Commodity Taxation in India

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India’s system of indirect taxation is notoriously fragmented. Since independence,

the sales tax has grown to become the most important source of State financing, in
part because it is the only major source of tax revenue constitutionally controlled by
the States. At the same time, systems in different States have diverged to a great
extent in scope, complexity, and rates. Most states have a large number of rates
charged on different commodities, often depending on the type of manufacturer and
identity of the buyer. Neighboring states will often have dramatically different tax
systems. Trade between the states is regulated by the Centre under an entirely
separate set of rules. We examine this complexity and provide some cross‐country
comparisons in our first memo, Commodity Taxation in Bihar, 1994‐2012.

The current system has two major drawbacks. The first is its very complexity: it is
costly for firms to understand the tax code well enough to be compliant, and for
governments to administer it. More importantly, the current system encourages
inefficient production in a number of ways. Firms restructure their supply chains to
avoid taxes, often in ways that they wouldn’t otherwise do. Because the sales tax is
sometimes charged twice on a given input at different stages in the production
process, shorter, within‐firm production processes are encouraged. For these
reasons, the Government of India has been moving towards a value added tax,
known as the GST, for over a decade. In 2005, States started adopting a tax system
known as the VAT, which significantly simplified the sales tax system and has some
characteristics of a true VAT.

Our second memo, Distribution of the Commodity Tax Burden in Bihar, 1994‐ 2010,
examines the shift from sales tax to VAT, and finds that the VAT reform of 2005
lowered rates, simplified the tax code, and brought rates closer to the national
average. The code also became somewhat more progressive; the top decile now
pays 30% more than the average taxpayer, rather than 8% more. Finally, in Rates,
Redistribution and the GST, we consider different scenarios for the switch to GST.
Across all plausible scenarios, the GST reform flattens the tax code. This is largely
by design — the GST has a smaller number of tax rates, and taxes more
commodities at the normal, middle rate of 20%. Those exemptions that do remain
tend to be used equally by the rich and poor.