Mainstream, VOL LIV No 36, New Delhi, August 27, 2016
GST: Revenue Neutral Rate and Macro Implications
Sunday 28 August 2016, by
The GST is expected to be implemented from April 1, 2017. While it has been hailed as the single biggest tax reform since independence, many worries have been expressed about it in the media. The FMs of Kerala and West Bengal (otherwise political rivals) have expressed concern about certain provisions. But most importantly, after this author pointed out that the implementation of the GST would raise the rate of inflation (Kumar, 2015), it is now widely accepted by other analysts also. This has been the experience of other countries that introduced the VAT or GST. This should worry the government since it is also said that in many countries the party in government that introduced this measure lost the next election. The NDA faces several important State elections in 2017 and the national elections in 2019.
Revenue Neutral Rate (RNR) and Inflation
Whether the GST would be inflationary or not would depend on the rate(s) fixed for the GST. If it is suitably low, it would not cause the rate of inflation to rise but if it is high or even moderate it would certainly lead to its rise. There is talk of a revenue neutral rate (RNR) of between 15 to 18 per cent. What is RNR? It is that rate of average tax (of the GST) at which the amount of tax collected under it would be the same as collected at present (before the GST is initiated). Collecting the same amount of revenue is important to prevent the fiscal deficit from rising since that is frowned upon by the international agencies. They believe, a deficit signifies fiscal profligacy.
A shortfall in revenue and likely increase in the budget deficit is a greater worry for the States since they cannot easily resort to a deficit budget. For the States, loss of revenue usually translates into cuts in the allocations to their welfare programmes, like, employment generation, education and health. It needs to be remembered that a bulk of the social sector expenditures are incurred by the States and not the Centre. Hence politically it is more important for the State governments that they do not curtail their welfare budgets and for that they need to collect at least as much tax as they do at present. The Centre has assured the States that if there is any shortfall, then it would compensate them for the same. However, if the States face a shortfall, then so would the Centre. So, where would it get the extra resources? Its deficit in the budget would rise even more. Under the circumstances, cuts in allocations are bound to occur.
A single RNR rate implies that some current rates of indirect taxes will rise while some others will fall. For instance, services are taxed at a rate of 15 per cent currently but if the RNR is fixed at 18 per cent, then all services prices will rise. However, if some good faces a combined excise and sales tax rate of 22 per cent, then its rate of tax would fall and so would its price. Thus, in the aggregate, prices should not rise with RNR. However, there is a catch—even with RNR, the rate of inflation is likely to rise. It is important to understand that.
Cascading Effect of Indirect Taxes
Indirect taxes not only ‘cascade’ from one tax to the other but they also feed from one good or service to another. Thus, where one levies an indirect tax and where its impact is felt are different. For example, even though wheat does not bear an excise or a sales tax but when these taxes are increased on diesel, transport cost rises and so do the prices of wheat. Thus, even those commodities that bear no indirect tax find their prices rise when indirect taxes are raised. The implication also is that the more basic a commodity, the more it is used in the production of other goods and if its price rises it makes the prices of other goods rise. Thus, an increase in indirect taxes on energy (which is used in the production of all goods and services) feeds into all prices, GST or no GST. Further, if a single rate or a small spread of rates is introduced, it may imply an increase in the tax rates on basic goods (unless special care is taken to keep their taxation low) and that would feed into inflation.
The GST is supposed to get rid of the cascading effect of taxes. But the introduction of the VAT for calculation of sales tax and excise and service taxes had already removed the cascading effect within each of these taxes. What the GST is supposed to accomplish is that the cascading effect across the different taxes would also be eliminated. Namely, the cascading of service tax on sales or excise or of sales tax on services and excise and other such combinations are expected to be eliminated.
The impact of the cascading effect of taxes is that the effective rate of tax becomes higher than the one on the statute books so that the price rise is also more than implied by the declared rate. Therefore, in the example of wheat given earlier, even though the rate of tax is zero, the effective rate may work out to be a few per cent. Thus, if the cascading effect is removed/reduced, then to collect the same amount of taxes as earlier, the rate of tax under the GST must rise. But under a one tax (or a few taxes) regime that could mean higher taxes on basics and, therefore, a greater inflationary impact.
GST and Simplification in Taxation
It is also said that 17 Central and State taxes would be replaced by one single tax. This would make for efficiency and lower costs and prices. This is not quite true. The tax is going to be very complex, requiring massive computerisation and a strong IT backbone. Thus costs would rise. Further, given the fraud that takes place in computer operations, the risks would rise. In the case of Satyam the software had been manipulated to show fictitious fixed deposits to the tune of Rs 6000 crores and 12,000 fictitious employees.
It is also an overstatement that 17 taxes will be replaced by one. A manufacturing firm does not have to pay entertainment tax and other such taxes. It basically pays three taxes—excise, sales and service tax. Under the GST also there will be three taxes—CGST, IGST and SGST. For SGST, registration may be needed in 31 States. The unit maybe paying Central sales tax and Octroi/Entry tax. But, Octroi is mostly eliminated in the country. Entry barriers at State borders will have to remain anyway for checking. So, there may not be much simplification.
Big companies buy in bulk and use that input to produce several products. They would have to apportion how much input credit they would get for each product to do the pricing. For example, if they do advertising as a company, how much credit they would take for each product sold would pose problems and could lead to disputes with the tax department. This is only one example and there would be many others also. Costs could increase due to litigation, etc.
Progressivity and Regressivity of Taxes
It is well known that inflation hits the poor more and especially if basic goods prices rise more. It is in this context that the macro economic impact needs to be understood. The proponents of the GST had been arguing that the GST would lead to a rise in indirect tax collection. As pointed out above, that would lead to a rise in prices. Further, if prices rise, demand would tend to stagnate or decline and that would adversely impact production and growth rate of the economy. Indirect taxes are also regressive since they tend to be a higher per cent of the poor person’s income than that of a well-off person. This would be the case even if luxuries are taxed more than the essentials. The reason is that progressivity/regressivity is defined with respect to income and not expenditures. For the rich, consumption is a small part of their income even though in absolute terms it is large. For the poor, almost the entire income is consumed (even though the magnitude is small) and often it is based on borrowing which implies that consumption is more than the income. Thus, what looks progressive with respect to consumption becomes regressive when calculated with respect to the income. The result is that increased collections of indirect taxes tend to increase disparities.
That is not the case with direct taxes which tend to fall directly on the individual’s income. In India, those with higher incomes have to pay higher tax rates. However, the tax rate is flat at incomes beyond Rs 10 lakhs, thus reducing the progressivity after that income level. Further, there are a large number of exemptions and deductions which are available to the well-off sections. This reduces the progressivity of the direct taxes. The exemptions and deductions are deliberately provided to benefit the rich. There are batteries of lawyers and Chartered Accountants whose sole task is to find ways of reducing their client’s taxable incomes using these loopholes; this is legal. In the famous Vodaphone case the company has managed to avoid paying thousands of crores of capital gains taxes due to the artful interpretation of the laws and the Supreme Court accepted their inter-pretation even though the company had lost in the High Court. Beyond the legal provisions used/misused, the huge black economy further reduces the progressivity of direct taxes because the rich do not declare much of their incomes. Thus, even though theoretically the direct taxes are progressive, in reality they also may turn regressive.
Warren Buffet in the US pointed out once that he pays less taxes than his secretary who earns around 0.001 per cent of what he earns. He started a move in the context of the global financial crisis that the ‘rich should pay more tax’. This was picked up in Europe by its rich also. Unfortu-nately, the Indian rich do not want to pay more taxes and seek to make the government depend on indirect taxes and that is the importance of the GST and a high RNR.
Feasibility of a lower RNR
The political implications of the GST are important. If inflation kicks up, inequalities rise, output stagnates and that impacts employment generation then the public reaction is bound to be negative even if big business is happy. It has also been argued (Kumar, 2015) that a single market may benefit big business but the small and the cottage sectors are likely to be adversely affected even if they are kept outside the GST net. Such a differentiation would further impact employment and growth of the economy since the small scale and cottage sectors are employment-intensive while the large scale is not. The rapid rise of the large scale production in the economy since 1991 and the decline in the share of the small scale production has led to the phenomenon of ‘jobless growth’. The GST could accentuate that.
The way out of this political quicksand would be to go for a rate lower than RNR. This is feasible because the tax base is supposed to expand both because the black economy is expected to be curtailed and because more stages of production are to come under the GST net.
A back of the envelope calculation suggests a low RNR is feasible. The GST would apply to non-agriculture which is 86 per cent of the GDP. Out of this, exempt items and those items that are not to come under the GST (like, petroleum goods) may be removed. Indirect taxes collected presently are about 10 per cent of the GDP and from this the customs duties may be subtracted along with those items which are left out of the GST (alcohol, tobacco, etc.). Further, assume that half of the unorganised sector production would be out of the GST but half of the black economy would come under the net (one of the suggested gains of the GST), then about five-six per cent of the GDP may have to be collected from about 50 per cent of the GDP. The RNR can then be between 10 and 12 per cent rather than the suggested 15-18 per cent. The NIPFP had apparently earlier suggested a rate of 24-27 per cent.
One may suggest, if the government believes its own rhetoric about the GST being a ‘game-changer’ and the biggest ‘reform’, it can keep the rate of the GST below what the official studies are suggesting and benefit both the common people of the country and itself. Further, to make it the biggest tax reform, the government can work to increase the direct tax collections by tackling the black economy and use that to further reduce the indirect tax collections.
[This article is based on a piece published in The Indian Express on August 12, 2016.]
Kumar, A., 2015, ‘Macroeconomic Aspects of Goods and Services Tax’, Economic and Political Weekly, Vol. L, No. 29, July 18.
The author is a retired Professor of Public Finance, Jawaharlal Nehru University, New Delhi. He is also the author of Alternative Budgets. He can be contacted at e-mail: firstname.lastname@example.org