September 01, 2020

There’s a way out of India’s GST compensation impasse

Excerpts below: 

"India’s recent attempts to rationalize the GST system were focused on tax cuts that have pushed the effective weighted tax rate, as estimated by the Reserve Bank of India (RBI), below what had been calculated at its launch as the revenue-neutral one—11.6% compared to 15.3%. However, the economic rationale for GST still remains valid. The integration of the Indian market as a result of this indirect tax reform helps rationalize fragmented domestic supply chains. GST ensures that only final consumption, rather than production across the value chain, is taxed, broadly meeting the requirements of the celebrated production efficiency theorem in optimal tax theory.


The blazing controversy right now is over the promised compensation to states to make up for any shortfalls in their tax collections due to GST implementation. As part of the grand federal bargain reached for its introduction, Parliament passed a law that states shall be compensated for any loss of revenue due to its adoption for five years. The Union government was guaranteeing 14% annual tax revenue growth, irrespective of the rate at which the underlying economy grew in nominal terms. This insurance undermined the incentive of states to seek a GST structure that maximized growth, though it was also necessary to assuage fears based on previous experience that verbal commitments would not be met. India’s major manufacturing states were especially concerned, since the GST regime shifts the tax base from production to consumption."


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