February 4, 2011

Less through the centre

Let the states tax goods and services at their own rates

In post-independence India, consumption taxes were primarily raised by direct taxation at the point of sale. But sales taxes were easy to evade, because one point in the supply chain felt the entire burden of the taxation. International best practices brought the Value-Added Tax (VAT) to India in the last decade. In a VAT system, a business pays VAT on whatever inputs it buys, but can use that VAT input as a credit against the VAT output it charges its buyers. This self-enforcing taxation allowed for a broader base, and hence lower rates. However, even post-VAT, many taxes such as excise continue to cascade downstream without input credits. Moreover, Input Tax Credits (ITCs) are not available for across-state transactions. This makes buying from within a state more beneficial than from another state, even if the two states have the exact same tax rate. Despite VAT rates being more congruent when compared to sales taxes, there is still a lack of homogeneity in rates across states.

The current Goods and Services Tax (GST) proposals aims for exactly the same tax rates across different states, ostensibly to integrate the markets. However, it is important to note that the use of information technology allows for ITCs across states even if states continue to have different tax rates (based on unique transaction IDs). An integrated market does not require a uniform tax rate across all states—the United States, European Union, China, Canada and Brazil all have an integrated market without forcing the same tax rates on all sub-national units.

The importance of fiscal federalism
Indian states cannot levy corporate and income taxes, and hence, revenue from sales tax and VAT is currently a significant part of the states’ income. With GST subsuming other indirect taxes, this ratio will only go up. However, if current proposals of GST become law, a state’s elected representatives would not be able to unilaterally cut taxes or prevent tax hikes, and therefore will have further incentives to increase spending to win votes. This will inevitably result in tighter conditionalities by the centre on spending by states and further centralise power. Welfare schemes would be homogenised even more across states, preventing healthy inter-state fiscal competition and experimentation in public policy.

A simple analogy might make it clearer—imagine 28 people going to a restaurant and sharing the bill in the ratio of their weights and hunger. They are more likely to order expensive food and frivolous deserts in this arrangement, as compared to if they all pay most of their expenses themselves. That is how state governments are likely to react—with inefficient spending, once taxation is centralised.

Fundamentally, a single GST and a dual but uniform GST are the same as far as tax incidence and incentives are concerned. As a result, states with high growth and stronger revenue bases might be forced to tax significantly more than their local spending and current horizontal redistribution needs require them to. Moreover low growth states might not be allowed to attract industries with tax reductions, and might be forced to spend more than their preferred levels.

How might these challenges be addressed?

First, the state component of the GST should be allowed to vary across states so that their autonomy can be preserved, and healthy inter-state fiscal competition can be enhanced. This proposal only needs an appropriate IT infrastructure for inter-state tax credits. Recently, Nandan Nilekani, chairman of the Unique Identification Authority of India, has been requested to help prepare such an infrastructure for the non-varying GST. The European Union, for instance, has achieved a single, efficient market while maintaining different VAT rates for its member states using the VAT Information Exchange System.

Second, there should be a fixed number of rate categories in all states to prevent favouritism and crony capitalism. By having similar tax bases and model-state GST legislations throughout the country, state politicians would not be able to offer arbitrary tax breaks. Federalism means allowing maximum flexibility in the policy of states so far as the rule of law is not violated—so any policy can be followed as long as select individuals or companies are not given undue privileges or discriminated against.

Third, to prevent excessive or destructive competition, the European Union maintains a minimum VAT rate for its member countries. To allay “tax war” fears, India could have a similar GST structure. (It is worth mentioning here that the “minimum” for American states is zero.)

Fourth, a state should tax the value-added within its own boundaries. That is, the GST reform should aim for a source-based rather than the currently recommended destination-based taxation system. A destination-based system would be unfair for states that have a “trade surplus” with other states as inputs provided by “net exporting” states would not be taxed by those states. The European Union has also moved with some success towards this from a pre-1993 exclusively “destination-based” system.

To better illustrate this, let us consider a simple case of an entrepreneur who wants to manufacture paper in West Bengal, and buys wood from Kerala at Rs 100 per unit. Let us assume that there are different GST rates in different states—say 10 percent in Kerala and 20 percent in West Bengal (adding both central and unique state rates). The trader would buy the wood for Rs 110 in Kerala post-GST, and value-add, say, Rs 40. When he sells the paper in West Bengal for 110+40+8 (Rs 8 = 20 percent of 40) at Rs 158, he would pay the West Bengal government Rs 8 in taxes. The Kerala and West Bengal governments would not have any dues to clear, but they would have to verify the transaction information—and that is where the better central database would help.

A huge economy and heterogeneous polity like India’s needs to be aware of the dangers of fiscal centralisation. The only major global economy that has had a same-rate GST or similar tax structure is Australia, and certain provinces there (such as Western Australia) are already expressing concerns about fiscal centralisation. We too can route less money through our central government—and we too will have a better standard of living as a consequence.

Harsh Gupta blogs at Swaraj India

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