Taxation

A killer tax

Print edition : September 02, 2016

At the Hyundai Motor India Ltd plant in Kancheepuram district in Tamil Nadu. Photo: REUTERS

The euphoria over the Goods and Services Tax masks the deadly assault on tax policy as a means of promoting equity.

The unabashed and unprecedented enthusiasm with which the impending imposition of the Goods and Services Tax (GST) is being welcomed borders on the surreal. Never before has so much hope and hype been placed on a tax. The media’s acceptance, without the slightest critical scrutiny or scepticism, of the promise that the tax would set India free has been truly remarkable. The rare sight of broad unanimity among parties across the political spectrum in and outside Parliament was also extraordinary, even if it revealed the manner in which grave and weighty issues of economic equity and constitutional propriety had been pushed far into the background. In short, never has so much good been promised to all Indians in the name of a tax.

Addressing the Lok Sabha on August 8, Prime Minister Narendra Modi invoked the name of Mahatma Gandhi and his clarion call to the British to “Quit India” on the same day in 1942 to term the GST as an instrument that would “liberate Indians from tax terrorism”.

Finance Minister Arun Jaitley repeatedly echoed the slogan “One Nation, One Tax” to suggest that the imposition of the GST was in keeping with the new-found zeal with which nationalism has been espoused, especially by the right wing of the political spectrum. His claim, amplified by others in the media, that the GST would result in a unified national market, appeared to go uncontested. Perhaps it would have appeared anti-national to ask what else the Indian market was all these years.

If politics played second fiddle to the grave, weighty and jargon-filled techno-economic logic that advocates of the GST offered on a daily basis in the run-up to the Constitutional Amendment Bill in the two Houses of Parliament, economists had already vacated the field quite some time ago, paving the way for a no-contest on this vital issue of tax policy.

Economists, especially those specialising in macroeconomics, which provides a broader context in which tax policy functions, have generally, until very recently, stayed away from the issue. The country has undoubtedly been poorer as a result. Euphoria, fed by reckless assertions such as claiming the GST would result in an almost 2 per cent increase in the gross domestic product (GDP), replaced economic logic, without which it would amount to nothing short of voodoo economics.

The long-cherished ideals in the realm of taxation, especially those pertaining to the promotion of social and economic equity and justice, have been thrown out of the window in the single-minded pursuit of a new ideal, that of improving the ease of doing business, which is mainly relevant to a narrow sliver of the population.

Logic of the GST

Truth be told, the GST is nothing but a hybrid version of the value added tax (VAT) that replaced the sales tax that was constitutionally guaranteed to remain in the hands of the States so that it offered a modicum of financial autonomy vis-a-vis the Centre. In fact, the “reforms” in the sales tax regime go as far back as 1986, when the Indian government introduced the modified VAT or Modvat. The argument advanced in the move towards these reforms was based on the notion that a tax on the value added, rather than the value of the transacted output, would prevent a “cascading effect”.

The provision for taxing only the value added during each stage of the production cycle would eliminate the scourge of “double taxation”, it was argued. Thus, VAT enabled companies to claim “credits” for taxes paid by input suppliers in the earlier stages of the production cycle. It, therefore, means that at any stage an economic agent only pays taxes on the quantum of contribution it has made to the value of the good it has processed. Moreover, the elimination of repeatedly taxing the same good makes it possible for the tax authorities to reduce the number of tax rates, implying a simpler and more compact tax system. Thus, it becomes possible for the system to align rates according to the policymakers’ social and economic objectives. For instance, essential commodities that are of importance to the poor could be assigned a “zero rate”, while tobacco, considered a “sin good”, could be taxed at a penal rate.

While the logic of VAT was pretty straightforward, there was nothing logical about the move to get the States to move into a straitjacketed system where they had very limited room to manoeuvre with rates depending on their individual needs and developmental priorities. At the time VAT was introduced (in 2005), the sales tax was the primary source of revenue for the States—on average about 80 per cent of overall revenues. But what VAT brought was more than just a mere improvement in the efficiency of tax administration; it curtailed the scope for the States to adjust the rate. What GST does is to take matters completely out of the hands of the States by tying all of them to a uniform rate, irrespective of their specific needs or priorities.

The 122nd Constitutional Amendment that enables the rollout of the GST regime in April 2017 provides for a compact list of categories of goods and services that would be concurrently taxed by the States and the Centre. There will be a “negative list” of goods, basically essentials, on which no tax would be liable. While industrial inputs and packaging material would be grouped together and subjected to a tax rate of about 5 per cent, bullion, gold, and silver would be taxed at the rate of about 2 per cent. Luxury goods such as high-end cars and “sin” goods like tobacco would attract a rate of 30 per cent or more.

Under persistent and vehement opposition from the States, petroleum and liquor, which account for almost 30 per cent of their revenues on average, have been kept out of the GST net for now. All remaining goods will be subject to the standard rate, which has been a subject of some controversy. While much attention has been focussed on what the so-called revenue neutral rate (RNR) ought to be, there has been little conceptual clarity from those championing the GST.

Business, especially big business, saw the GST as the most important tax/regulatory reform since Independence, said A. Sarvar Allam, Additional Commissioner of Commercial Taxes, Tamil Nadu. “Today, businessmen constitute the most influential and powerful section of society and hence, whatever matters to business is blown out of proportion,” said Allam, who has been a tax administrator for almost 30 years. Hinting at the misplaced priorities and the leeway given to businesses in general, he pointed to the fact that amendments to legal provisions on child labour now allow child labour in family-run businesses. “The imposition of the GST is not going to make any difference to the common man or woman, unless it results in inflation,” Allam told Frontline.

States’ apprehension

The Congress made an egregious error of judgment by demanding that the standard GST rate (inclusive of the State GST and the Central GST) be capped at 18 per cent in the Constitution Amendment Bill. Naturally, it found no support from any State, which feared that the cap would set a rigid limit that may affect their revenue streams in the future. In any case, the Congress was already on board, given that former Finance Minister P. Chidambaram was the first to initiate the move towards the GST during the course of his Budget speech in 2006.

Buoyed by the euphoria over the passage of a major hurdle in his reforms push, Modi made the candid admission that the “many doubts” he had had about the GST when he was Chief Minister of Gujarat helped him understand the worries of State governments. This was an obvious reference to the concerns raised by many States such as Tamil Nadu, Gujarat, Maharashtra and Goa. In fact, Members of Parliament from the All India Anna Dravida Munnetra Kazhagam (AIADMK) walked out of both Houses of Parliament when the Constitution Amendment Bill was moved, citing infringements of the constitutional guarantees of States’ rights in the matter of taxation.

The fact that the GST is essentially a tax on consumption implies that the States in which final consumption occurs get the privilege of collecting the tax. The serious implication this has for States that have an edge in manufacturing explains the opposition to the GST from States such as Tamil Nadu, Gujarat, Maharashtra and Haryana.

Typically, when a large industrial house establishes a base in a particular State, aiming to serve the national market, it is obvious that only a fraction of its output would be sold within its home base. It, thus, “exports” goods and services to not only other States but overseas too and these are the sites of final consumption of its products. The GST’s design as a destination-based consumption tax has important implications for States that are the home base of these manufacturing companies. They are worried that after having wooed these companies with fiscal incentives over the years, they now stand to lose revenues because of the GST’s design.

Allam cites the example of the Korean car major Hyundai, whose main base in India is near Chennai, to explain why States that are major sites of manufacturing activity are worried. Hyundai sells only about 10 per cent of its cars within Tamil Nadu; 40 per cent of its cars are sold in other parts of India and the rest exported.

During the manufacturing process the company would have procured goods and services from within the State, for which it would have paid a tax component. Now the providers of these components, capital goods, other inputs and services will take credit for the taxes they have paid. But if the final sales are mostly happening in other States, such tax credit would be apportioned to those destinations from the tax revenue gathered in the State where the manufacturing occurred.

So, even if the production has happened in one State, a portion of the GST revenue gathered in the manufacturing base has to be transferred to the State where the final consumption happens. In the case of exports, the State would have to refund to the manufacturer on a proportionate basis the portion of the GST revenue paid by the company. So, in the case of a company such as Hyundai, the State may end up losing a significant portion of the overall revenue that it “earns”. This also highlights the fact that the GST could actually be a fiscal disincentive to States aspiring to becoming manufacturing centres by climbing on to Modi’s “Make in India” bandwagon.

Hazards of ‘neutral’ rate

It is important to recognise that the RNR would still leave some States as losers without materially affecting the collections of the Centre. The shifting of the point of levy from one State to another is not going to materially affect the Centre’s overall take from the tax. But an individual State’s take would depend on a complex array of factors. A State’s trend in revenue collections over time, its relative tax buoyancy, the mix of its productive capacity—for example, how much of the State’s output is from manufacturing and its level of consumption of goods and services— and other factors would determine what its individual RNR ought to be.

Since these factors change over time, often on an annual basis (depending, for instance, on whether the State is affected by a drought or a flood in a particular year), they are even more difficult to calculate. There is, thus, a very real possibility that a straitjacketed RNR, which is fine from the Centre’s point of view, leaves the States to bear the burden of revenue shortfalls. No compensation, irrespective of how long it continues, can address this fatal flaw in its conceptual design. Fundamentally, this arises from its failure to incorporate a dynamic model that remains rooted in reality. The cynical motive behind this faulty design is the fact that the Centre would remain unaffected because it would get its share of the kitty in any case.

Allam says the lack of a “cross credit mechanism between service tax and VAT” means that the States do not have information on consumption of services by industries. “This is another difficulty experienced by the manufacturing States in determining not only what their standard rate ought to be but also to project the revenue losses they may incur because of the introduction of GST.”

Unless the list of goods and services exempted and those falling under different rates are finalised by the GST Council, which is to be chaired by the Finance Minister, it would be difficult for the manufacturing States to determine the RNR and the expected revenue loss, Allam said. “As the quantum of production, consumption and export of goods and services varies from State to State, logically there cannot be a single RNR for all the States. The RNR will not be based on any logic, it will simply be a rate,” he added.

It is being claimed that States that are mainly consuming centres of goods and services would benefit from the GST as they stand to gain from the resulting buoyancy in revenues. There is speculation that this is the reason why even Left-led States such as Kerala have welcomed the reform. For instance, it is said that the Kerala economy, which is heavily biased towards services, would benefit. But there are several problems with this simplistic assessment.

First, since consumption can only happen out of incomes, there are serious limits to how long this can go on in the absence of meaningful economic activity. Secondly, the levels of consumption in States such as Bihar, Jharkhand and Odisha are already much lower than in the rest of the country. What meaningful benefit would these States draw from a GST regime that is supposed to favour “consuming” States?

The design of the GST Council, which is to decide the rates, especially the RNR, and act as a body to settle disputes between States and the Centre is another issue raised by critics. It is also being burdened with the task of determining the nuts and bolts of the GST structure to become operational. Although all States are to carry a vote in the Council, the Centre is to have a one-third share of the votes. But any decision by the Council would require a three-fourths majority.

Jaitley has made much of this, pointing out that this has been done in the spirit of “cooperative federalism”. But the point is that by virtue of its share of votes in the Council, the Centre has an effective right to veto any move not to its liking. It is indeed laughable that a poor (or a weak or small) State with limited resources at its command would be able to get a favourable verdict in the Council without the blessings of the Centre, no matter how logical or fair its case may be, even if it has the support of other States. Moreover, given the nature of Centre-State financial relations, it is inconceivable that such States would wish to antagonise the Centre and jeopardise the discretionary transfer of resources to them from the Union government.

If the Council works like a katta panchayat (or khaps as they are called in the northern badlands) attempting to settle disputes among States and the Centre, there is the danger that the long history of tax jurisprudence may be jettisoned, raising the possibility of prolonged and messy litigation. A senior tax official told Frontline that the Council would require the support of “a strong secretariat manned by experts in taxation and public finance to be effective”.

The enthusiasm with which reforms in indirect taxation have been welcomed stands out in sharp contrast to the question of reforms in direct taxes, which are far more critical for an unequal society such as India. It is well known that indirect taxes are regressive in nature for two reasons. First, a consumption tax such as the GST falls equally on everybody irrespective of the disparities in income levels. Moreover, there is no escape from the tax because it is built into the price; this is not the case with income tax or other direct taxes because there are ways in which they can be avoided or evaded.

India’s tax-GDP ratio is about 16.6 per cent, much lower than in other emerging markets (21 per cent) and the average in the OECD countries (34 per cent). The contribution of direct taxes to the total tax of the Central government has declined from 61 per cent in 2009-10 to just over half in 2015-16. The direct tax-GDP ratio has declined from 6.30 per cent in 2007-08 to 5.47 in 2015-16. Although direct taxes account for half of overall tax revenues, their share in the GDP is half of indirect taxes (see graph).

It is significant that the Modi government has dropped even the pretence to reform direct tax laws to ensure that the rich are more compliant. Jaitley’s decision to pursue the direct tax code (DTC), which was initiated by the Congress in 2009, on the grounds that elements of the code have already been incorporated, amounts to an abandonment of the effort to restore some balance between direct and indirect taxes in the Indian tax system.

To make matters, real estate, one of the key methods of hoarding wealth, remains outside the purview of the GST. The tardy progress of the move towards a General Anti Avoidance Rules (GAAR), which would plug avenues for tax avoidance, is also an indicator of the current mindset.

A genuine pursuit of reforms in order to engender equity and build a fairer direct tax regime would have logically required the enlistment of the States as partners in the levy of such taxes. Allam said that individual member countries in the European Union, and the provinces of Canada and the States of the United States, are allowed to impose taxes on incomes. “So, why is this difficult in India?” he asked.

Two characterisations of the GST have been repeatedly made by those championing its cause, most notably sections of large business houses. The first is its “simple” structure, which, it is claimed, would have an almost automatic impact on tax buoyancy. The second is the uniformity in the rate, which, it is claimed, would actualise the move towards India emerging as a unified common market. The fetish of these two elements, at the cost of the neglect of all the canons of taxation, reflects a mindset that promotes the sectarian interests of a tiny minority in the name of furthering the public interest. Surely the pursuit of uniformity would be the nemesis of a democratic polity.

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