India’s Goods and Services Tax (GST) will be a game changer!

India was founded on the ideology of local self government or panchayati raj as espoused by MK Gandhi. It has a federal political structure similar to the United States and Canada. As per India’s constitution, the federal government has powers over defense, foreign affairs, railways, direct taxation, certain indirect taxation etc. mentioned in the Union List (97 items). The state governments have powers over land, law and order, certain other indirect taxation etc. mentioned in the States List (66 items). There are several other items that are on a Concurrent List (47 items) shared by both the state and the federal governments.

The consequence of India’s federal structure is that India is not a common market. Goods and Services produced in one state are usually at a disadvantage when sold in another state. Exemptions provided by different states distort the playing field and cause skewed investments.

Almost all states in India moved to a Value Added Tax (VAT) based system of sales taxation a few years ago. This was a positive development in taxation as it prevented multiple taxation of the same product and brought a lot of unreported transactions into the tax net. However, this was reform only at the state level. At the national level, state level distortions continued to affect the market.

The idea of the Goods and Services Tax (GST) is to unify all indirect taxes including excise duty, service tax, value added tax, luxury tax, octroi duty, entry tax etc. The GST is proposed to be value added tax at the federal level similar to the VAT currently in force at the state level. The 2009 election manifesto of the current Congress led government had promised implementation of the GST by 1st April 2010. Based on current ground realities, it is unlikely that the GST will be implemented even by 1st April 2012.

Importance of the GST: It is estimated that the GST will add about $500 billion to India’s GDP over the next 10 years. It is estimated that it will increase India’s GDP by about 0.5% to 1% a year once implemented. It will bring a large portion of India’s unreported economy into the tax net and will lower the incidence of tax on the legitimate economy. By eliminating area based exemptions and distorting state taxes, it will enable larger single location investments and will improve the efficiency of capital.

Importance of consensus: In India’s democratic political system, a consensus has to be built between the states and the union to implement GST. Implementation of the GST will require an amendment to the constitution that will permit the federal government and the state governments (since GST will be a shared tax) to undertake all indirect taxation. An amendment to the constitution requires a greater than 2/3rd vote in parliament.

States will give up their powers for indirect taxation under the GST and will share taxation proceeds with the federal government based on an agreed formula.

In my opinion, it is absolutely necessary that a consensus is evolved before such a major change is affected to the country’s system of taxation. While the benefits are known, many important potential pitfalls have been highlighted by several states during the process of consultation and consensus building. Incorporating those concerns into the GST will make it a stronger, more robust and more sustainable form of taxation for India for decades to come.

In my view, a China-like, draconian and top-down implementation of an important tax like the GST would create unintended consequences and discontent that would lead to an unraveling (both economic and political) sometime in the future. On the other hand, even if it takes India another 3 or 4 years (likely to happen sooner) to evolve consensus and implement the GST, it will be a sustainable and irreversible change that will power India’s growth in the decades to come.

Importance of Information Technology: As with everything else, India is leapfrogging generations of technological change by implementing the cutting-edge. A national value added tax system like the GST would be prone to manipulation and leakages if not implemented with a sound procedural backbone. For this, IT is the great enabler. Even as the consensus is being evolved on the actual law and constitutional amendments, India is moving ahead on building a strong national information technology system that will support the robust and effective implementation of the GST.

The GST will be a game changer for India and the future for this reform looks bright!