The GST anti-climax: Don't expect its roll out to boost GDP by 1-2% any time soon

A commonly-held belief used while advocating the rollout of the goods and services tax (GST), which was approved by the Cabinet yesterday , is that it would significantly add to India’s gross domestic product (GDP) growth rate.

The GST will subsume most major levies and taxes at both the state and central levels (such as excise, service tax, customs, VAT, octroi, etc) and replace them with a single, dual-structure state-Centre tax.

Since the GST is designed in the VAT structure, it would eliminate the economically-harmful effect of cascading taxes – that is taxes on taxes.

To illustrate with an example, since the sale of a computer processor by its manufacturer to an assembler has been taxed once, the assembler, after putting together the computer and selling it, will obtain a rebate for the tax on the processor, and all such items he may have used, which had already been paid for earlier (essentially, the tax being only the “value added” by the assembler).

Studies show that cascading taxes can have a large negative effect on productivity as well increase prices, and their removal can increase economic activity substantially.

Also, GST removes barriers for trade within the country and creates a national market, by virtue of having a single nationwide tax rate for all goods and services.

Further, by removing the cascading effect, layers of taxes and simplifying structures, the GST would encourage compliance, which is also expected to widen the tax base.

But virtually every media report that mentions the GST says that the tax reform has the potential to add up to 2 percent to India’s GDP.

If so, is it so that the GST comes across as some sort of a magic wand which would, from Day One of its implementation, bump up the country’s growth rate from, say, a decent 6 percent to an impressive 8 percent?

Let’s examine the assumption.

Upon looking around for the genesis of this belief, we found that it stems from statements by various corporates (such as its most vocal proponent, Adi Godrej) and other tax experts.

But are there any empirical studies that go back to prove this assertion?

This comes from a government-commissioned study done in 2009 by the National Council of Applied Economic Research, which concluded that the GST rollout would, ceteris paribus, “provide gains in India’s GDP somewhere within a range of 0.9 to 1.7 percent.”

The additional gain originating from the reform would be earned in all years in the future over and above the normal GDP growth, which would have been achieved otherwise.

Such gains will likely come from improvement in all three factors of production: land, labour (wages) and capital, and will also boost international trade, the research paper added. These will accrue from lower prices, lower deadweight loss as well as increased compliance. Readers with a functional understanding of economics can read the paper here .

However, the paper makes some crucial assumption such as pegging the revenue-neutral rate in the range of 6.2 percent and 9.4 percent.

The revenue-neutral rate is the rate for GST that will not make a net difference to the overall tax collection of the Centre and states. This will make sure states that incur a loss from the GST’s rollout can be adequately compensated by the Centre.

However, latest reports indicate that with the government ceding to states’ demand to keep lucrative items such as petroleum (which accounts for one-third of states’ and centre’s total indirect taxes) out of its ambit, at least for a few years, it would increase the revenue neutral rate (RNR) substantially.

A committee of state finance ministers had pegged the RNR at about as much as 27 percent . The assumption was based on states’ earlier demand of keeping petroleum, alcohol and entry tax out of GST (the latter two has not been agreed to, according to reports) but a rate even remotely as high as that is sure to negate any efficiency gains - though how much is not exactly clear at this moment.

A panel set up by the 13th Finance Commission had earlier proposed an RNR of 12 percent (7 percent for states, 5 percent for the Centre), but it suggested a much larger base for taxation by including almost all goods and services and even stamp duty on real estate transactions.

At a CII function, revenue secretary Shaktikanta Das had pledged that the intent with the GST was to have “a stable regime” – NDA-speak for a low tax rate, of which it has been an advocate – but he stayed away from giving an outright target, perhaps also because it will take some time to ascertain it.

But it becomes clear that any efficiency and compliance gains arising from GST’s rollout would most importantly hinge on the RNR, which in turn would depend on how comprehensively it is rolled out across goods and services and nature of transactions.

In the meanwhile, it may be safe to assume that immediate 1-2 percent GDP gains will likely not accrue starting FY16 (when it is being targeted for rollout).