National Value Added Tax (NATVAT)

Introduction

   A 2002 policy paper, outlined a vision of National Value added tax (NATVAT) that it suggested could be put in place by 2010 through a constitutional amendment, after creating genuine Central VAT (CENVAT) and States VATs (STATVAT) within the existing constitutional limits.[i] Given the degree of interest in the Goods and Service Tax (GST) among industry, financial participants, economists and the general public, a version of the NATVAT, which differs somewhat from the GST  is outlined below.  The two differ in relatively minor but critically important details.  In my view these difference would have made it easier to get political acceptability for the NATVAT  from States.

Indirect Taxes

Tax theory provides us a number of insights into the nature of indirect taxes that are best for a country.  The most important insight is that there should effectively be no tax (i.e. zero rate) on raw materials, intermediate goods, capital goods and services used for production of goods & services.  The second insight is that efficiency considerations drive the differentiated structure of consumer taxes towards higher rates on goods & services with low demand elasticity.  In the case of de-merit goods like cigarettes & tobacco products and (perhaps) hard liquor this proves easy to apply.  However, as necessities have lower elasticity of demand than luxuries this runs contrary to the equity objectives that tend to drive the tax structure in the opposite direction (assuming a reasonably strong desire for social equity as commonly professed in India).  The net result depends on the detailed elasticity.

There are two other lessons that involve a greater element of judgement:  That efficiency and equity considerations tend to balance each other and that a near-uniform structure of indirect taxes may be a useful starting point for a reasonably efficient and equitable tax system.  Another is that there is a case for taxing at a somewhat higher rate goods & services that are complementary with leisure (e.g. goods & service for entertainment), though the force of this argument is diluted in a large population countries (like India) with substantial or ‘hidden unemployment’ or ‘under-employment.

Why VAT

This is the appropriate point in which to bring in the problems of tax administration, evasion and corruption that loom so large in developing countries (emerging markets) and which this theoretical exercise has totally ignored.  Logically the structure of optimal taxes based on reality (varying administrative costs, evasion costs & corruption possibilities) would differ markedly from that given by the “ideal.” There is wide agreement among tax experts who advise governments on tax reform that these problems argue strongly for having an indirect tax structure that is simple and as close to uniformity as possible.  Complexity facilitates and encourages tax evasion and corruption.  It also provides an incentive for lobbying by powerful organised groups to obtain special favours for themselves.   This sets in motion a spiral of complexity, evasion & corruption that is not based on any empirical knowledge (of elasticity) and results in a tax structure that bears no relationship to the so-called ideal “optimal.” 

The second implication of this reality (administrative costs, evasion, corruption) is that the best way to implement a uniform structure of indirect taxes is through a value added tax.  A uniform value added tax (VAT) has the same efficiency & equity properties as a uniform sales tax on final finished consumer goods, but by collecting the tax at multiple points and in smaller doses it minimises the incentive for evasion.  It also has (in principle & if implemented properly) the property of catching at a later stage the tax evasion that has taken place at earlier stages of production/ value added.  These considerations have led an overwhelming majority of countries (not just developing but even developed) to replace their existing indirect taxes by a Value Added Tax.

An indirect tax structure for the country (Centre & States) that will be simple, efficient and equitable should ideally replace all central and state government taxes on goods and services.

National VAT

An ideal indirect structure for the country would consist of two sets of indirect taxes:  A single uniform rate National VAT on all goods and services (except for a limited number of pre-specified exemptions) and State (final) sales taxes on a dozen specified goods with a pre-specified upper limit on the sales tax rate for each of these goods.  The Central government would have the responsibility of setting the national VAT rate in consultation with the States and for administering it with the help of the States as needed.  Calculations done in the 2000s suggested that a VAT of 15% may be sufficient to ensure revenue neutrality with respect to existing Central & State indirect taxes.  The proceeds from this tax would be shared between the Central government and the States in the proportion necessary to ensure that there is no diminution of the States’ indirect tax revenues.  To ensure that the indirect system is equitable, and to support positive externalities, the following goods and services could be exempt from the VAT: Food, including processed (cereals, pulses, vegetables, fruits, milk & products and possibly sugar), Drugs, Medical Equipment & medical services (Diagnostic; Disability compensating or Disease preventing/curing), Environment friendly fuels (solar), Educational services and Knowledge services (Educational material, R&D, Testing, Consultancy).  There would also be a sales volume exemption of Rs. 5 lakh (say) based solely on the need for minimising compliance & administrative costs.  All other exemptions should be abolished.  Administration of the system for transactions up to some limit (Rs. 10/20 lakh say) could perhaps be decentralised to the States. States would also have to abolish Octroi one of the most inefficient taxes know,

Final Sales Taxes

In addition, the State government would have the right to levy sales taxes on a limited set of final, finished consumer goods (to ensure that there is no cascading & no taxation of intermediate goods).   The maximum total tax on any good or service should not exceed 50%. At this point, the incentive for tax evasion becomes so strong that corruption is sure to follow. This means that with a VAT rate of 15%, the sales tax must not exceed 35% (upper limit/maximum).  Such a high rate could however be applied only to de-merit goods such as tobacco products (cigarettes, cigars, chewing tobacco) and hard liquor.   Fuels with negative environmental externality, such as petrol & diesel, could be subject to a maximum sales tax of 25%.  The same maximum rate could also apply to cars and low (< 5%) alcohol beverages like beer & wine.  A few other items such as Air travel, Air Conditioners, Motor cycles/scooters & home entertainment products (excluding radio & TV), Entertainment services like cinema, Hotels & Restaurants service, could be subject to a maximum sales tax of 15% (i.e. 0% to 15%), as the VAT would replace the existing set of entertainment taxes, expenditure tax, sales tax etc.

 Across the world, Sales taxes are normally levied at the point of sale to the consumer.  Because of evasion & related problems, India follows the practice of “first point sales tax,” where the tax is collected at the point of sale by the producer.  Strictly speaking this is better termed as an excise tax.  However, as long as cascading and multiple taxation are avoided and all States follow the same method, either method can be adopted. Both the national VAT and the State Sales taxes would apply to imported consumer goods & services in the same way as they do to domestically produced ones.  The final point of sale collection (of sales tax) has the merit that each State can collect its own sales tax on imported goods.  If the first point Sales tax (excise) methodology is adopted then an excise/sales/SAD tax will also have to be collected (on the specified set of goods) at the customs point on behalf of the States.  This creates undue complexity if the States have different rates of tax on the same good. Imported goods would enter the VAT chain at the point of entry into the country and from there on be treated exactly as if they had been produced in India.

Administration & Evasion

 The single rate NATVAT allows a drastic simplification in administration & compliance,  which is the great advantage of a true VAT.  This simplification is based on a complete transformation of the collection and administration machinery.  It has the following related elements:

·         An invoice and accounts based system of checking in place of routine physical checking.

·         Basic data on the company (and its production units, warehouses, depots etc) would be entered once given an appropriate code number (VAN on the lines of PAN) and stored on the computer.   It would not have to be entered on every invoice as at present.

·         A simplified invoice form that focuses on values of inputs and outputs subject to the single VAT rate, and the source and destination of the inputs and outputs respectively (again represented by VAN).  This is most effective if there is a single uniform base NATVAT rate with all goods treated equally on both the input and output side with respect to this rate.  In this case the sale or invoice form would only require the total value of goods sold and the code number (VAN) of the originating and destination units.

·         Monthly, quarterly or annual aggregation of the sales and purchase slips depending on volume of business (i.e. SSI have to do only annual aggregation, and only the largest units have to do monthly aggregation).  The aggregation would involve showing total value of purchases and sales by seller & buyer respectively, during the relevant period.

·        A comprehensive computerisation of these aggregate returns, which allow cross checking of inputs, outputs value added and CENVAT paid, so as to detect evasion. Direct e- filing could be required for VAT payers above a certain size (Rs. 10 crore say).

·         This could be supplemented by industry wide database, which can be used to identify flow of goods and services entirely outside the VAT chain.

Conclusion

   In comparison to a Goods and Services Tax (GST) as proposed, the National VAT (NATVAT) greatly simplifies administration of the national system of indirect taxes, and would help in drastically reducing tax evasion. At the same time gives some flexibility to states to levy a half a dozen final sales taxes, so that they can meet fluctuations in revenues and expenditure by varying some taxes under their direct control.

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[i] Arvind Virmani, “Towards a Competitive Economy: VAT and Customs Duty Reform,” Planning Commission Working Paper No. 4/2002-PC, April 2002.  http://www.planningcommission.nic.in/reports/wrkpapers/wp_vat

Economic Growth and the New Government

with Prof Charan Singh, IIMB

Introduction

The new government has recently assumed office. The country is waiting with hope for new policy direction to revive the economy, especially given the disastrous growth record in the last two years (4.6% average).  To revive the sagging growth in the economy the need is to correct the mistakes of the previous government and re-establish confidence. In addition, it is a good opportunity to undertake fundamental economic policy and institutional reforms, in the first two years. Therefore, it is a good time to reflect on the vision for the economy and suggest agenda for reforms that the next government can consider. The government needs to sweep out the Fabian Socialist (or Nehru-Indira) Model of development that ensured that the License-Permit-Quota Raj seeped into every nook and corner of the Indian economy. This Statist model is unsuited to a young, proud, modern India that wants “equality of opportunity” and “equal treatment” from the Government it elects and the bureaucracy of “public servants” instead of humiliation, harassment and worse from a “Mai-Baap” Sarkar. And this is possible because of the thumping majority that BJP has received at the elections.

1990s and 2010s

There is a lesson to be learnt from the experience of the 1990s. The unshackling of the Indian economy during the mid- 1980s and early 1990s raised its real growth rate to 3.6 per cent points above the average growth of the world economy during 1992 to 2010 but since then the real growth differential has collapsed to less than 1.2 per cent point. The drop in the growth differential can be attributed to three domestic causes: First, an overemphasis on entitlements vis-a-vis empowerment; Second, deteriorating governance (including corruption allegations); and finally, failure to introduce policy, regulatory and institutional reforms, essential for sustaining growth and employment at its full potential. The fundamental objective of any Indian government must be to close the welfare gap of the Indian people with the rest of the World and provide employment opportunities through faster economic growth.

Employment Opportunities

  To take advantage of the demographic dividend, generate employment, and enhance public welfare, the government has to ensure that the economy revives to grow at its long term growth potential of 8 percent (or 6.5 percent per capita) per annum.  To help recovery, a reversal of the governance failures and regressive tax changes during 2010-13 could help. A return to the general philosophy of modernizing the tax system by reducing the plethora of State and  Central taxes to a few and simplifying these by reducing exemptions/ deductions and reducing marginal rates, is imperative. This also requires introduction of a GST or National VAT and approval of a new tax code.

 To revive growth, it is necessary that the government is able to establish credibility of its intentions. Therefore, it would be important to improve governance in terms of speed of decision making and ensuring implementation of those decisions. In view of the widespread allegations, a quick cleanup of the toxic residue left by the alleged scams would also help revive confidence in the government. Institutional reforms in political systems, police and judiciary would help to address the issue of pervasive, systemic corruption and restore good governance on a sustainable basis.

Laws

A review and revisit to a few controversial legal documents would also address the resentment of the larger public towards government’s policy making. Illustratively, some of these are - (a) Right to Education Act - proposed hike in salary structure of teachers so that thousands of charitable schools (NPO/NGOs) are not overwhelmed with losses; (b) Right to Food Act – the focus should be addressing the needs of genuinely hungry population and wasted/ stunted/malnourished children under 5 years of; (c) Land Acquisition Relief and Rehabilitation Act - laudable objective of fairness in compulsory acquisition of land has been converted into an expansive ecological and social agenda; and (d) Environment Protection Act which has become a bottleneck to investment because of its sweeping authority and expansive mandate. Similarly, need is to revise the Agricultural Produce Marketing Act and Essential Commodities Act which now serve to swell middlemen’s profits instead of helping farmers as originally anticipated.

Now that election is over, there is an urgent need is to rein in deficits, both fiscal and current account, and encourage domestic savings, and review fuel and food subsidies. Fiscal discipline would allow the RBI to ease monetary policy and stimulate investment and consumer durable demand without fear of increasing non-performing assets or inflation.

PSUs and Productivity

As empirical evidence suggests from cross-country experience, to stimulate productivity, there is also a need introduce competition in public sector monopolies.  The government could examine converting railways, ports and airports into publicly owned Ltd companies and set up professional independent regulatory structure to oversee their performance. Similarly, sale or disinvestment in competitive public sector units in industry and finance (e.g. steel, airlines, hotels, machinery; banks, insurance) could also be considered.  

To sustain higher growth, and facilitate trade and commerce, it is important to have good infrastructure both in rural and urban areas. Therefore, high quality national road network and encouragement to e-commerce would be the most cost effective stimulator of economic development. Finally, to ensure healthy population, and reduce disease, malnutrition and child mortality, sanitation projects need to be emphasized.

Conclusion[i]

A slew of fundamental reforms exploiting the inherent demand within India, especially rural, can sustain Indian GDP growth at over 8 percent for the next few decades despite global slowdown. It is not necessary to accomplish all the listed reforms but it would be essential to outline the broad direction of reforms and establish credibility in implementing them.

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A version of this article appeared in the Indian Express of Friday June 20, 2014, under the banner, "Now, rewrite the script."  http://indianexpress.com/article/opinion/editorials/now-rewrite-the-script/ .

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[i] For further details see, Arvind Virmani, “National Agenda For Growth and Welfare” Policy Paper No WsPp1/2014, January 2014. https://sites.google.com/site/drarvindvirmani/policy-papers .

Non-Govt Organisations (NGOs)

Q & A with Lola Nayar, Outlook Magazine

Q1: Your views on the IB report on foreign funding of NGOs and the charge that the issues raised by them and protests staged by them is responsible for 2-3 percent lower GDP growth?

A1: The IB report has highlighted the issue of foreign funding (under FCNRA) of organizations whose primary purpose is to agitate against development projects. This issue needs to be debated. Like CAG's estimates of 3G losses the estimate (in the covering letter)is quite arbitrary and unsupported by sound analysis.

Q2: How responsible and justifiable is this view?

A2: The IB's job is to provide intelligence to the government. It is for the public to debate issues of importance  to public welfare.

   In my view the decision of the UPA Govt (a few years ago)to insert a rule banning foreign funding under FCNRA for NGOs whose primary objective is to protest against government decisions on economic development (such as nuclear power, GMO crops) is justified.  However care must be taken by home ministry to ensure that transparent(audited) foreign funding (under FCNRA) of research organizations and social welfare organizations helping disadvantaged individuals, groups and the poor are not impeded.

Q3 In a democracy, can dissent or opposition to a policy or project be only seen in terms of corporate interest or should the human cost as in case of displaced people in land acquisition and environment costs also be factored in?

A3: There are a number of issues rolled into your question. My response to these diverse issues is as follows: 

a) In Indian democracy Indian citizens have and will continue to have the (fundamental) right to lawfully oppose projects and policy that they disagree with.

b) Rail roko, Chakka Dham, Dharnas and burning of public property are not mere "opposition" to a policy or project. Illegal activities should not be allowed in the name of opposition.

c) Organizations are not people. Organizations are set up under rules designed for their creation and must follow these rules to be allowed to function. 

d)India has 'land acquisition' and 'environmental protection' laws which factor in human costs. It is an insult to the majority of voters who choose one balance between the rights of many to development vs a minority that wants only the rights of the small group of people affected by a particular project. 

e) If these laws are not properly implemented due to corruption and/or bad governance, the proper course is to agitate against corruption and bad governance, which a plurality of citizens/voters agree on.

Q4: In your view, do NGOs play any fruitful role in the development goals of a country? Have the NGOs accused of being anti-development, served foreign interests in the issues raise by them?

A4: As in Government and Private Sector there are good and bad eggs in the Non-Government, Non-profit sector. The proportion of good vs bad varies across sectors. The ideological assumption that non-profit sectors are "good" and profit sectors are "bad" is a hangover of our Fabian socialist heritage. 

  Private sector can be kept honest through market competition and government and regulators enforcement of laws and rules. However, Corruption is now pervasive in government from the lowest level up. Many politicians have set up both profit and non-profit organization to disguise corruption. Therefore any assumption that all NGOs are knights in shining armour is self-delusion. Rich Foreigners have their own interests in mind when they fund Indian NGOs. To demand transparency in the receipt and usage of these funds from large, media savy Indian NGOs is perfectly justified! To harass all NGOs is not.

Other Questions

Q: Do you oppose Foreign funding of NGOs?

A: Certainly not! I strongly support foreign funding of NGOs/NPOs engaged in research (economic, social, technical) and of NGOs that do social work for the welfare-betterment of the poor, the socially dis-advantaged and the physically or mentally handicapped.

PM Modi’s Foreign Policy

President’s Address To Parliament

      PM Modi’s government has used the vehicle of the President’s address to spell out its foreign policy priorities: These are, (1) SAARC countries, who are also  India’s close neighbors in South Asia, (2) China, a neighbor and a Great power, which does and will continue  to impinge directly on Indian interests, (3) Japan, a long standing economic power house, which can help transform Indian Infrastructure and economy, (4) Russia a long time Strategic and defense technology partner and (5) USA, still the sole super power, which has multifarious possibilities for partnership, but whose promise has still to be fully realized. (6) The European powers (i.e. UK, France, Germany), which still have areas of technological and strategic strength from which India can benefit.  Though SAARC, a pluri-lateral organization is mentioned, the focus is clearly on bilateral relations with this set of countries, which together will have a high priority in the nation’s foreign policy. .

   Perhaps, underlying these is a more hard headed evaluation that real gains to India can come only from give and take between these countries and India rather than from drawn out discussion at (or with) multilateral and regional fora.

Foreign Policy Approach

     The selective list of countries mentioned in the speech, are those that can have the greatest impact on India’s economic development, the welfare of its people and its national security.  India’s  “values” and “soft power” will be balanced with “pragmatism” to achieve “mutually beneficial relations.” These words and inaugural actions, suggest that neither self-imposed ideological shackles nor fearful assumptions about the impact of bilateral relations on third countries, will be a constraint in pursuing India’s interests. However, PM Modi’s previously articulated interest in foreign economic relations (trade & investment) to promote India’s economic and technological development suggests a much greater emphasis on opportunities for mutual economic gain.

    The Modi led government is likely to shun grandiose concepts of global architecture and global governance and focus pragmatically on its economic and National security goals.  It is likely to have a business-like approach: Identifying opportunities and threats and pragmatically going about using the former and minimizing the latter, in co-operation with whichever country is most helpful in each case.   This does not imply an absence of strategic objectives, strategic doctrine or plan, but a shift in emphasis away from philosophical principles and moralism to more specific achievable economic and technological objectives.

SAARC

    A peaceful, economically integrated neighborhood tops the nation’s foreign policy agenda outlined in the President’s address. Historically, this included Myanmar, but the latter is now a member of ASEAN not SAARC. Though Myanmar is also a member of BIMSTEC this includes another ASEAN member Thialnd.
     Similarly, Tibet a part of India’s historical neighbor hood has for obvious regions to be dealt with as part of China policy.  The early invitation to SAARC leaders is suggestive of the fact, that the new government will give much closer attention to the SAARC countries than the previous one. Pakistan as the second largest country in SAARC, will undoubtedly get its due share (no more, no less) of attention within this grouping, both from the perspective of peace and security within the region and with respect to mutually beneficial economic integration and regional growth. 

China: Threat or Opportunity

       China, a great power neighbor obviously requires the sustained and serious foreign policy attention from India.  With the possible exception of China, all other countries in the Modi Govt’s list of foreign policy priorities can be seen as providing opportunities for economic and technological development. So is China, the second country on the list, a threat or an opportunity? China’s actions on its land (Indian) and maritime borders (S China sea and E China sea) have alerted the World to the “potential” threat of a rising and aggressive China.  But the unravelling of China's Export-Investment led growth model after the Global financial meltdown, suggests that the ultra-nationalist actions may be an attempt by the Chinese Communist Party leaders to divert public attention away from slowing economic growth to foreign concerns.  China’s economic weakness and counter-action by its maritime neighbors also provide a cautionary warning to its leadership and may strengthen those elements in China that are “pragmatic” and genuinely believe in “mutually beneficial relations” with India.  If this is true, then China can be converted from a potential threat into a potential opportunity for India.

   There are three basic issues that need to be addressed for India-China relations to become a win-win opportunity for both: (1) A border settlement: Premier Chou en Lai provided a template and a map which is reportedly still available in the Indian archive, but from which the Chinese have resiled.  This long buried proposal along with the India-China border agreement of 2005, can be the basis for a border settlement in which China accepts India’s claims in the East and India broadly accepts China’s 1960s claims in the West. Alternatively, if this is politically too difficult for the two sides to do, the ill defined LAC should be converted into a defined and agreed LOC. (2) The great asymmetry in trade relations arising from the ability of the Party (CCP) to control imports from India without any formal procedure. The massive trade imbalance can only be corrected if the party issues clear instructions to this effect.  India can provide greater access to China’s construction exports and FDI in infrastructure, in return for a shift of China’s Labor intensive export industries to India (some of its parts & components would also be imported from China). (3) China’s nuclear and missile proliferation to India’s neighbors:  By formally agreeing to support India’s entry into UNSC, NSG, MTCR, Wassanar group etc. China can partially assuage the deep distrust that such proliferation has aroused.

Japan

     To the surprise of some, Japan an economic power, is listed ahead of the USA on the list of countries that have priority in PM Modi’s administration. The primary reason for this is the perception that the Japanese government has the financial wherewithal, the ability and (under PM Abe) the will to help India solve its infrastructure problems, meet its energy deficits and efficient use of natural resources and thus accelerate economic growth significantly.  It also has a wide range of technological capabilities that it can use to help upgrade India’s strategic R&D and technological abilities. Given historical cultural links, shared democratic perspective and geographical location, it has the potential of becoming a true and equal “Strategic partner” for India in a decade or so, if it can resolve the political divisions between traditional, older pacifists and younger, modern, nationalists. Among the pending issues are an Indo-Japanese "Civil Nuclear Agreement" on the lines of those with France,UK, Russia etc and Japanese decisions on opening up Defence system sales and technology export.

Russia

   Russia is a valued partner because of its co-operation in developing strategic technology for mutual benefit. Despite the fact that its Defense industry was disrupted by the collapse of the USSR and has never quite recovered enough to meet its cost and time commitments, it remains a major partner. Its large energy and natural resources also have potential, which has not been fully exploited for mutual benefit. 

USA

      After a great start to the India-US strategic relationship under the Bush administration and some successes during the Obama administration(a la Ashton Carter, former Deputy defence secretary), the India-USA relationship has become increasingly transactional after the global financial crisis. We must however, be careful to distinguish between the Security related and Economic aspects of the relationship.  The former has the potential to become a solid and mutually satisfying strategic partnership while the latter is inherently more transactional, given the divergence in economic interests. As the Modi led government has few if any ideological constraints & self-imposed restrictions, there is an opportunity to transform the Indo-US security partnership (strategic technology, defense production, national defense, terrorism and internal security). 

   With the Govt’s desire to harness private investment & entrepreneurship private business relations are bound to flourish, given US firms are (in general) still the most technologically advanced and competitive in the World.. Thus it is advisable to use government to government interactions on economic policies to minimize the politically inspired conflicts between the two countries through honest give and take and transactional deals to satisfy political pressure groups and vested interests.

Conclusion

    Sometimes, a simple slogan can catch the essence of a new approach to National security and international relations. For PM Modi’s government there are in my view two such that people will eventually use to describe the new approach adopted by the Indian Government. These are, 
(1)    Speak Softly but Carry a Bigger Stick, ('speaking softly' may not come easy to some in BJP vis-a-vis Pakistan or China, but must be done e.g. "We want peace with Pakistan but it cannot be achieved through nuclear blackmail, terrorism and mutilation of our soldiers;" Similarly a 'bigger stick' is best signaled through informal channels rather than derogatory/rude language. Finally, those who accused PM Nehru of making empty threats in 1961-62 musn't make the same mistake).
         and 
(2)    Deterrence without Delusions (of converting ideologically driven opponents into peace-nicks through "Pappi-Jhappi" style of International Relations: National Power & the will to use it is the only way to deter or dissuade aggression and in this context, "Actions speak louder than words").