II. BENEFITS OF PROPOSED GST

2.1 Many benefits are claimed for the GST: that it will increase growth^*1; that it will increase investment by making it easier to take advantage of input tax credits for capital goods; and that it will reduce cascading*² While these are important, in our view three benefits stand out in today’s context: governance/institutional reform and “Make in India by Making one India,” which are two key pillars of the government’s reform efforts. The investment, and hence growth, benefits could also be substantial.

Governance

2.2 The government has placed a great deal of emphasis on curbing black money reflected in the Black Money Bill. These measures can be very significantly complemented by a GST, which, especially if it is extended to as many goods and services as possible (especially alcohol, real estate and precious metals), can be a less intrusive, more self-policing, and hence more effective way of reducing corruption and rent-seeking.

2.3 Under the GST, this can happen in two ways. The first relates to the self-policing incentive inherent to a valued added tax. To claim input tax credit, each dealer has an incentive to request documentation from the dealer behind him in the value-added/tax chain. Provided, the chain is not broken through wide ranging exemptions, especially on intermediate goods, this self policing feature can work very powerfully in the GST.

2.4 According to Pomeranz (2013), “The Value Added Tax (VAT) is a stark example of a tax believed to facilitate enforcement through a built-in incentive structure that generates a thirdparty reported paper trail on transactions between firms, which makes it harder to hide the transaction from the government (e.g. Tait, 1972; Burgess and Stern, 1993; Agha and Haughton, 1996; Kopczuk and Slemrod, 2006). This belief has contributed to one of the most significant developments in tax policy of recent decades (Keen and Lockwood, 2010): a striking increase in VAT adoption from 47 countries in 1990 to over 140 today (Bird and Gendron, 2007).”

2.5 The best evidence of the impact of the paper trail on evasion comes from an experiment in Chile which shows that firms that are part of the VAT chain are less responsive (in terms of evasion) to announcements of an increase in audit, suggesting that being part of the VAT itself performs the self-auditing function (Pomeranz, 2013). Moreover, the study finds that increasing the audit probability of firms suspected of evasion generates spillovers up the VAT paper trail that lead to an increase of their suppliers' tax payments. In a sense, the supplier, because of the paper trail left by the VAT, knows that his evasion will be more likely to be detected once his client is audited.

2.6 Second, the GST will in effect have a dual monitoring structure—one by the States and one by the Centre. Hence, there will be a greater probability that evasion will be detected. Even if one set of tax authorities overlooks and/or fails to detect evasion, there is the possibility that the other overseeing authority may not.

Make in India by Making one India

2.7 The current tax structure unmakes India, by fragmenting Indian markets along state lines. This has the collateral consequence of also undermining Make in India, by favouring imports and disfavouring domestic production. The GST would rectify it not by increasing protection but by eliminating the negative protection favouring imports and disfavouring domestic manufacturing.

2.8 These distortions are caused by three features of the current system: the central sales tax (CST) on inter-state sales of goods; other numerous inter-state taxes that will be replaced by the (one) GST; and the extensive nature of countervailing duty (CVD) exemptions.

CST^*3

2.9 The 2 per cent CST on inter-state sales of goods leads to inefficiencies in supply chain of goods. Goods produced locally within the jurisdiction of consumption attract lower tax than those produced outside. This tax encourages geographic fragmentation of production. The tax can be avoided partially through branch/stock transfers by manufacturers. However, the tax savings from branch transfers get substantially offset by the incremental costs of logistics and warehousing of goods in multiple locations.

 2.10 Consider a simple example, where intermediate goods produced in Maharashtra go to Andhra Pradesh for production of a final good which in turn is sold in Tamil Nadu. Effectively, the goods will face an additional tax of 4 per cent, which will reduce the competitiveness of the goods produced in Andhra Pradesh compared with goods that can be imported directly to say Chennai from South and East Asian sources.

2.11 How quantitatively significant is the impact of the CST? We have some suggestive evidence based on data provided by six States: Maharashtra, Andhra Pradesh, Karnataka, Gujarat, Tamil Nadu and Kerala. In these States, stock transfers, on average, account for as much of inter-state trade as the trade subject to the CST (in the case of Gujarat and Andhra Pradesh, stock transfers are more than twice as much) (Table 2). In other words, the distortion affects fifty per cent of the total trade that flows between States.

Table 2: Impact of the Central Sales Tax (In Rs. Crore)

Source: Committee’s calculations

2.24 Indian tax policy is therefore effectively penalising domestic manufacturing. How can this anomaly be remedied? Simply by enacting an exemptions-free GST. In one stroke the penalties on domestic manufacturing would be eliminated because the GST (central and state) would automatically be levied on imports to ensure neutrality of incentives. In effect, India would be promoting domestic manufacturing without becoming protectionist and without violating any of its international trade obligations under the World Trade Organization (WTO) or under India’s free trade agreements (FTAs).

2.25 In the meantime, the effect of the GST can be partially simulated even now by eliminating the exemptions applied to CVD/SAD. The default situation should be an exemptions-free regime. If particular sectors seek relief from the CVD/SAD, they should be required to make their case at the appropriate forums.

2.26 In a sense, India finds itself in a de facto state of negative protection on the one hand, and calls for higher tariffs on the other. It is win-win to resist these calls that would burnish India’s openness credentials and instead eliminate the unnecessary and costly penalty on domestic producers.

2.27 All these three sets of costs—the CST, the CVD exemptions, and other inter-state taxes— should be viewed as undermining Make in India because in all cases, they favour foreign production to domestic production. GST can then be thought of as a trade and productivity shock and one that can be harnessed without recourse to protectionism: in effect, the GST will be eliminating negative protectionism. 2.28 This increase in inter-state trade will then have another powerful consequence. A common market will help attain convergence within India because production can be based on comparative advantage. In other words, implementing the GST will help the lagging regions catch up with the more advanced regions by making the former more profitable production destinations.

The growth effect via the boost to investment

2.29 Under the current tax system, while the Union excise duties and State VAT applies to all capital goods, input tax credits are generally limited to manufacturing plant and equipment. For example, no input tax credits are allowed for the Union excise duties on capital equipment acquired for use in transportation, infrastructure, distribution, or construction sectors because these sectors are all outside the scope of excise duties which are applicable to manufacturing only. Similarly, no credit is allowed for the State VAT on capital goods acquired by the service sector (e.g., telecommunications, transportation, finance, insurance, and IT services).

2.30 Estimates vary on how much of current investment in a given year suffers from non creditable excise duties and/or VAT. For example, indirect tax collection data for 2014-15 indicate that the total amount of capital goods purchases for which CENVAT credit was claimed was Rs. 1.6 lakh crore, divided between goods (Rs. 1 lakh crore) and services (Rs. 0.6 lakh crore). National income accounts data suggests that investment in plant and equipment for the same year by the non-government, non-household sector was about Rs. 7.4 lakh crore. Apparently, the blocked input taxes could amount to as much as 75 per cent of total investment. What could account for the difference and could the GST fill this gap?

2.31 If the GST could provide for a more seamless and efficient crediting of taxes paid on capital goods, then capital goods prices would become effectively 12-14 per cent cheaper (because they are taxed at the standard rate of 12.5 per cent currently by the Centre), increasing the demand for capital goods, raising investment and hence growth.

2.32 Assuming an elasticity of investment demand with respect to price to be -0.5, GST, by allowing full input tax credit for capital goods, could higher investment in capital goods by 6 per cent, resulting in 2 per cent higher investment (as machinery and equipment account for around one-third of total investment), which in turn could lead to incremental GDP of 0.5 per cent, assuming an incremental capital output ratio of 4.

2.33 Prior to the introduction of GST in 1991, Canada also had an excise duty regime similar to that in India. Studies for Canada estimated this beneficial impact of GST to be 0.5 per cent as a result of the GST at the federal level only. The extent of tax cascading in India is much greater because of more stringent rules in India for claiming tax credits.

2.34 In sum, investment is discouraged under the current system through the application of excise duties and VAT to capital goods, for which no set off or input tax credit is provided. This increases the cost of capital goods and reduces investment, which in turn leads to lower employment and output.

Notes:

1 An oft-cited study by the NCAER (2010) suggested that growth would increase by 0.9-1.7 per cent of GDP, purely based on the elimination of the cascading of taxes on exports. What is unclear is the quantitative importance of the elimination of the embedded taxes on exports under the GST relative to the current regime of zero-rating of exports. In other words, how incomplete is the current zero-rating of exports and how much will the GST improve upon it are questions that need further investigation.

2 Whether cascading is a serious problem and why is discussed by Keen (2013).

3 The proposed Constitutional Amendment bill provides for a 1 percent duty on inter-state sales for a limited period. We strongly recommend that this provision be deleted for the very reason that the CST militates against Make in India.

4 JPS Associates (2011), “Economic Cost of Inter-State Barriers in Goods Traffic,”

5 Leemput (2014), “A Passage to India: Quantifying Internal and External Barriers to Trade.”

6 World Bank (2014), “Supply Chain Delays and Uncertainty in India: The hidden constraint on manufacturing growth.” Report No: ACS14223, Republic of India Manufacturing Plan Implementation.

7 There will also be gains stemming from simplification of the documentation requirements under the GST.

8 The CVD exemption strips the tax from its effective way of taxing the informal sector – where imported inputs are used directly or indirectly by the sector.