Little-known stops on the road to GST

Indirect-tax reform is still a work in progress, but from no tax on services to GST, India has come a long way since 1976

There have been several important articles in this newspaper examining the logic and substance of the liberalising reforms initiated 35 years ago that helped change the structure of incentives, accelerate growth, and reduce poverty. However, not much has been written about the transition from the extortionary, discretion-based and distortionary tax system that existed earlier to a simpler, less-distortionary and more competitive tax system. 

Until the mid-1970s, the tax system was seen as the main instrument for establishing a “socialistic pattern of society”. The personal-income tax had 11 slabs, with rates rising monotonically from 10 per cent to 85 per cent. Combined with a surcharge of 15 per cent on the basic rate, those earning more than ₹2 lakh faced a tax rate of 97.75 per cent at the margin and, when the wealth tax was added, a rate exceeding 100 per cent. 

The implementation of the recommendations of the Tax Reform Committee (TRC), which was chaired by Raja Chelliah, reduced the number of tax slabs to four, with the top marginal tax rate of 40 per cent. Of course, further simplification of the personal-income tax was done in P Chidambaram’s “dream budget” of 1996, of which N K Singh was an important architect as the revenue secretary. 

The history of indirect-tax reform leading to the goods and services tax (GST) has been much more convoluted and the system is still in mid-stream crying for further reforms. The experience shows that tax reform is a process, not an event. Prior to the reforms, the only objective was to collect revenue.  Minimising  compliance and distortion costs was never a consideration. Of course, achieving the “socialistic pattern of society” required designing multiple rates based on judgements about the consumption pattern to make the tax system look progressive. 

The first systematic attempt at reforming indirect taxes was made by the Indirect Taxes Enquiry Committee, chaired by L K Jha, in 1976. The Committee recommended that the excise duty should be made ad valorem, the prevailing plethora of rates should be reduced and rationalised, and the tax should eventually be converted into a manufacturing-stage value-added tax (Manvat). Nothing was done for 10 years, and in 1986, the excise duty was converted into a modified value-added tax (Modvat) without making the necessary changes in the structure suggested. 

This only compounded the administrative, compliance and distortion costs. The tax structure with several rates — both ad valorem and specific — continued to be levied, often with an inverted structure and severe problems in getting tax refunds on exports. The reform, rather than increasing the revenues, led to its sharp decline. The TRC recommended a reduction in the number of tax rates, clearer classification of goods and simplification of the tax system. The attempt to unify the tax rates followed gradually when Modvat was replaced by the central value-added tax (Cenvat) in April 2000. 

The introduction of taxation of services has an interesting history. All through the years, the consumption tax was confined to goods. There was no mention of taxation of services either in the Union List or in the State List in the Seventh Schedule. An article written by me for the Asian Development Bank in 1993 (“Taxation of Services in Asian and Pacific Region”, Asian Development Review, Vol. 11, No. 2, pp. 154-171) underlined this and argued that neutrality required taxing services alongside goods. This attracted the attention of Raja Chelliah, who had assumed the role of adviser to the Union finance minister after submitting the TRC recommendations. At his request, a note was prepared with the assistance of Gautam Ray, a director in the Central Board of Excise and Customs. It was argued that, as there was no mention of service taxation in the Seventh Schedule, the Union government had the legislative competence to levy that tax as a residual entry. The note recommended that a modest beginning should be made by taxing three services — non-life insurance, stock brokerage and telecom. 

Thus, the tax was introduced for the first time in 1994 on the three services at 5 per cent, and over the years, the list of taxable services was expanded. By 2011-12, as many as 119 services were taxed, the tax rate was increased, and the levy was applied to all services, excluding those on a negative list, in 2012. The revenue from the tax increased from ₹407 crore in 1994-95 to 

₹2.1 trillion in 2015-16. 

At the state level, following the TRC recommendations, the finance ministers of the states were engaged in discussions to simplify and rationalise the complicated and cascading sales taxes into a VAT. A committee of state finance ministers was constituted to deliberate on the issue. To understand the experience of the reform, the state finance ministers visited countries that had successfully implemented the VAT in three groups — one covering Canada and Brazil, the second covering the European Union, and the third, Thailand and Indonesia.  

A draft transition plan was prepared in 1994-95. The committee of finance ministers got institutionalised when it was converted into the Empowered Committee of State Finance Ministers in July 2000 with Ashim Dasgupta, West Bengal’s finance minister at the time, as its chairman.  The committee, after several deliberations developed the blueprint for transforming sales taxes into a VAT, which was accomplished in 2005. 

The proposal for integrating domestic consumption taxes at the Union and state level was recommended by the Expert Group on Taxation of Services, which was chaired by your columnist, in March 2001.  The expert group had five major recommendation: (i) tax all services excluding those in the small negative list; (ii) provide tax credit for both excise duty and service tax to achieve a goods and services tax at the manufacturing stage at the Central level; (iii) provide concurrent tax powers to the states to levy tax on services to enable them to levy the goods and services tax when the states replaced the sales taxes with a VAT; (iv)  withdraw the central sales tax on inter-state transactions and work out the place-of-supply rule to trace the destination of inter-state transactions; and (v) zero-rate for all exports.  Some of this required amendment to the Constitution.  Besides submitting the report, the expert group presented the recommendations to the Task Force on Indirect Taxes at the request of its chairman, Vijay Kelkar, and these were included in its recommendations.  

Of course, that was just the beginning, and considerable work had to be done to implement the reform by the Empowered Group of State Finance Ministers. This included estimating the revenue-neutral rate, determining the structure of the tax and mechanisms to track and settle the destination of inter-state transactions, working out a clearing-house mechanism, adoption of appropriate technology and, finally, undertaking training and education programmes on VAT in various states. There were serious objections to the levy by some of the producing states, including Gujarat, and the reform could not be carried through by the United Progressive Alliance government. Eventually, the National Democratic Alliance government implemented the reform on July 1, 2017.   

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The writer is former director, National Institute of Public Finance and Policy, and a member of the 14th Finance Commission. The views are personal