4. The GST of the story is bad policy


The delay in introducing a national sales tax regime is a boost for smugglers and hurts honest citizens

By Jaithirth Rao

Jaithirth RaoMANY HISTORIANS have often pondered over the differences in the economic evolution of the United States and its Latin American counterparts. The US has emerged as the most prosperous country in the history of humankind. Despite their vast natural resources, none of the economies south of the Rio Grande have ever lived up to their promise and potential. Geography has been cited as one factor. The Andes make transportation difficult in South America. History has, of course, drawn considerable attention. The Anglo-Saxon political traditions of the US have been lauded as being superior to the Spanish viceregal political traditions. Even the old argument of differences in “racial stock” have been trotted out from time to time.

But there is one factor dealing with the structure of markets that takes overwhelming precedence in explaining the divergent trajectories. The US is one large market for goods, services, capital and labour. The countries of Central and South America are all relatively ‘small’ markets and they all have barriers to trade and investment in small or large measure. Just imagine if there had been trade barriers between New York and New Jersey or between Pennsylvania and Virginia. That is how Latin America is organised. The existence of a large market without trade barriers has been perhaps the single most important reason for the economic success of the US. Very early in the country’s history, the US Supreme Court ruled that state governments don’t have the power to impose restrictions on “inter-state commerce”. This one judgment has had far-reaching implications for the development of what today is the largest consumer market in the world.

The Founding Fathers of the Indian Constitution also envisaged that India would be one integrated market. There was never any ambiguity that the right to impose and collect customs duties existed only with the Central government. The states had no role to play. Unfortunately, the Founding Fathers did not foresee everything. They were human after all. The Constitution gave the state governments the power to impose sales tax on goods consumed within the state boundaries. In the normal course, this should not have caused any problems. But somewhere along the line, state governments started discriminating against goods produced in other states. Some states cleverly levied taxes on all goods sold within their borders but “refunded taxes” or provided “subsidies” for those goods produced within their borders.

As any entry-level economics student will tell you, the combination of such a tax with a refund/subsidy is identical in effect to the imposition of a customs tariff. By this and other sleights of hand, gradually India has ceased to be one market. In other words, we are imitating Latin America rather than the US. This is one (by no means the only one, but a significant one) factor that is reducing our growth rate as a country and the prosperity of our citizens. It is quite common for companies to maintain “token” factories and unnecessary warehouses in different states, increasing inefficiency and driving up costs all around, costs which are finally borne by Indian consumers.

The structure of sales tax in India has a built-in inflationary bias also. There are repeated instances of double or triple taxation as raw materials are turned into intermediate goods and then into final consumer goods. In any intelligently designed indirect tax system anywhere in the world, cascading of taxes and the consequent price escalation is avoided by allowing each seller to take into account the taxes he/she has paid while buying the inputs and “offsetting” the taxes paid earlier in the supply chain. But given that the taxes are levied by different states, this has not been possible in India.

THE VENERABLE Chanakya (who is rarely read by our leaders) has told us that the sovereign should not impose taxes that are difficult to collect, which are seen by citizens as onerous and easily avoided. Unfortunately, our multiple sales tax systems legislated and implemented rather whimsically by different states has resulted in just that. It is not just about Mumbai residents driving around in cars registered in Daman. Such absurdities have only a limited distorting impact. The fact is that we have trade barriers between states. And when there are trade barriers, there will be smuggling. (As an aside, I invite the attention of interested readers to a passage in Walter Scott’s Guy Mannering where an intrepid Scotsman argues that he is not a smuggler, but merely a believer in free trade!)

Today, we have inter-state smuggling on a massive scale. This smuggling results in several distortions. Since smuggling by definition is illegal, no taxes are paid on this entire range of economic activity by the agents involved. Ironically, it is not just sales tax that is evaded. If you are not paying sales tax, and are therefore indulging in illegal activity, you are hardly likely to declare the income from that activity in your income tax return. The state and honest taxpayers are losers on three counts: higher prices, uncollected sales taxes and unpaid income taxes. If you are a strict neo-classical economist believing in utilitarian ideas, you might, of course, argue that there are welfare gains to dishonest traders and corrupt sales tax inspectors who are the recipients of bribes from the former. I leave it to the reader to decide whether our governments should be aiding and abetting the well-being of crooked traders and tax inspectors.

For so long now, we have known that the multiple state sales tax process is bad news. It makes us poorer as a country; it is inefficient and inflationary; it encourages criminal activity as people take recourse to smuggling rather than legitimate inter-state trade; it reduces state revenue in more ways than one and it penalises honest citizens.

The fact is that we have trade barriers between states. And when there are trade barriers, there will be smuggling

The academic literature criticising the present system and recommending alternatives is literally decades old. No serious economist of any ideological persuasion defends the existing system. And yet, we have not been able to do the simple, sensible thing, i.e. replacing the existing mess with a national sales tax process that includes the provision for offsets, which therefore eliminates cascading inflation, which eliminates incentives to set up unnecessary token factories and warehouses — which in short restores to India the position of a single market in keeping with the spirit of our Constitution, and quite frankly, in the interests of economic and fiscal sanity. Despite being an intelligent people and knowing what the right course of action is, why we refrain from pursuing our own rational self-interest remains a mystery. All one can say is that we are like that only.

The introduction of a national sales tax system (known as General Sales Tax or GST) has been on the legislative anvil for years on end. A completely fatuous and specious argument has been making the rounds. GST, it has been suggested by some, goes against the principle of federalism and reduces the powers of states. This misses the point completely. While it is true that the Constitution did envisage sales tax as a state subject, there was never any intention to allow this provision to result in inter-state tariffs being surreptitiously imposed. The spirit of our Constitution is entirely dedicated to the proposition that India should be one market. Otherwise there would have been provisions for multiple currencies, states’ rights to impose custom duties and impose internal visa restrictions — pretty much converting India into a lookalike of Latin America.

If we don’t have a national GST in place by 2014, the UPA can give itself an award for having wasted two full terms in office

WHAT THEN is the cause for the endless delay in implementing GST, something that no rational person can object to? The answer lies in three words: Politics, money and incompetence. The politics involved is so subterranean and Machiavellian that even cynical Indian citizens are in for a surprise. During NDA rule, the BJP was a votary of the GST. Now it has become the defender of the bogus states’ rights argument. Quite simply, the BJP leaders seem to be willing to thwart any proposal of their political opponents. And they call themselves patriots.

Money is something that one can never wish away. There is some legitimacy to the argument by state governments that they might lose revenue. This is particularly true during the period of transition from one system to another. It is also true that once a national sales tax is in place, the Centre may be in a position to starve states that they do not like of their legitimate dues. Since over the years, this has been behaviour that is par for the course, anticipating this problem is also entirely correct.

One would think that given the enormous gains that a national GST would produce, the Centre would be extra generous in transitional compensation and in legislating to protect the states from manipulating the Centre over the long term. No such luck. The Centre’s approach has been one of bureaucratic high-handedness. “Just trust me, even though I have a long track record of discriminating against states ruled by Opposition parties” — this has been the obdurate stance of the Centre. This is hardly likely to elicit cooperation from the states.

And lastly, incompetence, the hallmark of the UPA government. There has been no attempt to communicate the benefits of GST to citizens at large, there have been endless and totally unnecessary delays in building up the Information Technology infrastructure needed to process GST, its offsets, its record-keeping and refunds. This task is so easily done and its cost is trivial given the benefits involved. But instead of doing it, we keep talking about it and appointing committees and task forces. Indian incompetence at its best or shall we say its worst.

illustration: Sudeep Chaudhuri

I’m not given to subscribing to conspiracy theories. But one wonders if dishonest traders (I’m sorry, I meant inter-state smugglers), corrupt sales tax inspectors (I’m sorry, noble civil servants defending the rights of state governments in a federal system) and their political protectors are not secretly meeting in sinister cabals in different parts of the country and writing up plans to sabotage the GST? Possible, but hardly plausible. Government incompetence (no conspiracy there — just staying true to form) is the simpler and more likely explanation. Come 2014, if we do not have a national GST in place, the UPA government can give itself an award for having wasted two full terms in office and not implementing something that this country and its citizens desperately need. Should we call this a Padma-Foolish or a Padma-Dummy award?

To return to the comparative histories of the US and Latin America, countries do not become prosperous merely because they have natural resources. Sometimes, natural resources can be a curse. In relative terms, Venezuela was actually doing very well before the oil-price hike of 1973, which turned its ruling elite into a rentier class. Our large population and large market are strategic assets for India. They can be a source of competitive advantage. We are in danger of frittering this advantage away by perpetuating the existence of “mini markets” and internal tariffs.

From up there in the skies as they watch their beloved benighted India, Sardar Patel and VP Menon must be gnashing their teeth. They were the most fanatical fighters of internal barriers blemishing our fair land. We are certainly leaving several percentage points of GDP and several thousands of crores of legitimate fiscal revenues on the table. Delaying GST amounts to supporting smugglers and their protectors and hurting honest citizens. Why don’t we wake up not tomorrow, not next year, but today?

One of India’s foremost right-wing economic thinkers, Jaithirth Rao is founder and chairman of Value and Budget Housing Corporation, a company in the affordable housing space.


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