incentivizing people towards desirable behaviour such as buying insurance and dissuading them from harmful activities like smoking. This resulted in multiple GST rates and numerous exemptions. Recent reforms reflect this trade-off. Removal of the 12% tax rate and placing most of the items in the 5% and 18% rate categories are steps towards higher efficiency.

Fewer rate categories will reduce administrative burden and enforcement costs of the tax department. Now similar products such as all kinds of parathas, popcorns and textiles face the same tax rates. This will reduce evasion opportunities and tax disputes arising from product misclassification. It also helps address the problem of inverted duty structure where inputs were taxed at a higher rate than outputs leading to constant refund claims by businesses.

Potential impact of rate reduction on demand and producer incentives

The reduction in tax rates will impact consumer demand and tax evasion. Lower tax rates will impact prices though the effects will vary according to market structures and price sensitivity of demand. Firms are more likely to reduce prices in sectors which are competitive and demand is highly price-sensitive. Conversely, sectors which are dominated by few companies or where the demand is less price sensitive such as high-end luxury cars, may not witness significant decrease in prices.

Tax cuts will also reduce incentives for tax evasion. Taxpayers facing lower rates will be less likely to inflate their input costs through fake invoices or underreport sales. It will also incentivize more businesses to become formal as a significant cost of entering the tax net, that is, tax rates has been reduced.

Room for improvement

However, there are various ways in which the current rate structure can be improved for greater efficiency and broader equity. GST rates can vary based on the value or characteristics of a product creating artificial thresholds that can distort pricing and production decisions.

For instance, car manufactures would be incentivized to produce cars that are slightly below 4000mm in length and 1200cc in engine capacity to avoid higher tax slabs. Similarly, footwear priced below the threshold of Rs 2500 is taxed at 5%, but once the price crosses this threshold, the tax rate jumps to 18%. As a result, the manufacturers will avoid pricing the goods just above Rs. 2500, since it will increase their tax liability by more than the extra rupees earned. Removing these thresholds altogether or targeting them only towards the wealthiest consumers might be the way forward.

Downside of removing input tax credit

Some services such as low-cost hotel accommodation and beauty services have been transferred to 5% category with no option to avail input tax credits (ITC). Health and Insurance services have been provided exemption which also implies that these providers cannot claim ITC.  This converts GST from a value-added tax to a turnover tax for these services.

GST increases revenue because it creates opposing incentives for sellers to under-report sales and buyers to over-report purchases. Without ITC, buyers and sellers can collude to under-report sales, weakening GST’s self-enforcement mechanism. It also implies differential tax burden with firms having higher profit margins paying lower effective tax rates. Thus, weakening the characteristic of GST as a value added tax may not be desirable in the long-run.

With the recent reforms, the gap between tax slabs is wider which can result in increased skewness and uncertainty in revenue collection. Tax receipts will rely more heavily on products which are taxed at higher rates and firms operating in the formal sector. This will increase the correlation between government revenues and performance of these sectors. If there is a downturn in these sectors because of external shocks such as tariffs, then it has the potential to significantly affect government revenues.

States’ anxiety over revenue impact of GST changes

There is a legitimate concerns among states regarding the revenue impact of the GST reforms. Until tax cuts generate enough demand buoyancy to raise overall collections, states that rely more heavily on GST as a share of their total revenue will be most affected. The removal of compensation cess will disproportionately affect states which failed to grow GST revenues by more than 14% annually over the base year of 2017. If these states experience significant revenue losses, then the next-generation reforms, such as bringing petroleum products under the GST net, will be harder to implement.

The key, as the finance ministry has rightly identified, is increasing the tax base through greater formalization and lower evasion. Reforms related to streamlining registration and refund procedures and setting up effective dispute resolution mechanisms are steps in the right direction. The Center can support the states facing revenue shortfall by investing in capacity building of state tax officers enabling them to use GST digital architecture more effectively. This includes better analysis of the GST data to curb evasion and track sector-wise revenue trends. At the central level, more attention is needed in removing anomalies in the rate structure and identifying areas of improvement through more rigorous data analysis.

(Bhanu Gupta is Assistant Professor of Economics, Ashoka University.)

Views are personal and do not represent the stand of this publication.