IV. ESTIMATING INDIA’S REVENUE NEUTRAL RATE (RNR) UNDER THE GST

4.1 The Committee had the benefit of 3 technical approaches to estimating the RNR which are described in detail in Annexes 1-3. These will constitute the basis for the Committee’s recommendations on the RNR.¹ These are briefly summarised in this section.

4.2 Before describing the recommendations, it is important to make a point relating to terminology. Throughout this report, the term RNR will refer to that single rate, which preserves revenue at desired (current) levels. In practice, there will be a structure of rates, but for the sake of analytical clarity and precision but also to facilitate comparisons across methodologies, it is more useful and appropriate to think of the RNR as a single rate. It is a given single rate that gets converted into a whole rate structure, depending on policy choices about exemptions, what commodities to charge at a lower rate (if at all), and what to charge at a very high rate. That single rate will be the focal point for the RNR. The RNR should be distinguished from the “standard” rate defined as that rate in a GST regime (which has more than one rate), which is applied to all goods and services whose taxation is not explicitly specified. Typically, the majority of the base will be taxed at the standard rate, although this is not true for the States under the current regime.

4.3 The essence of calculating the RNR is highlighted in the simple equation: t=R/B where t is the RNR, R is equal to revenues (both Centre and state) generated from existing sales and excise taxes, which will be replaced by the GST. The revenues to be replaced are estimated to be Rs. 3.28 lakh crore for the Centre, and Rs. 3.69 lakh crore for the States, including the revenues that will have to be compensated for the elimination of the Central Sales Tax (CST). The total amounts to Rs. 6.97 lakh crore (excluding revenues from petroleum and tobacco for the Centre, and from petroleum and alcohol for the States) or 6.1 per cent of GDP, with all numbers pertaining to 2013-14 (the date chosen for all the technical studies) and for 29 States and 2 UTs. What all the RNR exercises attempt to do is to calculate B, the total tax base for generating the required GST revenues. The three approaches presented to the Committee can be called, respectively, the macro, the indirect tax turnover (ITT), and the direct tax turnover (DTT) based approaches.

Macro approach

4.4 The macro approach—presented by the staff of the International Monetary Fund--makes use of national income accounts data and supply-use tables to arrive at the base B. It uses the following formula:

 B = Σ(Y + M − X) − [(1 − e) Σ(N + 1)]

Where B is the potential GST base; Y is domestic output, (M-X) is net imports (imports minus exports); (N+1) is consumption of intermediate and capital inputs; e is the exempt output ratio (i.e. the tax base associated with inputs used in the production of exempt final consumption); and the summation is over 140 goods and services and 66 sectors, based on the 2011-12 national accounts. The following assumptions were made: (1) full compliance; (2) full pass-through of the GST into prices; (3) no behavioral response; (4) the GST has a single positive rate, and a zero rate on exports.

4.5 Under a standard scenario exempting health, education, financial intermediation and public administration, the GST’s potential base is 59 per cent of GDP. Exempting basic food items in addition (essentially unprocessed foods) reduced the potential base to 55 per cent of GDP. However, exempting petroleum or electricity increases the potential base to 67 per cent of GDP—given that such items are largely consumed as inputs rather than final consumption, their exemption increases the base due to cascading. Assuming that the maximum revenue to be replaced is 6.1 per cent of GDP, these estimates for the GST tax base, ranging from 55 per cent to 67 per cent of GDP, suggest that the GST RNR rate, itself ranges between 9.1 (0.061/0.67) and 11.1 per cent (0.061/.55).

4.6 Losses in the order of 10 to 20 per cent of potential revenues are common in OECD countries; assuming 20 per cent increases the range of the RNR from 9-11 per cent to 11-14 per cent.

4.7 In summary, this analysis suggests that the GST RNR rate ranges between 11 to 14 per cent, depending on key policy choices regarding exemptions. The scenario that corresponds closest to the proposed Constitutional Amendment bill yields an RNR of 11.6 percent after factoring in a compliance rate of about 80 per cent of potential GST revenues.

Indirect Tax Turnover Approach

4.8 This approach, presented by the National Institute of Public Finance and Policy, estimates the base in a three step process. First, it estimates the goods base at the level of the States. This base is estimated by converting data on actual collections and statutory rates into a goods base. In other words, the effective rate becomes the basis for the estimation of the goods base. In the absence of data for all the States, the key assumption is that States collect revenues at the three rates (1 per cent, 6 per cent, and 14 per cent) in such a proportion so as to yield a total taxable base of Rs. 30.8 lakh crore.

4.9 In the second stage, the services base is estimated based on turnover data of 3.25 lakh firms from the newly available MCA database (this base is estimated at Rs. 40.8 lakh crore).

4.10 In a third stage, adjustments are made to this base to remove IT-related services, because a large part of them are exported, and to remove most of real estate and financial services from the base because of the manner in which these items will be treated under the GST. This adjusted base is then subject to an input-output analysis to deduct from the base taxable inputs used for service provision and also deduct services used as inputs into taxable manufacturing. All these adjustments result in an incremental services base (incremental to whatever has already been incorporated in goods) of Rs. 8.5 lakh crore and a combined base (goods and services) of Rs. 39.4 lakh crore.

4.11 This base, in turn yields a single RNR of 17.69 per cent under the scenario of having to compensate the States for the 2 per cent CST. The corresponding standard rate under current structures of taxation is estimated at 22.76 per cent. It is worth recalling that an earlier analysis based on the same methodology by NIPFP was presented to the Empowered Committee of the GST in February 2014. That analysis yielded an estimate of the RNR of 18.86 percent and a standard rate of 25 per cent.²

Direct tax turnover Approach

4.12 A third approach—which was described in the Thirteenth Finance Commission--is based on using income tax data which are available for about 94.3 lakh registered entities (including companies, partnerships, and proprietorships but not charitable organizations). The data are classified into 10 sectors and 75 sub-sectors. These data allow the potential base for the GST to be calculated. Unlike the indirect tax turnover approach but like the macro approach, this approach yields a combined base for goods and services, rather than separate bases for goods and services.

4.13 The profit and loss accounts provide data on value of supply of goods and services (which is equivalent to turnover) to which can be added imports of goods and services. This yields the tax base of at about Rs. 222 lakh crore in turnover terms. Deducting the exempt sectors from this base (petroleum, land component of real estate, the interest component of the financial sector, electricity, gem and jewellery, education, health, and agricultural produce) narrows the output tax base down to about Rs. 194 lakh crore.

4.14 Next, purchases are divided into 2 categories, those that reduce the base because of the availability of input tax credits and those that add to the base either because they are purchases by or from exempt sectors.³ The former include intermediate goods and services (Rs. 183 lakh crore) and capital goods (Rs. 6 lakh crore). The latter include purchases by exempt sectors (Rs. 25 lakh crore), purchases of primary goods (Rs. 11 lakh crore) and purchases from unregistered dealers Rs. 24 lakh crore). This yields an input tax base of Rs. 130 lakh crore.

4.15 Further adjustments are made to take account of the value added of firms that will fall below the exemptions threshold (removed from the taxable base); of the alcohol sector (removed from the taxable base); and the rail sector (added to the base because this sector is not part of the data set in the first place).

4.16 Putting all these together gives a potential tax base of Rs. 58.2 lakh crore, yielding a combined RNR of 11.98 per cent.

4.17 Table 5 highlights the estimated GST base and corresponding RNR of the three approaches to estimating RNR.

Table 5: Summary of approaches to estimating RNR

1 There have been other attempts at estimating the RNR, including by the Thirteenth Finance Commission and NIPFP, We restrict the scope of our technical inputs to the three studies described in this section as they are the most recent by way of data and methodology; they are also the three that were discussed within the Committee.

2 “Revenue implications of GST and estimation of revenue neutral rate: Estimates for 2011-12” submitted to the Empowered Committee of State Finance Ministers in February 2014.

3 The export sector is exempt with full refund (i.e. zero-rated).