AN UNFORTUNATE COMPROMISE

The Goods and Services Tax will replace a bunch of state and federal levies in what is being called the biggest tax reform since independence. The best way to understand the grand federal bargain is to consider it a victory of immediate political concerns over potential economic gains. In other words, political optics have overpowered economic logic.

The tax rates that have been approved by the finance ministers in the GST Council are clearly a reflection of three political economy concerns. First, the impact of the new tax regime on the prices citizens will pay. Second, the impact on government budgets through changes in tax collections. Third, maintaining an element of progressivity on what is essentially a regressive tax, as all indirect taxes are. The overarching goals of the negotiations thus seem to have been to ensure that the inflationary impact is minimal, government revenue is protected, and the new tax system explicitly appears to be pro-poor.

The problem is that these dominant political economy concerns have led to a complicated tax structure with multiple rates, exemptions and even cesses – a far cry from the clean goods and services tax that had been proposed initially more than a decade ago. The multiple rates on services are beyond belief. Fears of a flawed GST structure have now been confirmed.

Why should this be a worry? The complicated tax structure that has now been decided in many ways is a copy of the current tangle of excise duties. Consider some examples. There are separate GST rates for roasted coffee and instant coffee. The tax rates on restaurants have been decided in a way that would do the interventionist Indian bureaucracy proud. The sheer complexity of the GST structure will result in tax disputes, lobbying and corruption.

The second problem with a complicated tax structure is that it will lead to distortions. The GST, even in its current form, will lead to efficiency gains in the Indian economy—and hence lead to higher growth. But the growth dividend is likely to be far lower than what a better structure would have delivered. HSBC India chief economist Pranjul Bhandari has estimated that the addition to economic growth in the medium term will be 0.4 percentage points, rather than 0.8 percentage points from an ideal GST structure.

The GST council has taken a static rather than a dynamic view. On the one hand, a more complicated tax structure will actually increase business costs, while on the other, exemptions will mean cascading of costs because of the absence of input tax credits. Higher economic growth as well as a bigger tax base would also have ensured revenue neutrality despite lower tax rates. The optimality in a tax system should be judged on elasticity.

A simple GST structure, with zero taxes on a few essentials, a high tax rate for a few sin goods and almost everything else taxed at a single rate would have added clarity, transparency and boosted growth. The GST structure that has been decided on is too complicated and distortionary for India to reap the benefits.

Economic reformers will now have to push for a simpler GST structure in the years ahead. There are two ways to do this. First, governments should gradually remove exemptions, on the one hand and equally gradually, bring taxes on most goods and services to a standard rate on the other hand.

Second, there is now a strong case to push ahead with the direct taxes code so that higher collections of income and corporate taxes create fiscal space for a rationalisation of indirect taxes. That is easier said than done, because the GST council could present classic collective action challenges.

India will now begin with a flawed GST structure. There is no doubt at all that it is an improvement over the messy system of national, state and local taxes that it will replace. GST will integrate the Indian market, promote economic efficiency by taxing final consumption, encourage voluntary compliance and create a new architecture for cooperative federalism.

However, it is unfortunate that we will have a complicated tax structure that may seem politically less risky at this point in time but is most likely to compromise on the growth and efficiency gains that a simpler GST would have delivered. The original GST crusaders now have another important battle on their hands.

THE BEST WAY TO UNDERSTAND THE GRAND FEDERAL BARGAIN: IT IS A VICTORY OF IMMEDIATE POLITICAL CONCERNS OVER POTENTIAL ECONOMIC GAINS