The economics of GST
Yet another session of Indian Parliament begins with hopes that there will finally be a political agreement to clear the way for the goods and services tax (GST), which will replace the confusing array of indirect taxes levied by various governments in the federal structure with a single nationwide tax. Prime Minister Narendra Modi has reached out to all political parties in an attempt to get a consensus.
The new tax has had a long journey since it was first formally proposed during the regime of Atal Bihari Vajpayee. And it is now more than a decade since P. Chidambaram called for a consensus on the issue in his budget speech of 2006. In fact, he said that a consensus already exists: "It is my sense that there is a large consensus that the country should move towards a national level goods and services tax (GST) that should be shared between the Centre and the states. I propose that we set April 1, 2010 as the date for introducing GST. World over, goods and services attract the same rate of tax. That is the foundation of a GST. People must get used to the idea of a GST." A similar paragraph has featured in every budget speech since then, with a call for quick move to GST as well as a date when it will be introduced, mostly the first day of the next fiscal year.
The intense political bargaining since then-between New Delhi and the states as well as between various political parties-has attracted most of the public attention. There have also been many technical debates about the compensation due to the states for giving up their ability to tax economic activity, the GST rate that will be neutral in terms of revenues, whether there should be a small addi- tional levy on the movement of goods across state borders and whether a maximum GST rate should be written into the constitution. The political battles as well as the technical debates have so dominated public discourse that the original economic rationale for GST has receded from the spotlight. It is worth reiterating once more.
There are three important political economy issues that need a fresh airing. First, there is the fundamental idea from Adam Smith that the division of labour is limited by the extent of the market. In other words, the integration of the domestic market through the GST will improve economic efficiency. The needless fragmentation of Indian supply chains will be minimized. India will truly become a common market, nearly seven decades after its political integration. The GST debate can also be seen as a tussle between a national elite that sees economic value in a common Indian market and local elites that are worried about the reduction of their taxation powers despite the dual structure of the proposed GST.
Second, two classic papers in the modern theory of taxation by Peter Diamond and James Mirrlees-both Nobel laureates-presented the theory of optimal taxation. One of the lessons from their celebrated productive efficiency theorem is that optimal tax systems should not tax the production of intermediate goods. The idea underlying this insight is that taxation on intermediate goods leads to the diversion of resources away from the production of final goods. The burden of taxation should fall on income and consumption in order to maximize efficiency. The GST is actually a tax on final consumption rather than a tax paid across the value chain, and is hence close to the Diamond-Mirrlees norm. The GST in effect will eliminate taxes on production and distribution-only final consumption will be taxed. Third, the landmark paper written by Arbind Modi for the finance ministry in 2009-where there was a strong case made for what was described as a flawless GST-had argued that the new tax would not be regressive. It would benefit the poor. A new discussion paper published by the finance ministry last year makes the opposite point: "It is worth emphasising that the GST is intrinsically a regressive tax, and the higher the rate, the greater the regressivity."
The key issue here is that a high GST rate will hurt the poor. The Arbind Modi report was perhaps less worried about regressivity because the call then was more a modest 12% tax rate, shared between New Delhi, the states and the third tier of government. The report published last year came at a time when many of the proposals about the revenue neutral rate had drifted up, some as high as 26%. Hence its warning about the effects of a high GST rate on the poor. The politics of GST has dominated public discourse in recent years. The grand federal bargain is undoubtedly important in a complicated country such as India. However, it is worth reiterating the economic promise of the new tax in case people wonder what the fuss is really all about.