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November 12, 2009

PROPOSED GST IN INDIA:


TOWARDS A MORE EFFICIENT TAX REGIME

The release of the discussion paper on the Goods and Services tax (GST) by the
empowered group of ministers on November 10th is the first step in the process of
setting up a formal system to introduce a uniform and harmonized system of indirect
taxation across the country. While the discussion paper is underlined by significant
lacunae, it contains in it a broad direction for the rationalization of government
finances. The ultimate implementation of GST would lead to greater revenues and
consequently aid more prudent fiscal management while spurring economic growth.

Basics of GST:

The Goods and services tax is a uniform indirect tax levied on all goods and services
produced in the country and all goods and services imported from abroad. GST will
be a single uniform indirect tax which will treat India as one market. It will replace
all Central and state indirect taxes like CENVAT, excise, customs, VAT, state excise,
etc. The GST will enable a benefit to the economy from a fall in product prices, a
single price of a product across the country, lower working capital for companies and
a more simplified tax system. The basic features of GST as explained in the
discussion paper are as follows:
 There is a dual system of taxation at state level and the central level. The
dual system is for essential goods and services and standard goods and
services. At the states level the GST would replace VAT, entertainment tax,
luxury tax, taxes on lottery, betting and gambling, state cesses and
surcharges, entry tax levied in lieu of octroi. The central taxes to be replaced
include service tax, excise duty, additional excise and customs duties,
countervailing duty, surcharge and cesses.
 There also is a separate categorization of precious metals and a list of
exempted items.
 The centre would impose an Integrated Goods and Services tax (IGST) which
would be a composite Central and state goods and services tax (CGST and
SGST).

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 Both CGST and SGST will be levied on imports of goods and services. Exports
would be zero rated.
 The system provides for a system of input credits in line with the earlier Vat
system to smoothen out any losses arising to the producer from possible
multiple taxation.

Rationale for GST


Governments obtain their tax revenues either from direct taxes like income taxes,
wealth tax, corporate tax, etc and indirect taxes like customs, excise duties, services
taxes, VAT, etc. An ideal indirect tax system is said to have at least five attributes.
Firstly, it should generally follow a system of low tax rate and broad base or a low
tax rate would link to greater voluntary compliance a la the laffer curve. Also, the
transaction costs to the tax payer should not be sufficiently high so as to act as a
disincentive and administrative costs should not be large enough to add a fiscal
burden. Secondly, it should be neutral in the sense that it should not inherently
distort a flow of resources towards particular sectors or between services and
commodity segments. Thirdly, the tax should be easy to understand and levied only
at one particular point preferably at every stage of the production process. Fourthly,
it should be aiding the formation of a common market ie it should be harmonious
and neutral across regions of the same country.

In this background, the Indian system of taxation is underlined by significant


lacunae. . There are multiple taxes on commodities and services at the central and
state level including excise, CENVAT, central and state sales tax (VAT), etc. Moreover
a system of exemptions and multiple rates are glaring in several cases, especially the
CENVAT and service tax levied at the central level. Tax rates also vary state-wise.
Hence the tax system is cascading in nature with a strong distortionary bias. Also the
diverse nature of taxes not only increases the transaction costs for the income tax
payer but increases the effective tax rate thus acting as a strong disincentive besides
having the same commodity being taxes multiple times.

The Goods and Services tax is an attempt to introduce a harmonized unified tax
system on consumption of all goods and services produced or imported into the
country.

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Sion East, Mumbai – 400 022. INDIA Tel # 022 6754 3456 Fax # 6754 3457

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The discussion paper: issues and challenges

Despite forming a positive step, the discussion paper leaves out some crucial issues.
Firstly a definitive framework for services has not yet been delineated. Important
sectors like real estate, oil and gas have been kept out of the scope. Moreover issues
continue to underline the integrated goods and services tax in the case of flow of
products across multiple states. Moreover while small traders have been exempted,
the criteria to be adopted may differ across state which may again go against the
rationale for a harmonious tax system. Also ambiguity exists in the nature of the
exempted list.

The way ahead:


The fact that all states have agreed to a uniform system of indirect taxation in
principle is a key positive. However, it appears that sharp differences continue to
exist between states regarding the contours of GST. Some states like Tamil Nadu
have proposed a floor rate based system as a measure to introduce flexibility.
Moreover the omission of items in the exempted list and delineated guidelines for
services does indicate that consensus still eludes significant facets. Moreover,
substantial amount of taxes remain outside the GST ambit, especially the one’s
levied by municipal corporations like octori, entertainment tax, etc. While the draft
constitutional amendment is proposed to be ready by November end, the actual
process of passage of legislation and its implementation will be long drawn. The
issue of compensation for revenue loss and subsuming of state taxes continues to
have a few standouts. In this background the April 1, 2010 deadline announced by
the finance minister appears to be difficult to achieve.

Implications for Public finances:

Despite its lacunae, GST should contribute to a greater stability in revenue sources of
state and central governments. It may be pointed out that the overall effect of Value
Added Tax (VAT) the first step towards a value added tax taken in 2005, has been
positive for states. Despite the provision of a system of compensation for revenue
loss, a majority of states have not availed of these. In 2007-08 for example, taxes

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Sion East, Mumbai – 400 022. INDIA Tel # 022 6754 3456 Fax # 6754 3457

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on VAT related items for 33 states/Union Territories which had implemented the
system increased by 24 per cent y-o-y. And provisional figures for 2008-09 (April-
December) indicate the growth in these as 19.1 per cent despite the onset of
recessionary pressures on public revenues. Hence, despite a mixed impact as
regards extent of benefit across states, overall the VAT system has provided a more
stable system of taxation. A more rationalized system would hence help in improving
revenue buoyancy in Central and state government revenue receipts which would
contribute to fiscal management.

Implications for the Macro-economy:

The greatest impact of the implementation of the GST would be in the creation of a
unified market for goods and services produced domestically and imported into the
country. In the absence of significant fiscal options, incentivized policy to attract
investors to states would shift to greater emphasis on structural reforms and
macroeconomic policy as also investments in human resource development. In short
investment attractiveness will become more linked to general economic environment
in a particular state.
Finally a more rational tax system would lead to lesser disruptions to the market
economy and more efficient distribution of resources within industry.

Analyst Contact
Name: Venkatesh Rangan
Tel # 022 6754 3456
Mobile # 99674 85422
Email:venkatesh.ranganl@careratings.com

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Credit Analysis & Research Ltd., 4th Floor, Godrej Coliseum, Somaiya Hospital Road
Sion East, Mumbai – 400 022. INDIA Tel # 022 6754 3456 Fax # 6754 3457