Second-Gen GST reforms needed for simplicity, equity, competitiveness

Streamlining rates and expanding GST coverage can enhance revenue and reduce distortions; political buy-in remains a key challenge

In my last column (Business Standard, September 12, 2024), I argued for initiating second-generation reforms in the Goods and Services Tax (GST) system to make it simpler, more transparent, and less cascading. Reforms are necessary to make the consumption tax system more comprehensive, less distortionary, and export competitive. 

Enhancing the revenue productivity of the tax system and reducing cascading in the consumption tax is important to achieve the aspirational goal of reaching the developed country status by 2047. Tax reforms tend to be more successful when the economy is on the upswing, as the risk of revenue loss is lower. The three important suggestions made are (i) restrict the exemption list to perishables and necessities; (ii) reduce the number of tax rates to two, with a third rate reserved for sumptuary or “sin” goods, without sacrificing revenues, and (iii) extend GST to currently excluded items — namely, petroleum products, electricity, and real estate to make the self-enforcing system more comprehensive. 

Admittedly, it is difficult to carry out the “Big Bang” reforms in tax policy in India.  Therefore, what is sought is a directional change toward achieving a simpler and more efficient consumption tax system.  There is a general principle in public choice theory that the larger the number of coalition partners, the more difficult it is to make decisions due to multiple preferred choices. Naturally, with the Union government and all the states and Union Territories (with legislatures) being a part of the GST Council’s decision-making process, it is not easy to implement game-changing reforms. However, if the required directional change is clear, gradualism can work towards achieving what is desired eventually.  Unfortunately, what has been done so far is merely tinkering with the system without clear directional changes toward greater simplicity, transparency, and minimising the costs of collection, compliance, and distortions.

The general refrain against the suggested direction of reform, also the theme of R J Jagannathan’s column (Business Standard, October 1, 2024) is on two grounds (i) equity and (ii) political expediency. The rate differentiation is justified in terms of ensuring progressivity in the tax system. It is nobody’s case that the taxes should be paid only by the poor, but to expect a tax to be a major policy instrument to redress unequal income distribution may be illusory. 

Experience across the world has shown that the capacity of tax policy to reduce inequality is limited. In the US, for example, a series of studies by Joseph Pechman of the Brookings Institution for the period 1966-85 using alternative assumptions on the shifting of taxes concludes that the US tax system is not significantly progressive. The benefits of exemptions and low tax rates levied on items assumed to be consumed by the poor are also availed by the non-poor. If, on the other hand,  the focus on equity is reducing poverty, the relevant policy instrument is to empower the poor through public spending on education, healthcare, skill development and direct anti-poverty interventions. 

Of course, financing these initiatives must be done through taxes, and progressivity in consumption taxes is imparted by exempting essential food items and keeping the threshold at reasonably high levels. Even in countries that levy value-added tax (VAT) at differential rates, it is typically applied at only two rates.  In India, however, there are too many rates, not calibrated according to the income elasticity of demand (for equity) or the labour intensity of production. 

A classic example is the 28 per cent tax on building materials used in the labour-intensive construction industry. Reducing the number of rates will minimise the classification problems and disputes.  For example, a standalone restaurant may classify catering services as restaurant turnover to reduce its tax rate from 18 per cent to a compounded levy of 5 per cent.  The point made by the owner of Sree Annapoorna Hotel in Coimbatore about the taxation of cream buns is just one of many such anomalies. While switching over to one tax rate, as recommended by Vijay Kelkar, may not be politically feasible, there is no reason why the GST Council cannot deliberate on reducing the complexity by reducing the number of rates to two without compromising on revenue or equity.

The second concern about the suggested reform is their political acceptability. The argument that the tax system has settled and, therefore, does not need reforms is fallacious. Equally fallacious is the justification that the tax system elsewhere (including the US) is chaotic and we can maintain the status quo.  Peace-loving people often have no choice but to accept a tax system even when it is bad. The indirect taxes levied by the Union and state governments before the implementation of GST were well-settled, even though they were bad. Yet, there was a concerted effort to move towards a better system.

Incidentally, the US is the only Organisation for Economic Co-operation and Development country that has not opted to adopt VAT.  It is a well-organised market economy and, the base of the retail sales tax levied by the states is conceptually equivalent to VAT without having to levy it in multiple stages. Surely, we now need a better GST if we have to make the GST a “money machine” to take care of our fiscal woes and render the economy more competitive to achieve the cherished goal of being a developed country.

Political acceptability for tax reforms comes when leaders are assured that the reforms, while improving the economic environment, do not entail revenue losses.  When GST was implemented on July 1, 2017, the states were willing to sacrifice their revenue autonomy to embrace tax harmonisation on the assurance that any revenue losses would be generously compensated. 

Given the pattern of rate-wise revenue collections, unifying the 12  per cent and 18 per cent rates at 16 per cent would shield 75 per cent of revenue collections. Bringing down the rate on building materials from 28 per cent to 16 per cent will help the labour-intensive construction industry to expand and reduce the grey market for these goods. Similarly, including petroleum products in the GST base would allow for more comprehensive taxation of the transport sector and provide substantial relief from cascading, making the tax system more competitive. 

Since the government aims to phase out fossil fuels, it could safeguard revenues by introducing a separate green tax, over and above the GST levied at the general rate. Surely, tax reform is a process,  not an event, and it is important to focus on it to ensure movement in the desired direction.

The author was a member of the Fourteenth Finance Commission and was director, NIPFP.  The views are personal