COMMENTARY
Feasibility of Introducing GST in April 2010
M Govinda Rao
It is, therefore, not surprising that the union government and the Empowered Committee of State Finance Ministers have agreed to reform the existing domestic indirect taxes at the central and state levels into separate value added taxes on goods
April 2010 was the target date set three years ago for introduction of the Goods and Services Tax, but the economy is far from ready for the switch over. This article cautions against hasty implementation and lists the measures that need to be taken by the centre and the states in order to reap the benefits of the new indirect tax.
M Govinda Rao (mgr@nipfp.org.in) is with the National Institute of Public Finance and Policy, New Delhi.
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The principal objective of any major tax reform exercise is to minimise the compliance cost as well as the cost to the economy from the distortions that the tax creates. From this point of view, the “national” GST would have been ideal. The simplicity of the tax would have reduced the administrative cost. It would have also minimised compliance cost to the taxpayers as they would have had to deal with only one tax agency. The complete crediting of input taxes on domestic production and complete zero-rating of exports would have helped to minimise the tax-induced distortions as well. However, in a federal polity, the objective of minimising tax-induced distortions will have to be balanced with considerations of fiscal autonomy. As sales taxes contribute more than 60% to the states’ own revenues, the states would not give up their tax power.
July 18, 2009
and services at the two levels. In this “dual” GST, there will be two separate taxes as the two levels will retain their powers to levy the tax. There will be some attempt at standardising the tax base, but the taxpayers will have to submit separate returns to the union and state governments. While this will go a long way in harmonising domestic trade taxes in the country, it must be noted that this will still have a higher compliance cost (as the taxpayers will have to deal with multiple tax authorities) and some cascading as the central GST cannot be credited against state GST and vice versa. Nevertheless, this is a landmark reform and, therefore, should be a priority.
Preparatory Work
A major tax reform initiative like the introduction of GST, however, requires considerable preparatory work. Although substantial progress has been made in reforming the central excise duties into a “CENVAT” and converting the cascading type state sales t axes into an intra-state VAT, much more preparatory work needs to be done before moving over to a comprehensive GST. Experience shows that tax reforms undertaken without sufficient preparation can create serious compliance problems and distortions.
In India itself, the introduction of Modified Value Added Tax (MODVAT) in 1986 by converting the central excise duty with more than 20 rates without adequate preparation led to serious compliance problems with the manufacturers claiming credit or seeking refunds for input taxes which were never paid and this continues to plague the tax system. Furthermore, the inability to levy proper VAT at the centre has led to the introduction of several schemes for refunding the taxes on exports such as duty draw back and the Duty Entitlement Pass Book (DEPB) instead of a simple system of zerorating. While one needs to be cautious and not implement reform without sufficient preparation, this note underlines the u rgency for speeding up the preparatory
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work so that we will be able to move over to the new tax regime at least by April 2011.
Preparatory work for switching over to the GST can be discussed broadly under three heads namely, (i) legal/constitutional changes; (ii) reforms in policies; and (iii) chan ges and strengthening of institutions.
Constitutional/Legal Changes
The proposed dual GST requires that both central and state governments should have the power to tax both goods and services up to the retail stage. After the amendment to the Constitution, a separate entry (92C) was inserted in the Union List to empower it to levy the tax on services. Prior to this, the service tax was levied on the basis of the residual power entrusted to the union government in the Constitution. However, as far as goods are concerned, the union government can levy “duties of excise on tobacco and other goods manufactured or produced in India” (Entry 84). Although wholesale and retail trade falls in the category of services, it would be erroneous to presume that with this inclusion, the central government can levy the tax on goods up to the retail stage. The GST at wholesale and retail stages are still tax on goods and the present arrangement does not enable the central government to tax beyond the manufacturing stage. Levying a retail stage GST would require that the central government should be enabled to levy the tax b eyond the manufacturing stage.
An equally important measure is to empower the states to levy the tax on services. Although the Constitution assigns them the power to levy taxes on some specified services such as entertainment, transportation of passengers and goods and luxury taxes on services of hotels, they do not have power to levy taxes on other services. As goods enter into the production of services and vice versa, giving comprehensive credit on the input taxes requires taxing all services at the state level. A comprehensive goods and services tax and facilitating a complete refund of taxes on exports at the state level requires that they should have the powers to levy taxes on all services.
Policy and Institutional Reforms
A number of reform measures have to be undertaken by both central and state g overnments before implementing the GST and these should be initiated without any loss of time. During the last few years, although the CENVAT rate has converged, a number of rates still exist and these need to be unified. It is important to keep the structure of GST simple and, therefore, it is necessary to avoid multiplicity in tax rates. The commodities on which specific rates are charged need to be converted into ad valorem rates. Rate differentiation is also made on equity grounds, but these, while not contributing much to redistribution, have added to administrative complications and have provided fertile ground for lobbying for lower rates from various special interest groups. If, indeed, some items need to be taxed at higher rates either for sumptuary (tobacco) or for environmental (petroleum products) reasons, a separate excise tax may be levied on them in addition to the GST. Thus, there is a need to rationalise the prevailing excise duty.
In the case of tax on services, the reform is even more fundamental. The centre has continued the selective taxation of services in spite of the recommendation by the Expert Group on Service Tax in 2001 that the tax should be converted into a general tax with a small list of exemptions for equity or administrative reasons and a small negative list of services with significant externalities. In fact, it was this expert group that recommended that the central government should convert its MODVAT into a goods and services tax at the manufacturing stage. Levying a general tax on services will obviate the need for defining each service; only “service” will need to be defined. This will avoid the litigation that plagues the service tax legislation at present. It will also enable provision of tax credit for input taxes on all services.
Equally important is the need to set up a proper computerised information system. The present level of computerisation in the excise and customs department is inadequate to deal with a modern tax like the GST. The fact that the central excise department continues to follow ad hoc measures to give tax credit on inputs instead of simply crediting the tax paid on inputs against the output tax is a testimony to the lack of capacity of the present information technology (IT) service provider to deal with the problem. In fact, a smooth functioning of any VAT system is possible when the tax is simple and the information system is effi cient. Indeed, the complexities in the tax system including various types of exemptions given continue to be a problem. Hopefully, we will have a clean GST when it is introduced, but the success of GST will depend on its revenue productivity and this will crucially depend on having a modern information system to facilitate crediting of all input taxes, ensuring that taxes do not escape the net and enabling zerorating of exports.
Reforms at the State Level
The reforms required to levy the GST at the state level are equally formidable. First, the state governments should be empowered to levy taxes on services. A comprehensive GST at the state level which provides complete
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input tax credit and refunds the taxes on exports entirely, requires that the states should have concurrent powers to tax services. If they are assigned powers to levy taxes only on services falling within their geographical range, then crediting input taxes with interstate span is simply not possible. It will also make the state GST extremely complicated and cumbersome. Assigning concurrent powers to tax services to the states, however, creates the problem of assig ning revenues from services having interstate jurisdiction. In the case of telecom, for example, the services are gene rated somewhere, purchased somewhere else, consumed in a different place and paid for in yet another place. There is no problem if these services form inputs into the production of another good or a service, but if they are in the nature of final consumer goods or services, it is necessary to negotiate and settle assignment of reve nues among the states. In C anada, generally, the province collecting the revenue retains it. This may not be entirely satisfactory, but it is a workable solution. Whatever be the arrangement, this needs to be negotiated and settled before the states levy the GST.
The most important precondition for a successful GST at the state level is the computerised information system for interstate transactions.
A successful GST would require that when a commodity or a service is exported from one state to another, it does not carry any tax from the state of origin. This can be done by zero-rating the tax in the exporting state and starting the tax chain in the destination state. Alternatively, the purchasing dealer in the importing state may be asked to pre-pay the tax to his state to ensure that the transaction is, in fact genuine, and on getting the information on the tax payment, the exporting state would refund the taxes collected from the goods and services sold interstate.
As the central sales tax will be abolished when the GST comes into play, tracking interstate transactions is critical for the success of GST and this would require a well designed computerised information system on interstate transactions. An a ttempt to develop this through the Tax Information Exchange System (TINXSYS) has not been successful as only some states opted for it. It is necessary to contract a competent service provider to undertake this task without much loss of time.
Structure of State GST
It is also necessary to have a re-look at the structure of state GST. The Empowered Committee of State Finance Ministers has been discussing this issue and the available information is that they are thinking of a GST rate of 16% and 8% to be levied each at the central and state level. Hopefully, both the centre and the states will keep one rate each which will avoid administrative complexities. However, this could imply differential revenue implications for different states and each state will have to work out the revenue implications of the tax before agreeing to a common rate. Of course, the central government may provide comfort by stating that the losses to any state would be compensated for a certain number of years. Never theless, at a time when the economy has slowed down, some states could have signi ficant revenue losses and they would be wary of the compensation formula. It must be noted that the VAT was introduced when the economy (particularly the manufacturing and service
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sectors) was on the upward phase of the cycle and that ensured high buoyancy of the tax in virtually every state. If indeed the reform is introduced when the economy is at the bottom of the cycle, there is a fear of revenue loss and the GST introduction may be termed a failure for no fault of the tax. For this reason also, it seems advisable to shift the date for the introduction of GST to April 2011. At the same time, it is necessary to work out a clear action plan for getting both the centre and states ready so that when the tax is introduced, it will be a success in terms of not only raising adequate revenues but also in minimising both compliance cost and distortions to the economy.
A major tax reform like the introduction of a GST would require an institutional a rrangement for resolving interstate and centre-state issues. Harmonising the tax system requires adherence to the agreed discipline and an institutional arrangement is necessary to ensure this. As the central government itself is a player in the game, it cannot be a referee. As it is, the states have a number of issues including administered pricing of goods by the c entral government which impacts the VAT collections. The Empowered Committee of State Finance Ministers is an informal entity without any statutory backing and it is doubtful whether it can enforce discipline among the states. It has not been able to enforce the agreed VAT rates at 4% and 12.5% and there are a number of violations among the states. A strong institutional arrangement with a sound legal foundation is an important need to ensure harmonised levy of GST in the country.
Measures in the Union Budget
The reiteration of the resolve to switch over to the GST in April 2010 in the budget speech is important as it can galvanise the preparatory work. Whether or not there is a complete transition by the due date, the statement will help both the central and state government departments to begin the preparatory work in right earnestness.
Unfortunately, beyond the statement, there is not much in the budget in terms of either structural changes, or changes in administration and implementation system. Of course, the attempt to unify the excise duty rates at 8% on those that were below 8% is important. Even so, exceptions have been made for food items, important drugs and medical equipment and items of common consumption. While the products of the small-scale industry are exempt, and basically processed and packed food items are taxable, it does not make much sense to tax them at lower rates. Surely, taxing Kellogg’s cornflakes or fruit juices in tetra packs or pressure cookers does not serve the purpose of equity. Similarly, there are a number of items which are taxed at higher rates and the attempt should be to unify them. In the case of services, taxing goods transport in railways and inland waterways, and legal services given to corporates is important in expanding the base. But the GST would require taxation of all services with a small list of exempted services and continuing with selectivity will make the transition much more difficult. The union finance minister could have demonstrated the resolve to move over to the GST with some concrete measures to unify the tax rates on goods and services.
April 2010 Unrealistic
In the prevailing scenario, a smooth transition to the full-fledged GST by April 2010 does not look optimistic. Nevertheless, the central government can certainly convert the CENVAT into a GST at the manufacturing stage by April 2010. This requires unifying the rates of CENVAT, which during the last five years have tended to multiply. Another important policy measure to be taken is to convert the selective tax on services into a general tax as mentioned above. Extending the tax on all services will signi ficantly expand the tax base, which will help augment revenues at a time when the centre is faced with a large fiscal deficit. This will also e nable GST to be levied at a low rate when it is i ntroduced. More importunately, expanding tax base to all services will help the taxpayers to claim input tax credit on all inputs. The selective taxation of services prevents getting tax credit from untaxed services.
Along with the above measures, the central government can unify its CENVAT and service tax to evolve GST at the manufacturing stage. The unification can be done by having a common threshold and a uniform tax rate and enabling input tax credit for both goods and services. The government may keep the threshold at Rs 1 crore which is much higher than the prevailing threshold for service tax, but much lower than that for union excise duties. This will help expand the tax base. To begin with, levying the tax at 9% would be revenue neutral and since it is the GST at the manufacturing stage, when the GST base is expanded up to retail stage, the rate could be reduced to 7 or 8%. In respect of sumptuary items of consumption such as cigarettes and petroleum products, a separate excise may be levied in addition to the general GST.
Conclusions
It must be noted that the Empowered Committee of State Finance Ministers has done a commendable job of achieving a broad consensus on several contentious issues relating to the introduction of GST in the country. The decision to introduce a dual GST and the agreement to introduce a uniform GST among states are i mportant among them. However, they are yet to decide on the level and structure of GST rates among the states and relaxations on the uniform base and rates in respect of individual commodities and services. Once this is decided, the mechanism for compensating any revenue losses and the number of years for which compensation should be assured will have to be discussed and r esolved with the central government. They will also have to decide on the mechanism to relieve the tax on the goods and services sold interstate and the ways the information system can be developed to ensure effective implementation of the chosen scheme. There are also contentious issues to be agreed upon relating to the assign ment of revenues from the taxation of ser vices with interstate jurisdiction.
GST reform is essential and it will be a landmark in the history of tax reform in I ndia. In an open market economy, it is necessary to minimise the distortions caused by tax policy and simplify the tax to minimise compliance costs. Nevertheless, it is necessary that this major reform initiative should be preceded by sufficient preparation to ensure a smooth switch over. Considering the present state of preparedness, the prospect of making a smooth transition in April 2010 does not look very optimistic. Hopefully, both central and state governments will initiate the preparatory measures expeditiously to make a smooth transition at least by April 2011, if not earlier.
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