Tax Analysts Blog

Lessons from India's Ambitious Tax Reform Adventure

Posted on Jul 24, 2017

Will tax reform necessarily contribute to economic growth? It’s tempting to answer with a resounding yes, but the better response is more cautious. The outcome depends on the details, suggesting that stakeholders would do well to manage their expectations.

The relative success of any tax reform effort is partly a function of one’s starting point. The greater your preexisting inefficiencies, the stronger the potential for reform to be transformative. A useful illustration is provided by India’s recent experience.

India has undertaken the most significant tax reform project in the country’s history. The government is implementing a VAT, and concurrently eliminating an assortment of irritating regional levies that stifle trade. Like several other countries, India calls the regime a GST (goods and services tax), but don’t be confused by the label. This is a classic credit-invoice VAT – similar to the ones used in about 160 nations worldwide.

The adoption of the GST is expected to add 2 full percentage points to India’s GDP. That’s saying something given that the country’s GDP is already healthy, having grown by 7 percent in 2016. The prospects of any U.S. tax reform package (assuming it happens) providing a comparable boost remain uncertain.

The rosy forecast for India does not rely on budgetary gimmicks or dubious assumptions. The stimulative effect comes from the elimination of internal trade barriers that are well known to Indian businesses. The GST will replace a patchwork of local levies that function like tariffs on goods produced in other parts of the country. They are based on the origin principle, and protectionist in nature. They’re less about generating revenue to support public spending, and more about favoring local merchants at the expense of rivals in other provinces.

For instance, as the Financial Times recently explained, trucks carrying commercial goods from Madhya Pradesh into Uttar Pradesh must stop at the border and pay an excise tax, without regard for taxes already incurred during manufacturing. Imagine if U.S. states operated under such a system, with companies being required to stop and pay border tax each time their cargo crossed state lines. The inefficiency would be staggering. Many Indian firms have adopted the practice of selectively declining sales because the prospective customer resides in a part of the country where the tax rules are overly burdensome. You know it’s time for fundamental tax reform when businesses are turning away perfectly good transactions solely due to internal tax obstacles.

The GST will change all of that; it will make India a true single market for tax purposes. That’s an encouraging scenario for the ability of tax reform to boost GDP. Note that the GST is based on the destination principle, which is neutral in regard to cross-border trade. (Usually cross-border taxation is discussed in the context of national borders, but here the efficiency gains relate to subnational borders.) The destination approach ignores where goods are produced; instead, the tax depends on where consumption occurs.

Politically speaking, the Indian tax reform process has been a marathon. It’s taken well over a decade to hash out how the GST will operate. One Indian news organization has compiled a 17-year timeline  that tracks the tax’s snail-like progress. The numerous delays had less to do with economics, and more to do with regional political sovereignty.

The ability to manipulate the local tax base carries significant clout, and India’s regional authorities have fought desperately to retain that prerogative. The last thing they want is for tax sovereignty to be transferred to the feds, but that’s exactly what the GST does. Students of U.S. state tax policy will observe a commonality; fierce opposition from state revenue departments is largely why VAT proposals will always face an uphill challenge here.

The advent of the GST is so noteworthy that some commentators have seen fit to invoke Nehru’s famous “Tryst With Destiny” speech, which marked the eve of India’s birth as a nation in 1947, with a clever “Tryst With Destination Tax” essay, tracking Nehru’s words almost verbatim:

At the stroke of the midnight hour, when businesspersons and consumers spend a sleepless night, India will awake to a new tax regime. A moment comes but rarely in our economic history, when we step out from the old to the new, when a century ends, and when the taxpayers of a nation long oppressed hope to find a new dawn. ]

Inspirational stuff, although written half in mockery. So did India get it perfect with the design attributes of its GST? Of course not, but perfection is a high standard.

When it comes to a federally harmonized consumption tax, my preference is for as broad a tax base as possible and as few rate categories as possible. For simplicity’s sake, perhaps a uniform rate. After all, one of the key goals of tax reform is radical simplification. That’s not where India ended up. Not even close. Regrettably, the GST will not be as straightforward as hoped. Among the defects, the GST will apply at multiple rates to different categories of goods and services – with little apparent reasoning to the outcomes.

Some of the more baffling rules are as follows:

• Personal grooming products like shampoo or after-shave are taxed far more heavily than consumer electronics like cameras and computer monitors.

• There’s no uniform GST rate for chocolate bars; the rate depends on the cocoa percentage.

• There’s no uniform GST rate for eating out at a restaurant; it varies depending on whether the establishment has air conditioning.

There’s a common theme behind some of these odd rules. India’s government was trying to make the GST less regressive. The intention is admirable, but it leads to perplexing outcomes. Besides, consumption tax regimes are inherently regressive. Policymakers should accept that, and understand that efforts to make the overall tax system more progressive are better directed elsewhere – to things like income taxes, property taxes, or inheritance taxes. No amount of bureaucratic tinkering with rates will render the GST or VAT a tool for progressive taxation – unless you think heavily taxing shampoo is a useful means of sticking it to the wealthy.

In summary, India’s GST is a remarkable achievement that was a long time coming. Economic harmonization doesn’t come easy for a country with more than 20 constitutionally acknowledged languages. That said, drafters could have done better in terms of striking a balance between administrative simplicity and notions of vertical equity. The path they’ve taken seems to defeat the whole point of one nation, one tax.

Read Comments (1)

Mike55Jul 31, 2017

Great article summarizing an important development in the tax world.

I'm not optimistic India's VAT will deliver what's promised. Improved tax policy is never a bad thing of course but, at least from a multinational's perspective, poor administration/enforcement practices are the primary obstacle in India. If my company's trucks are being stopped on the highway to extract a payment, the design of the law being enforced is sorta irrelevant: the stoppage/extraction itself is the problem.

Perhaps it will be different with the new VAT regime, but the absurdly short period of time companies have been given to prepare themselves to collect does not bode well.

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