GST RATE AND ITS EFFECT ON GOVERNMENT REVENUE

Ashwath Narayana B Sanket

Tuhina Kumar

Introduction

The aim of this research paper is to critically examine how important it is to have the appropriate rate of GST and how this rate will affect government revenue. This is done by analyzing the various factors that affect the appropriation of the GST rate. We will also examine the impact of GST on inflation and the effects of having a high or low RNR rate. We conclude by examining the long-term effects of implementing GST.

Need for GST

In developing countries like India, the government plays an important role in augmenting the growth and development, given the paucity of private capital and initiative. The government is also responsible for supporting the economically backward classes, maintaining law and order and security of the country ⁽⁹⁾. To carry out these responsibilities, the government needs sufficient revenue. Revenue collection is done through various means like taxes, fines, fees and charges, and foreign grants of which taxes form a major chunk.

Table 1: Revenue from taxes, Source: (8)

The government earns 14,49,490 crores from taxes, the breakup of which is given in Table 1. Indirect taxes contribute a significant 44.95% to the total tax revenue. Hence, it is important to streamline this tax base. Introduction of GST will remove the multiplicity of taxes and simplify the tax structure.

Revenue Neutral Rate (RNR)

Since GST is a value added tax that provides tax credits for the taxes charged on the preceding stage of production, it will eliminate the cascading effects of taxes. This, in turn, might reduce the total government revenue from indirect taxes. To avoid this loss in revenue, the government will have to raise its taxes. This increased tax rate that ensures the government earns consistent revenue is called the revenue neutral rate (RNR). The committee headed by the Chief Economic Advisor of India, Arvind Subramanian, submitted a report that suggested an RNR of 15-15.5%. The principle behind calculating this RNR is defined by the following basic equation:

t=R/B

where ‘t’ is the RNR, ‘R’ is equal to the revenue generated from the current sales tax (12.5%) and the exercise tax (14%). This revenue which will be replaced by the GST is estimated to be 3.28 lakh crore from the center and 3.69 lakh crore from the state, which sums up to 6.97 lakh crores (Excluding revenues from petroleum and tobacco for the Centre, and from petroleum and alcohol for the States) or 6.1 per cent of GDP. Now the total potential tax base ‘B’ should be determined to calculate the RNR⁽¹⁾.

The committee has used three methods to determine the total potential tax base; the macro approach, the indirect tax turnover (ITT) approach, and the direct tax turnover (DTT) approach. This paper will explain the macro approach. In this approach, the tax base is calculated using the data from national income accounts. As per the Arvind Subramanian report, the base ranges from 59 per cent to 67 per cent of the GDP. This calculated base excludes the basic food items, petroleum, and electricity⁽¹⁾.

As stated earlier, the total revenue to be replaced by the GST is 6.1 per cent of the GDP. By using the basic formula t=R/B, the GST RNR ranges from 9.1 (0.061/0.67) to 11.1 per cent (0.061/0.55). For OECD (Organization for Economic Co-operation and Development) countries, there is commonly a loss of 10 to 20 per cent in revenue ⁽¹⁾. Taking this loss into account the RNR ranges from 9-11 per cent to 11-14 per cent⁽¹⁾.

The aforementioned approaches have their own merits and demerits because of the underlying assumptions and data used. The Subramanian committee evaluated these and made suitable adjustments to arrive at an RNR rate of 15-15.5%

Standard Rate of GST

The standard rate is calculated using the below mentioned formula ⁽¹⁾:

R=αLG +βSG +γSS +μDG

Where ‘R’ is the RNR, ‘LG’ is the lower rate on goods, ‘SG’ is the standard rate on goods, ‘SS’ the standard rate on services, and ‘DG’ the demerit rate on goods; α, β, γ, and μ are the respective shares of these four rates in the underlying tax base, and together add up to 1⁽¹⁾. Hence the whole rate structure depends on policy choices about exemptions, what commodities to charge at a lower rate, and what to charge at a higher rate. Figure 1 shows the standard rate of GST in some emerging economies.

Figure 1: Standard rate of GST in high income and emerging markets economies, Source: (1)

The average standard rate in emerging market economies (EME’s) is 14.1% and the highest standard rate is 19% while for high income countries, the average standard rate is 16.8%. As India is an emerging market economy, an RNR of more than 15-15.5% will lead to a standard rate of 19-21%⁽¹⁾.

It should be kept in mind that GST is a regressive tax, which means that an increase in price due to increase in tax rates will extract a higher proportion of income from a consumer belonging to a lower income group. Developed countries can effectively offset the impact of regressive taxation by increasing their government spending and introducing many social security schemes. But India, being an emerging economy, will be unable to do so in their already limited budget. Hence India needs to be cautious of very high interest rates.

Learnings from other countries

As observed in countries like Australia, New Zealand and Canada, the implementation of GST will lead to a one-time price increase in the short-run but this inflationary effect will be stabilized in the long-run.

Canada follows a dual-rate GST system like the proposed GST system in India. Its initial GST rate of 7% lasted for 15 years after which it was reduced twice by 1% in 2006 and 2008. Canada has been decreasing its dependence on the consumption tax, which is contrary to the world trend. Many studies have proved that consumption tax is the most efficient way of taxation⁽⁵⁾. This means that a reduction in consumption tax leads to a very small change in the economic well-being of people as it causes a very small distortion effect on an individual’s decisions and does not change their investment decisions or the type of economic activity they practice. So the cut in the tax rate would only lead to a minimal increase in the consumption expenditure in the short run and might not lead to an increase in savings or investment to have any long term effect. Hence, Canadian government’s decision to reduce the GST rate may not be in the best interest of the economy at large.

Also, the GST system has become increasingly complex over time like the sales tax on manufacturing goods⁽⁵⁾. This is mainly due to the complexity of Canadian tax legislation, the number of taxes companies are subject to, and the multi-jurisdictional tax system. Furthermore, as more people came under the purview of the taxation system (because GST is a broad based tax), more people had to deal with this complex tax structure increasing their adjustment costs. A useful learning from Canada’s example is that a country should keep the taxation structure fairly simple to comply with. Also, as consumption tax is the most effective way of taxation, India should increase its dependence on indirect taxes.

Another useful learning can be taken from the example of Malaysia that faced a lot of opposition from its businesses even after providing 1.5 years to prepare for the change in the tax regime⁽⁶⁾. Since India plans to implement GST from 1^st April 2017, it may be very challenging for the businesses to adjust to this change in less than nine months.

Using Malaysia’s strategy, India could also release a probable tax structure for each segment to aid this transition.

Inflationary impact

 It is essential to understand the inflationary impact of GST on different goods and services. Some necessary goods will be exempted from taxes as the poor may not be able to afford them at high prices. For example, if we consider the pharmaceutical sector, it expects to gain from the overall increase in efficiency due to costs saved on the supply chain. However, if the rate is more than 12%, it will have a negative effect as healthcare is a necessity and it should be charged at a low rate with input credit funds available so that the end cost does not increase considerably⁽²⁾. It will be interesting to see how existing indirect tax exemptions and inverted tax structures are modified to ensure that the overall costs of pharmaceutical products do not increase on account of GST.

Figure 2: Weightage of different categories in CPI, Source: (1)

Moreover, a major part of the Consumer Price Index (CPI) basket (as shown in exhibit 3) which includes categories like food and beverages, clothing and rent, are either exempted or taxed at low rates as these are essentials for the lower income group. The effective tax rate on CPI is 10.4%. However, this includes goods outside the purview of GST like petrol, diesel, and alcohol. If we exclude these items, only 46% (approx.) of the CPI will be taxed. Out of this, 32% is taxed at a low rate and only 15% is taxed at a normal rate. This builds up to an effective tax rate of 7% on CPI because these excluded goods are charged at very high rates ⁽¹⁾.

However, if a good is exempted from taxes, it does not necessarily mean that the net tax charged on that good is zero. This is primarily because the embedded taxes on inputs, like the taxes paid on fuel during the transportation of these goods, are carried forward to the final product. Also, if food, fuel, and light are exempted from taxes and the Public Distribution System (PDS) continues to subsidize, the net price impact on the consumption of these goods for the poor will be minimal.

The proposed GST structure is a dual-rate tax structure and its inflationary impact will depend on the RNR rate and the standard rate. An RNR of 15% with a lower rate of 12% and a standard rate of 17-18% will have no inflationary impact⁽³⁾. This is so because the revenue received by the government remains the same. Moreover, while the prices of some goods will go up, the prices of some other goods will go down negating the inflationary pressure. A higher RNR of 17-18% with a lower rate of 12%, a standard rate of 22% will have an inflationary impact of 0.3% if only the headline tax rate is considered. Furthermore, when the change in price is adjusted to the cascading input taxes, the net inflationary impact will be around 0.7% ⁽¹⁾.

Effect of different rates of RNR

Since we don’t know the RNR rate, we can only speculate the effects of a high and low RNR rate. If a low rate of RNR is set, it will lead to a fall in revenue. As the center has promised to compensate the states for any loss of revenue over a five-year period, it will have a huge negative impact on the center as it has to support the states while it faces fall in its own revenue. Also, if this compensation is delayed, then it will lead to a loss of trust between the center and the state. The loss in revenue can also lead to a reduction in the growth rate of the country and this will further reduce the revenue⁽⁴⁾.

We need to keep in mind that India is a developing country with diverse needs. Economic and social disparities have to be addressed while we simultaneously invest in education, healthcare, transport, energy, infrastructure etc. to boost development. This requires huge capital investments. GST rate will be set in order to meet these investment demands and any loss of revenue due to a reduction in rate will defeat the purpose of this taxation system.

Conclusion

In the long-run, GST is expected to benefit the economy in many ways. It provides credits on input taxes paid at the previous stage of production, decreasing the burden of tax on the end consumer. It also fosters greater compliance due to its multi-point collection system and an invoice trail that minimizes tax evasion because one needs to issue and obtain invoices in order to set-off the taxes from the previous stage of production. It increases the efficiency of the supply chain by saving travel time due to a reduction in hindrances and better warehousing and distribution of goods, leading to more cost-efficient decision making. On the whole, it will induce growth in the economy by creating an integrated economy with a common market while increasing the ease of doing business by streamlining the tax structure.

Bibliography

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About the authors:

The author is currently a student of the PGDM batch of 2016-18. His areas of interests are micro and macroeconomics. He is also a Committee member of TAPMI Toastmasters Club. You can contact him at:  ashwath.18@tapmi.edu.in

The author has done economics and is currently a student of finance in the PGDM batch of 2016-18. Her areas of interest are Economics and Finance. The author also has a keen interest in the financial news of around the world. You can contact her at: tuhina.18@tapmi.edu.in