India - Revenue-neutral rate for GST

One of the most crucial design elements of the Goods and Services Tax (GST), being considered by the Centre and the states for introduction in 2010, is the base of the tax and the rate at which it is to be levied.

It is now widely recognised that if its benefits are to be reaped the tax should ideally be levied at a uniform rate on virtually all goods and services in the consumer basket. A broad base permits a significant reduction in the tax rate, which, in turn, helps both enforcement and compliance.

In discussions on the GST design for India, it has been suggested that the tax would need to be levied at a combined Centre-state tax rate of 20%, of which 12% would go to the Centre and 8% to the states (vide, for example, the Kelkar Task Force Report).

While they fall below the present statutory rate of 28.5% (Cenvat of 16%, and VAT of 12.5%), GST at these rates would encounter significant consumer resistance, especially at the retail level, and would give rise to pressures for exemptions and/or lower rates for items of daily consumption.

With the notable exception of Scandinavian countries, where the tax is levied at the standard rate of 25%, few countries have been successful in levying and sustaining a VAT/GST at such high rates.

Successful GST models adopted by other countries had a very broad base and a relatively modest tax rate, especially at the time of inception. For example, the New Zealand GST was introduced at the rate of 10%, with a base consisting of virtually all goods and services with the exception of financial services. Singapore GST rate was 3% at inception, which has now been raised to 7%.

Our calculations show that if the GST were to be levied on a comprehensive base, the combined Centre-state revenue-neutral rate (RNR) need not be more than 12%. This rate would apply to all goods and services, with the exception of motor fuels which would continue to attract a supplementary levy to maintain the total revenue yield at their current levels.

Here are some basic ingredients of the RNR calculations for 2005-06, the latest year for which the necessary data are available. The total excise/service tax/ VAT/sales tax revenues of the Centre and the states in that year were Rs 134 thousand crore and Rs 139 thousand crore respectively.

Assuming that approximately 40% of the central excise revenues and 20% of the state VAT/sales tax revenues are from motor fuels, the balance of the revenues from other goods and services that need to be replaced by the GST are Rs 89 thousand crore for the Centre and Rs 111 thousand crore for the states, making up a total of Rs 200 thousand crore.

In 2005-06, the total private consumer expenditure on all goods and services was Rs 2,072 thousand crore at current market prices. Making adjustments for sales and excise taxes included in these values and for the private consumption expenditure on motor fuels, the total tax base (at pre-tax prices) for all other goods and services is Rs 1,763 thousand crore.

These values yield a revenue-neutral GST rate of approximately 11% (200 as per cent of 1,763 is 11.3%). The RNR for the Centre is 5% and for the states 6.3%. Allowing for some leakages, the combined RNR could be in the range of 12%. These estimates are by no means precise. Even so, they give a broad idea of the levels at which the rate or rates of GST could be set to achieve revenue neutrality for both levels of government.

A remarkable insight emanating from this exercise is that a relatively low rate of tax can yield the same amount of revenue as now if the base is comprehensive enough. Further, contrary to widespread impressions, it is the states, not the Centre, which would command the dominant share in GST revenues if one goes strictly by the norm of revenue neutrality at both levels.

It is pertinent to ask in this context whether it is practical or politically feasible to apply GST to a comprehensive base of all consumer expenditures. The GST is being applied in several international jurisdictions in such a manner. This fact alone should suffice to convince the sceptics of its feasibility from both technical and political perspectives.

The GST is being levied in one form or the other in over 130 countries. Their experience suggests that the GST can function in a reasonably satisfactory manner in developed and developing countries alike.

The key to its success is the simplicity of its design. If levied at a single rate on a comprehensive base, it does not require much sophistication on the part of tax administration or taxpayers. Besides simplicity of design, the tax rate also has to be kept low to bring about a tangible improvement in tax compliance.

There would undoubtedly be political arguments for leaving out of the tax base essentials like food, medicines, and clothing. International experience suggests that exemptions from GST are not an effective or efficient means of assisting those in need.

The benefit of an exemption is proportional to amounts spent on exempt items. Exemptions thus benefit upper-income families more simply because of their larger spending power. These arguments were persuasive in New Zealand in keeping the base broad. In Japan and Singapore, no groups were successful in making a convincing case for exemptions from a tax levied at 3%.

The RNR would, of course, go up if essentials like unprocessed food are left out of the base or taxed at a concessional rate. Assuming that, as the national accounts data show, food constitutes about one-third of the total consumption, the RNR of 12% jumps to 18% if food is totally exempted, and to about 16% if food is taxed at 5%. The RNR rates would be even higher if the preferential treatment were to be extended to other essentials like medicines and clothing.

Tax reforms entail hard choices to be made, which should be based on long-term considerations of nation-building, rather than narrow parochial interests or issues of the day. A tax at 20% with limited base broadening would not serve the needs of fundamental tax reform like GST.