India made the biggest tax system reform in its history when it transitioned to the goods and service tax (GST) regime on Friday night. This is not only a change in the tax system, but this will also usher a big change in the federal system in the country. The states are giving up arguably much of their most important power: to impose taxes. So, on balance, will we, the people, be better off?
There seems to be a variety of taxation systems in place in several federal systems. For example, Australia has adapted a GST system in which the central government administers the GST, and the revenue is shared between the Centre and the states.
United States of Taxes
In Canada, it is a mixed model — a harmonised sales tax (a value-added tax, VAT) — that is administered by the central Canada Revenue Agency. But one state, Québec, imposes its own state-level taxes. In the world’s largest economy, the US, each state imposes a different sales tax, which differs across states, and there is no revenue-sharing.
How can adopting GST as a tax system across the country benefit us? The obvious answer is that by replacing a really messy system of indirect taxation, it will be easier for firms to do business across the country. With Virtualauditor Experts in GST Registration, the taxing system is now quicker and more convenient. This will increase investment and, through that, growth in the country. With added growth, welfare of citizens will rise. This is the strongest argument favouring the implementation of GST.
Till now, there were multiple and complex set of taxes that differed across states. This was a deterrent in establishing and expanding business.
Anything simpler is welcome. So, indeed, there will now be gains through this channel. Though even in this regard, the actual implementation of GST leaves something to be desired.
Instead of one single GST rate, there will be several. A variety of goods and services will be taxed at different rates, reducing the simplicity that GST promises to bring with it. Also, adding complexity and cost is the requirement to register with both the central tax authority and state tax authority for each state a firm wants to do business in. This will certainly increase complexity.
GST is also supposed to reduce the administrative cost of tax collection.
Till now, the number of indirect taxes, central and state, were in double digits. Often, different agencies were involved in collecting taxes, which was costly. This reduces the net tax collected. Since all these taxes have now been subsumed under GST, the cost of administering and collecting indirect taxes is likely to come down.
However, GST will have two different components: state GST (SGST) and central GST (CGST), and a firm has to pay one to the state tax authority (authorities, if it does business in multiple states), and one to the central tax authority.
This will increase the cost of tax collection compared to the situation where a single authority collects taxes (as in Australia and Canada) and the revenue is shared. Moreover, multiple and possibly overlapping jurisdictions can cause conflict, further reducing the benefits of GST.
Poof! Which Taxes?
An important aspect of this transformation of tax system is that individual states will no longer be able to change their tax rates. The tax rates will be decided by the GST Council, which has representation from all states and the Centre. This has serious implications.
First, both central and state governments have obligations to provide public goods and services. Though there is some overlap between the public goods provided by the Centre and the state, they mostly provide different public goods.
For example, the Centre has the responsibility of providing defence for the country while, primarily, states are responsible for law and order, health and education. Thus, each state has to garner enough revenues to pay for these.
State governments will earn the SGST part of the GST (and a share from the consolidated revenue of the Centre, as determined by the Finance Commission). But it will not have the ability to change that to respond to local shocks like droughts or floods. The only instrument that will remain with states is borrowing.
The maximum amount a state can borrow is limited by the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. In the future, we can expect this to be severely tested.
This is also precisely the insight from the 2008 paper, ‘Is It Is Or Is It Ain’t My Obligation? Regional Debt in a Fiscal Federation’, published by Russell Cooper, Hubert Kempf and Dan Peled in the International Economic Review (goo.gl/gy7ZHs). They find that if the central government is unable to commit to bail out the states, states may borrow excessively.
Only Less Taxing
Note that holders of a particular state bond are not limited to the residents of that state. So, we can expect a spillover effect, and the welfare of residents across states may be affected. Given this context, in the paper, ‘Optimal Taxation in a Federation and GST in India’ (goo.gl/TjBpXH), this author and Trishita Ray Barman try to understand the short-term and long-term dynamic effects of this change to GST.
The paper finds that the variability of aggregate consumption can be expected to be lower under the GST system.
However, whether aggregate consumption will increase depends on the relative weight of public goods and services provided by the Centre and the state. In such a situation, if the ability of states to provide the state-level public good is impaired, then people may be worse off.
The study uses currently available data to calibrate the model used to further understand the differential effect of the GST across states. First, let us think about the short run.
The big discussion point in the short run is whether the state governments’ revenue post-implementation of GST will increase or decrease. This has been at the heart of the political negotiations between the states and the Centre in adopting GST across the country, and something that held up the transition to the GST system for nearly a decade.
The stated objective in setting GST rates is to make the GST rate revenueneutral — that is, with GST now kicked in, the revenue will be unchanged. But the question is: for whom will it remain unchanged? Given the variation in government revenues and consumption across states, the revenueneutral GST rate for each state will be unique and different.
Taxable to the T
Using a calibrated model to calculate the revenue-neutral rates corresponding to each state, one finds that it varies from 5.1% (corresponding to Manipur) to 20.1% (corresponding to Tamil Nadu). The median rate is 11.4%
That means if the effective GST rate is 20.1%, then the Tamil Nadu government’s revenue will remain unchanged.
Anything less, there will be a dip in Tamil Nadu’s revenues. However, if the effective rate turns out to be 20.1%, then revenues for all other states will increase post-GST
So, is adopting the highest revenueneutral rate good? Hold on. Using state-level data from the past few years, the study shows that higher taxes will reduce the growth rate in the state.
Thus, by adopting a high effective GST, even though there will be a bump in the revenue collection in the short run, in the long run, the governments’ revenue may be less than what would have been possible with a lower tax rate — not to mention the welfare loss due to higher tax rate.
Note that the states have agreed to move to the GST system only after the central government has promised to compensate them for five years for any loss in their revenues.
What really happens across states depend crucially on what the effective GST rate turns out to be. The GST Council, in its wisdom, has decided to go for multiple tax rates. So far, it has bunched an array of goods and services into five different rates: 0%, 5%, 12%, 18% and 28% (gold and raw diamond have their own rates). In addition, there will be cess.
So what the effective tax rate in the economy will be is still a mystery. And, in balance, will we be better off? It depends on this unfolding mystery. What should have been a simple countrywide tax rate, like many things in life, is anything but simple.
But we shall know soon enough, as India has taken the first radical step towards the removal of clutter in its tax system. Let many more required for further simplification follow.