Tax on tax

Only 1.7% of Central Govt Petrol Taxes Shared with States – Where Has Cooperative Federalism Gone?

Note: Detailed analysis takes time. Like this piece took three weeks to write. Hence, please continue supporting this effort. Every rupee helps. 

Chintan Patel and Vivek Kaul

The devil, as they say, is always in the detail.

Nevertheless, in an era of instant digital journalism, where you, dear reader, are constantly bombarded with information, the real story, or should we say stories, often get buried under numerous headlines, lazy journalism, government press releases and the false news that is the flavour of the day.

But if one is willing to do some basic number-crunching, like we are, some interesting details and narratives can emerge.

This is one such story of the central government taking both the states and the common man, for a ride and that too in broad day light. At the risk of stretching the metaphor a bit too far, the scene of the crime is the petrol pump and the motive, the dire state of the economy.

But to do this story full justice, we need to set up the background with some dry, academic points as well as digress into some adjacent details.

So, kindly bear with us. While sensational things might get you excited and help us get a few more clicks, but as we said at the beginning, the devil is in the detail.

And here’s presenting the detail.

What’s the point?

Over the years, the central government has been sharing less and less of the overall taxes that it collects, with the state governments. This is the main point we make in this piece. 

The annual budget of the central government is presented in February ever year. The budget is analysed by the media in minute detail.

However, amidst all the analyses, one subject that is often ignored is the financial relationship between the central government and the state governments. After all, much of the services that the government provides are in fact delivered by local and state governments.

It is worth remembering that while the central government collects the bulk of the taxes in the country, it’s the states that the taxes ultimately come from. And given that, this money in one way or another needs to go back to the states.

But does it? The short answer is no. And there is a longer answer which explains the reasons, has some nuance and which forms the heart of this piece.

This piece is divided into three sections. The first section provides a background on how tax revenue is transferred from the central government to the state governments and the role of the Finance Commission.

The second section focuses on a special tax category – cess and surcharge, their increased prominence in recent times, and how that raises prices of petrol and diesel.

The third and final section examines the trend of total transfer of funds from the central government to the state governments.

This is an opportune time for such an analysis, since this year’s Union budget was accompanied by the unveiling of the 15th Finance Commission’s report for the period 2021-22 to 2025-26.

So, read on, to find out.  

Who Gets How Much?

The Constitution stipulates how taxes are collected and split between the central government and the state governments. It empowers the central government as well as the state governments to raise revenues from different sources of taxation.

The central government gets to collect more taxes while the state governments end up with the bigger portion of the expenditure, leading to a mismatch. This mismatch of money that is earned through taxes and other routes and money that needs to be spent, is referred to as a “vertical imbalance”.

Take a look at Figure 1. In 2018-19, the Union Government raised 62.7 per cent of the aggregate resources raised by both the Union and states, whereas the states spent 62.4 per cent of the combined aggregate expenditure. While Figure 1 shares data for just one financial year, what’s true for 2018-19 has also been true for other financial years.


Figure 1: Vertical imbalance (2018-19)

           Source: 15th Finance Commission Report. 

To offset this imbalance, the Constitution provides mechanisms for intergovernmental transfers – the transfer of funds from the central government to the state governments. A key player of this setup is the Finance Commission.

The Finance Commission (FC) is an advisory body that is appointed by the President every five years and which evaluates the state of finances of the central as well as the state governments, and determines how taxes collected by the central government are to be distributed between the central government and the state governments, and among the state governments.

Over and above this, the FC also recommends grants to states based on revenue needs, grants for local governments and grants for specific purposes e.g. health sector grants etc. Thus, there are two broad channels of transfer of funds under the FC umbrella – i) devolution of taxes, and ii) grants. 

At the heart of the idea of intergovernmental transfers and tax devolution is the concept of ‘divisible pool’. The divisible pool is the portion of the taxes (technically referred to as the gross tax revenue) collected by the central government, which is distributed between it and the state governments. What this means is that all the taxes collected by the central government aren’t shareable with the state governments.

Till the tenth FC which tabled its report in 1995, only union excise duties and personal income taxes made up the divisible pool. Under this arrangement, 85% of the personal income taxes and 40-45% of excise duties were shared with the state governments.

In 2000, the tenth FC recommended a constitutional amendment to expand the divisible pool to all central taxes. The central government accepted this recommendation and the 80th Amendment was passed making a certain portion of  central government taxes shareable with the state governments, effective retrospectively from April 1, 1996.

Further, the portion of the divisible pool that is shared with the states is referred to as the devolution of taxes and is determined by the FC. Before the14th FC which came into effect from April 2015, 32% of the divisible pool was shared with the states.

The 14th FC increased the share of the state governments in the divisible pool to 42%. At the same time, the sector-specific grants were eliminated. This decision was primarily in response to grievances expressed by the state governments. State governments prefer funding through devolution since such transfers are unconditional.

Other transfers of money, whether they are through FC grants, or through channels outside the FC (like schemes from central government ministries) impose policy priorities set by the central government over the state governments, compromising the latter’s fiscal flexibility or the ability to spend money as the state government deems fit.

To give an example, a FC health-sector grant can only be used for health spending by the states, or funds transferred to the states under Pradhan Mantri Gram Sadak Yojana can only be used to make roads.

When state governments have more flexibility in allocating funds for various initiatives, they can craft policy that is more responsive to the needs on the ground than having to blindly follow policy that is framed in New Delhi.

The 14th FC recognised this and increased the state share of the divisible pool from 32% to 42%. The intent behind this increase was not to increase the amount of transfers but rather change the composition of the transfers – from diverting conditional funds to diverting unconditional funds, to state governments.

The 15th FC tabled in 2021 lowered the divisible pool marginally to 41%, from the earlier 42%. The is because Jammu and Kashmir is no longer a state and the money allocated to it has not been counted as transfer to a state government. Given this, the 15th FC has kept the divisible pool distribution unchanged.  

And now we come to the most important point of this write up. A key detail in this entire discussion is that the only tax revenue that is excluded from the shared divisible pool are different kinds of surcharges and cess.

As we shall see next, this exclusion has proved to be the back door that the central government has been using to divert funds from the states governments’ kitty to its own.

A Tale of Two Taxes

Before we get into the details, let’s first try and understand what surcharge and cess actually are.

A cess is tax on a tax imposed by the central government attached to a specific purpose. For example, an education cess collected should be utilised only for financing education and not for any other purpose. It is worth remembering here that the education cess is imposed on the total income tax and not on the total taxable income.

Hence, as explained earlier, it is a tax on a tax. Examples include infrastructure cess on petrol and diesel, krishi kalyan cess, health and education cess on Income Tax, etc.

In theory, money collected under a cess is to be spent on the specific purpose for which it is collected but that’s not always the case.

A Comptroller and Auditor General (CAG) report for 2018-19 indicates that only Rs 1.64 lakh crore of the Rs 2.74 lakh crore or around 60% of the amount collected from cess and surcharge during 2018-19 had been transferred to their respective funds. Around 40% was still retained in the Consolidated Fund of India, which is the general-purpose fund of the Indian government.

The provision of levying a cess was intended to be used for shorter specific purposes. So, the procedure for introducing a cess is comparatively simpler than introducing new taxes, which usually require change in the law.

Coming to surcharges, a surcharge is also a tax on a tax, but is not tied to a specific purpose like a cess is. Let’s take the example of the surcharge on income tax. It is an added tax on the taxpayers having a higher taxable income during a particular financial year. So, an individual having a taxable income  between Rs 50 Lakhs and Rs 1 crore pays an income tax surcharge of 10%.

Further, an individual with a taxable income between Rs 1 crore and Rs 2 crore, pays an income tax surcharge of 15%, and so on.

Note that this surcharge is only on the base income tax, not on the income itself. So, if an individual earning Rs 1 crore in a year needs to pay an income tax of Rs 20 lakhs, the applicable surcharge would be Rs 2 lakhs (10% of 20 lakhs).

A surcharge can be utilised for any purpose of the government, without having to bend the rules, like they do sometimes for cess collections.

In the last few years, these surcharges and cess, which do not need to be shared with the state governments, have become the central government’s go-to tools to address the tax revenue shortfall.

Take a look at Figure 2a, which basically plots the total amount of surcharges and cess collected by the central government over the years, along with the surcharge and cess it hopes to collect during 2021-22, the current financial year.

Figure 2a: Total cess and surcharge revenue (in Rs crore).

Source: Union budget documents.  

Figure 2a clearly shows that the general trend is upwards, with small blips in 2017-18 and 2018-19. The government expects to collect total surcharges and cess of Rs 4,45,822 crore (revised estimate) in 2020-21.

This is surprising given that overall tax collection during the year is expected to come down. In comparison to the years before 2020-21, the collections for 2021-22 are also expected to be at a very high Rs 4,48,821 crore.

The collections of cess and surcharge surged from Rs 2,53,540 crore in 2019-20 to Rs 4,48,822 crore (RE) in 2020-21, an increase of a whopping 77%. This huge increase is almost entirely due to increased cess and surcharge on petrol and diesel – in particular, the road and infrastructure cess and the additional duty of excise on motor spirit (which is a surcharge), which increased by Rs 1,92,792 crore. Motor spirit is the technical term for petrol.

The increased reliance on cess and surcharge is also seen in Figure 2b below, which plots the total cess and surcharge earned by the central government as a proportion of the Indian gross domestic product (GDP). This is done in order to take the size of the Indian economy into account as well.

Figure 2b: Cess and surcharge revenue expressed
as a proportion of the GDP (in %).

Source: Union budget documents.

The above figure makes for very interesting reading. The total amount of cess and surcharges earned by the central government went up from 1.25% of the GDP in 2019-20 to 2.29% of the GDP in 2020-21, a massive jump of 104 basis points. Some of this jump was obviously because the size of the economy or the GDP is expected to contract in 2020-21. Nevertheless, the fact that cess and surcharges collected by the government went up in a year when the economy contracted, does come as a surprise.

In Figure 3, let us look at the breakdown between cess and surcharges earned by the central government over the years. Looking at the below figure it is evident that cess collections form the bulk of the total revenue.

Figure 3: Cess and surcharge breakdown (in Rs crore).

Source: Union budget documents.

Clearly, cess is bringing in more money for the central government, though the contribution of surcharges has also jumped up since 2019-20.

Now let’s try and understand, why has the central government increasingly become more dependent on earning money through cess and surcharges, and in the process it is sharing lesser proportion of taxes with the state governments.

This increased reliance on cess and surcharges in the last two years can be understood when one looks at what is happening with the total tax revenue. Figure 4 plots the total taxes earned by the central government or gross tax revenue as a proportion of the GDP.

Figure 4: Gross tax revenue as a proportion of GDP (in %).

Source: Union budget documents 

While the negative economic impact of the covid pandemic has been a telling blow, the downward trajectory in tax collections of the central government had started as far as back as 2018-19. The twin economic debacles of PM Modi’s first term – demonetisation and a shaky GST implementation – meant the economy was already tottering before the covid pandemic hit.

An obvious casualty of this slowdown has been a declining tax revenue as a proportion of the GDP. In the normal scheme of things, this would have meant that the central government would have ended up with lesser taxes for itself, after sharing with the state governments.

But this fall has been cushioned with the central government earning a higher amount of taxes through cess and surcharges (as can be seen from Figure 5).

Figure 5: Cess and surcharge as a proportion of total central government taxes. 

Source: Union budget Documents
RE = Revised Estimate
BE = Budget Estimate

 In 2019-20, the total taxes earned by the government or the gross tax revenue had stood at Rs 20.1 lakh crore. In 2020-21, it is expected to fall by 5.5% to Rs 19 lakh crore. The net tax revenue of the central government (what remains after sharing taxes with the state governments) in 2019-20 was at Rs 13.59 lakh core.

This is expected to fall to Rs 13.45 lakh crore in 2020-21, a fall of 0.9%, which is much lower than the 5.5% fall in gross tax revenue. While, the total gross tax revenue is expected to fall by Rs 1.1 lakh crore (Rs 20.1 lakh crore minus Rs 19 lakh crore), the net tax revenue is expected to fall by just Rs 14,000 crore (Rs 13.59 lakh crore minus Rs 13.45 lakh crore). 

In percentage terms, in 2019-20, the central government kept 67.6% of the taxes for itself in 2019-20. This shot up to 70.8% in 2020-21. 

Clearly, the state governments have been short-changed here, with their share of taxes falling from Rs 6.51 lakh crore in 2019-20 to Rs 5.5 lakh crore in 2020-21, a fall of a little over Rs 1 lakh crore or 15.5%, in such economically difficult times.

This is primarily because the share of cess and surcharge in total taxes collected by the central government has jumped from 12.67% in 2019-20 to 23.46% in 2020-21. Do remember that cess and surcharges are outside the divisible pool.

So, when the inflow of these taxes increases, the central government gets to keep all the revenue, as opposed to sharing 41% (15th FC guideline) with the state governments. So, it is far more efficient for the central government to increase cess and surcharge when it needs to increase tax collection. 

This overuse of cess and surcharges by the central government has not gone unnoticed. In fact, the chairman of the 15th FC, NK Singh has talked about introducing a constitutional amendment to include them in the divisible pool.

As he said: 

“I see no viable solution except a constitutional amendment. If that constitutional amendment is introduced, recognizing some proportion of cess and surcharge to the divisible pool, it will certainly allow greater flexibility to the successive Finance Commissions subsequently to be able to calibrate a framework.”

Ultimately, as we said at the very beginning, whatever might be the term used, a tax, or a cess or a surcharge for that matter, it is being paid by people. And hence, the money thus collected should be shared with the state governments.

How does all this affect you, dear reader?

If you have managed to make it thus far, many of you by now would be like how much gyan are these guys going to give. Why can’t they tell me straightaway how does all this impact me or the world at large or the aam aadmi?

Well, sometimes it is important to take a look at the bigger picture first and then arrive at how it impacts all of us.

The government’s increased reliance primarily on cess actually has had a direct impact on most citizens – in the form of increased prices at the petrol pump.

The biggest contributor to the spike in cess collection over the last two years has been cess collected on the sale of petroleum products. The figure below charts the total cess collected on petroleum products (crude oil, petrol and diesel) over the last five years. While the cess on petrol formed at least 50% of total cess each year, it was as high as 69% of the total cess revenue in financial years 2019-20 and 2020-21. 

Figure 6 clearly shows that the government has resorted to taxing petrol and diesel to make up for revenue shortfalls. This conclusion is hardly a revelation to anyone paying attention to prices at the pump, but the numbers help understand the government’s motivation.

Figure 6: Total cess on petroleum products (in Rs crore).

Source: Union budget documents

There is another way of looking at the cess on petrol and diesel. Table 1 below gives a breakdown of the union taxes on petrol and diesel for 2020-21 and 2021-22. Note that the table below only analyses central excise tax and excludes customs duty. There are technical complications in figuring out the per litre customs duty.  

Table 1: Central government tax breakdown on petrol and diesel.

Source: https://www.ppac.gov.in/content/149_1_PricesPetroleum.aspx

 

The total union excise duty on petrol and diesel, in 2021-22 are Rs 32.90 per litre and Rs 31.80 per litre, respectively, which are marginally lower than the previous year. All taxes other than basic excise duty, including special additional excise duty, which is a surcharge, are exempt from the divisible pool.  

1) For 2021-22, only ~5% of the excise taxes on petrol and diesel will go to the divisible pool. The rest (~95%) will be kept by the central government. In 2020-21, this portion was at around 91% for petrol and 85% for diesel. Clearly, the government is keeping a greater share of petrol and diesel taxes for itself.

2) The above point does not clearly bring out the gravity of the situation. Let’s do a simple calculation to show that. In 2021-22, the total excise duty on petrol stands at Rs 32.90 per litre. Of this, the basic excise duty of Rs 1.4 per litre is the only part which is a part of the divisible pool and hence, will be shared with the states. It is worth remembering only 41% of this or around 57 paisa per litre needs to be shared with the state governments.

What this means is that just 1.7% of the total excise duty earned by the central government per litre of petrol will be shared with the state governments. It was at 3.8% in 2020-21.

3) Now let’s carry out the same exercise for diesel. The total excise duty earned by the central government on the sale of one litre of diesel will be Rs 31.80 during 2021-22. Of this only Rs 1.8 per litre will be shareable with state governments. 41% of this amounts to around 74 paisa per litre.

This amounts to around 2.3% of the total excise duty of Rs 31.8 per litre earned by the central government per litre of diesel. It was at 6.4% in 2020-21.

4) In 2021-22, a new agriculture infra cess has been introduced. It amounts to Rs 2.5 per litre on petrol and Rs 4 per litre on diesel. This has led to the reduction of basic excise duty on petrol from Rs 2.98 per litre to Rs 1.4 per litre and that on diesel from Rs 4.83 per litre to Rs 1.8 litre. As mentioned earlier, only the basic excise duty needs to be shared with the state governments.

Hence, by introducing a new agriculture infra cess, the central government has ensured that state governments get an even lower share of taxes from petrol and diesel in 2021-22.

The general public is quite sensitive to price rise at the petrol pump since it is a highly visible and recurrent cost. That the government has still resorted to this strategy for increasing revenue, speaks to the lack of better options – a fact that is a direct consequence of the tepid economic scenario even before the pandemic began. Of course, the covid pandemic has only made things more difficult for the government on tax front.

Nonetheless, things are even more difficult for state governments, which don’t have many avenues to raise tax. Clearly, this amounts to the centre shortchanging the state governments during difficult economic times.

Oh wait, there is more – Total intergovernmental transfers

Other than the divisible pool of taxes, there are other channels of intergovernmental transfers between the central government and the state governments. So, to get the complete picture on the flow of money from the central government to the state governments, it is instructive to examine the total intergovernmental funds transferred in more detail.

Before diving into those details, a brief overview of intergovernmental transfers would be useful. Figure 7 below is a good graphical representation of all the ways in which the central government can transfer funds to the state governments.

Figure 7:  Vertical fiscal transfer channels. 

Source : Asian Development Bank

Broadly speaking there are two instruments of fund transfers.

1) Finance Commission funds: As discussed earlier, this includes the 41% of the divisible pool revenue, general-purpose grants for states with weak revenue raising capacity and specific purpose grants for funding local governments (panchayats and municipalities) and funding certain specific initiatives (eg. health-sector grants by the 15th FC). Most of the funds provided via the FC channel are not conditional and don’t require state government contributions.

2) Funds from central ministries: In addition to the FC funds, the central government also gives specific purpose grants through the respective ministries. These funds are transferred either through centrally sponsored schemes or central sector schemes. Central sector schemes are entirely funded by the central government. Some examples include the free LPG connections provided to poor households, crop insurance scheme etc.

The centrally sponsored schemes require a matching component from the state governments i.e. they have to fund a portion of the scheme. Examples of this include the Pradhan Mantri Gram Sadak Yojana, the Swachh Bharat Mission etc.

As Figure 7 shows, the mechanism of intergovernmental transfer underwent a major transformation in 2015. Two things led to this. Firstly, the 14th FC gave its recommendations for increasing the devolution share of state governments from 32% to 42% and eliminating a host of specific purpose grants. The underlying rationale was to change the composition of state transfers to increase the “no-strings-attached” outlays and reduce conditional grants to give state governments more financial headroom.

Secondly, the newly elected NDA government disbanded the Planning Commission and replaced it with the NITI Aayog. While the NITI Aayog has some shades of resemblance with the Planning Commission, the five-year plans, which was the responsibility of the Planning Commission, were scrapped.

The five-year plans would have their own grants for states in the annual budget of the central government. The establishment of the NITI Aayog and the approval of the 14th FC recommendations were two initiatives that formed the basis the oft-cited “cooperative federalism” mantra of the NDA government, especially in the early years.

The argument put forth to claim this catchphrase was that the Modi-led administration was reversing the centralising tendencies of earlier governments and ushering in an environment where states had greater fiscal autonomy.

Does the data corroborate these claims? Let us examine. Figure 8 below charts the tax devolution to states as a portion of the gross tax revenue.

Figure 8: Tax Devolution vs Gross Tax Revenue (in %).

Source: Union budget documents

  

Some interesting observations can be made from Figure 8.

1) The first few years after the 14th FC came to effect (April 2015) saw a significant increase in the portion of taxes devolved to the states.

2) This increasing trend of devolution peaked in 2018-19 when the devolution was 36.6%. The last three years have seen this number come down, with the 2020-21 figure (~29%) close to the pre-2015 levels. So, all the talk about cooperative federalism has gone for a toss, in the last few years.

3) Note that these numbers don’t reflect the 32% (pre-2015) or 42% (post-2015) devolution share prescribed by the FC since cess and surcharge revenue is not devolved. This also explains why the devolution percentage has dipped sharply in the last two years, a period when cess revenue has had a corresponding increase (as shown earlier in Figure 5).

While the 14th FC may have been the catalyst, the Modi government can rightfully claim credit for strengthening fiscal federalism, at least in its first term. However, most of these gains have been reversed in their second term. This justifies N.K Singh’s lament: 

“ It should not be a cat and mouse game that every finance commission raises the devolution number and it then neutralised simultaneously by an increase in cess and surcharge leaving the states where they were, nor the opposite way.”

Next, in Figure 9, let us look at the total transfers made to state governments in recent years, not just tax devolution. The total transfers to states includes tax devolution, finance commission grants, centrally sponsored schemes, central sector schemes and other miscellaneous items listed as state transfers in the union budget.

The figure below charts the total transfers made to states as a percent of the total expenditure of the Union government.

Figure 9: Portion of total expenditure of central government
transferred to state governments (in %).

Source: Union budget documents

 There are two caveats on the chart above.

1) Starting 2014-15 there was a change in how expenditure for central schemes was routed to the states. The figures for 2013-14 have been adjusted to make the comparisons with the subsequent years correctly.

2) We have excluded loans made to states from the total transfer amounts and only included grants and devolution, since loans do need to be repaid.

That said, these figures also lead to similar observations made from Figure 8. The period from 2015-16 to 2018-19 (roughly co-incident with NDA’s first term) had a significant increase in funding to the state governments.

While the increased devolution of taxes could be attributed to the recommendations of the 14th FC, the increase in total transfer of funds was certainly government policy. The last two years (and the projections for the next year) show a steep decline in the intergovernmental transfers.  
The huge spike in cess and surcharge collections which are not shared with states and declining tax revenues during this period contributed to this effect.

There are two other conjectures one can make based on the trends seen above. First, when Narendra Modi won in May 2014, he was a sitting chief minister and his perspective on governance was heavily biased towards the challenges of governing a state.

Hence, financial outlays were perhaps favourable to the states. In the second term, he was well-entrenched as a national leader and the instincts were now honed favouring centralisation.

Second, the Bhartiya Janata Party has adopted an increasingly overt approach favouring homogenisation of the country. Whether it is the abrogation of Article 370, the passage of national farm laws, or flirtations with one-nation-one-language, it is evident that impulse is towards uniformity and centralisation. In this context, the trend of holding back funds from states, seems a natural accompaniment. 

What Mainstream Media DID NOT TELL YOU About GST

On August 3, 2016, the Rajya Sabha, the upper house of Indian Parliament, finally passed the 122nd Constitutional Amendment Bill for the introduction of the Goods and Services Tax(GST).

The passing of the Bill will be looked at as an important achievement for the Modi government. Also, credit must be given to the Modi government for reaching out to the opposition and getting almost everyone on board (excluding the AIADMK party) to get the Bill passed in the Rajya Sabha.

To be honest, I didn’t think this would happen and which is what I had said in my past pieces. Nevertheless, the Bill could have been passed during the period 2009-2014, if the Bhartiya Janata Party, which is in power right now, hadn’t opposed it as vehemently as it did.

The television and the print media have gone totally gaga about the whole thing. If you were watching any television channel after the GST Bill was passed on August 3, you would think, looking at the excitement of the anchors, that the Indian per capita income had just crossed that of the United States.

The excitement of the mainstream media notwithstanding there is a lot that remains to be done for a Goods and Services Tax to become a reality. Here is what needs to happen on the legislative front:

a) The Constitutional Amendment Bill will first go back to the Lok Sabha in order to clear the amendments made to it in the Rajya Sabha. The Lok Sabha had earlier passed the Bill in May 2015. This should be fairly straightforward given that the Bhartiya Janata Party led National Democratic Alliance has the required numbers in the lower house of the Indian Parliament.

b) After this is done, 15 or more states will have to ratify the Constitutional Amendment Bill.

c) Then 29 states and two union territories will have to pass their own GST Bills.

d) The Parliament will have to pass the actual GST Act and the interstate GST Act, which will specific the structure of the tax and enable its collection.

As of now this seems doable given that the two Acts that need to be passed by the Parliament need a simple majority of more than 50 per cent and not two-thirds majority as was the case with the GST Constitutional Amendment Bill. Nevertheless, this will take time and when things take time, it is always possible that political parties change their mind.

Further, the GST Constitutional Amendment Bill will lead to the creation of the GST Council comprising of the finance minister of the union government, who will be its Chairperson, as well as the finance ministers of state governments. The GST Council will essentially go about setting the tax rates.

Before we go any further, it is important to understand what GST exactly is, and how will it help improve India’s taxation system.

What is GST?

India currently has many indirect taxes. Indirect tax is essentially a tax on goods as well as services and not income or profits, for that matter. India currently has a plethora of indirect taxes both at the state government level as well as the union government level. The GST will subsume many of these taxes. It hopes to have one indirect tax for the whole nation and this will convert the country into one unified common market.

The GST or value added tax(VAT), as it is known in other parts of the world, is already present in large parts of the world, as can be seen from the following chart.

Goods and Services Tax in India

How do things stand in India as of now?

Up until now, the Constitution empowers the Union government to levy an excise duty on manufacturing. Let’s take the case of a company which manufactures cars. It needs to pay an excise duty to the union government on every car that it manufactures. The current rate of excise duty is 12.5 per cent on small cars. While, the company pays this tax to the government, it ultimately recovers it from the end consumer who buys the car.

The union government can also levy a customs duty on exports as well as imports. Further, the constitution allows, the Union government to levy a service tax on the supply of services, which the state governments can’t.

On the other hand, the State governments are allowed to levy a value added tax(VAT) or a sales tax on the sale of goods. This division has essentially led to a multiplicity of taxes.

As the Report of the Select Committee of the Rajya Sabha on the 122nd Amendment Bill of the Indian Constitution presented in July 2015 points out: “This exclusive division of fiscal powers has led to a multiplicity of indirect taxes in the country. In addition, central sales tax (CST) is levied on inter-State sale of goods by the Central Government, but collected and retained by the exporting States. Further, many States levy an entry tax on the entry of goods in local areas.”

This multiplicity of taxes has led to an inherently complicated indirect tax structure. As the Select Committee Report points out: “Firstly, there is no uniformity of tax rates and structure across States. Secondly, there is cascading of taxes due to ‘tax on tax’. No credit of excise duty and service tax paid at the stage of manufacture is available to the traders while paying the State level sales tax or VAT, and vice-versa. Further, no credit of State taxes paid in one State can be availed in other States. Hence, the prices of goods and services get artificially inflated to the extent of this ‘tax on tax’.”

Let’s understand this through an example

Let’s take the case of a dealer in one state buying goods from another state worth Rs 1,00,000. As the goods are moving from one state to another, on this, he has to pay a central sales tax of Rs 2,000 (2 per cent of Rs 1,00,000). His effective purchase price works out to Rs 1,02,000. On this he builds a margin of Rs 8,000 and his sales price works out to Rs 1,10,000.

When he sells this good, the state sales tax (or the value added tax) will be charged on Rs 1,10,000. If the tax rate is 5 per cent, then it will work out to Rs 5,500 (5 per cent of Rs 1,10,000). This means that the final price of the good would be Rs 1,15,500 (Rs 1,10,000 + Rs 5,500).

In this case, the state sales tax is also being paid on the central sales tax of Rs 2,000 that has already been paid. Central sales tax paid while purchasing goods from one state is not available as an input tax credit while selling the goods in another state. This leads to a cascading effect as tax on tax needs to paid. In this case the cascading effect is Rs 100 (5 per cent of Rs 2,000 of central sale tax). This ultimately gets built into the price of goods, making them more expensive than they should be.

What are the practical implications of this?

The cascading effect and the fact that the indirect taxes already paid in one state cannot be deducted while paying indirect taxes in another state makes many Indian businesses uncompetitive. The Report on theRevenue Neutral Rate and Structure of Rates for the Goods and Services Tax (GST) (or better known as the Arvind Subramanian Committee Report) has an excellent example.

As the report points out: “Consider a simple example, where intermediate goods produced in Maharashtra go to Andhra Pradesh for production of a final good which in turn is sold in Tamil Nadu. Effectively, the goods will face an additional tax of 4 per cent, which will reduce the competitiveness of the goods produced in Andhra Pradesh compared with goods that can be imported directly to say Chennai from South and East Asian sources.”

This basically happens because goods move between states twice and a 2 per cent central sales tax has to be paid each time. As mentioned earlier, tax paid in one state cannot be deducted while paying more indirect taxes in another state. This essentially means that a programme like Make in India cannot take off in many cases.

What are the other implications?

Other than central sales tax, state governments levy entry taxes as well. These can be like octroi in order to fund a local municipal body or otherwise. These taxes are collected while goods are entering the state or a town. This explains to a large extent why trucks in India move as slowly as they do. This essentially drives up logistical costs.

As the Subramanian Committee report points out: “One study suggests that, for example, in one day, trucks in India drive just one-third of the distance of trucks in the US (280 kms vs 800 kms). This raises direct costs (wages to drivers, passed on to firms), indirect costs (firms keeping larger inventory), and location choices (locating closer to suppliers/customers instead of lowest-cost location in terms of wages, rent, etc.). Further, only about 40 per cent of the total travel time is spent driving, check points and other official stoppages take up almost one-quarter of total travel time. Eliminating check point delays could keep trucks moving almost 6 hours more per day, equivalent to additional 164 kms per day – pulling India above global average and to the level of Brazil. So, logistics costs (broadly defined, and including firms’ estimates of lost sales) are higher than the wage bill or the cost of power, and 3-4 times the international benchmarks.”This will be possible if GST becomes the order of the day. The entry taxes will be subsumed under GST. This will lead to a dismantling of check posts at state borders and there will be no need for trucks to be held up.

Around 72 per cent of Indian freight moves through roads. Hence, eliminating check posts will lead to a faster movement of goods through the length and breadth of the country. Crisil Research estimates that “eliminating delays at check posts will yield additional savings of 0.4-0.8% of sales [of companies].”

While, the state governments are yet to agree to removal of border check posts, as and when this happens, it will be one of the bigger benefits of the GST. If it doesn’t, it will make GST a little less useful.

What will GST do about all this?

The GST will subsume multiple indirect taxes. Take a look at the following table. It points out the indirect taxes which will come under GST and indirect taxes which won’t.

GST TAX table

While GST plans to subsume many indirect taxes it does leave out several taxes as well. Hence, in that sense GST is not a one nation one tax that it is being made out to be.

How will GST work?

The GST will take the cascading effect of tax on taxes out of the equation. It will allow input tax credit for indirect taxes that have already been paid irrespective of what kind of indirect taxes have been paid and where they have been paid.

Take a look at the following table:

Basic Information/Kind of TaxManufacturerWholesalerRetailerTotal
A. Transactions (exclusive of tax)
1. Sales6008001,2002,600
2. Purchases06008001,400
3. Value-added (A1-A2)6002004001,200
B. VAT/GST
4. Tax on sales (10% of A1)6080120260
5. Tax on purchases (10% of A2)06080140
6. Net tax liability (B4-B5)602040120
C. RST
7. Tax on retail sales (10% of A1/R)––120120

Source: Professor Mukul Asher of the Lew Kuan Yew School of Public Policy, National University of Singapore

There are three levels in the above table- the manufacturer, the wholesaler and the retailer. Let’s start with the manufacturer who sells a product for Rs 600 to a wholesaler. He does not purchase any inputs and makes everything in house (I know this is an unrealistic assumption, but it just keeps the Maths a little simple).

On this, the manufacturer pays a tax at the rate of 10% which amounts to Rs 60. The wholesaler sells the product for Rs 800. On this he has to pay a tax at the rate of 10 per cent. This amounts to Rs 80, but he also gets credit for Rs 60 indirect tax which the manufacturer has already paid. Hence, his tax outflow amounts to Rs 20.

The retailer finally sells the product for Rs 1,200. On this he pays tax at the rate of 10%. This amounts to Rs 120. But he gets credit for Rs 80 (Rs 60 paid by the manufacturer and Rs 20 paid by the wholesaler). Hence, he actually pays a tax of Rs 40. In this way, there is no cascading effect and all the tax that has already been paid is taken into account.

What this also tells us is that GST is a destination based tax and will finally accrue to the government once the final customer has bought the good or the service. This explains why parties that rule states like Bihar and Uttar Pradesh have come out in its support. While these states may not have a large industrial base, they do have consumers.

How does all this help?

The GST has a self-policing feature built into it. As the Subramanian Committee report points out: “To claim input tax credit, each dealer has an incentive to request documentation from the dealer behind him in the value-added/tax chain. Provided, the chain is not broken through wide ranging exemptions, especially on intermediate goods, this self-policing feature can work very powerfully in the GST.”

As Crisil Research points out: “Since input tax credit will be available for all taxes paid earlier in the value chain, firms would require evidence of compliance from the preceding links to claim set-offs. Thus, they would prefer sourcing inputs from compliant firms. This could increasingly bring unorganised players under the tax net, thereby reducing their price competitiveness vs. organized players.” This will be one of the biggest benefits from the GST over the long-term as it will make the entire system more transparent.

This could also bring down the price competitiveness of unorganised players as they will have to go legitimate in order to keep their business going. This will increase their costs and could help the more organised players, who already have a strong information technology infrastructure in place. The following table shows the proportion of unorganised players sector wise.

GST Sector table

But there might be some starting troubles on this front. The onus is on the customer to prove that all the suppliers in the value chain have paid their share of taxes, if he wants to take the input tax credit. This is as per Section 16(11)(c) of the Act. Basically what the section says is that if a supplier has not furnished proper returns or made the correct payment, then the customers of the supplier cannot avail of the input tax credit. And if it has been given, it will be reversed.

What will be the rate of tax?

This is something that the GST council headed by the finance minister needs to decide on. The Subramanian Committee has basically recommended four rates of taxes. A rate of 2 to 6 per cent for precious metals. A low rate on goods of 12 per cent. A standard rate on goods and services between 16.9 per cent to 18.9 per cent. And a high rate on goods at 40 per cent.

It is important that the GST council chooses a reasonable rate of tax. The unweighted OECD average rate for GST was 19.1 per cent in 2014 and 18.7 per cent in 2012. The recommendation of the Subramanian committee of a standard rate of 16.9 per cent to 18.9 per cent is in line with the OECD average.

Given the current rate of service tax is 15 per cent (including the cesses), a tax rate of 16.9-18.9 per cent is likely to make services expensive in the short run. This basically means that stuff on which you pay service tax (from your mobile phone bills to your credit card bills) is likely to become more expensive.

Crisil Research expects inflation as measured by the consumer price index is likely to go up by 60 basis points in the short-term. This will be in line with global evidence where inflation does go up in the short-term wherever good and services tax is actually implemented.

The trouble is that the rate of inflation is already looking up. Also, by the time GST becomes the order of the day, the next Lok Sabha elections will be around one to two years away. Will the government be willing to take on this risk? In the run up to the Lok Sabha elections the rate of inflation as measured by the consumer price index anyway goes up, as the government increases subsidy spends.

Why states like the idea of GST?

The state governments have come around to the idea of GST primarily because it allows them to tax services, which isn’t the case as of now. The GST being adopted has a dual structure with both the union government as well as the state governments levying a GST. Both the central GST and the state GST will be levied on every transaction of supply of goods and services, happening within a state. The taxes will not be levied on exempted goods and services.

As Crisil Research points out: “Multiple exemptions exist under the present tax system – the Centre has ~300 items exempted from central excise duty, while the States (together) have ~90 items exempted from VAT. These will be merged into a Final synchronized exemption list under the GST regime.”

It needs to be mentioned here that longer the list of exempted goods and services, higher the standard rate of GST will have to be. Given this, the government will have to limit exemptions if it wants a proper GST.

Other than central and state GST, there will be an interstate GST for transactions happening between states and it will be collected by the union government. The interstate GST will be roughly equal to the central GST plus the state GST. Input tax credit will be available on interstate GST. The following chart shows how the interstate GST will work.

IGST Model

What are the potential areas of conflict?

The former finance minister P Chidambaram of the Congress party has been talking about a standard GST rate of 18 per cent. The Kerala finance minister Thomas Isaac has remarked that capping the 18 per cent rate is too low. Other finance ministers have said the same thing.

A report in The Times of India suggests that Isaac has recommended a standard rate of 22-24 per cent, in order to ensure that states do not lose out on revenue. The situation as of now seems to suggest a standard rate of 20 per cent or more, will be arrived at.

To this Arvind Subramanian, chief economic adviser to the ministry finance said that a standard rate of “higher than 18-19% will stoke inflation”. This is primarily because the tax on services which is currently at 15 per cent will see a huge jump.

It remains to be seen what rate the GST council comprising of state finance ministers and the union finance minister come around to.

R Jagannathan writing for Firstpost makes this point in the context of small cars. An excise duty of 12.5 per cent is levied on small cars. Then there is the state level sales tax or value added tax of 12.5-14.5 per cent. The union budget this year added a one per cent infrastructure cess on cars. Over and above all this, some cities charge an octroi as well.

Hence, we are talking about an effective tax rate of around 28 per cent. If the standard rate of GST is 18-19 per cent then prices of small cars will come down. Crisil Research expects that the prices of small cars to come down by about 10 per cent.

But this is assuming that state finance ministers come around to the idea of 18 per cent standard rate of GST. As Jagannathan asks: “Why would any sensible finance minister at Centre or states reduce this to 18 percent?”This will continue to remain a tricky issue given that states need to subsume a whole host of taxes into the GST and are likely to demand (in fact they are already demanding) a standard rate of 20 per cent or more.

Also, there is the question of how will states compensate municipal corporations for taxes that are subsumed into the GST. Take the case of octroi. The Brihanmumbai Municipal Corporation makes a lot of money through octroi. If GST were to become the order of the day, the octroi will be subsumed into it.

As R Jagannathan writes in a column on Huffington Post India: “The Mumbai Municipal Corporation’s Octroi collections annually are in the range of Rs7,000-8,000 crore. Will GST collections in Maharashtra be enough to finance this revenue loss?” This is a question worth asking.

Further, the GST system as it has been envisaged will need a solid information technology backbone. This information technology system will essentially lead to a lot of lower level bureaucracy, which runs India’s indirect tax system, becoming useless. (Think of all those employees manning check posts on state borders for one).

While, the government does not fire employees, a move to GST will lead to the income from corruption for the lower level bureaucracy coming down. And this is unlikely to go down well with them. They, as always, remain in a position to create problems.

Also, in a recent interaction with a few economists, I was told that the state level bureaucracy remains unprepared for implementing the GST. The fact that GST is a destination based tax and not an origin based one, which is one of its core points, remains unclear to many of them.

The fiscal deficit conundrum

For the first five years, the union government will compensate the states for the loss of revenue arising because of GST. This is the known unknown that can really create a problem. If the compensation demands from states are more than what is expected, the fiscal deficit of the central government can shoot up. Fiscal deficit is the difference between what a government earns and what it spends.

In this scenario, achieving the fiscal deficit target that finance minister Arun Jaitley has set for the government will become difficult. In the budget speech made in February 2015, Jaitley had said that the government will achieve a fiscal deficit of 3.5% of GDP in 2016-17; and 3% of GDP in 2017-18. Running up a higher fiscal deficit will have its own set of repercussions.

What are the advantages of GST?

As we have already seen GST is basically a self-policing system and makes the entire system more transparent. The Subramanian Committee report points out that the GST “is a stark example of a tax believed to facilitate enforcement through a built-in incentive structure that generates a third party reported paper trail on transactions between firms, which makes it harder to hide the transaction from the government.”

This basically ensures that the tax collected by the government goes up. As analysts Saurabh Mukherjea, Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital point out: “Cross-country evidence suggests that the introduction of GST boosts the tax-to-GDP ratio by 1-2% points.” The analysts feel that GST will boost tax collection in India by bringing the unorganised sector which accounts for 59 per cent of India’s economy, under the purview of taxation.

While the rate of inflation is initially expected to go up, over the longer term, the inflation does come down as the cascading effect of indirect taxes is done away with and the cost of doing business comes down.

As the Ambit Cpital analysts point out: “Whilst the introduction of a single GST helped reduce inflation in New Zealand as well as Canada, inflation rose moderately in Australia and Thailand. However, the increase in inflation in Australia as well as Thailand was driven by unique factors such as domestic supply constraints. After adjusting for these factors, inflation in these two countries too was lower post GST implementation.”

And what about the GDP?

The finance minister Arun Jaitley has said in the past that GST is likely to push up the Indian GDP growth by 1 to 2 per cent. “This (GST) has the potential to push India’s GDP by one to two per cent,” Jaitley had said in April 2015. Jaitley’s statement was probably made on the basis of a December 2009 report brought out by National Council of Applied Economic Research(NCAER). In this report NCAER said that other things remaining the same the implementation of GST is likely to push up India’s GDP “somewhere within a range of 0.9-1.7%”.

The evidence on GST increasing GDP growth (or economic growth) is at best sketchy. As the Ambit Capital analysts point out: “Whilst it is difficult to assess the impact of GST on economic growth (as GDP growth is affected by a range of variables), cross-country evidence suggests that there is no clear evidence that the introduction of GST necessarily leads to higher GDP growth. Although the introduction of a single GST limits inefficiencies created by a heterogeneous taxation system, there is little evidence that it helps boost GDP growth rates.”

To conclude, there are many good things about the GST. Nevertheless, it is not a done deal yet and a few major issues remain, which will continue to test the Modi government in the days to come. Also, it is not the be all and end all, that the media is making it out to be. It is just one of the factors that will set India right in the years to come.

This column originally appeared in Vivek Kaul’s Diary on August 5, 2016

Postscript: I will be taking a break from writing the Diary and will be back after August 15. Here is wishing everybody a Happy Independence Day in advance.