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The Arithmetic Behind India’s Goods and Services Tax

The Wire
By Professor  

Termed as one of the biggest reforms of India’s complicated indirect tax base since 1991, the passage of the Constitution Amendment Bill, enabling the introduction of the Goods and Services Tax (GST) seems to have become a reality at last. On March 29, 2017, with the passing of four bills related to different aspects of the GST via the Lok Sabha, the Indian parliamentary system has demonstrated a strong will for enhancing cooperative federalism by signing off on a ‘pooling of sovereignty’ in taxation matters applicable for all 32 states.

The realisation of a common indirect tax, like the GST is critical for the semblance of a common Indian market where all goods and services, depending on the elasticity of their consumption, will broadly be governed under a common indirect tax rate system.

In an earlier article, I discussed how regressive India’s tax structure has been (under a total tax slit of 35:65 ratio between direct-indirect taxes), where, over the last few decades, owing to a complicated web of cesses, surcharges and other indirect taxes (imposed on different baskets of goods and services), the burden of such an imbalance has fallen directly on the consumer regardless of their income.

The implementation of GST could very well be a step in this direction, in untangling the complicated web of the indirect tax base in India. However, one may add here that, the imposition of the GST (from July) is a minor step in the direction of reducing the incidence of indirect taxes in relation to the overall tax burden.  

The arithmetic of GST

So, how would the GST work?

An illustration below covering the supply chain (that is, manufacturer-wholesaler-retailer) of a car manufacturer in India is formulated to explain how an effective and much lower GST incidence (tax burden) would ideally work for such a manufacturer in India.

For our case, let’s take the producer to be a manufacturer of a car and assume that he purchases raw materials (rubber for tires, steel, engine parts, bolts, etc) for $1,000, in which he includes a tax of $100.

By using these raw materials, the manufacturer can make a new car to be sold in a given automobile market. While the process of manufacturing involves a degree of value addition (adding value to the raw materials he bought), we assume this value added by him to be $300. The gross value added for his car then becomes $1000 + $300 = $1,300.

At a tax rate of 10%, the tax on output (of the car) becomes $130. Under GST, the car manufacturer has the opportunity to set off this tax ($130) against the tax he has already paid on raw materials, that is, $100. In other words, the effective GST incidence or tax burden on the manufacturer becomes $30 (130-100).

As the car manufacturer sells the car to the wholesaler or dealer, the wholesaler purchases the car for $1,300 and adds his profit margin to this value – say $50. The gross value of the car he sells would then become $1,350 (1300 + 50). A 10% tax on this amount will be $135, but with the GST passed now, the wholesaler will have the opportunity to offset the tax on his sale, that is, $135 against the tax on his purchased good from the car manufacturer ($130). Whereby, the effective GST incidence on the wholesaler becomes $5 ($135- $130).    

Next comes the retailer, who buys the car from the car wholesaler (or dealer). From the retailer’s purchase of $1350 (which was the selling price of the car from the wholesaler), the retailer again, adds a profit margin to this value, of say $50. The gross value now goes up to $1,350 + $ 50, that is, $1,400. The tax of 10% on this will become $140. With an opportunity to off-set this tax ($140) against the tax on the purchase from the wholesaler ($135), the retailer can reduce the effective GST incidence or tax burden on himself to $5 (140-135).

From the producer to the retailer, the GST through the manufacturer, wholesaler and retailer becomes $100 + $30 + $5 + $5 which is equal to $140.

The incorporation of GST thus, does away with the cascading indirect effect of a “tax on tax” (under the VAT and CENVAT tax system) which is usually calculated on the compounded value as the good (in this case, the car) keeps moving across the supply chain (from state to state).

More importantly, with a more uniform, simple tax structure like the GST, compliance becomes easy under a centralised tax calculating and collecting structure.

The probable impact of GST?

It may be difficult to realistically depict a quantifiable impact of GST across various sectors unless a specific GST tax rate is known from the government’s end, which analysts earlier estimated to be somewhere around 17% or 18%.

Considering that the discussion across the board on the GST tax rate started with rate discussions of 12% and 18%; the four slab rates of 5%, 12%, 18% and 28%, with identified de-merit goods subject to levy of cess over and above peak rate of 28% was a dampener for the industry, as argued here.

The newly designed multiple rate structure is derived from the fact that current effective indirect taxes (both centre and state) over certain bands are maintained for revenue neutrality and linked to above rate slabs.

The likely winners from the imposition of the GST as a centralised indirect valued added tax, will be from the manufacturing segment, including the automobile manufacturers, the FMCG (Fast Moving Consumer Goods) segment, the retail sector (provided consumer demand picks up) and the cement sector. 

One of the key losers could be the telecom sector, with the rise in GST tax rate, unless the VAT and CENVAT simultaneously see a marginal drop in their rates too. The sector is already plagued with serious problems pertaining to data volumes and slow bandwidth penetration across the country.

Another caveat with the GST has been with the constitution of the GST council – as mentioned in the tabled GST bill earlier – against which the AIADMK government (in Tamil Nadu) and few others in the opposition parties objected. While the formation of the council is aimed at resolving disputes and fixing tax rates, the council as a constitutional body, encroaches on the legislative sovereignty of the state legislatures and the parliament. This can now be seen as a step to enhance federalism at the cost of pooling the sovereignty of the states, which I must add, are as much as a stakeholder as the Union government thanks to a long, inclusive, state-level consensus building efforts undertaken by the Union government. 

Tax reforms like the GST is history in the making and the final passing of the GST bill (now in its final stages) will be termed as one of India’s biggest legislative success.

Having said that, it would be pertinent for the current government to exercise utmost discretion in regulating the GST tax rates, periodically through a well-managed float, in a way where the emerging economic and business landscape within states (particularly the lesser developed states) are efficiently safeguarded without imposing any negative externalities.

A multiple rate structure with increase in tax compliance for service providers will push input costs for producers, causing inflationary tendencies (via cost-push effects); moreover, the administrative cost of tax collection and distribution will test the Union government’s capability, in the future, to act as a benevolent sovereign. 

Deepanshu Mohan is assistant professor of economics at Jindal School of International Affairs, O.P. Global Jindal University.