Financial Express, July 1, 2013

A reform success story for India

 We are used to highlighting the shortcomings of economic reform in India, both in process and outcomes. These shortcomings are particularly apparent now, when the economy is struggling on several fronts: growth, inflation, and the external balance. In this context, it is good to revisit an ongoing success story of Indian economic reform: its tax system. In the last two decades, India has made tremendous strides in terms of reforming income taxes and consumption taxes. These reforms have included improvements in tax policy as well as in administration. The former has helped the latter: rationalising tax policy has made tax administration easier to conduct effectively, but there have been direct improvements as well in the technology of tax administration.

Better tax policy has meant cutting inefficiently high rates, whether in the income tax structure, or in areas such as import tariffs. In the case of consumption taxes, it has meant replacing a complicated tangle of sales taxes and duties, often piled on each other, with a simpler, more transparent value added tax (VAT). As the VAT nomenclature implies, this avoids the problem of taxes being applied to quantities that already include other taxes—a cascading effect that can create unintentionally high rates, and multiple inefficiencies. Better tax administration has been built on the foundation of new information technology systems, which support mechanisms such as deducting income taxes at source for those who pay them, and tracking of purchases and sales required for VAT credits along the value chain. 

The goods and services tax (GST), which is inching toward implementation, represents an important new step in the process of Indian tax reform. The sooner it is put in place, the better for the economy. In particular, there is some reason for thinking that the GST will give the central as well as state governments a firmer, broader revenue base, which is less subject to political distortions than is the income tax: the GST is a VAT, better coordinated than the present system, and applied more broadly and consistently. A key institution in the process of introducing the GST, as it was earlier for introducing the VAT and for managing state sales tax incentives, is the Empowered Committee of State Finance Ministers (EC). This EC met in May, and then, on June 7, its chairmen met with representatives of industry associations and consulting firms, where an EC paper formed the basis for discussion. This discussion paper is a model of clarity, and illustrates how this complicated process of introducing a major overhaul of the tax system is proceeding. There are several facets of the process worth noting.

Technical policy formulation: There is a clear understanding of the technical issues involved in introducing the GST, including changes in revenue receipts at different levels of government, trade-offs involved in specifying tax bases in different ways (based on turnover levels), and mechanisms for administration (especially across different levels of government). One might expect this clarity, given the time it has taken to get where we are, but time has not been a guarantee of quality in other cases of policy formulation. There is also a clear use of technical inputs from the main national source of such expertise, the National Institute for Public Finance and Policy.

Political management: There is a clear understanding of the constitutional issues involved in introducing the GST, of course, but also a polite and pragmatic statement of the needs of the states in terms of some protection against revenue uncertainties that might come with the reform. In this context, the national government appears to have been somewhat lax in its political management of a complex Centre-state issue—the compensation being requested by the states seems to be quite small relative to central tax receipts, or even as a percentage of the fiscal deficit.

Institutional innovation: The creation of a GST Network (GSTN), which will be a non-profit company with ownership shares of the Centre, states, National Securities Depository Limited, and three selected financial institutions. The GSTN will provide a common IT infrastructure to support the introduction and implementation of the GST. As the EC discussion paper elucidates, issues of monitoring and control versus costs of compliance, can all be dealt with effectively with a combination of the right policy framework and a solid information infrastructure.

One hopes that the EC discussion paper, which distils many years of discussion and analysis, marks the end of the process of agreeing on the details of the GST, and the beginning of efforts to make it happen. The GST will be a major milestone in Indian economic reform. Tax reform has not been perfect. There is much left to do. For example, the GST, in coordinating taxes on the same bases (in this case, business sales) may provide a model for reform of the income tax system, allowing States along with the Centre to tax personal incomes. The GST use of information infrastructure might point the way to methods for strengthening property tax systems across India’s creaking, bursting cities, as well as other aspects of local tax systems. Tax reform is important, and it is very much alive in India.

From Financial Express October 18, 2012

The virtues of tax reform

Last month, I introduced the idea of virtuous growth, which includes the fairness objective of inclusive growth as well as an additional goal of building positive human values. I gave the example of local government reform in India as a practical step towards virtuous growth. Giving people more responsibility over public spending at the local level has the potential to increase the quality and level of civic engagement.

The issue of local government reform in India actually requires a rethink of India’s structure of tax authorities. Currently, the system in operation gives the Centre more tax authority than the states. Local governments have very little scope for taxing their constituents. These statements need to be qualified, of course. State and local governments in India actually tax less than their power to do so. One reason for this is that there is an elaborate system of sharing central tax revenue to the states, and state tax revenue to local governments. There is some justification for collecting taxes at higher levels of government—it can be more efficient, and less distorting of individual economic decisions. But transfers distort the revenue-raising decisions of the recipient state governments.

One way to get the efficiency advantages of higher-level government tax collection and the incentive advantages of a lower-level government tax authority is to allow piggybacking of lower-level governments on the higher-level government’s taxes. This has not really been done in India. The Constitution of India assigned different tax bases to different levels of government. For example, the Centre was given the authority to tax non-agricultural income, while the states were given the authority to tax agricultural income. This was one of the worst features of India’s tax system, since the states lacked the political will or capacity to tax farmers, even rich ones, and it also provided a route for disguising non-agricultural income and evading tax on that income.

In any case, the idea of different governments taxing the same base did take hold in India, using loopholes in the constitutional language. For example, state-level sales taxes and central excise duties were imposed on the same goods. This turned out to be very inefficient, since there was no coordination or transparency, and because one government’s taxes were imposed on values that included taxes by another government. The value added tax (VAT) system introduced in India a few years ago began to deal with this major inefficiency. The planned goods and services tax (GST) will extend the efficiency principles of the VAT to a broader array of commodities, and include services as well.

The details of the GST still need to be worked out and bargained over. Since it replaces existing taxes, the state governments, in particular, are worried about losing revenue as tax rates and tax shares are adjusted. The Centre needs to do more to sort out these problems and create a winning coalition for reform. One feature retained by the GST is likely to be fixed tax rates for the Central and state portions of the tax: the 13th Finance Commission follows the GST Task Force in recommending rates of 5% and 7%, respectively.

A piggybacking approach would allow states the possibility of increasing their individual rates up to some maximum level. One state might choose a rate of 8%, another of 7.5%, for its GST portion. The GST structure easily allows for this possibility. Piggybacking can go further. Urban and rural local governments could be allowed to add their own surcharges, up to some maximum. For example, one city might choose an additional 0.25%, another 0.5%. The point of these surcharges is that the lower-level government decides the rates. Surcharges can be determined by elected representatives or by referenda—the key idea is that, at the margin, the residents of a jurisdiction decide to tax themselves to finance public goods within their jurisdiction.

One could potentially extend piggybacking to the personal income tax, but the GST is an easier place to start, and the occasion of introducing something new like the GST can open the door for this additional innovation. The key idea is that piggybacking allows communities to make public revenue decisions at the margin, rather than relying only on transfers from a higher level government. Civic engagement should not be just about spending, but also about financing that spending. A modern information system for administering the GST would allow local surcharges to be collected and distributed. All of this is done in the US, for example.

One of the big problems in India’s governance is that individuals do not see the connection between the taxes they pay and the services the government provides. Individuals can see this connection better if they decide on taxing themselves at the margin, in small enough constituencies so that their decisions have weight. Piggybacking on a broad tax base avoids the problem of only being able to tax small activities, and reduces the cost of administering and collecting local taxes. It may even make it easier to get a consensus agreement on the GST, giving states more flexibility as well. Freedom combined with responsibility can be a virtue.