Towards a good and simple tax

Despite making gains, next-generation reforms are required to expand and streamline the GST

The implementation of the goods and services Tax (GST), which replaced 14 indirect taxes of the Union and state governments, is surely a landmark reform. There has been a steady increase in revenues, with a record collection of  Rs 2.1 trillion in April 2024, 15.5 per cent higher than the previous year. 

The collections in the first quarter of this financial year are Rs 5.57 trillion, compared to Rs 5.05 trillion in the corresponding period of the previous year, recording a growth of 10.2 per cent, which is much higher than the estimated nominal growth of gross domestic product (GDP).  This is due not only to the impressive growth performance of the economy but also to better compliance with the tax owing to improvements in tax administration, particularly the firming up of the technology platform.  Considering the continued high growth of the economy expected in the medium term, along with better administration and enforcement of the tax, GST collections are likely to remain buoyant.

Despite the gains, the tax structure still falls short of the desired goal, and considerable additional reform measures are required to minimise distortions, reduce the compliance cost, and make the tax a “money machine”.  Much remains to be done to make it simple, efficient, and conform to international best practices, and that should be addressed by the next generation of reforms as has happened in many countries. 

The second-generation reform of the tax is necessary to expand the base, simplify the rate structure, and improve the revenue productivity of the tax.  The vision of becoming a developed country by 2047 can be achieved only by having a competitive tax system with high revenue productivity and low distortions and compliance costs.  So far, the GST Council has been engaged in tinkering with the system to avoid inverted rate structures and tackling administrative issues as and when they arise.  Now is the time for basic reforms in the structure and administration of the tax.  Basic tax reforms are successful when they are undertaken during periods of rapid economic growth so that the reform does not adversely impact revenues.

While it is clear that there cannot be a “one-size-fits-all” principle in designing the structure and operational details of GST, some basic principles must be adhered to.  It is also known that once some bad elements get included to make the reform acceptable, it is very difficult to remove them.  The basic principle of having a broad-based tax with minimum exemptions and exclusions is important not only for revenue reasons but also to ensure a comprehensive value-added tax (VAT) chain.  While exemptions for perishables and unprocessed food items are unavoidable due to administrative problems, it is important to include all other items in the tax base.  Equity is better served by keeping the threshold at a reasonably high level so that the focus is on the “whales rather than the minnows.” Having less differentiated rates is important to avoid misclassification, inverted duty structures, and litigation arising from these.  In addition to these, most VAT administrations are supported by a competent technical group comprising experts from various fields, including administration, taxation, accounting, economics, law, and big data analysis, to undertake continuous knowledge renewal and research.    

From the above perspective, GST in India is in urgent need of reform.  As the tax has settled, the time is now opportune for expanding the tax base by pruning the list of exemptions.  A major anomaly in Indian GST is the exclusion of petroleum products, electricity, and real estate from the base.  Petroleum products have been excluded primarily for revenue reasons, as excise duty and sales tax on these products contribute over 40 per cent to internal indirect tax collections by both the Centre and states.  However, the adverse effects of this exclusion on the competitiveness of Indian manufacturing are enormous due to the cascading effects of high taxes on transportation. 

It is also important to amend the State List to exclude electricity duty and include electricity in GST.  These measures will make the system more comprehensive and help in better formalisation.  If revenue consideration is the critical issue in including petroleum products in GST, the GST Council should consider levying a separate “green excise”, in addition to including it in the GST base, and the proceeds may be earmarked for climate action.

There are many items currently exempted for reasons of equity.  While designing the structure, almost 50 per cent of the items included in the consumer price index have been kept out of the tax to minimise the effect of GST on prices.  This large-scale exemption goes against the principle of VAT.  It is desirable to limit the exemptions to unprocessed food items and perishables and tax all other items currently exempted at the lower rate of 8 per cent. 

As mentioned earlier, the cause of equity is better served by keeping the threshold high as low-income households, particularly in rural areas, purchase their supplies from small traders.  The data from Karnataka for 2023-24 showed that GST dealers with less than Rs 50 lakh turnover constituted 93 per cent of the total taxpayers, but accounted for 6.5 per cent of the total turnover, and 12 per cent of the tax paid.  Focusing on the whales rather than minnows would ensure better compliance with the tax as well.

The other important reform needed is rate rationalisation.  Ideally, levying GST at a single rate, with a minimum list of exemptions, should be preferred. But that may not be politically acceptable at present and the attempt should be to reduce the number of rates to two and eventually move towards a single rate.  The rate category-wise revenue collection in Karnataka in 2021-22 shows that 75 per cent of the tax is collected from 12 and 18 per cent rates. Converging them into a single rate at 16 per cent would be revenue neutral.  The items taxed currently at 5 per cent accounted for 6.2 per cent of the revenue, and this could be increased to 8 per cent.  It would be desirable to restrict the 28 per cent rate solely to demerit goods and transition items such as building materials and passenger cars into the general rate category.  Construction is a labour-intensive activity, and passenger cars have a highly labour-intensive service segment.  As the cesses will cease to exist after 2026, the structure of the tax will be much simpler with effectively two rates to make it a “good and simple tax”.

The writer is former director, National Institute of Public Finance and Policy, and member, the Fourteenth Finance Commission.  He is also the chief economic adviser at Brickwork Ratings.  The views are personal