Tyranny of GST status quo: Incremental changes fail to address the problem

The reluctance to undertake comprehensive rate rationalisation, fearing revenue loss, is short-sighted

The GST Council meetings have become routine, tinkering with goods and services tax (GST) rates and making minor administrative changes as needed by the exigencies, rather than transforming the tax structure towards the best-practice approach.
 

The Council seems to take a short-term view that the system has stabilised, stakeholders are well-acquainted with and have accepted the system, and decisions are made merely to address immediate needs and introduce minor corrections.  There is no attempt to take a long-term view to direct the structure towards minimising the three costs associated with taxes, namely, collection costs, compliance costs, and economic distortions.  Implicit in this way of thinking is also the fear of losing revenue and the lack of basic research to support the improved tax structure without compromising revenue.  Not surprisingly, the Council meeting held on September 9 made only incremental changes, such as exempting the import of services by foreign airlines, reducing rates on cancer drugs and helicopter rides, and setting up two groups of ministers to examine life and health insurance premiums and the compensation cess. 
 

The prevailing GST structure is sub-optimal and needs major reforms if we want to make it competitive while ensuring revenue productivity.  India’s aspiration to become a developed country by the middle of this century requires having a competitive tax system with minimal cascading effect.  It is important to reform the tax system to steer it towards international best practices to have a broad base, lower and less differentiated rates, and a simple and transparent structure.  In such a system, the three costs associated with taxes — collection costs, compliance costs, and economic distortion — are minimised.  This is the right time to embark on the directional change in the tax system because major reforms are best implemented when the economy is on an upswing to ensure revenue buoyancy.
 

Indeed, global experience with value added tax (VAT) reforms has shown that there is no “one-size-fits-all” model; each country adopts a structure and administration that best suits its unique conditions and is acceptable to its stakeholders.  Nevertheless, most countries adhere to certain general principles to minimise the three costs mentioned above.  The important general principles recommended by most experts are: (i) aim for a global tax with few exemptions and exclusions; (ii) focus the tax system primarily on revenue generation, rather than using it to achieve too many other goals; (iii) maintain a reasonably high threshold to target the “whales” rather than the “minnows”, as this will serve to minimise administrative costs and help to make the tax more equitable; (iv) avoid multiple rates to evolve a simple structure to minimise administrative, compliance, and distortion costs; (v) do not collect more information than is required and can be processed; (vi) actively encourage good record-keeping and aim for the long-term goal of self-assessment.  The experience also shows that if some “bad” features such as too high or too low thresholds, overly extensive exemptions, or multiple rates are adopted as a political compromise or for reasons of acceptability in the first place, they may not be easy to remove later.
 

At the heart of the reform is the urgent need for rate rationalisation.  Since 2000, of the 31 countries that have implemented VAT in one form or another, 25 have adopted a single rate of tax, and it is rare to find countries with more than two rates, aside from India. Multiple rates create classification disputes, introduce anomalies in terms of inverted duty structures, and induce unintended changes and resource allocations, besides increasing compliance and administrative complexity.  Unfortunately, the GST Network does not provide rate-wise revenue collections, but the information collected from Karnataka shows that more than 75 per cent of GST revenue in 2023-24 accrued from two rates — 12 per cent and 18 per cent.  A back-of-the-envelope calculation shows that combining these two rates into a 15 per cent rate will be revenue-neutral.  Similarly, limiting the 28 per cent rate to demerit goods would free the construction and passenger vehicles industry from the excessive burden, and can improve the labour-intensive construction sector and passenger car services sectors.  Even if some revenue is sacrificed on this account, this could be offset by pruning the large list of exempted items and increasing the 5 per cent rate to 6 per cent.  Thus, effectively, the number of rates can be reduced to two with an additional rate on sumptuary or demerit goods without sacrificing revenue.  
 

Another major reform needed to make the tax system comprehensive and competitive is the inclusion of petroleum products and electricity in the GST base.  In 2019-20, excise duty on petroleum products accounted for 29 per cent of the Centre's consumption tax revenues.  The sales tax on petroleum products in the non-special category states was almost 53 per cent, varying from 36 per cent in Bihar to 61 per cent in Telangana.  The exclusion penalises exporters, as they cannot zero-rate the input taxes on transport used in the production and distribution processes.  Besides, it renders the tax base narrow as the entire transport sector, except for air travel and air-conditioned and first-class train travel, is exempted.
 

In general, there is resistance to change, and that is particularly true of the tax system.  As stated by Paul Johnson and David Miles of the Institute of Fiscal Studies while reviewing the report on tax reform in the UK by a Committee chaired by James Mirrless, “…In the real world, the proposals for tax reform are constrained by politics. Those who lose from tax reforms tend to be vengeful and those who gain, tend to be ungrateful.  This can lead to tax policy, perhaps more than any other policy, to a tyranny of status quo”. The GST Council has appointed a group of ministers to review the rate structure and recommend changes.  However, very little progress has been made in this regard, partly because, in the absence of credible research, no one is willing to risk revenue.  The argument that the people have come to accept the rate structure and, therefore, there is no need for any major change is short-sighted and does not consider the invisible economic damage caused by the distortions.  Hopefully, rate rationalisation and measures to make the GST comprehensive will be taken up sooner.

The writer, a former director of NIPFP, was a member of the Fourteenth Finance Commission. The views are personal