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The Structurally Flawed GST

Finding an Alternative

Arun Kumar (arunkumar1000@hotmail.com) is the Malcolm Adiseshiah Chair Professor at the Institute of Social Sciences, New Delhi.

The inherent flaws in the design of India’s goods and services tax are identified, which make its implementation inefficient. Can an ad valorem GST levied at the final stage of production solve the problem?

The goods and services tax (GST) has been in operation in India since 1 July 2017. More than a year later it is still a work in progress with changes being announced almost daily. By 1 May 2018, more than 400 notifications and orders had been issued leading to confusion not only among the public but also the experts (Pampapathi 2018). The policymakers seem to be groping in the dark even though they put up a brave front.

That the GST is a very complex tax has been known for long. The Indirect Taxation Enquiry Committee Report (1978) first suggested it in the form of a “comprehensive value added tax (VAT).” But soon it realised that a tax regime with such complexity is infeasible to be implemented in India. It thus suggested a VAT at manufacturing stage (MANVAT) on a restricted number of manufactured products. Even this could not be implemented. Each of the subsequent committees on the indirect tax reforms in India had simultaneously toyed with the suggestion of implementation of the VAT because of its pecuniary advantages, and also recognised the practical difficulties in implementing it in such a diverse economy (Kumar 2019).

Potential Benefits of GST

While pushing the implementation of the GST, various advantages are listed, which potentially generate a win-win situation for all sections of society (GoI 2018, 2015a, 2002). These range from:

(i) increase in the growth rate of the economy, (ii) decrease in the rate of inflation, (iii) increased tax collection leading to rise in the social sector spending, (iv) the mitigation of the black economy with potentially more tax collection, (v) improvement in market efficiency leading to the “ease of doing business” and higher level of exports, and (vi) fiscal gains to the poorer states since the GST is a last point tax.

These claims, however, are contradictory (Kumar 2015). If the collection of an indirect tax rises, then prices will rise rather than fall. It was shown that even if the government goes in for a single revenue neutral rate (RNR) of tax, inflation will rise since the basics and intermediates will have to bear a higher rate of tax. It was also shown that if prices rise and the government collects more revenue which is used to keep the budget deficit down, then demand will suffer and growth rate will fall rather than rise. Even if the extra tax collected is used to increase expenditures, overall demand will stagnate and output will not rise so that the claimed increase in growth would not materialise (Kumar 2019).

Further, given the complexity of the tax, its impact of the black economy is arguably marginal (Kumar 2018a). In fact, the chances are that the black income generation process might receive a boost over time. It is argued that the large number of registrations of businesses under GST would not automatically lead to a rise in the tax to GDP (gross domestic product) ratio (Kumar 2019). With the finance ministry propounding that 5% of the indirect taxpayers pay 95% of the tax while 95% of taxpayers pay 5% of the tax, an increase in the number of registrations is no guarantee of more tax collection (Kumar 2018a). Reports of businessmen evading taxes are coming in daily. Even the income tax data shows that a large number of those in the tax net show either nil income or very low income (Kumar 2016).

Theoretically, it is known that all taxes are “distorting.” Each time a tax is levied it creates distortions. The proponents of the GST suggest that since a single tax, that is, the GST, replaces 17 different taxes, it would be less distorting than the earlier system. This would reduce the welfare losses and make the system more efficient. However, most supplies currently under the GST had to bear utmost three or four taxes, and not 17 as claimed. Moreover, now with the GST in place there are still three main taxes, namely the central goods and services tax (CGST), the state (union territory) goods and services tax (SGST/UTGST) and the integrated goods and services tax (IGST). There is also a cess on certain items. So, by and large, the number of taxes faced by a supplier are not less. However, many more stages of production and distribution are taxed now. Thus, the number of times a tax is levied in the system now is more than that earlier. Thus, distortions will not decline and efficiency will not rise (Kumar 2019). It is then unclear how the business climate will improve, as claimed by the proponents of the GST.

The claim that the GST leads to greater equity is also debatable. When goods go across the state borders, the tax goes with them. Thus, all the tax accrues to that state government where the final sale takes place. That is why, the GST is called a last point tax. With the poorer or less developed states having proportionately less production and more consumption than the better-off states, the former are called the consuming states while the latter are the producing states. The argument goes that the tax collection will be proportionately higher in the consuming states. That is why, to begin with, the producing states like Tamil Nadu and Gujarat were worried that they would lose revenue. They agreed to implement the GST only after they were assured by the central government that it would compensate them for five years for any loss of revenue.

But the tax benefit to the poorer/consuming states will get nullified by the fact that these have proportionately more of the unorganised sector which is getting hit badly by the GST (Kumar 2018b). Thus, the loss of incomes and employment would be much more in the consuming states than in the producing states. In the net, any revenue gain by the poorer states due to GST would be overwhelmed by the loss of output and employment they would suffer.

The GST, therefore, undermines fiscal federalism by truncating the autonomy of the states with a “one-size-fits-all” policy. An additional problem in this context is faced by the third tier of the government, that is, the local bodies, which are ignored in this reform of the indirect taxes (Kumar 2015). Their revenue sources are being curtailed without assigning new ones. This will have deleterious effects for decentralisation.

This state of affairs reflects a lack of clarity regarding the theoretical issues relevant to the GST. These are taken up in the following sections.

Not a Simple Tax

The GST, unlike the erstwhile indirect taxes, is not levied on the “act” of production, sale and so on, but on any “supply” of goods and services. Thus, a variety of distinctions that existed earlier such as those between production and sale of good and service is no more relevant. Since it is on any “supply,” many more stages of production and distribution are now under the tax net. But arguably this change in definition has also created many complex situations (Kumar 2019). Primarily, the confusion around the GST is because of the lack of a holistic view on the part of the policymakers. A very difficult tax is being implemented in a very complex nation where one-size-fits-all is inappropriate. India has diverse production and distribution structures ranging from the cottage to the small, medium and the large units producing and distributing various goods and services. To take care of these complexities, various exemptions are provided. But these have only added to the complications.

Say, for example, a multiple tax rate system, especially for the items of mass consumption (which are either exempted or placed in a lower GST slab (IANS 2017)), is common-man friendly, prima facie, but its execution is problematic. With the various exemption and tax slabs such as, 0%, 5%, 12%, 18%, 23%, 43% and a few others, an already complex tax has become even more complex. Multiple objectives are sought to be achieved with one tax and that has historically been known to lead to problems of implementation (NIPFP 1985; Kumar 1985). Complexity and multiple rates are known to make it easy to generate black incomes (Kumar 1999).

The states worried about possible revenue losses have ensured that items such as alcohol for human consumption and petroleum products, that have high revenue earning capacity, are kept out of the purview of GST. Real estate and electricity are also kept out of the purview of the GST. This is indicative of the lack of faith within the government itself, on the official claim that GST will lead to greater collection of taxes.

Further, all these exemptions and the logic of going in for multiple tax rates have meant that the cascading effect may decrease, but it does not go away (Kumar 2015, 2019). This was supposed to be one of the attractions of the GST (GoI 2002, 2009). Thus, there is a design flaw in the GST as it is implemented in India.

High Costs of Implementation

The GST in India is levied as VAT, and a VAT can be calculated in a variety of ways (GoI 2015b; Kumar 2019). The one chosen in India, is in line with the global practice of providing input tax credit (ITC) to suppliers. This requires keeping track of all the inputs and the tax paid on them and then of all the outputs and tax to be paid on them and that is a herculean task for businesses. For the government it is an even bigger task since it has to aggregate the data from all the activities of all the businesses to ascertain the tax to be collected.

The collection and processing of such massive volume of data can only be handled by computerisation. Thus, setting up of a large computer network became essential and a GST Network (GSTN) was created. To keep track of all the transactions of businesses, a unique identification number GSTIN has been allotted to all those who have registered. Further, to keep track of the movements of goods so that tax evasion can be mitigated, an e-way bill is required. Each trucker has to register and obtain a 15-digit number called TRANSIN. Each consignment transported has to carry an e-way bill and the TRANSIN number, among other things. Thus, billions of pieces of information have to be coordinated every month. Processing this vast amount of data often leads to the systems crashing or slowing down inordinately thus delaying the filing of data by the producers.

Businesses, simultaneously, have had to incur additional costs for processing these large amounts of data. While the large- and medium-scale producers were already computerised and habituated in dealing with big data, that is not the case with the small and the micro sectors. But even the large and the medium sectors have had problems dealing with the mass of data and the new (ever changing) rules. As a result, their accounting costs have also risen. It is argued that exemption to the small and the micro sector would imply that they will not have to worry both about the tax and its administrative costs. But this has not been the case in reality.

Unorganised Sector’s Plight

It is a common knowledge that the poor and small producers in this country are a part of the unorganised sector, and they cannot cope with the burden of additional taxation. So, they have been left out of the GST (GoI 2015a). But what is seemingly a relief turns out to be a disadvantage.

The GST being calculated as a VAT (not as “specific” or ad valorem) is supposed to be levied on the value addition at each stage of production and distribution. Whatever tax is levied at the earlier stage (on the inputs) is subtracted from the tax due on the current stage of production (output). This lowers the input costs and cheapens the output.

But because the small and the micro sectors are out of the GST network, they are not eligible for the ITC and their input cost becomes higher than that of the large- and medium-scale producers. Further, they cannot provide ITC to those purchasing from them. Thus, their selling price would also be higher than that of those who pay GST, unless they cut their already meagre profits. If not, buyers will shift from them to those who pay GST. If now, they register themselves under the GST network, then their accounting costs rise substantially further denting their profits. Still then they cannot get the benefit of ITC since they do not have to pay the GST. Thus, registration would imply double disadvantage for them.

These units usually lack the capacity to supply to the distant or interstate markets. If they operated near some state border, they could earlier supply across the state boundaries in their neighbourhood. Under the GST, now they cannot do so, thus, their market size shrinks. Anyone who is registered under the GST and buys from them will have to pay the taxes that these small units should have otherwise paid. This is called the reverse charge mechanism (RCM), which imposes additional costs for the buyer. In brief, for the small and the micro sectors, the GST poses severe problems whether they come under GST or stay out of it (Kumar 2015; Banerjee and Prasad 2017; Kumar 2019).

The disadvantage of the unorganised sector has become the advantage of the organised sector. As the former has become less competitive, its market has shrunk and that space has been taken up by the latter with its rate of growth rising at the expense of the former (Kumar 2018b; Srinivasan and Shankar 2018). The result is a dichotomous growth. But it also means that the growth rate of the economy is less than the one officially announced, based on the quarterly data that only accounts for the corporate sector, which may be taken as a proxy for the organised sector of the economy. Thus, the decline in the unorganised sectors is not captured in the growth statistics (Kumar 2017). If this decline is taken into account then the rate of growth today would turn out to be less than 1% and not 7%–8% as claimed by the government (Kumar 2018b)

In brief, the various gains from the GST, as claimed by its proponents, are unlikely to materialise. So, what is to be done? Can the GST now be abandoned and the nation return to the earlier system? Indeed not, an alternative is needed which can take care of both the past difficulties and the current problems that have cropped up with the implementation of the GST.

The Way Forward

How can an alternative be devised? The clue to this lies not only in the design of the GST itself but also in the problems that were encountered in the earlier tax system. Some of the important ones to mention are: (i) the cascading effect of taxes leading to higher effective tax rates; (ii) distortions and loss of efficiency due to taxation at all the stages of production and distribution; (iii) complexities in GST due to ITC and RCM; and (iv) adverse impact on the unorganised sectors and the poorer states, even though GST is a last point tax.

It is repeatedly emphasised that even if the GST is collected at all the stages of production and distribution, it is a last point tax. That is, it is collected at each stage of supply but passed on to the final point of sale where it is collected from the consumer. If that is the case, why collect it at all the stages and not just at the final stage? An example would illustrate this. A produces X which is an input for B who produces Y which is an input for C who produces Z and sells it to the consumer. The tax paid by A is the ITC for B. So, B subtracts the tax paid by A from the tax they are to pay. The tax paid by A and B is then the ITC to C. So, C subtracts this from the tax due from them. C sells to the consumer and the price that is charged includes the tax paid by A, B and C.

So, under the present GST, tax is due again and again (from each supply) and subtracted from what is due (for each supply) and the difference paid. That is why there is complication in accounting and calculations. The example is a simplified version but in reality, it is far more complex because there is transportation, storage, accounting and other overheads for each supply (X, Y, Z in the above example) and each one of them is also taxed and the ITC becomes applicable at each stage. The complexity is further enhanced due to the exemptions and the RCM. So, underlying a final supply of a product, there are many transactions and each is taxed and accounted for, making the system very complex.

After all this complex system of accounting, the tax is collected from the final stage. So, why not eliminate the intervening stages of taxation and levy an ad valorem tax only at the final stage. It may be clarified that an ad valorem tax at the last stage only will be equivalent to the VAT collected at every stage. For example, to make utensils, one starts with iron ore, then makes pig iron and converts it into steel, which is finally used to make utensils. All the tax is collected from the consumer when she buys the utensil. So, in the proposed scheme, taxation of iron ore, pig iron, steel, their storage, transportation, accounting and overheads would be eliminated. The proposed scheme would not require ITC, RCM, IGST, e-way bill and so on which would simplify GST enormously. In brief, the same amount of tax would be collected as at present without the complications of intervening stages of accounting and taxation.

Exemptions: But there could be a problem when a product is both a final and an intermediate one depending on its use. For a household, spices and lentils are final products but for a restaurant, they are raw material or input for the final dish that is served to its customer. Flour may be a final product for a household but a raw material for the bread industry. This problem is not insurmountable. Industrial products are classified as basic, intermediate and final products. Similarly, services are classified as productive and consumptive. So, the tax can be levied on the final products in the industrial classification and on consumptive services.

As in the present GST, essentials such as unprocessed food items, education and health, can be left out of the proposed regime. Further, there can be a turnover exemption limit below which the supplier will not be required to register or pay the tax. This can be kept at ₹ 50 lakh annually, instead of the ₹ 20 lakh at present. There would be no need for something like a composition scheme as most of the small businesses supplying intermediates would be outside the tax net.

So, in the above example, utensils will pay the tax and the restaurants that use them in their business will face a slightly higher cost. But on their purchase of vegetables, rice, flour, lentils, etc, there will be no tax. On bread to make sandwich, there will be a tax and that will raise their cost marginally. While the cost of a few things the restaurants buy will rise, they will save on many other inputs and on the cost of accounting. Similarly, for services, transportation by trucks, accountant’s service, advertising, storage, etc, being productive services would not be taxed. Travel by buses, stay in hotels, entertainment and the like being consumptive services would get taxed. Some businesses that require travel by bus or a stay in hotels will face slightly higher cost since there would be no ITC for them on these supplies.

Minerals and forest produce are inputs into other items so would not be taxed. Thus, most of the primary sector will be out of the GST net. Producers of goods will also be outside the net since the final sale for consumption is by the traders who should collect and deposit the tax with the government. However, to avoid dealing with a large number of traders, the tax may be levied on the dealers. This would simplify the tax further. For services, those producing final consumptive services will bear the tax. With the turnover limit of ₹ 50 lakh, only a small number of entities supplying final services would be in the tax net. The total number of entities that would fall in the tax net would be a fraction of the presently registered 11 million. If one goes by the finance ministry’s figure of 5% being the effective taxpayers, the number would come to about half a million.

Most goods are labelled with a maximum retail price (MRP) and this can be the basis of tax to be paid at the final stage. The producer would be required to calculate the MRP, including the tax at the end (and the costs). Presently, too, that is what the producers are required to do.

An objection can be that the paper trail created all down the production and distribution chain under the present GST would be missing in the proposed system and more black incomes may be generated. That is not necessarily true. There will be no need to guess the costs and figure out under- and over-invoicing. The tax will be included in the proposed MRP, and sale at a higher price than MRP would be illegal for which prosecution can be launched. Sale at a lower price due to discounts would be the producer’s choice who would have to forgo a part of the profit.

Tax slabs: Some cascading effect will continue when some of the supplies taxed as final goods and services are also used to produce some other goods and services. However, such items where there will be an overlap between final and intermediate items will be small in number. So, the cascading effect will be less than that under the present GST where it is the result of the multiplicity of tax rates and exemptions to some major items of consumption such as the petroleum goods and liquor for human consumption.

The tax rates can be kept simple, zero for essentials and exports, low rate for some items and a normal rate for the rest of the final goods and consumptive services. This rate structure can be based on the RNR calculations as at present. However, this exercise would be much simpler than the present one because of the simplicity of the tax in general. According to the GoI (2015b) the calculation of the RNR for the present GST is “more of an art than a science,” given the complications in it. Once these complications are eliminated, the RNR calculation would be easier.

The total indirect tax collection is about 11% of GDP at present. This would be required to be collected from the GST (for the RNR). Of this, about 2% would come from customs duties and another 4% from the exempt goods like petroleum and liquor. So, about 5% of the GDP would need to be collected from the GST. The base for this would be the final consumption which is about 68% of the GDP. Net imports are about 2% of the GDP, and already counted under customs duties. With this, the base is reduced from 68% to 66%. If agriculture, a part of the production of unorganised sector, and education and health are taken out, that would further reduce the base to about half, that is 33%. Thus, 5% of the GDP would have to be collected from a base of approximately 33% of GDP. The RNR would then crudely work out to almost 15%.

Luxury goods could be taxed at around 25% and the normal goods at 10% to collect the same amount of tax as at present. Sin goods may have an added cess of say, 15% (as at present) and if this is done, even petroleum goods and liquor can be brought under the GST net. Further, environmentally sensitive goods whose production needs to be curtailed, can also be taxed higher by imposing the cess on them. For instance, on petroleum products and items made out of heavy metals and chemicals.

Tax filing: In the present GST, each registered business person is required to fill in a host of forms. Before some temporary changes were introduced in the GST, it was calculated that a business operating in 31 states of India would have had to file 37 forms per annum per state making it a total of 1,147 forms annually. Under the proposed system, only one form per month and one annual return per state would be needed to be filed. So, the forms to be filled would be around one-third of the present system and the paperwork would be far less since ITC, RCM, etc, would be no longer required. The required monitoring would also get greatly simplified. This will help to check tax evasion.

Relief to Unorganised Sector

Businesses in the unorganised sectors would benefit because they would not have to register themselves or pay a tax. This advantage would help them compete with the producers in the organised sector who will pay the tax but have advantages due to technology, scale, warehousing, etc. The disadvantage that the unorganised sector faces under the present GST due to ITC and RCM would no longer exist. The better competitive position would enable them to sell more and expand output resulting in more employment, higher demand and faster growth. The poorer states would actually benefit because the last point characteristic of the tax would be maintained and the disadvantage due to the adverse impact on the unorganised sectors would no more exist. In fact, the benefit to the unorganised sector would be beneficial to these states.

Distortions of the markets, resulting from the taxation of each stage of supply would decline substantially since only one stage of the entire chain would be taxed rather than of the multiple stages under the present system. This would lead to huge “efficiency” gains for the economy and actually result in the “ease of doing business” that can lead to an increase in investments.

Conclusions

The above discussion provides the broad details of a proposed alternative and its advantages over the present GST. The key point emerging out of this discussion is that a simplified or less complex tax structure than the present GST will potentially be effective in achieving the intended benefits of such indirect tax reforms. More details, however, would need to be worked if such modifications are to be taken up.

Along with this reform of the indirect tax, there is an urgent necessity to reform direct taxes to increase the revenue receipts from them as suggested in Kumar (1994). Once this happens, then the indirect taxes can be further reduced by bringing more items of final consumption
under the exempt category. This will have other macroeconomic advantages.

Another reform required in the present GST is that provision needs to be made for the local bodies. Their autonomy is getting truncated in the present GST. It is well known that they are best suited to deliver local services to the citizens (Panta 2015). So, local bodies need their own tax sources to pursue their specific requirements. To restore their autonomy, the revenue collection from certain goods and services can be designated as the revenue for the local bodies and transferred to them automatically by the states.

In brief, the present difficulties in the GST are not just implementation issues but structural ones. So, a new and simplified GST on final goods and services is needed to overcome these and to resolve the problems currently plaguing the economy.

References

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Panta, K R (2015): “Fiscal Decentralization, Public Service Delivery and Poverty: A Case Study of Nepal,” mimeo PhD dissertation submitted to the Jawaharlal Nehru University, New Delhi.

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Updated On : 4th Mar, 2019

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