June 21, 2013

Taxing poorly with LBT

The Local Bodies Taxes levied in Maharashtra is poorly planned and designed. It ignores the lessons learnt from tax reform experiences.

Maharashtra plans to complete the process of replacing the Octroi, a tax levied on goods as they enter a city (or a designated area), with Local Bodies Tax (LBT) by the end of 2013. Nearly all 26 municipalities of the State have already introduced LBT without serious public debate or dialogue. Its proposed introduction in Mumbai from October 2013 has however led to widespread protests by traders and other businesspersons. The resulting public debate has provided an opportunity to examine whether the decision to introduce LBT is consistent with India’s national priorities, and with the lessons learnt from tax reform experiences in India and elsewhere.


Maharashtra introduced Octroi tax in 1965, and has become the last State in the country to abolish it. Over time, the Octroi became a prominent source of revenue for the municipalities. Thus in 2012-13 (Budget Estimates), Octroi contributed 38 percent of total revenue of Mumbai amounting to Rs20,473 crores. The other major source of revenue was the Property Tax (about 20 percent). Pune exhibited a similar revenue composition pattern. While its revenue significance at the local level is high, it is relatively small in relation to the state government revenue. Thus, the combined revenue from Octroi of all the municipalities of Maharashtra was around one-eighth of the total revenue receipts of the state in 2012-13. In contrast, various taxes assessed over the years by the state but not realised were equivalent to about a fifth of the State’s revenue, and nearly a quarter of the state’s Gross Domestic Product in 2010-11. However, only about a third of assessed taxes are not under dispute, and therefore more likely to be actually realised.

The above nevertheless suggests potential for raising substantial additional revenue by the state by modernising tax laws, administration and compliance mechanisms. As there are policy options at the state-level for replacing the revenue currently generated by the Octroi, its replacement need not be at the local level.

Several states, including Gujarat, have used a combination of state-level levies (for example VAT and entertainment tax) and non-tax measures, such as giving greater revenue raising powers to local bodies, to compensate the municipalities for the loss of revenue from Octroi. There are also options for encouraging the cities to acquire competencies in obtaining revenue from monetising land assets, greater collection efficiency of property taxes and user charges, and accessing municipal bond markets. These are more consistent with India’s growth strategy and with the urbanisation challenges facing the country than the Octroi or the LBT.

The Thirteenth Finance Commission had argued that a specified proportion of revenue generated from the proposed Goods and Services Tax (GST) could be directly made available to the cities for strengthening their fiscal positions. This is a sound proposal seriously meriting consideration as GST deliberations progress nationally.

The Octroi, dating back to the Roman Empire, has rightly been criticised as a grossly distortionary, inefficient and inequitable tax, with significant administration and compliance costs, and for providing opportunities for leakages, undermining an environment conducive for greater voluntary compliance. Rent seeking channels from Octroi tax have become established and have been a major political economy constraint in replacing it.

Its replacement therefore should not only minimise the above undesirable features of Octroi, but also be consistent with India’s aim to establish a unified internal market, minimising ease and costs of doing business along with addressing the rent seeking proclavities across the whole country. The analysis of Maharashtra’s choice of LBT to replace Octroi however suggests that it does not meet these requirements and therefore the lessons of sound tax design and efficient administration have not been learnt.

The LBT is designed by the state, but is administered at the local level. Unlike Octroi, which requires entry-exit points requiring time consuming physical checks, LBT is an account based tax, levied on consumption, use, or sale inside the tax jurisdiction. These terms are difficult to define and administer in a consistent and non-discretionary manner. The use of such terms as ‘goods’, ‘dealer’, ‘business’, which also contain ambiguities, accentuate administration and compliance costs of the LBT.

The skill-sets and work-processing infrastructure needed for the LBT– an account based tax and Octroi are different. It appears that implementation of LBT has been characterised by insufficient manpower training and development of requisite skill sets. As each city will administer its own LBT, the hardware and software needed may not provide sufficient scale economies, raising transaction costs. Implementation of the shared services concept under which certain services (such as computer and software systems) are provided at a centralised level (in this case the state level) could address this limitation.

The LBT is levied on final goods, intermediate goods or inputs, whether for consumption, trading or production, and whether new or used. The rate structure of the LBT is quite complex, involving large number of rates. Items on which LBT is to be levied and the respective rates are stated in detail; and so is a long list of exempted items. This represents a throw-back to the 1960s, when India was not integrated with the world economy, and when reliance on administered mechanisms rather than markets was common. Such a rate structure also assumes a static rather than dynamic economy, an assumption inconsistent with India’s economic size reflected in 2011 GDP of $1.9 trillion, and international trade in goods and services of $1.1 trillion.

Unlike the Value-Added Tax (VAT), the LBT cannot be credited against the output tax. Therefore, it has what is known as cascading effects, i.e. tax is also levied on tax previously paid, thereby accentuating the impact on final price. As LBT jurisdiction is relatively small, a particular set of goods passing through multiple LBT jurisdictions could be taxed several times, creating multiple effective tax rates i.e. the LBT amount assessed on a good divided by its retail price.

As the LBT is levied on inputs and on mass consumption items, it could reduce real household income of aam aadmi, disproportionately burdening bottom half of the population. This effect will hold even if LBT yields revenue equal to Octroi, as its effect will not be fully reversed when LBT is levied. The LBT is levied on goods, not on services. This burdens the lower half of the income group as share of expenditure on services has a tendency to rise with income. The LBT will make it more difficult for Maharashtra’s cities to continue to retain and form new businesses, especially small and medium enterprises generating most of the urban livelihoods.

A 2013 Ernst & Young report on Managing Indirect Taxes in rapid-growth markets has argued that minimising transactions and compliance costs of indirect taxes are conducive to operations of global firms. As Maharashtra is a major location for both domestic and foreign firms with global operations, the LBT will also have an impact on their operations. India’s rank in global Doing Business Index was 132 (out of 185 economies) in 2013; while its ranking in paying taxes deteriorated from 149 in 2012 to 152 in 2013. Among the city rankings, Mumbai ranked tenth out of 17 cities in 2009.

This is of critical significance as creation of livelihoods has substantially lagged behind new job entrants. A paper by the Institute of Applied Manpower Research (IAMR), a think tank attached to the Planning Commission, reported that employment in the five year period ending 2009-10 grew by only one million, while each year entrants to labour force number 12 million. More recent data are also likely to exhibit livelihood creation falling significantly behind new entrants. There are also indications, reflected in increasing number of casual workers and negative growth in self-employed, that the quality of jobs has also been declining. The LBT is thus not conducive to generating more livelihoods which are productive and sustainable.

A major drawback of the LBT is that it is not consistent with objectives of the GST, which are to create an internal unified market by taxing goods and services in an integrated manner, and to reduce transaction and compliance costs associated with a sales tax. The LBT will create artificial tax barriers within the state, and give states with no LBT a potential advantage.

The VAT infrastructure in Maharashtra is fairly well developed, and its Sales Tax Department will also be administering state level GST. Using modifications in VAT (GST) rates to replace the Octroi rather than levying LBT therefore merits serious consideration. This requires coordination between the Finance Department in charge of VAT and the Urban Development wing, a task that is the responsibility of the political leadership. The lack of professionalism and low level of economic literacy evident in the choice of LBT to replace Octroi, and in the design and administration of LBT will further detract from Maharashtra’s ability to improve business climate, and assist the aam aadmi cope with rising cost of living.

The above analysis of Maharashtra’s LBT strongly suggests that without much greater professionalism in planning and designing resource mobilisation policies, and without incorporating requisite economic reasoning into them, India’s urban financing challenges will not be met. It is time to insist that such neglect be brought into political and public policy debates, and has electoral consequences.

Photo: Meena Kadri

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