Building a better GST: New reforms mark progress, but more is needed

The debate on India’s goods and services tax (GST) has been stimulated. The leader of the Opposition, Rahul Gandhi, offered a four-point critique: The existing system is overly complex arising from multiple rates; disadvantages micro, small, and medium enterprises (MSMEs); undermines fiscal federalism; and prematurely excludes petroleum products. In response, Prime Minister Narendra Modi has announced a “double Diwali” package of “next-generation GST reforms”, promising to simplify the tax structure by collapsing it into two main slabs of 5 per cent and 18 per cent. These developments can be assessed by measuring them against the principles of “the perfect GST” as conceived by its original architects.

The GST rate structure conundrum

The seven-slab, multi-rate structure (0.25, 3, 5, 12, 18, 28, and 28+ per cent plus cess) has led to significant economic distortions and compliance challenges. These are very high rates in objective terms.

The  call for a single rate correctly identifies this multiplicity as a central problem. The Prime Minister’s proposal to streamline the system into a five-slab structure, with a 5 per cent rate for most consumption goods and an 18 per cent rate for general goods and services, is a step toward rationalisation and rate reduction. Nearly 99 per cent of items at 12 per cent will go to 5 per cent, and nearly 90 per cent of items at 28 per cent slab will go to 18 per cent. The 28 per cent slab with cess will be consolidated into a single 40 per cent rate, while the 0.25 per cent and 3 per cent concessional rates will continue to apply to specified high-value items.  

This is progress, but it is not the perfect GST. A low single-rate system, a global best practice, is really the only way to go.

The present 5 per cent rate is a bit of an illusion. In many aspects, today, input tax credits (ITC) are restricted or capped. This is a full negation of the vision of GST. The effective tax burden is then much higher. Gross tax collections at the 18 per cent rate tend to be overstated as ITC is not taken into account. This design leads to cascading and gives complexity without meaningful net revenue.

The time has come to go to a single GST rate with full ITC. A value of about 12 per cent is a wise solution, with a slice of this GST going to the city government. We estimate that shifting to a low single-rate system would give an additional 0.7 to 1.4 per cent of gross domestic product (GDP) in revenue.

MSMEs and the cronyism debate

The assertion that GST fosters “crony capitalism” by disproportionately burdening MSMEs is politically framed, but it has a foundation in the realities around us. The perfect GST would enable seamless ITC, but the present implementation has created a structural disadvantage for smaller firms.

While large businesses can fully claim ITC on their inputs, which are often taxed at the standard 18 per cent rate, MSMEs frequently fail to do so due to a combination of factors, including compliance barriers, liquidity constraints, and a dependence on informal suppliers. This imposes a high tax burden on them and pushes them to remain small and informal.

MSMEs will be helped by reforming the core rate structure, reducing the standard rate on inputs from 18 to 12 per cent, thereby easing MSME participation and making compliance a more viable option. 

Fiscal federalism 

The debate surrounding the timing of GST fund transfers to states, which has been cited as a breakdown of fiscal federalism, shows the political frictions that arise from a structural design flaw. The friction over transfers stems from the architecture of the integrated GST (IGST). 

IGST collections come to the Union, and are then apportioned to the states. Delay or disputes become political conflicts. The issue is not one of intent but of design. It is better to split IGST into two distinct levies: A Union-IGST and a state-IGST at the outset, each component could be credited directly to its respective government in real time. This would eliminate the need for complex cross-credit settlements and remove friction with states. 

The road not taken: Petroleum, electricity, and broader reform 

The demand to include petroleum products within the GST framework misrepresents the economic function of the current taxation structure. The Union excise on petroleum functions as a corrective tax to internalise their negative externalities: Carbon emissions, solid particulate matter emissions, and congestion. State VAT serves as a consumption tax. The transformation required is deeper. The excise on petroleum needs to be fused into a single “eco” or carbon tax, applied to petroleum and coal, administered by the Union for the last decades of these industries. Once that is done, petroleum products and coal should become an ordinary part of a single-rate GST. 

The electricity duty on the other hand is a clear and compelling reform priority. The fragmented tax treatment on electricity leads to cascading effects that undermine Indian exports. Making electricity an ordinary product in GST would be wise.

The taxation of gold and luxury goods requires improvements. The current 3 per cent GST on gold and bullion should be reconsidered; international best practice treats bullion as a savings instrument, not a consumption good, and thus exempts it from VAT and customs duties. Jewellery, however, should be fully taxed at the new single GST rate. Luxury and sin goods should be subject to specific excises imposed concurrently by the Union and states, but fully separate from GST, to ensure that GST itself remains a clean, broad-based consumption tax. 

Similarly, all GST exemptions should be comprehensively eliminated. Redistributive objectives should be met by cash transfers.

Fixing Indian tax policy remains central to Indian success. The announcements constitute progress. But the unfinished agenda remains clear: A decisive move to a single rate, a structural reform of the IGST settlement mechanism, and the inclusion of key inputs like electricity into the GST fold. 

 

The authors are affiliated with Pune International Centre and XKDR Forum