Outline for GST 2.0: Steps that will make it a good and simple tax

The eight-year journey of goods and services tax (GST) has been much like the mythological story of the churning of the ocean by the devas: The toxins of transition, aided by technical glitches in the system software, surfaced early — but now we are seeing the nectar of higher revenues, with  two consecutive months of gross GST revenues exceeding ₹2 trillion. 

 

While GST reform was truly transformational, some work remains. The tariff winds are nudging policymakers to rationalise GST rates. The key point here is that rate rationalisation should not be viewed in isolation as a revenue exercise, but as one integrated with trade policy and broader macroeconomic objectives. In its trade negotiations with the UK, EU, and the US, India is seeking greater market access for labour-intensive manufacturing sectors such as textiles, leather, food processing, and toys. It logically follows that domestic taxes on products of these sectors must be at the merit rate under GST. The critical question, then, is what that merit rate should be. There is a strong case for making the merit rate 8 per cent instead of 5  per cent. Otherwise, crucial input tax credits (ITC) will accumulate and these products will not be able to fully utilise ITC on key imports. 

 

On the import policy side, all single-use inputs and intermediates used in these four sectors should bear zero import duty, along with a waiver of all non-trade barriers, including quality control orders. This integration between GST rate rationalisation and trade policy will stimulate employment by raising the employment elasticity of investment, which has dropped from 0.44 in 2000 to 0.16 in 2024.  

 

Once we have the merit rate of 8 per cent, we can merge the 12 per cent slab into the 18 per cent standard rate after bringing medicines and textiles to the merit rate. With this, the textile sector, which has a dual rate of 5 per cent (for cotton yarn and lower-value apparel) and 12 per cent (for higher-value apparel), will uniformly bear the single merit rate of 8 per cent. In addition, bringing all food products under the merit rate will remove the multiplicity of classification disputes currently widely commented upon in the media.

 

The next step in the rationalisation exercise is to phase out all exemptions. The guiding principle should be to restrict exemptions to those that were value-added tax-exempt in the pre-GST regime, as recommended by the Committee on Dual Control, Threshold & Exemptions in its 2015 report. The non-exempted products would move to the merit rate. 

 

Another area of rationalisation is the thinning of items in the 28 per cent slab. All durable white goods — including air conditioners and dishwashers — should be moved to the 18 per cent slab. This would expand the market for these products, making domestic investment more viable. Similarly, two-wheelers should also be brought under the 18 per cent slab. 

 

Finally, the big-ticket change would be bringing cement down from 28 per cent to 18 per cent. While this will result in significant revenue loss, it would be partly offset by reduced expenditure on construction projects. The measure would also give a boost to affordable housing, which is currently lagging. To compensate for the revenue loss from cement, the government should raise the duty on gold and gold ornaments from 3 per cent to 6 per cent. According to an NCAER study, the top two income deciles account for over 80 per cent of the purchase and sale of these items. The tradeoff may be justifiable on grounds of equity. 

 

The biggest complexity in the GST system arises from the compensation cess, levied at different rates using different measures on sin goods like cigarettes,  aerated water and pan masala. As the cess is set to expire next year, this is an opportunity to merge it into the general rate of 40 per cent, levied on an ad  valorem basis uniformly on all sin goods. At present, if we factor in the compensation cess and add it to the 28 per cent rate, the overall rate ranges from 36 per cent to 38  per cent. This can be rounded off to 40 per cent to raise the average GST incidence, which has declined since the pre-GST era. The rationalisation exercise can also be used to green the GST. All electric vehicles, regardless of size, should be moved from the current 28 per cent slab to 18 per cent.  This would result in  a three-tier slab structure of 8, 18 and 40 per cent, with minimal exemptions and the phasing out  of multiple cess rates.  

 

The proposed GST structure would achieve several objectives — simplify the rate structure, eliminate multiple cesses, boost labour-intensive manufacturing, and green the GST. It would also raise the incidence of GST duties from the present level of around 12 per cent without stoking inflationary pressures. A wide section of the population would benefit from lower taxes on mass-consumption goods such as medicines, clothing, and affordable housing. Further, integrating GST rationalisation with trade policy will stimulate foreign and domestic investments in labour-intensive  manufacturing by lowering the cost of doing business.  The GST 2.0 structure outlined above could be followed later by GST 3.0. Its implementation would require expanding GST coverage to sectors such as electricity, real estate, and parts of the petroleum sector — a move that would significantly impact factor market reforms. To forge consensus with the states, a white paper — perhaps prepared by the chief economic adviser in consultation with the Central Board of Indirect Taxes and Customs (CBIC)—should be submitted to the NITI Aayog for circulation and discussion. This could then be brought to the GST council  for acceptance. 

 

In conclusion, the suggested rationalisation exercise will make GST a good and simple tax. The GST journey also offers a lesson for other reforms,  demonstrating what can be achieved when the Centre and the States sincerely embrace  cooperative federalism.

 

 

The  author is a former member, CBIC