GST: Some Questions

Q1: What in your opinion are the key challenges that need to be addressed before the GST regime is formally rolled out early next year?

A1: The most important thing is to view it as a historic opportunity. It is the first major economy related reform of the Constitution that has happened. It is also an opportunity to create a 21st century tax system. Of course, this is one part of the indirect tax system so we are really not touching the corporate or income tax. Let’s say even if you call it half or even two-third or three quarters of the tax system, there is an opportunity to put in place procedures, rules and administrative systems which we can be proud of. Now there is a bit of trade-off here because it has been decided to introduce it by April 01, 2017. This is a good thing in general. But my only fear is I hope the deadline will not override the first point I am making. Once you put in place the structure of tax collection, it becomes very difficult to change it because vested interest develops. So that in my view is the biggest challenge in the structural sense.

Q2: What are the vested interests that might come into play?

A2: Well the vested interests are already there because within the existing tax structures, which are going to be merged to form the new GST, you have 29 state tax administrations. I don’t think the vested interests at the central level are strong as the Prime Minister and the Finance Minister are sitting on top of them. And already the effort towards e-governance, Digital India and all the related things is pretty strong. So I don’t think there will be any problem in the Central Board of Excise and Customs (CBEC) etc. But out of 29 states, who knows where the vested interests are stronger and where they are weaker. But I am sure that among the larger states, there are many vested interests. And we know what these things are. They generally have to do with poor governance and corruption. So those are the vested interests or what we call “tax terrorism”. One of the issues directly related to this that has recently come up is what kind of registration and payments system are you going to have. Now it is very clear that if you are setting up this whole electronic system of collection, it should be totally digitized. What does that imply in structural terms is if we have a company ‘A’ which operates in ten different states, all that it needs to do is register once. That registration should automatically go to all those ten states. It should not be like in the old days where we had to register in every single of those ten states. The registration can always be updated and automatically sent to everyone concerned.

Q3: Following the very interesting observations that you have made, at the first meeting of the GST Council held on September 29, the Centre and states agreed to an exemption threshold of Rs20 lakh for all states, which has been set at Rs10 lakh in case of North Eastern states. The Council also adopted a cross-empowerment model for tax administration to compensate states and agreed to subsume all levies into the new tax. How do you see these developments?

A3: I gave the overall challenge, but there are specific challenges from my perspective as an economist who has worked on these issues for 15 years. And those have to do with two or three different things. One is the variation from uniformity. We talked about this broad rate. If you want to talk about the standard rate, or whatever else you may want to call it, and then there are exemptions on one side and higher rates on the other. The two challenges associated with this are always to make that standard rate as broad as possible and to minimize the two ends, so to say, the lower rate and higher rate. And the second one, which has been widely discussed in the media is to make it revenue-neutral. Now I find that a lot people are confused over the term revenue-neutral rate (RNR). Revenue-neutral always applies to things that this new tax is replacing. Just to give you an example, if liquor or petroleum is out of this system for the time being, revenue neutrality has nothing to do with that. So you are talking about the set of taxes which will go away when the GSTN is introduced from April next year and not what will happen in 2018, 2019 or 2020. That liquor part is not in the system so it’s totally irrelevant to this calculation. Similarly, as of today at least, the petroleum is not inside it. So that has no relevance to the RNR which is going to be introduced from April 01, 2017. Having said that, what is generally in transition is useful to minimize disruption. If you adopt that principle, it becomes very simple. The exemption part then is probably most efficient at this point at least as of April 01 to keep the things that are already exempt. They are two or three major ones. One is education and the other two are certain types of well-defined healthcare issues and certain government transactions. The government part I am not so sure as it is a big organization and it should be able to take it. So that government part is still an issue. I don’t know what the government and GST Council will decide. In my view, the government should pay the taxes and get the thing back as the money goes to them only. But they may decide to follow the principle that applies to private goods also to government. It’s understandable though one would prefer it to be changed. Currently, government-to-government transactions don’t pay taxes such as excise and stuff. Actually, in a proper system, all of that should be paid because you are getting the money and then you use it whatever way you want as against education and health which are private. The other issue I believe is sadly a self-created problem. I had actually recommended a uniform rate and about four or five sales taxes so that there is no higher rate. Why is higher rate a problem? Because if we collect the items that have the highest five rates they are all different. In my system that would have been easy. You take six items and to start with, you keep the same rates, with some adjustments. But now what they will have to do is make that uniform. Again, sad but feasible. The second challenge is to focus on that higher rate and to be able to take that adjustment which will then have to happen in the people who actually pay the taxes. And the third one is actually the trickiest because we are also integrating the service type of taxes with the goods type of taxes as part of this GST. And that’s actually the most difficult for the consumers so to say. What we know is that on an average the final sales tax is lower than the final goods tax. So when you have a uniform rate in the standard category, the average service tax will go up and the average goods tax will go down. But it’s not as simple as that. The goods people will also get input credit on services and service people will get all input on goods. So actually the real increase in services will be less than what appears to be so. And that’s a challenge. The challenge is to make the people understand, both the producers of the services that you are getting some rebate back so don’t charge in full. Let’s take a simple example. Let’s say the existing service tax is 12% but the revenue neutral rate is taken as 18%. In principle they would think of raising it by 6%, but they are also getting an offset. So actually if you are paying 18% to the government, you should not raise it by 6%. You should in some case raise it only by 2% to 4%. So this is the real challenge. And it really will have to be the government, industry bodies and service associations, which will have to educate producers of services who have to levy this so that they make a revenue neutral calculation. The idea of introducing is not for companies to make money but to put in place a revenue neutral rate, which over time is going to benefit everyone, including the producer, consumer and government. So these three are the specific challenges besides that overall thing which really concerns the centre and states.

Q4: Will the GST regime help in reducing production costs by eliminating cascading nature of taxes on the Infrastructure Sector?

A4: This question is easier to answer in generality than specifics. I will tell you why. All the things in the infrastructure sector which are specifically related to the good and taxable services, which we have just discussed, they actually stand to benefit. But the difficulty here is the third element. I had mentioned here certain goods like education, health and government-to-government transactions. But the construction part of the service sector is unclear. Who taxes it? What happens? To what extent it comes into the GST net? We took three challenges. This is the fourth challenge: how that comes into the GST net? But right now it’s kind of ambiguous. As things stand, it’s not clear even in the existing system. So that is where it could go either way. For some infrastructure sectors there could be a marginal increase, for others there could be effective decrease and for still others it may remain more or less the same. I don’t have any specific answer as of this point as we don’t know what will be the change on treatment of various construction services.

Q5: There seems to be a clear division within the Indian Infrastructure Sector on GST’s service tax component. While some have gone so far as to claim that it’s a negative aspect of the new tax regime others term it overall positive? What is your own take on this issue?

A5: There are two reasons why it is definitely positive. One is, as I indicated to you, having a single rate makes accounting very easy. That is why I told you, I would have preferred a single rate across the board, with a few sales taxes which separate out because the trail becomes very easy to follow. You just need two numbers: how much you bought and how much you sold, and the rate is the same. If you have three different rates, you are going to have three different channels and it becomes 3 X 3 = 9. So a single rate is actually a tremendous benefit, which is why I have long argued for it. Unfortunately, I lost the argument to my friend Vijay Kelkar who proposed this structure. It’s his committee report which is being followed. Why services benefit, as I said earlier, they don’t get this chain. Once the chain is there, then they will get the offsets also. That’s one. And it will make both export and import of services much smoother. The second reason is, in India, people have long complained that our economy is much more heavily service oriented than manufacturing oriented. What this will do is change that bias. And this is something that people are not understanding. If the effective tax rates on good, which is basically manufactured goods, goes down and services goes up, then the bias towards services will be corrected. People forget that and start complaining. They complain in one bucket and then in the other one they complain again. But these things are linked. If the tax on services goes up by as little as 2% to 4%, that’s a good thing because the structural bias towards services and against manufacturing will be corrected. This is something which people should focus on.

Q6: So how can India Inc. gear up to take advantage of this new tax regime?

A6: There are two types of people. One is those companies which are already operational across the system. If registration and other things are simplified in the manner which I have suggested, then what they will set up a much more efficient cross India structure to ultimately benefit consumers. Initially they will, of course, improve their efficiency and profitability, but over time with competition it is going to benefit consumers. Once that system is made clear by the government over the next six months, then there will be programs. It’s connected to what I said earlier. If there are hundred different rates it becomes very complicated. If you reduce it to three, including zero rate or whatever, the level of complexity goes down tremendously and it becomes easier to write these programs. You just need to enter in each requirement and everything will come out nicely. It’s a different issue for smaller firms. Initially those who are not digitized will face some difficulty, but then they stand to gain a lot in the long term. They have to make this effort now or get left out of the digital economy. The government has to communicate to them that it’s in their long term interest as the whole country and the world are going digital. There are firms who are operating on inter-state borders and for whom it was a huge effort to register in one state to other state. Let’s say you are on the Punjab-Haryana or Uttar Pradesh-Bihar border. For all such firms located on state borders it becomes easier to legally sell their goods across the border. I hope again that people are sensitized to this and the process of registration is made easy. I anticipate smaller firms, once the system is functioning smoothly, to gain significantly. And that’s good as we all keep talking about promoting small and medium sized enterprises.

 This interview on the GST regime is published in the October 2016 issue of India’s premier B2B magazine Infrastructure Today.

http://www.infrastructuretoday.co.in/News.aspx?nId=o%2FhfySjqj8UT3JqUacnrtA%3D%3D

 

Interview to Business Today on October 24, 2016

Q1: How much do you think the inflation worry is playing in the mind of the government as it decides on the GST rate? How inflationary do you think an 18% uniform GST rate would be?

A1: A revenue neutral is not inflationary at all. The inflationary concerns arise because some States are asking for much higher standard rate. The Union govt must be supported in resisting such pressure from States.

Q2: Would a four-slab GST regime be a disaster even if it is just a temporary arrangement? Do you think it would be a smooth transition to GST regime with a four-tier tax rate?

A2: The key gain from GST is the replacement of a dozen indirect taxes by I single debt. In the National VAT I had recommended there were exempted good as in GST and only one Standard rate for all other goods & services. However, I had recommended retention of few final consumer sales taxes (~6) on specific goods such as liquor, tobacco products, polluting fuels & 2-3 consumer goods like cars. This would have made monitoring of the tax set off chain much simpler. 

  The Proposed rates for GST are messier, but won't be anywhere near a disaster. There are always transition problems but I don't expect them to be surmountable given a positive attitude of tax bureaucracy.

Q3: Another issue is reaching consensus on compensation package especially when each state has already floated their loss figures? How much do you think the compensation package impact the central government's exchequer?

A3: Base for compensation has been agreed. Calculation of compensation shouldn't be a problem. The potential compensation will be calculable only after the rates & items are decided.

Q4: Do you think the idea of cess on certain goods under GST is central govt's way of ensuring that it does not face revenue shortage due to compensation to states?

A4: The center wants to impose a temporary cess to raise funds for compensation, to protect against the need for rate changes in near future. This will also ensure greater certainty for Union govt budget allocations/expenditures.

 

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