How direct tax reform can help create the room for a single, moderate GST rate.

There are several reasons why this newspaper has been an enthusiastic supporter of the goods and services tax (GST). It will integrate the Indian market, promote economic efficiency by taxing final consumption rather than intermediate goods, encourage voluntary compliance and create a new architecture for cooperative federalism.

There were two underlying assumptions for a truly successful GST. The new indirect tax would be levied at a single rate (with a few exceptions) so as to reduce distortions based on rent-seeking behaviour. And the tax rate would be low so as to minimize the regressive character of such indirect taxes, including the ones that GST is replacing. India seems to be drifting away from the goal of a single, moderate GST rate.

The news coming from the meeting of the GST council last week is thus far from encouraging. It seems that India is moving to a multiplicity of rates, with a cess thrown in for good measure. And it is likely that India is going to end up with a relatively high GST rate. This is in stark contrast to the idea of a flawless GST that was proposed in the December 2009 report of a task force headed by Arbind Modi, who was then in the finance ministry, and the 12% rate recommended by the Thirteenth Finance Commission.

The stalemate in the GST council was expected. It was always unlikely that the complex federal bargaining would be over in three days. There are many months of negotiations ahead. What is worrying is the direction these negotiations are taking, rather than the time needed to strike a deal. The political class is quite naturally worried that a low GST rate will hurt budgetary revenue. Further, an increase in the prices of items of mass consumption could lead to a political backlash, hence the multiple slabs rather than a single rate.

The states would do well to consider two factors in their calculations. First, they can take the risk of beginning with a low GST rate since any potential revenue losses are to be compensated by New Delhi for five years, so there is insurance against the downside. Second, they have agreed to shift to GST based on the assumption that the new tax will both increase the existing tax base as well as give the economy extra momentum, which will make a lower tax rate possible. The state finance ministers are currently taking a static rather than a dynamic view of indirect tax collections under GST.

The issue of the GST rate actually needs to be seen in tandem with the broader issue of tax reform. What is happening now is the overhaul of the indirect tax system. The direct tax system has not been touched as yet. A lot of preparatory work had already been done by the finance ministry under P. Chidambaram on a new direct tax code, which was then inexplicably shelved. Its promise was similar to that of GST—low rates, minimal exemptions and a wider tax base. Higher direct tax collections will create fiscal space for India to experiment with a lower GST rate.

India began to reform its tax system in 1991 when almost nine out of every 10 rupees flowing into the national treasury came from indirect taxes rather than direct taxes. One of the explicit goals of economic reforms was to raise the contribution of direct taxes in the total kitty. There was good reason to do so. Most large economies depend more on direct taxes because they are progressive while indirect taxes are regressive. One of the many hypocrisies of Indian socialism was that it was built on one of the most regressive tax systems in the world.

The 1991 tax reforms did succeed. The year 2009 was an important milestone, when direct taxes overtook indirect taxes in the central kitty. The balance has since been reversed, partly because of the drop in corporate tax collections in the subsequent industrial slowdown as well as the increase in fuel taxes over the past two years. The tax system has become more regressive, as we had pointed out in these columns a year ago.

Lower direct tax collections mean there is pressure to collect more indirect taxes. The problem of a high GST rate can be traced to this underlying problem with the direct tax system. A more dynamic view is needed. The growth dividend from GST will ensure that total tax collections are not harmed despite a lower tax rate. And a renewed push for direct tax reforms should ideally create fiscal space for a lower GST rate.

The upshot: The debate on the GST rate needs to be framed against the larger issue of tax reforms if India is to avoid a messy transition to the new tax.