Tax reform is a major item on the new Bharatiya Janata Party government's agenda and will vastly improve India's business environment and fiscal accounts if implemented, but finding an acceptable compromise with state governments remains difficult.
IHS perspective | |
Significance | A goods and services tax (GST) is envisaged to replace India's current complicated system of indirect taxes levied by state and central governments. |
Implications | The government estimates the average net tax rate on applicable goods purchases will fall from between 25% and 30% for goods (and 12% for services) to the proposed 16% for the GST; easier compliance will widen the tax base so that tax revenues will rise overall. |
Outlook | However, the Bharatiya Janata Party government's target of implementation by April 2016 is unlikely to be achieved; late 2017 is more likely. The central government must negotiate with India's 36 states and Union Territories how they will be compensated for their loss of state-level revenues under any proposed regime. |
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Finance minister Arun Jaitley arrives to deliver his budget |
Indian finance minister Arun Jaitley said on 21 October that the central government would present a revised constitutional amendment bill introducing the goods and services tax (GST) in parliament's winter session, which begins in November.
GST rollout central to India's fiscal reform
Recurring fiscal deficits remain a key constraint to economic growth in India. The average combined central- and state-government deficit was over 7% of GDP in each of the past five years, owing to high government spending (particularly on subsidies) and India's narrow tax revenue base. India's tax to GDP ratio remains below 20%, compared with an OECD average of 35%.
Traditionally, India's tax regime has relied heavily on a series of indirect taxes levied by state and central governments, given the unfeasibility of levying direct taxes in a poor country. These taxes vary across states raising the overall cost of compliance for firms operating across Indian states or considering market entry. At present, the tax burden on goods is estimated by the government to be in the range of 25–30%, while the services tax stands at 12%. But indirect tax revenues have fallen gradually as a result of tax reforms initiated in the early 1990s from over 80% of total revenues during the 1980s to 61% in fiscal year 2013.
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The GST is intended to replace all state and central indirect taxes with a few exceptions yet to be finalised by the central and state governments. As India is a federal state, there will be a dual GST system: a central GST and a state GST simultaneously levied on an agreed common base. Central and state taxes will be collected at the point of sale and charged on the manufacturing cost, making it a destination-based tax on consumption and shifting the tax base away from investment and production. The GST rate is currently expected to be between 16% and 20%, equal for goods and services. Moreover, the plans envisage an integrated GST levied on the sale of goods and services between Indian states.
As per the current proposal, GST on inter-state transactions will be levied at the same rate as the combined revenue neutral rate. The state component of inter-state GST would go to the importing state, in contrast to the present system of the exporting state getting the proceeds of the central sales tax on cross-border commerce. Imports will also be considered as inter-state supplies and hence, the GST will be applicable to them in addition to custom duties.
By harmonising a large part of the tax regime across Indian states, the National Council of Applied Economic Research estimates that the GST could potentially boost GDP growth by somewhere between 0.9% and 1.7%.
Winners and losers from GST implementation
Many industry bodies, especially those in manufacturing, have been lobbying hard for the GST's faster implementation. Once in place, the GST should protect businesses from the cascading costs of India's complex regulatory structure. The distorting effects of aiming to minimise state-level tax burdens would be removed from sourcing, distribution, and warehousing decisions. Although automotives manufacturers hope the GST will help them recover from a three-year slump, the IT and electronic sectors would also want the GST's implementation to boost domestic and international competitiveness.
With the tax base shifting towards retailers and subsequently consumers, the latter will initially see higher prices for goods and services, but as producer cost savings are being gradually passed on to consumers, overall prices are expected to come down in the long run, helping to boost consumption and increase sales.
The GST should result in higher revenues for the central government, as well as consuming and importing states, while states that are major manufacturing, services, and technology hubs may see some initial revenue loss resulting from abolition of a range of indirect taxes. States such as Gujarat, Maharashtra, Tamil Nadu, Karnataka, and Kerala may be among those with major revenue losses, unless compensated from the central government budget. Mineral-rich states, such as Odisha, and those with big oil refining capacities may also see a decline in revenues. The revenue loss arising from the GST implementation has therefore become the major hurdle in negotiations between the centre and the states.
Struggle between the centre and states
Prime Minister Narendra Modi has set the government an April 2016 deadline for the GST's implementation. However, the central government has an arduous task in addressing the different concerns of state governments in that timeframe. A major one has been the revenue loss arising out of a reduction in Central Sales Tax, and other indirect taxes. This is partially political grandstanding. When the Congress-led United Progressive Alliance (UPA) government tried to push through the GST, it was opposed by the Bharatiya Janata Party (BJP)-ruled Gujarat and Madhya Pradesh state governments. After the BJP's win in the May 2014 election, Congress-ruled state governments have been more opposed to the GST in its present form.
A common problem for the states has been the compensation mechanism for removing the Central Sales Tax, from which proceeds are given entirely to the states' exchequers. The UPA government refused to compensate states for the losses caused by the removal of the Central Sales Tax beyond 2010, which fuelled opposition to the proposal. Although finance minister Jaitley has assured state governments that the compensation backlog will be cleared, disputes have emerged about its precise mechanism. States such as Tamil Nadu are demanding a constitutional amendment to ensure compensation. However, the finance ministry is opposed to constitutional guarantees. The compensation timetable has also been disputed, with the states demanding compensation from the centre to last for five years whereas the centre has so far agreed to a three-year compensation.
State governments across party lines have also been opposed to the inclusion of tobacco, alcohol, and petroleum under GST with taxes on these contributing to the bulk of the state revenues. Although the central government has agreed to the exclusion of alcohol, it had remained adamant that petroleum and tobacco products remain included under the ambit of GST. As an interim measure, the centre is considering keeping the GST rate at zero while allowing states to levy VAT on these products.
Outlook and implications
On a broader level, even the structure envisaged that would implement the GST is yet to be agreed upon. States including Tamil Nadu and Bihar are opposed to the establishment of a GST council comprising of all finance ministers that would make recommendations on taxation rates, turnover threshold, and exemptions. Many states irrespective of political dispensation have opposed the GST council as they believe it would take away the states' legislative and executive powers. Besides, details on methodology of compensation, administrative processes for collection and information sharing, and tax rates in terms of revenue neutrality are yet to be finalised.
Despite a broad realisation among state government that GST reform is needed to boost long-term growth, these outstanding issues are unlikely to be resolved until at least next year. Considering the issues to be overcome, and procedural aspects including a constitutional amendment that would require the assent of 15 Indian states, the implementation of the GST, even partially, is unlikely before the latter half of fiscal year 2017.