GST Bill passed in Lok Sabha but Jaitley needs to offer states more lollipops to sign up

The finance minister on10 December tried to bribe states to sign up for the goods and services tax (GST) by compensating them for the loss of Rs 34,000 crore following the reduction in the central sales tax (a tax on inter-state good s movement) some years ago. The first tranche of Rs 11,000 crore of compensation will be paid to states by March 2015 despite the centre’s difficult fiscal situation. The balance, hopefully, will come over the next two years, Arun Jaitley told parliament.

States had agreed to a one percent reduction in CST when introducing value-added tax (VAT) at the state level. The centre had asked them to make good this loss by raising their VAT rate, but the states saw no point in raising VAT further when inflation was already raging in 2008, and a hike in VAT would have worsened prices. Instead, they asked the centre to pick up the bill. Some states had anyway jacked up VAT rates and the centre argued that since they had done so, they could not claim compensation

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Jaitley’s promise is thus intended to bridge this “trust-deficit” between centre and states. However, this alone is not going to get the states to queue up before the GST signing register. In fact, he will have to offer them more lollipops, and also be flexible on the implementation schedule. It is unlikely that the full benefits of GST will accrue anytime before fiscal 2017-18.

The reason is simple: despite the huge economic gains that could ensue from having a unified GST and a national market for goods and services, states will be losing a huge part of their revenue flexibility.

Consider what the states will be sacrificing by agreeing to GST: apart from VAT, they also can’t levy octroi, entry tax, luxury tax, etc. In fact, almost all taxes on goods and services levied by states will be subsumed under GST.

Worried that they will lose all revenue flexibility, states are trying to keep some item or the other out of its GST’s ambit: alcohol, petroleum goods, even taxes on land, says this Financial Express editorial.

But the more the number of taxes you keep out, the less the point in having a GST.

For example, if all taxes levied by states are part of GST, the 13th finance commission headed by Vijay Kelkar (who also recommended the introduction of GST as head of an earlier committee) had estimated that the revenue-neutral GST rate should be 12 percent - much lower than the aggregate level of taxes now levied by centre and states together.

But as you start excluding items from GST (alcohol, or petroleum, both big revenue earners for some states), the revenue-neutral rate can go as high as 27 percent - much higher than current rates. At this rate, GST makes no sense at all.

So is GST really worth all the trouble? It is. The National Council of Applied Economic Research (NCAER) has estimated that the introduction of GST could push up GDP rates by between 0.9-1.7 percent, depending on how comprehensive the GST turns out to be.

That kind of growth surge is clearly worth having, but, as indicated earlier, it comes at the cost of revenue federalism. GST is inherently anti-federal, as it reduces revenue flexibility for states.

So if Jaitley wants to gets the states on board, he will have to offer them more than just the CST sweetener for past revenue losses.

Here’s what he could do:

One, make all centrally-sponsored scheme fully funded by the centre, with states having to make no matching or any contributions. States should not only get funds for schemes like NREGA or the National Rural Health Mission as grants, but also be allowed flexibility on using the funds for other related programmes.

Two, apart from compensating for CST, the centre should offer states a simple guarantee - full compensation for any loss of revenue in the first three years of GST implementation, when there is likely to be some revenue and trade disruption when everyone is still new to the tax and IT glitches cause heartburn.

The key thing is to not oversell GST as a source of instant GDP nirvana or revenue gusher. It may also have a short-term downside. Once GST is implemented, transactions that previously could evade tax may have to be taxed - which means there could even be a short-term cost-push spike in the prices of some goods and services.

The new system of obtaining documents for taxes already paid by suppliers down the line will take some time to settle down, as it needs a robust IT system to capture it all.

There is still two years of hard work - maybe even three - ahead before GST becomes reality. One can’t realistically expect the benefits to flow before fiscal 2017-18 - and that too assumes that the constitutional amendment is passed in the next budget session, and the states pass the law over the six-nine months after that. GST can technically be implemented only from 1 April 2016 - which is the official target date.

Don’t be surprised if there are slip-ups.