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M Govinda Rao: 2 steps forward and 1 sideward

Setting up an SPV for the IT platform is important, but the 3-rate GST structure is a bad idea

M Govinda Rao 

The last couple of weeks have seen focused activity on the tax reform front and that bodes well for the country. The finance minister’s assurance to the states that their loss of revenue arising from the introduction of the goods and services tax (GST) will be compensated in full, and his proposals on the threshold and tax rates to be levied by the states are very reassuring. Even more significant is the agreement by both the Union finance minister and the Empowered Committee of State Finance Ministers to the proposal put forth by Nandan Nilekani, the chairman of the Unique Identification Authority of India (UIDAI), to set up a special purpose vehicle (SPV) to erect the information-technology platform for GST. Hopefully, the momentum will be maintained and the next few weeks will see agreements on structure and implementation issues as well as constitutional changes and regulatory systems at both central and state levels.

Every tax involves three types of costs. The first is the cost of collection and having a simple tax system with minimum exemptions and preferences, and low and less differentiated rates minimises the collection cost. The second is the compliance cost and a simple and transparent tax system and the use of technology in tax administration to avoid the interaction between the taxpayer and the tax collector minimise the compliance cost. The third is the cost to the economy in terms of the distortions the tax creates. The best practice approach to tax reform advocates broadening the base and levying the tax at low and less differentiated rates. The destination-based consumption type GST is supposed to reduce all the three costs and ensure seamless trade throughout the country. While the introduction of VAT at the state-level in April 2005 has helped substantially simplify and rationalise the consumption tax system, GST is the next stage in the transition.

In developing countries, tax administration is tax policy and in the modern world, technology is a critical element of tax administration as it will help minimise all the three costs associated with taxation. Therefore, the agreement to set up the SPV for creating the IT infrastructure required to facilitate input tax credit, smoothen inter-state transactions in goods and services, and ensure accurate and timely zero rating of taxes on exports is the most significant development. The past tax reform exercises in indirect taxes did not include strengthening of the information system and, therefore, did not enhance the revenue productivity to the desired extent. The improvement in revenue productivity resulting from the institution of the tax information network in the case of income tax is well known as in just three years from 2003-04 to 2007-08, the revenue from income tax relative to GDP increased by over three percentage points. In this sense, the agreement by the Union finance minister and the Empowered Committee of State Finance Ministers to the proposal by the UIDAI chairman to incubate the information-technology platform with a technology partner such as National Payments Corporation of India or National Securities Depository Ltd and set up an SPV with majority stake held by the central and state governments is the most significant development. Of course, a lot of work will have to be done to erect the platform and surely the partner chosen will have the capability.

The second important development is the Union finance minister’s offer to compensate the loss of revenue arising from both the abolition of CST and state VAT. In a cooperative tax reform initiative like the levy of dual GST, building the trust and confidence between the Centre and the states is important and the finance minister’s offer to provide insurance against loss of revenue even if the amount is larger than that was recommended by the Finance Commission is commendable and this will help in keeping up the momentum. This will help restart the process that was partially jammed on account of the “all or nothing” recommendations of the Finance Commission.

A disappointing aspect, however, is the suggested rate structure. Surely, it is ideal to have a low and uniform rate of tax to reduce all the three costs associated with taxation. However, the suggested three-rate system for the Centre and a similar structure for the states is not in keeping with this tenet. It is suggested that besides an exempted list, a lower rate of 5 per cent on essential goods, a general rate of 10 per cent on goods and separate rate of 8 per cent on services will be levied by the Centre and the same has been recommended to the states for adoption. These are supposed to converge into a single rate of 8 per cent on all goods and services over the next three years. In fact, adoption of different rates for goods and services defies logic, for, goods enter into services and vice versa, and differentiating the rates between them will increase the compliance cost, create administrative complexities and classification disputes, and add to distortions. If revenue-neutral calculations warranted levying the tax at a higher than 8 per cent, the general rate could have been pegged at 9 per cent for both goods and services and there was no need to tax goods at 10 per cent and services at 8 per cent. Indeed some of the states still want higher rates and want that the empowered committee should merely stipulate the floor rate, leaving the states the autonomy to choose their own rates above the floor rate. Although it is possible to accommodate this in the IT platform, it will definitely increase both compliance cost and cost in terms of distortions.

There are still a number of steps to be taken before GST is put in place. The most important steps relate to the constitutional amendment and a monitoring mechanism, and both are beset with serious differences between the Centre and the states. The trade-off is between states’ fiscal autonomy and tax harmonisation. Given the momentum created, the next few weeks will be exciting as these issues will be resolved and a mechanism to ensure conformity to the rules and discipline for a harmonised GST by both the Centre and the states will be put in place.

The author is director, NIPFP. The views expressed are personal. Comments at:  

First Published: Tue, August 03 2010. 00:21 IST