The introduction of the Goods and Services tax (GST) is being looked upon as the single most important change in tax policy proposed in modern India. It is more than a decade since the proposal was first mooted. The latest budget statement indicates that it may be implemented soon-perhaps in the next financial year.
The benefits of GST are many and have been well documented. Key among them is the removal of cascading tax, and the creation of a single uniform tax rate across the country. However, one benefit that is often held out as a reason for GST is lower tax evasion. As we will see, this is not self-evident.
The experience and the theory
In 1993, the Canadian Tax Journal published a study by Peter Spiro titled, "Evidence of Post-GST increase in the underground economy". The paper concludes; "there has been a substantial increase in the underground economy since the introduction of GST… the empirical results imply that the shift towards underground activity caused tax revenue loss of roughly $2.3bn at all levels of government in 1992".
This is in direct contradiction with the statement "as the (input tax) credit chain will function only if all the transactions are recorded, GST environment would lead to improved disclosure of economic transactions"-a part of the Standing Committee of Finance report of the fifteenth Lok Sabha dated August 2013.
Why is it that the theory-as laid out in the standing committee report-at significant variance to the observed data? Let us look at the way GST operates.
Nature of GST
GST is a consumption tax. Taxes are levied and paid at each stage of the production and distribution of goods and services. However, the tax paid at one stage can be set off against the tax liability at a subsequent stage so that in effect, the entire tax is paid by the final consumer. This set-off of "input tax" is possible only if each part of the chain reports the transactions. Therefore, it will make no sense for any subsequent buyer to purchase from a non-GST registered supplier since the tax upto that stage is not available for set-off. This is supposed to bring the entire economic activity above the ground.
Since taxes are supposed to be charged at a single rate across all services and goods, and all input taxes are fungible and can offset output taxes, the theory suggests that compliance would increase because
(a) The uniform tax would be lower than corresponding rates charged currently
(b) The set-off is available against all types of input tax-as opposed to the current situation where central taxes like CENVAT are not available for set-off against state VAT. The effective tax rate will fall, triggering greater economic activity and providing buoyancy to tax revenues. This would also encourage people to offer their income for tax.
Who believes the government?
This argument is flawed on several counts. First, even if the initial tax rate is low (the current proposal is to have a 6 per cent Central GST and a 7 per cent State GST) it may not induce compliant behaviour beyond a point. In fact a very interesting study by Giles 1998 "Minimizing the size of government" shows that while there is a positive and causal relation between tax revenues and the size of the hidden economy, over one half of the hidden economy is unresponsive to changes in tax rates. In other words, even with near zero taxes, approximately 5 per cent of the economy would remain in cash.
Presumably, this happens because of the convenience of using cash in several transactions. It also perhaps reflects citizens' disbelief in the promise of low tax rates being sustained.
Full recovery of input credit on part sale
No business usually operates totally underground. Leakage in a tax system happens due to underreporting of revenues, not non-reporting. An example will make this clear. Suppose a manufacturer sells goods at `100 with a GST of 13 per cent (`13). Additionally, suppose the inputs used in manufacturing cost `50 with a corresponding GST of `6.5. Only 50 per cent of sales have to be invoiced to allow full recovery of input credit. In other words, if the manufacturer was to sell say 10% of his output without an invoice, there would be no loss of input credit. The subsequent supply chain can sell to the final consumer without GST.
This currently is not possible since excise is levied at the point of despatch from the factory and cannot be set off against VAT levied by the state. What this implies is that cost of ensuring compliance can go up substantially since the number of small businesses that may need to be audited by the taxman can rise by a factor of hundred compared to the audit currently required.
Benefits are many
The benefits of GST far outweigh the negatives. If implemented properly, it could reduce inflation, improve price competitiveness of exports and provide support against imports. It also removes tax arbitrage as a reason for setting up production units and eliminates benefits associated with export promotion zones. In sum, GST is a significant improvement on the current system-just don't expect it to remove world hunger.
Anand Tandon is an independent analyst.
This column appeared in the August 2014 Issue of Wealth Insight.