Opinion: GST, Historical Tax Reform, At 5 Years, Has Lost Its Way

Five years ago, India's federal and state governments struck a historic deal. From July 1, 2017, a uniform tax on goods and services - marketed by Prime Minister Narendra Modi as "One Nation, One Tax, One Market" - replaced a bewildering array of local sales and entry levies. But the many compromises that were struck to bring more than 1 billion people living in 29 states on board are impairing the groundbreaking reform.

At first glance, nothing seems terribly out of place. After years of pulling in 1 trillion rupees ($13 billion) a month or less, GST collections nowadays are consistently 50% higher. The technology has stabilized. Uniform taxation across the country has gone a long way toward making India a common market; logistics and e-commerce have benefited; apart from checking evasion, real-time data on supply chains promises to help small firms access cheap financing. Yet, for all its apparent success, the GST is out of fuel - or more accurately, fuels are out of its purview. As a result, high indirect taxes continue to overburden consumers and producers and hurt competitiveness. States' support will be required for fresh reform, but subnational governments controlled by opposition parties fear that New Delhi will shortchange them.

Chances of a bold fix appear slim. Instead of fresh thinking, what's coming out of the GST Council - a constitutionally established joint forum of federal and state authorities  - is ad hoc incrementalism. Take, for instance, the council's latest recommendation to impose a 5% levy on hospital beds that cost more than 5,000 rupees a day. Hospitals can't offset this tax against any GST they already pay on inputs going into treatments. Which means they will have to pass on the extra burden to patients, including those with Covid-19.

At a time when consumers are already squeezed by high inflation, making them pony up more for medical emergencies smacks of overreach. Besides, this isn't even a GST, except in name. As economist Vijay Kelkar and others point out, the simple theory that "works wonders in other tax jurisdictions" is that a value-added tax must allow businesses to claim input-tax credit on most of the goods and services they procure along the way. The Indian reality is very different. Airlines can't get credit for the taxes built into jet fuel because most petroleum products aren't covered by GST. Nor is electricity, an input for every industry. Completed real-estate, a cesspool of tax evasion, is similarly left out. "An end-to-end tracking of the money involved, right from the land owner to the sand supplier to the interior decorator is necessary to plug rampant tax leakage," Kelkar and his co-authors note in their November 2021 paper, optimistically titled as "Moving Towards A World-Class GST." 

A world-class GST can't possibly operate with five different rates: 5%, 12%, 18% and 28%, besides zero for unpackaged food. Luxury cars, which fall in the highest bracket, are charged a further "sin" tax that puts half the purchase price of a sports utility vehicle in the government's pocket. Carmakers have complained bitterly about being clubbed with cigarettes. But the sin taxes helped New Delhi run a "compensation" fund, which effectively guaranteed states annual 14% revenue growth for the first five years under GST. This was deal-clincher, as it persuaded states to forgo most of their own taxes. Those five years have just ended. But because the pandemic had depleted the fund in its final two years - forcing New Delhi to borrow to keep its pledge - cars might have to remain super-expensive until the debt has been repaid by March 2026.  

The end of compensation, however, doesn't mean fiscal self-sufficiency. During the past three financial years, only one large Indian state - Odisha - recorded more than 14% annual growth in its GST collection. Four other states chalked up growth rates of between 10% and 14%, while 16 others saw single-digit expansion. Uttarakhand, which relies on tourism in its hill resorts, witnessed a decline. It is, for this reason, that "compensation has become such an important source of revenue for states," says Indian Ratings and Research, a unit of Fitch Ratings Ltd. "Without it, the GST revenue growth of most states will not reach 14%." 

That makes now the perfect time for Team Modi to negotiate a new bargain, one that will give states a reasonable assurance in exchange for broadening the GST to include alcohol, gasoline, diesel, jet fuel, electricity and real estate. Three industries with long supply chains - textiles, automotive and property construction - will get the boost to create much-needed jobs. More so, if the revamped tax junks three out of the five rates, and become a true, value-added levy: Businesses paying GST should be able to claim maximum credit on inputs. 

The current inflationary environment is shoring up tax collections and breeding complacency. GST for May, collected last month, jumped an impressive 56% from a year earlier to 1.45 trillion rupees. Some of this growth is an optical illusion: May 2021 was especially bad month for consumption in India because of a massive outbreak of the delta variant. Beyond the temporary boom, however, there is simmering unease in states like Tamil Nadu, Kerala and West Bengal, where Modi's Bharatiya Janata Party is not in power. At present, GST collections are shared equally between New Delhi and the states. But the latter want the split to be tweaked in their favor if there's to be no further compensation from "sin" taxes, which until recently were set aside entirely for them.

The discontent runs deeper than bickering over a formula. A consumption tax is, by definition, regressive: It hurts the poor more than the rich. Overreliance on GST has reached the point that even the fee that banks charge for a new checkbook will now be taxed at 18%. Meanwhile, direct taxes on corporate profit have been slashed by the Modi government. Opposition politicians that want to get re-elected on the basis of pro-poor policies are finding that their hands are tied. Since GST is highly correlated with gross domestic product, more than half of a state's own tax revenue is on autopilot. If they give up levies on alcohol, electricity, gasoline and diesel, they will lose control over another one-third. "You've effectively turned states into municipalities," Tamil Nadu's Finance Minister Palanivel Thiaga Rajan, a former Wall Street banker, recently told the Hindustan Times. 

This is when municipalities in India need their own separate fiscal bargain to speed up urbanization minus pollution and squalor. According to Kelkar and his co-authors, a revamped Indian GST, its remit broadened, could stabilize at 14% - 6% for New Delhi; 6% for states and 2% straight to civic administrations. But this will weaken Modi's near-monopolistic grip on the vote-grabbing potential of welfare projects. That's perhaps the No. 1 reason why the prospects of another big-bang reform of India's indirect taxes are practically nonexistent.

(Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.)

Disclaimer: These are the personal opinions of the author.