Ashok K Lahiri: Getting the GST rate right

At its third meeting, scheduled from October 18 through 20, the Goods and Services Tax (GST) Council will decide on the GST rate structure. The decision will have important implications for the economy.

The prospective efficiency gains from the GST are well recognised. By consolidating almost a dozen-and-a-half central and state indirect taxes, the GST will simplify the taxpayer's life and reduce compliance cost. It will reduce cascading and give the states the right to tax services. It will usher in a common market, facilitate inter-state movement of goods, enhance external competitiveness and give a boost to investment and growth.

The important issue of GST rates has not been resolved as yet. Rates too high will burden the consumers and introduce inefficiencies in terms of what economists call "dead-weight losses". Rates too low will result in revenue short-falls, increasing deficits and macroeconomic problems.

The search is on for a GST rate - the weighted average when there are multiple rates - that will be consistent with the present level of revenue collected by the Centre and the states. The GST Council will struggle to discover this elusive "revenue neutral rate" (RNR). The GST will consist of central GST (CGST) and state GST (SGST). After this discovery, the Council will have to design a rate structure with CGST, SGST and differentiated rates for merit, standard and sin goods that produces this average RNR.

The RNR is already a matter of debate. There are at least three RNRs floating around: 12 per cent, 15 to 15.5 per cent, and 17.7 per cent. All three cannot be right. And, of course all three may be wrong. Consider the three in turn.

A task force under the Thirteenth Finance Commission (2009) had recommended a combined RNR of 12 per cent, with five per cent CGST and seven per cent SGST. The task force had assumed that electricity duty, taxes on petroleum products, alcohol, tobacco, and the real estate sector should be and would be a part of the GST base. The proposed GST from April 1, 2017 has invalidated these assumptions.

A committee under the chief economic adviser was set up by the Ministry of Finance (MOF) in June 2015 to recommend, among other things, the RNR. It considered three approaches: A macro approach with gross domestic product (GDP) adjusted for exports and imports, a direct tax turnover approach, and an indirect tax turnover approach. At the end, in December 2015, it recommended an RNR of 15-15.5 per cent.

The Empowered Committee of State Finance Ministers had commissioned the National Institute of Public Finance and Policy (NIPFP) to do a state-wise analysis of the revenue implications of the GST and find the RNR. The NIPFP used the tax turnover approach in preference to that of GDP adjusted for exports and imports because of lack of disaggregated national accounts data on exempted sectors such as liquor, petroleumand exports. With assumptions ratified by the Empowered Committee, NIPFP determined an RNR of 17.7 per cent.

The RNR in the MOF and NIPFP studies differ mainly because of three reasons. First, is the intriguing difference in the share of taxable turnover in gold and high value goods - two per cent in the NIPFP study and 11.6 per cent in the MOF study - and the GST rate to be applied on such sales: Two per cent, according to NIPFP and two to six per cent, according to MOF.

The very persuasive reasons for taxing gold and high-value goods at the rate of two to six per cent are well documented in the MOF report. However, policy making is the art of the possible. On gold jewellery, most states levy one-per cent VAT, and in the context of the CENVAT of 12.5 per cent introduced from this year, the Centre also offered an optional scheme of one per cent excise duty without input and capital goods credit. The RNRs of MOF and NIPFP will have to be jacked up, if, for any reason, gold cannot be taxed at two and six per cent.

The second reason is the differential impact of GST on tax compliance. The replacement of VAT, CENVAT and many other indirect taxes by GST will undoubtedly increase efficiency, boost GDP, and by being taxpayer friendly, improve compliance. But, by how much? Pessimistic NIPFP assumes no improvement, optimistic MOF a base expansion of five per cent. The MOF assumption is based on an econometric study with cross-country data, which by its own admission, is "a simple econometric study" There are obvious pitfalls of such simple studies, and its finding of one per cent increase in the standard rate leading to 1.22 per cent decline in compliance may ring like the Laffer curve reinvented for Indian GST.

The third reason is differential cascading. NIPFP assumes that all GST taxpayers will only buy from registered dealers and avail of full input tax credit, a bit of an extreme assumption. MOF assumes that such purchases from unregistered dealers will fetch GST revenue of Rs 45,000 crore in unclaimed input rebate. With GST providing strong incentive to registered dealers to buy from each other, only time will tell how much cascading remains.

Like for introducing GST, the struggle for imposing fiscal discipline at both the Centre and the states has been on for more than a decade. The Fiscal Responsibility and Budget Management Act (FRBMA), 2003 is still an unfinished agenda. It will be unfortunate if the GST regime comes with low rates and derails the fiscal consolidation reform agenda.

There are news reports of a growing chorus for low GST rates, compensating the states from the central kitty for five years as per the provisions of the 101st Constitutional Amendment and relenting on FRBMA, if necessary. There is the simplistic claim of this being superior in terms of its "inflation impact". Many have been working against FRBMA not because of the difficulties inherent in observing fiscal discipline, but their difficulties in recognising the importance of fiscal discipline.

If GST, an important reform, comes with a low RNR and derails FRBMA, it will be a classic case of two steps forward and one step backward. May the GST Council save us from such an outcome.

The writer is a former chief economic advisor