Ajay Shah: Mission GST

The Goods and Services Tax will make India a competitor in Chinese-style manufacturing and employment.

The two best examples of far-reaching reforms in India are telecom and the stock market. In both cases, there were difficult political economy problems, but despite them, revolutionary reforms took place. In both cases, India is now at the frontiers by world standards.

Not enough credit is given to the far-reaching reforms of Indian public finance. A visitor to India in the mid-1980s would have been horrified at every single feature of the tax policy, tax administration and public finance. Indeed, these weaknesses had a lot to do with the poor economic performance at the turn of that decade. However, a succession of finance ministers and prime ministers has doggedly chipped away at doing the right thing. The story has had many a twist and turn, but it adds up to nothing less than a revolutionary transformation.

Customs rates have been dropped sharply, and the elimination of customs is now visible at the end of the tunnel. Taxation of turnover is diminished, though turnover taxes or excises have not been fully eliminated. Rate dispersion has dropped sharply, and with it the associated rent-seeking. Early steps towards VAT have taken place. Tax rates have come down and administration has improved.

The processes of consensus and multi-party decision making have achieved three big wins, in the form of the State VAT, the FRBM and the 88th Amendment to the Constitution. It adds up to a far-reaching transformation, one that inspires confidence in the Indian State and its political processes. Indeed, these improvements have a lot to do with the superior economic performance of 1992-2007.

A mature market economy is one with sound institutions on fiscal, financial and monetary economics. In India's case, the glass appears to be half full on fiscal policy. Progress on an institutional transformation of finance lags, and a reinvention of monetary policy has not yet begun.

The last big piece of the puzzle in tax policy is the Goods and Services Tax (GST). Ten years ago, wise fiscal experts felt that a GST was impossible. But things changed: the 88th Amendment clarified the picture on taxation of services; the automation of income tax showed that India can build IT systems; the State VAT effort showed that coordination between states could happen. With this track record, the GST is feasible. The finance minister has promised a 2010 date for going live with the GST.

Done right, the GST will be accompanied by removing almost all other existing taxes, leaving only three taxes: the income tax, the GST and the property tax. This will reduce compliance costs, economic distortions and harassment. Many of the taxes that would be removed are "bad taxes" on turnover such as the stamp duty or octroi.

The GST will enable the next phase of customs reform. The sound architecture is one where imported goods are charged GST at entry, and exports are refunded the full GST. By this arrangement, local firms face fair competition in both the domestic market and the global market. Once this is in place, the end-game of customs reforms involves eliminating customs altogether.

The GST would unleash India as a common market. Even though India is a giant economy with a GDP of nearly a trillion dollars, firms often operate within one state. Nationwide optimisation of production, storage and logistics is not taking place. The GST would make possible productivity gain, GDP growth and lower prices.

When market forces govern behaviour, firms gravitate towards low-cost production centres. A firm that sells in Gujarat might set up a factory in Madhya Pradesh. But this evolution""which tends to reduce inter-state disparities""is blocked by barriers to movement of goods. With the GST, poor states adjoining rich states will obtain increased investment and inter-state disparities will decline.

Global manufacturing now involves a large number of processes, spread across many firms in many countries. India has not been able to achieve Chinese-style employment-generation in manufacturing partly because of the burden of cascading taxes. The GST will make India a competitor in Chinese-style manufacturing and employment, and set the stage for a great boom in employment-intensive and FDI-intensive manufacturing exports.

How might the GST be achieved by 2010? Complex fiscal reforms require delicate handling. An Empowered Committee for GST Implementation now needs to be set up, chaired by the finance minister, in order to pursue four areas of work.

The first task concerns IT systems. The Tax Information Network (TIN) system is the right foundation for implementing the GST. TDS in an employer/employee context is exactly the same as the GST in a supplier/purchaser context. Since TIN does TDS, it is ideally placed to do GST. TIN already reaches 700,000 establishments. IT development work needs to be initiated at NSDL, for enlarging the TIN to do the GST for the identical 700,000 establishments.

The first test case for the new IT system should be a merger of CENVAT, the service tax and VAT on imports (i.e. CVD) into a single tax called the Central GST. This needs to be announced in the Budget speech of February 2007 and become operational in April 2007.

The next task is that of arriving at a "grand bargain" with states. The most fair formulation involves placing the entire GST collection into the hands of the Finance Commission for sharing with States. As all commentators have emphasised, a piecemeal allocation of certain services for taxation by States will derail the possibility of such an agreement. The fair deal that States should be offered is one where they tax all services, in return for cooperation in the administrative of the GST, and removal of distortionary taxes.

The last task is that of coordinating tax administration with the states. Each firm should face only one taxman, and all firms should face the same IT system. One possibility is that of using the Centre as tax collector for big firms and the state as tax collector for small firms.

An empowered committee pursuing this four-pronged strategy could make enough progress over 2007-10 so that the stage is set for a single GST in April 2010. Even if some states do not cooperate, it is feasible to start with an "Indian Common Market" of a few states, and gradually other states can join in. The Finance Commission can use fiscal transfers as a tool for mopping up the stragglers.