Busting GST Myths: Why There’s No Such Thing As A Revenue-Neutral Rate

Anybody who believes that moving from constitutional enablement of a unified goods and services tax (GST) to the actual GST law will be a politically smooth process is living in a fool’s paradise. You only have to read a news story today in The Economic Times (14 September) to realise that the Congress, having gotten isolated on the issue in the past, is planning a comeback to ensure Congress-ruled states back a “pro-consumer and anti-inflationary GST rate.”

Nothing wrong in this goal, except that this is a political posture, not really about the consumer. The Congress has been trying to push 18 percent as the standard rate in GST, first by insisting that this should go into the constitution, and when that ploy failed, saying that it should be legislated into the actual GST and Inter-State GST laws – something few states agree with. Former Commerce Minister Anand Sharma has been quoted as insisting that “the GST rate be fixed at 18 percent” since this “is based on the revenue-neutral rate proposed by the Modi government’s very own Chief Economic Advisor.”

If Narendra Modi is clear on the importance of GST, he has to assume that the government’s first crack at GST will be a messy affair, both politically and economically. It is not going to be possible to arrive at a clean GST standard rate in the first attempt. As an intensely political process of negotiation, this is simply impossible.

One also needs to understand that macroeconomists cannot by themselves arrive at a revenue-neutral rate (RNR), for they simply do not have the competence to do so. Maybe, one can take a stab at guessing the RNR for the central government once GST is operationalised, but no such data exists for states, as Vijay Kelkar and V Bhaskar explain in a detailed note in Mint on “The road ahead for the GST Council.”

They write that “computing the RNR for states individually is difficult at best and impossible at worst.” Reason:

“There are difficulties in estimating the share of service tax of individual states given the lack of state-wise service tax collection data. In any case, as was seen during the implementation of VAT, finance ministers are notoriously conservative in their estimation of their respective state’s RNR. Expectedly so, given the extreme dependence of state governments on indirect tax revenue.”

When the experts are telling us that calculating the RNR is “difficult at best and impossible at worst”, one wonders how the economic geniuses in the Congress party decided that 18 percent is the RNR, based on what the Arvind Subramanian committee recommended.

In order to proceed cautiously but steadily on the road to GST, the Modi government would do well to regard its own Chief Economic Advisor’s calculations with some degree of doubt. Here’s why.

The RNR can be arrived at product-wise, assuming we have microeconomists and sector experts who understand elasticities of demand and likely consumer responses to a given GST rate, whether higher or lower. But this competence does not exist inside government as of now. At best, a few sector specialists among private research outfits may understand their own sectors well. It is time the government associated them with this exercise.

Take a simple example – cars. Govindarajan Chellappa, Managing Director of Jefferies Equity Research, reckons that in the current cascading structure of tax rates, the tax element on top-end SUVs is close to 53 percent. This means even at the proposed 40 percent top GST rate, prices will fall for the rich man’s set of wheels. Jefferies expects a drop of 7-10 percent in almost all car prices, depending on how each type of car/SUV is categorised under GST. Mid-sized cars could see even bigger cuts.

At the bottom end of the spectrum, even the Maruti Alto pays an effective tax rate of 30 percent. While demand in this segment may well be price-elastic, a reduction in tax rates to 18 percent means a potential explosion in the purchase of small cars, which can clog city roads. Does this tilt towards cheaper private transport make sense when public transport is already abysmal? It would compound a policy failure on public transport to ridiculous levels.

The other question is this: will the cut in rate result in a commensurate or greater increase in demand for high-end SUVs or will demand remain the same, since they are anyway very expensive? If demand remains the same, the 40 percent rate would reduce revenues, and would be a mistake.

The Jefferies report, in fact, suggests that expectations of lower tax rates after GST may, in fact, lead to a slump in demand in the short run. It says:

“At current proposed rates, prices of all vehicles, with the exception of tractors, would fall 7-10 percent (we assume all benefits would be passed on). Could this stimulate demand? In the medium term, yes. However, in the short-term (confused) expectations of large price cuts could result in a slump in demand and massive discounting across all segments in the runup to the actual (GST) implementation.”

So the first myth that needs busting on GST is the assumption that we can know the RNR on any product, leave alone all products put together, in advance of actually proposing a rate. We can estimate revenues only after a rate is posited for a specific product category. We can aggregate the estimates for major product categories and then arrive at the right RNR. We are not going to get the right RNR at first attempt.

Conceptually, the idea of RNR comes from estimating the current share of indirect taxes in total GDP and then using this figure to estimate what the RNR for GST should be. But translating RNR from the current share of indirect tax in GDP is fraught with risk, for consumers do not react to general tax rates, but what is specific to the product category he is interested in. You can know how a consumer responds to a specific product rate only once it is set and known. Final tax collections could overshoot or undershoot estimates, depending how the economy is going, and levels of actual consumer confidence at the time of GST implementation.

The second myth that needs busting is that RNR is what we want. It is only a failsafe figure, not a real one. Consider how we got the states to sign up for GST. They agreed because they believe they will get more revenues, not less or the same, through the GST. No state would have signed up if promised only an RNR. RNR is a safety net, not a target.

The third assumption we need to discard is to assume that there will be only three GST bands, and one zero-rated category. This kind of clean thinking works only in theory. It is certain that services have fewer duty setoffs than goods, but we assume both must get the same GST rate. What is the logic is saying services, which generate the bulk of our GDP, should be taxed higher than now in the interest of providing a uniform rate? As the car example above shows, why presume that we want only two rates for cars – one standard, and one non-merit rate at 40 percent? Why not three rates, or four? Why is it necessary to have one standard rate, and just two other rates, one above and one below, just because the arrangement looks neat to an economist?

The simple point is this: we should look at converging rates after a period of trial and error with various rates, and not retrofit all existing products into three rates right at the outset. Having two middle rates, one for services, and another for goods, and two or three other bands of rates will enable more acceptance among states than having such narrow bands and a moderate standard rate. In a politically-determined process of setting GST rates, you may initially have to accept a messier rate structure in order to ensure everyone is on board; the convergence can happen later, once states discover the benefits of lower rates generating more revenues from higher economic activity.

As I have noted in another article in The Times of India yesterday (13 September), it is best to hasten slowly on GST. You can never separate the politics of GST from its economics. So it is best to tread carefully in order to keep centre-states ties on an even keel. This may not be what the Congress wants, but this is what will help the Centre navigate a difficult piece of reform.