Why a cap on the proposed Goods and Services Tax is a good idea

Yet another Monsoon Session of Parliament, yet again, a nervous hope for the passage of the Goods and Services Tax Bill.

It has been six years since the bill was introduced and it now awaits the approval of the Rajya Sabha.

This time, the Congress has been accused of playing spoilsport by demanding a ceiling on the GST rate. The ruling BJP does not agree, which has led to an impasse.

As always, politics has shrouded the merits of the debate. Leaving aside the political brouhaha, it is clear that some sort of a ceiling on GST is imperative in the Indian context. It is needed because of the way India’s tax structure impinges on people’s lives.

Regressive Indirect taxes

For example, take South Mumbai, home to some of India’s wealthiest individuals. It is not uncommon to find a wealthy industrialist and a young call-centre employee eat dosas or chaat in the same restaurant.

They both pay the same service tax (an indirect tax) of 15% on their bill. The industrialist probably earns the majority of her income through long term capital gains and dividends. She does not pay tax on this income since these are exempt from income tax (a direct tax) in India. The call-centre employee pays an income tax at the rate that is commensurate with his income level.

The proposed Goods and Services Tax is an indirect tax that will subsume all other indirect taxes.

Since, indirect taxes are the same for every citizen, they are considered regressive as they pinch the poor more than the rich. Taxes on income or wealth, which are direct taxes, are considered to be progressive as they vary as per the levels of the individual’s income.

For the sake of fairness, it is an established wisdom that nations should generate more of their tax revenues through direct taxes and less through indirect taxes.

Most nations globally follow this dictum. Except India.

On average, most countries (at least countries that are part of the Organisation for Economic Co-operation and Development) collect 65% of their tax revenues through progressive direct taxes and 35% through regressive indirect taxes.

India does exactly the opposite across the Central and state governments. This means that India’s tax structure is one of the most regressive in the world.

Widening the tax net

In the last 15 years, the average Indian has grown three times richer. In this period, the income tax rate on salaries have remained constant and tax rates on income from dividend and capital gains, which accrue primarily to the rich, have been reduced to zero.

But service taxes – that will be merged into GST – which everyone pays, irrespective of income levels, have been increased five times from 5% to 15% in the same period.

In the year 2012-’13, a mere 100 Indians reported an income of Rs 10,000 crore through long term capital gains made by selling shares. They paid no tax on this since such income is tax exempt.

To offset this loss of tax revenues to the government, an indirect tax such as the Swachch Bharat tax is imposed that will now garner the same Rs 10,000 crore from a billion Indians, rich and poor.

A large, developing economy such as India needs an equally large income base to provide for education, health and security of its citizens (but not for funding losses of government businesses).

Due to their inability to collect sufficient direct taxes to meet expenses, all governments over the past several decades have resorted to regressive, indirect taxation. It is time to put a stop to this by imposing a ceiling on such tax rates.

We have the opportunity to achieve this now by enacting a cap on GST.

Sometimes, in an attempt to mitigate the impact of indirect taxes on the poor, the government resorts to patronage. For instance, Hawai chappals are not levied an indirect tax but branded slippers are. Unbranded shampoo does not attract indirect taxes, but a branded shampoo does.

This implies that a poor woman should not wash her hair with a branded shampoo or wear branded slippers, even if she so desires – a perfect example of a nanny-state.

One of the justifications for levying indirect taxes is that they are ostensibly easier to collect from people as they are based on their consumption, while income taxes are very difficult to collect as is evident in the miniscule number of people who pay income tax.

The justification given is that a “minimal damage” indirect tax structure is the best alternative.

But in today’s age of Aadhaar and mobile banking, this justification sounds a bit trite. Ease of tax collection cannot be an alibi for regressive taxation.

Lazy taxation

A ceiling on GST can stop future state and central governments from resorting to lazy taxation by increasing GST rates incessantly to increase tax revenues. A legal ceiling can force governments to better collect progressive income taxes by both expanding the tax base and being firm in ending tax exemptions such as long term capital gains that accrue predominantly to the wealthy.

This can help wean governments away from a reliance on unhealthy indirect taxes to healthier direct taxes and bring India in line with other nations.

An upper limit for the GST will act as a strong deterrent for such backdoor tax collection. The maximum rate for the GST can be added to the GST bill and not to the Constitution, which can then also incorporate the flexibility to increase it in case of national emergencies.

If there is a cap on GST, then perhaps the distinction in tax rates between branded and unbranded shampoos can be removed. This is a much cleaner structure than the current maze of government-dictated life choices.

At a time when the world is rife with growing class divisions stirred by growing inequality, it is time to acknowledge India’s widening inequality too. A GST ceiling can potentially help mitigate this.

Praveen Chakravarty is Senior Fellow at IDFC Institute, a Mumbai think tank. Ajit Ranade is an economist.