India’s Far-Reaching Tax Reform

This article was first published in GARP Risk Intelligence on March 02, 2018; Co-author: Anisha Sircar and Nitya Bodavala

http://www.garp.org/#!/risk-intelligence/market/financial-markets/a1Z1W000003Q23JUAS

The objectives of the Goods and Services Tax are clearly stated, but the implementation is complicated

On July 1, 2017, the Indian economy experienced its second historical policy overhaul in under 12 months (demonetization being the first). The Goods and Services Tax (GST), the most dramatic tax reform in the country since 1947, had been under way in parliamentary dialogues for almost a decade – in contrast to the sudden implementation of demonetization. 

Seeking to unify many central and state taxes and streamline the existing indirect tax system, GST had ambitious goals mapped out for the country’s economy.

The potential positives of GST have been well-touted: the common tax system will reduce the incidence of double taxation, lower business costs across sectors, bring India’s informal sector into the mainstream, and increase exports, benefiting the overall fiscal health of the country.

But there are several issues related to the implementation of the GST, among them: reliability of the information technology, documentation hassles, potential revenue losses, and an abstruse anti-profiteering clause.

What is GST?

The Constitution Amendment Bill for Goods and Services (GST) was passed on August 3, 2016 by the Rajya Sabha, upper house of the Parliament. A single, uniform tax levied across India, on all goods and services, GST was proposed to sew together a common market by removing fiscal barriers between states. 

It was anticipated that India’s tax structure would become more comprehensive, a common market would develop, and the cascading effects of multiple indirect taxes on the movement of goods and services would be reduced.

In theory, GST is simple. The government charges a series of indirect taxes (alongside direct taxes) to raise revenue for public expenditure. Under GST, at least ten types of “indirect taxes” are subsumed under a single system, putting an end to the hitherto several levels of taxes levied on commodities as they move through the production cycle. Taxes under the system are collected on a “value-addition” basis, at each stage of sale or purchase in the supply chain.

Impact on the Economy

GST is viewed as a game-changing reform because it impacts the structure, incidence, computation, payment, and compliance of indirect taxes, as well as credit utilization and reporting. 

Its main purpose was to eliminate the compounding effect by combining central and state indirect taxes and fixing a final tax rate, where all goods and services would fall into five distinct tax categories, and where value-added tax laws did not differ across states, thus making it less problematic for both the producer as well as consumer at each stage of in the supply chain.

Before, myriad taxes were applied at the central and state levels. After the implementation of GST, only three types of taxes are applied:

• Central Goods and Services Tax (CGST), levied by the center on intra-state supply.
• State Goods and Services Tax (SGST), levied by the state on intra-state supply.
• Integrated Goods and Services Tax (IGST), levied on goods and services for intercourse trade or commerce, imports, and exports.

Under the new system, transactions have “slabs” of tax rates, depending on the nature of the good or service. All items, ranging from agricultural and necessity goods to luxury goods and consumer durables are categorized in the five major tax slabs of 0%, 5%, 12%, 18%, and 28%. The range is from zero on items deemed as essential or necessity, 28% on goods deemed as luxury.

‘Level Playing Field’

With this system replacing the multiple-tax structure, a more uniform regime has been implemented, state-specific advantages and disadvantages are set to diminish (because smaller businesses now get to make higher profit margins, and offer lower prices than their competitors, thus “leveling the playing field”). 
The average costs of goods and services across the country are reduced with the elimination of double taxation; inflation may decrease in high-productivity categories; and commodities can easily move across the country, with reduced transaction costs and transportation inefficiencies for businesses.

An ancillary benefit is that the threshold for companies exempt from paying indirect taxes has been reduced from Rs. 15 million to Rs. 1 to 2 million, depending on the location of the company, thereby attempting to bring the informal sector into the fold of the formal sector of the economy.

Further, taxes paid by the consumer are not only structurally straightforward and transparent (as opposed to a slew of overlapping and elusive taxes), but the final tax itself is set to reduce, thereby having a positive effect on consumption and boosting the economy at large. In this way, the simplicity of the tax structure appears set to bring about greater tax compliance, increasing the tax base and, in turn, revenue for the government.

With an overall decrease in production costs, and with GST not levied on exported goods and services, India’s international competitiveness is expected to increase.

From a macroeconomic perspective, then, the long-term impact of GST on the economy seems favourable: improving efficiency, widening the tax base, narrowing the gap between the informal and formal sector, and increasing overall fiscal health.

Technology and Other Challenges

One of the hallmarks of this tax reform is the introduction of the Goods and Services Tax Network (GSTN), which records all GST transactions and is supposed to be conducive to seamless documentation, debit recording, and credit disposal.

However, a lack of timely migration into the network can be detrimental to the viability of the tax program, because the IT infrastructure is the only means to track and implement the new system.

Also, verifying and legitimizing the data provided online is a mammoth task, given its estimated 70 million users. Because GSTN has refused the Comptroller and Auditor General of India access, citing its “private entry status,” there is little scope for auditing the authenticity of GSTN information, which could compromise public trust.

Additionally, particularly in the short-term, small and medium-size businesses are facing difficulties in integrating and transitioning to the new system, in terms of cumbersome documentation requirements, complex and unaudited IT systems, and adapting to the new taxation on their businesses. 

There have been day-to-day business disruptions and revenue losses during the transition phase. And lower thresholds for tax exemption imply that a manufacturer, service provider, or retailer who did not face a tax levy, will now enter the GST network, which could increase their costs.

The fundamental drawback with the tax code is that the onus is placed on the purchaser, who is responsible for filing all documentation on behalf of the supplier, in order to acquire input tax credit. Problems could arise if inconsistencies are found in suppliers’ documentation at later stages, in which case the buyer would end up having to pay for not only his/her share of tax, but also for the supplier’s share – or be forced to pay back the tax reimbursement to the government with interest. 

This problem could be fixed in the long run by market forces, which ensure non-compliant suppliers lose out on customers; and by a government mechanism to allow customers to pinpoint such defaulters, which is expected to take effect in the future.

Finally, the anti-profiteering clause requires that businesses pass on any benefits of the changes to the final consumer. However, because of ambiguity in the framing of this clause, firms might be affected as tax authorities will be given the leeway to make arbitrary judgments about whether a business is engaged in profiteering or not.

 Simultaneously, consumers will be affected because of the lack of transparency in the ruling, giving rise to fears that political connections or corrupt practices will affect these judgments. Again, this ties in to a compromise in the public confidence in GST – a fundamental determinant of the success or failure of the new tax regime.

Course Corrections

The GST Council, empowered to oversee tax rates and regulations, and composed of finance ministers from the states and center, has been meeting monthly to take stock and propose alterations with respect to the implementation of GST. The council has lowered the rates on several items to help distressed industries and eased the burden of compliance in response to problems faced by traders. The deadline for firms to file their forms was also extended, which was welcomed as a huge relief for businesses.

While these are welcome alterations, several issues remain unaddressed. The GST system is expected to span the country by April 2018. It remains unclear how inter-state business interactions will be impacted, and industries have good reason to worry about extant as well as fresh complications. 

But amidst the flurry of documentation requirements, IT adjustments, and anti-profiteering provisions, it would bode best for the government to work to bring more clarity to the remaining grey areas and instill a stronger sense of confidence, for both producers and consumers, in the theoretically promising policy endeavor. Most strikingly, the issues surrounding GSTN and auditing the complex IT infrastructure remain a fundamental barrier to all-important public confidence.

If implemented correctly, the outcomes from the reform will reflect its much-needed economic rationale. Eliminating double taxation and multiple tax hassles, increasing efficiency, assimilating the informal sector, lowering transaction costs and product prices, and intra- and inter-state movement of goods and services could be overwhelmingly positive boosts for Indian markets.

 Perhaps with a committee to oversee complaints, a more comprehensive auditing system, more specific delineation of what is “anti-profiteering,” and more widespread educational efforts, much-needed corporate and public confidence in GST could be instilled.