Turnaround GST rates to make them more palatable

Wednesday’s meeting of the finance ministers and the proposals discussed at the meeting are a significant milestone in the journey to the Goods and Services Tax (GST). Finance Minister Pranab Mukherjee has done a yeoman’s job of building consensus on the basic structure of the tax. Its implementation by April 2011 is now looking more and more certain. However, a not-so-happy aspect is that it may not be the ideal, flawless model that the industry has been hoping for.

The most significant announcement on Wednesday was about the GST rates. While full details are still awaited, the finance minister has proposed a triple-rate structure of standard rate of 20 per cent for goods, 16 per cent for services, and a special lower rate of 12 per cent for essential commodities. In the third year, the three rates would converge to a single uniform rate of 16 per cent for all goods and services. Unfortunately, this structure is flawed and will perpetuate inefficiencies of the current system. It is a 20th century legacy which would not serve the needs of the 21st century India.

First, the rates proposed are far higher than the revenue-neutral rates in the range of 12 per cent anticipated by the industry, and as recommended by the 13th Finance Commission. The minister proposes to address the upward bias in the rates by lowering them, but only gradually over the next three years. Taxpayers would be skeptical of such promises, given the international experience of rates always moving in the opposite direction.

Second, a visible tax of 20 per cent at the retail level would not be popular and lead to widespread evasion. Even mature industrialised countries face tremendous resistance in collecting tax at such rates.

Third, this rate structure, with most inputs taxable at 16 per cent or 20 per cent and outputs taxable at 12 per cent, would lead to inverted duty structure, where inputs credits always exceed output taxes.

Fourth, a separate tax rate of 16 per cent for services would give rise to classification disputes and complexities in applying the tax to mixed supplies of goods and services, such as car repairs, works contracts, and maintenance service agreements.

One way to get around these complexities would be a turnaround of the rate structure. The tax rate of 12 per cent has been mentioned as the lower or special rate. However, this could be turned into the standard rate applicable to most of the consumer items. All capital goods, raw materials, and services would be taxable at this rate.

The special rate in such case would be the higher rate of 18-20 per cent which would apply only to specified items, which would include only the final consumer goods, like motor vehicles and home air conditioners, which are supplied through the organised sector and do currently attract tax at relatively higher rates. Such items are consumed primarily by the high income groups who can well afford to pay higher tax. It could also include tobacco, alcohol, and petroleum, if they were to be included within the ambit of GST. The special list could be longer initially, and truncated subsequently.

With a large majority of the goods in the 12 per cent standard tax rate bracket, and the services also taxed at the same rate, the distortions resulting from the separate treatment of goods and services would be minimised. It would also prevent the clamour for preferential treatment to be given to various items.

The move would provide necessary stability to the rate structure and obviate the need for reducing the rate in future. The finance minister would only need to tweak the higher rate of 20 per cent in the next two years.

At present, almost two-thirds of the indirect tax revenue is derived from the low rate basket. The government would not be able to truncate the basket. The rate turnaround may not really affect the revenue potential. But politically, it could have a dramatic impact and save the government the agony of confronting multiple pressures.

Satya Poddar, Tax Partner, Ernst & Young
(Views expressed are personal)