Wednesday, August 3, 2016

Why the GST Will Have Only A Marginal Effect On the Indian Economy - Yet It Is Important

Arun Jaitley in the Rajya Sabha on an earlier occasion (Courtesy: The Hindu)

The doors to this temple of the tax gods have been finally opened, and a new deity by the name of Goods and Service Tax (GST) is being prepared for installation with the Prana Pratishtha currently being undertaken in the Parliament's Upper House. While there are points being extolled in its favor, and state parties and regional leaders voicing concerns of revenue loss to their state administrative budgets, there is a near unanimous consensus on the bill being made a reality. The country is being unified into one market in terms of the indirect tax net. Even across the various cabals and lobbies the unanimous chants of 'this is a landmark reform' are gaining strength.
Even as we scour the layers of discussions and platitudes piling up across various fora, the benefits are being overstated. Yes, there is a need for a simpler taxation structure, and yes, free movement of goods and services should not be a problem. However, it is pertinent to note that the only comparable economy in terms of size and federal structure, The United States of America, has never indulged in entertaining this idea. Simpler taxation is certainly a utopia for everyone including state administrators; however, viewed from the prism of the political economy, one can notice several inconsistencies in the process. A GST in its present form takes away in a snatch the advantages of working in states that worked hard to simplify the processes in order to attract investments and greater economic activity. It will also benefit states that do not work towards simplifying such measures, awarding perverse actions on their parts. While the former loses revenue, the latter gains significantly. While this is being addressed through compensation, the change will make no significant impact on the fortunes of the poorer, less developed states. The policy structures being much simplified, and the inherent geographical amendments they own, the poorer states need not do anything about easing the business environment, thus continuing the status quo on the front of employment and overall development. For example, Maharashtra and Gujarat will continue to remain important investment destinations, while states like Bihar will fail to attract investment. Moreover, states that want to attract investment will struggle to find ways to provide incentives to potential investors.
Another interesting layer is the impact on transaction cost in the economy. Many transaction costs in the Indian economy are of an indirect type, and most belong to the informal, unaccounted economy. There are enough bribes that flow in this economy - be it at the checkpoint, be it the excise inspector, be it the underreporting, and be it the inability to trace low margin-high volume transactions that are the hallmark of the Indian economy (think your haircut, or your tailor refitting your dress). While transaction costs can be reduced partially, states have no incentives to reduce the transaction costs of the informal nature in the current setup. It is not clear if states will make the effort to simplify registration procedures, revenue reporting procedures, excise processes and a bevy of several layers of bureaucracy. Moreover, there are several delays in clearances that add further layers of transaction costs. While these are being addressed to some extent through several reforms, the inability to tap into the informal economy will persist. How will the government remedy this without resorting to tax terrorism? That question needs to be addressed suitably. It is essential to note that India has seen considerable growth periods without having a unitary market, and this had more to do with reducing transaction costs, and this clearly shows that considerable political capital has been spent over the past decade on something that only marginally addresses these issues. For instance, claims that buying a flat in Delhi-NCR would be cheaper are laughable, since the real challenge lies in a combination of demand-supply constraint, pre-tax property overpricing, and significant informal black money transactions thanks to underreporting involved. Au contraire, the prices would go up in the short run, as services will become expensive. This can be a major bitter pill in the short and mid term, given the service-sector driven nature of the Indian economy. If multiple GST rates are announced, this defeats the purpose of GST - a single uniform rate.
Another challenge lies in the benefit transfer to the end consumer.  As can be seen with fuel pricing, the end consumer never gets the benefit of falling prices; however, rising prices are immediately transferred to the end consumer. In no way is the end consumer benefited, so unless a mechanism that directly benefits the consumer - either in the form of a refund or a discount - does not arise, all such claims to benefit do not hold water.
All that said, GST does put forward advantages in a different sense. Increased revenue collection from indirect taxation can have a direct bearing on fiscal health of the economy. In a country like ours, where barely 20-30million people pay income taxes, indirect taxation has always been the real revenue source of the state, and this can be used as a bargaining chip by the middle class voters to directly push for lower income tax rates, pushing further towards the milestone of zero income tax, an idea which seems to be moving one step closer towards realization with the GST. It does make operations in the market easier. But the benefits will not be as great as are being bandied about.
So while the GST mantras are chanted, let us not fool ourselves about the benefits of GST.

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