The Indian GST: Another botched reform

India’s Goods and Service Tax is far from a true economic reform but rather the product of a political compromise in a wildly diverse country. It disregards economic principles and is full of imperfections. Nonetheless small steps forward are better than nothing.

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Who cares about real reform after the photo shoot… (Photo: Narendra Modi/Flickr)

by the Know Nothing Enquirer   29/06/2017              

Introducing a unified Goods and Services Tax (GST) has been discussed by various Indian governments in the past decades. The government and businesses hoped that such a tax would be fairer, less complicated, more transparent and especially result in less red tape. However, the GST that will be inaugurated by Prime Minister Narendra Modi on July 1 is not very convincing. The new tax regime will cover more than 1,200 categories of goods and services at 0%, 0.25%, 3%, 5%, 12%, 18% and 28%, excluding electricity, real estate, alcohol and petroleum products, that will be taxed under the old system. The system doesn’t seem to follow any economic or political logic. The rate for gold (3%) is lower than that for matchboxes (18%). The rate for hybrid cars will increase to the same rate as luxury SUVs. Soaps will be taxed at 18%, but detergents at 28%. Sparkling Water at 28%, but plain water at 18%. In other words, a tax regime that was supposed to simplify and unify indirect taxation across India could potentially just make everything even more complicated.

 

Of course, this is a slight exaggeration. Anyone who has visited India and travelled by car between two states has witnessed the long queues of lorries waiting to pass through internal customs checkpoints. For an aspiring economic superpower the current situation is simply unacceptable. It makes trade between Indian states unnecessarily complicated.

 

When Modi was voted into office in 2014 Indian businesses and the middle class saw in him a reformer who was able to turn India into an economic powerhouse akin to China. A high ranking employee of a large Indian IT company told the author of this blog that he viewed Modi as the messiah of Indian businesses; the strongman who will be able to change the destiny of the country. When I raised concerns of Modi’s questionable past (i.e. the 2002 Gujarat riots and his RSS membership), I was quickly reminded of Western Islamophobia and the results of the war on terror. While there have been several worrying communal incidents in the past years, including cow vigilantes killing Muslims and the election of the extremist Hindu nationalist Yogi Adityanath in Uttar Pradesh, the government mostly focussed on reforming the country and pushing through development projects, such as Digital India and Swachh Bharat Abhiyan (Clean India Movement). However, most attempts can be best described as compromises or even worse as failures. Further, most of the reforms predate Modi’s term and should be seen as successes for the previous government, including the GST.

In November 2016, Modi stunned the world when he announced that 500 and 1,000 banknotes - 86% of all rupees in circulation - would be scrapped overnight. He argued that this would be needed to fight corruption. It took several months for the economy to return to normality. After all, India is a country where most transactions are done in cash and a large proportion of the population doesn’t even have a bank account. Because it was such a hush-hush operation only very few people were involved, which dramatically increased the impact on the economy, as the new bank notes weren’t compatible with existing ATMs and the central bank didn’t have the capacity to print enough banknotes in such a short period of time. The reform resulted in chaos that was completely preventable. While it may have encouraged many Indians to open bank accounts and eventually result in a cashless society, at the time it hit the poorest and small businesses worst and hardly affected the corrupt elite with anonymous bank accounts in Switzerland or other money laundering operations. Surprisingly, demonetisation didn’t impact Modi’s approval ratings; quite the contrary, he’s never been more popular.

 

It might be tempting to compare the GST to demonetisation, but that would be too easy. Not only has the GST been thoroughly discussed over several years, it is also the result of a complex political process in which all states and union territories agreed to give up their right to impose a VAT on goods, as well as the central government agreeing to give up its right to impose excise and services taxes. Instead of each state imposing their own taxes, all states and the central government decide together on the tax rates. In a diverse federal country as India this is somewhat of a radical reform. Even though the BJP, Modi's ruling party, does control most big states and the opposition is virtually non-existent. There are many benefits to introducing a unified indirect tax and most stakeholders would agree. However, there is one big loser - the states. By losing the right to levy sales taxes, they will lose an important controllable source of income, and therefore, political autonomy. Of course, the loss in revenue will be compensated by the central government, guaranteed in the constitutional amendment. The tax levels of many states in the past have often been determined by special interest groups. The unified GST will put an end to this practice. However, it also explains why there are so many tax rates and exemptions. Without making concessions to special interests in the states, the GST would have never been accepted by all states. A classic case of a political compromise and a far from perfect outcome. In other words, one of Modi’s apparent greatest achievements isn’t a smart plan drafted by tax experts but rather driven by political interests of numerous stakeholders. Old habits die hard.

This also explains why the tax rates are so arbitrarily set. Most countries have different categories in their GST or VAT tax regimes. For example, European Union countries have a minimum standard rate of 15% and not more than two reduced rates (unless otherwise agreed in their EU Accession Treaty). The lower rates usually apply to essential commodities, such as non-luxury foodstuffs. To be fair the system in most European countries is far from perfect. For example, in Germany sparkling water is taxed as a luxury good but goose liver and lobster are considered essential commodities with a reduced tax rate. Similarly odd: fresh truffle is taxed at the reduced rate, whereas pickled truffle is not. Of course, ideally there would be no exceptions, with New Zealand’s GST coming closest to the tax purists wet dream.

 

But introducing a GST in India can’t be compared to Western countries. Despite many middle class Indians eagerly pointing out the fact that the economic growth rates are higher than China, according to the World Bank, per capita GNI is at a meagre $1,590 (2015) and 21.2% live on less than $1.9 a day. Despite glitzy marketing campaigns by the BJP government, 71.5% of the rural population doesn’t have adequate access to sanitation facilities (i.e. no loo), opposed to 36% in China. In other words, an Indian GST has to make numerous exceptions for essential goods consumed by the poor. Failing to do so would otherwise result in the poorest Indians suddenly being even worse off.

 

The biggest problem of the GST is that it will result in harming small companies most. Large corporations will have already hired experts to deal with the newly created tax regime. An owner of a small manufacturing company in Delhi told this blog that small businesses have been left completely in the dark by the government. Even though the GST is supposed to ease business, many small entrepreneurs are struggling to comprehend how to deal with the new system. The Delhi-based entrepreneur says that many small companies have significantly scaled back their production while they are figuring out the paper work - a situation that sounds vaguely familiar to November 2016.

 

In conclusion, the new indirect tax regime is far from a true economic reform but rather the product of a political compromise in a wildly diverse country with huge differences in interest. It disregards economic principles and is full of imperfections. Yet Modi is trying to position the policy as something groundbreaking and in stark opposition to the dirty old politics of Congress. Of course it is true that there is a groundbreaking element to the GST: Instead of various categories of complex taxes in every state there will be only one tax structure in the country. However, the government didn’t use the chance to truly reform the system by implementing a simple system with little exceptions. Instead it is all about big talk and little action. Something observers to India have become accustomed to. Most reforms or campaigns initiated by Modi are introduced by glitzy events but are often forgotten about after a few months. They are quick fixes to symptoms rather than sincere efforts at tackling the sick system. The “Make in India”, “Clean India” and “Digital India” campaigns are good examples. The first was supposed to lure in foreign investments by easing business for foreign businesses. Yet hardly anything has been done to make the country a more attractive manufacturing location. Most companies investing in India come despite the red tape, corruption and catastrophic infrastructure. They are simply attracted by the massive market of 1.3 billion consumers. The campaigns seem more like a bad excuse for Modi to take selfies (after Donald Trump he is the most followed politician on social media) with international business leaders than an honest attempt at reform. Rather, the government seems to be obsessed about protecting cows and giving the illusion of an India steps away from economic and political greatness. Nonetheless small steps forward are better than nothing.

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