Don’t listen to the politicians. Here's why the GST might actually end up harming India

It finally happened. Late on Wednesday, the Rajya Sabha approved a bill that will change the way India collects taxes.

The Goods and Services tax, which aims to get rid of the current patchwork of indirect taxes and to improve tax compliances, has been in the headlines for some time now. When the Manmohan Singh government was in power, the Bharatiya Janata Party flatly refused to support the tax, even though the first discussions on it had been initiated by the Vajpayee government. After the BJP was elected to office again in 2014, it had a rather quick change of heart and started to push the GST – only to find that the Congress now had a few issues with the tax (although, in the Congress’ defence, its opposition was conditional).

So why did the BJP do such a neat U-turn on the issue? And is the tax really as transformational as its being made out to be? And, more basically…

…just what is the GST?
The Good and Services tax will take India’s complex indirect tax system and replace it with a more simplified tax structure. Taxes such as excise duty, value added tax (both taxes on manufactured goods), Central sales tax (levied on inter-state trade) and octroi (levied on goods entering a district/city), among others, will all be wrapped up and replaced by a single tax: the GST.

The contours of this single tax (rates, items exempt etc.) will be seen to by a GST council consisting of the Union and state governments. The Union government will hold a third of the votes while all the states combined will hold two-thirds. All decisions will be made with a three-fourths majority – which, given its vote weightage of 33%, in effect means that the Union government holds a veto.

The GST council would also mean that states would transfer almost all their powers of taxation to this body. To help balance this, the Union government is promising them increased tax collection.

Reducing taxes is good. No wonder everyone is happy with the GST. Right?
Finance Minister Arun Jaitley – and even the Manmohan Singh government before that – has been hard-selling the Goods and Services tax. Enticingly, Jaitley promises that it will bring a 2% bump in India’s GDP growth. And it’s not only the Union government – large sections of India’s economic elite are riding the GST train as well.

It’s easy to see why Jaitley likes the tax. The GST is paid by the end-consumer, which makes it difficult to evade and easy to administer. It’s also a sledgehammer tax, levied on everyone, rich or poor (unlike an income tax), which usually results in a lot of money for governments. The tax also helps the Union government become more powerful – using the council, it can now control tax rates in the states.

It’s also obvious why large business like it. Large corporations buying and selling in a number of states can find it difficult to navigate India’s thicket of taxes. Having to pay only one tax would really ease things up.

Of course, India is larger than the Union government and its large corporations. The argument why the GST is good for India postulates that by creating a single market, it will boost economic growth. As we saw earlier, Jaitley even put a nice round figure to it – 2% – even if he did not to explain how.

That last paragraph sounded a bit sceptical. Everyone isn’t happy with the GST?
There’s been a lot of noise about the GST in India as the best thing since sliced bread. Flipkart’s founder Sachin Bansal even drew a grand parallel with Vallabhbhai Patel’s integration of the princely states, claiming the GST would have a similar impact on our “economic unity”, given that it will create a single market.

The GST is great for the Union government and large corporations; but things start to get a bit more complex if the entire country is considered. If abolishing state taxes were some sort of silver bullet to creating efficient markets and economies, one would have thought the United States – the largest capitalist economy in the world – might have at least considered it. But it doesn’t. Not does the second-largest common market in the world, the European Union.

In both markets, it is unthinkable that states (in the United States) or countries (in the EU) would give up their taxing powers.

What’s so great about states having the right to tax?
In the Indian system, the state government does most of the actual governance. They administer the police, run schools and hospitals as well as look after India’s most-critical sector: agriculture.

If states don’t get to control their funding (i.e. taxes), it leads to what economists like to call the “preference revelation problem”. There is no way, for example, for Tamil voters to signal if they want more or fewer public services from Chief Minister Jayalalithaa, given that under the GST, she cannot even change tax rates. Tamil Nadu can only get more money if it convinces the GST council to raise rates.

What signalling means is that if the same body is raising taxes as well as providing services, there can be a give and take between the government and the people. If, for example, voters vote for better services (signalling), they know that they will have to pay for it with their taxes. So there’s a push-and-pull to the process of demanding for better services. Voters know there’s no free lunch.

Moreover, with taxes not being a state government responsibility anymore, the GST incentivises states to spend recklessly. After all, with taxes a constant anyway, what’s stopping political parties using it inefficiently?

This disconnect between services and taxes itself is bad enough for large, federal countries like the US to wash their hands of a GST completely. In India, this disconnect gets even more acute given that this is a continent disguised as a country. At this scale, the problems of Gujarat and Tripura are vastly different. To force them to both be governed by identical taxation systems is to put both of them in a straitjacket.

In sum: if India’s states – the ones that provide almost all of its governance – are divorced from the process of taxation, it’s a recipe for disaster.

Okay, but if having a unified market means a better business climate, that’s still something right?
Except that the GST might not really end up creating a better climate for business. In fact, it might even end up making things worse.

GST supporters point to that fact that the tax would simplify tax collection, making India a unified market. That’s true but the unintended consequences of all states having the same tax rate might make things more complex than that.

For one, manufacturing states would lose out, given that GST is a destination tax collected in the states where the product is purchased. Tamil Nadu, one of India’s manufacturing powerhouses, for example, has sent the Union government a rather tart note opposing the GST for this reason. “It is expected that the extent of revenue loss under GST would be around Rs 9,270 crores,” it points out.

The effect of this will be significant: the GST would distort the incentive structure for states to attract manufacturing. If the GST council will decide tax rates and the money will go to every state anyway, why should any state take the effort of wooing manufacturers?

Moreover, with taxes being frozen across states, no chief minister can use that anymore to attract business. The United State’s prosperity is built on the fact that its provinces compete for industry – recently, as many as seven states wrestled each other for Elon Musk’s “gigafactory”, which might revolutionise human transport. With the GST, every state will just take its share of taxes from the India kitty. In this system, it doesn’t matter a lot whether Tata Nano sets up its plant in Gujarat or West Bengal.

Eventually, the GST’s hyper-centralisation will be Modi’s freight equalisation policy. The 1952 scheme saw the Nehru government subside the transportation of minerals to facilitate the equal growth of industry all over India. In practice, it ended up devastating mineral-rich east India, with states like Bihar, West Bengal and Jharkhand being denied the advantage of their own natural resources.

Sure, the GST might be great for large businesses in the short term. But once you factor in everything else, it could actually be quite disastrous for India’s economy – and that’s what everyone should keep their eye on. The Union government or large corporations don’t add up to India.