Selected Issues

Abstract

Selected Issues

Summary

India has been one of the fastest-growing economies in the world in recent years, partly reflecting key structural reforms that have been implemented. Among these reforms are the inflation-targeting monetary policy framework, the Insolvency and Bankruptcy code, the goods and services tax (GST), and steps to liberalize foreign direct investment (FDI) flows and the ease of doing business. This background paper for the 2018 Article IV consultation with India explores possible further enhancements to the structural reforms, including to help reap the full benefits of India’s potential demographic dividend over the next few decades.

The first chapter discusses potential trade-offs of simplifying the GST—a milestone reform in India’s tax policy. While the GST unified and harmonized numerous indirect taxes, it has a complex structure, which could be simplified without sacrificing progressivity of the current GST and with potentially significant gains from lower compliance and administrative costs.

The second chapter analyzes states’ finances, which have deteriorated in recent years. Traditionally, fiscal discipline has been imposed on states through central control over state borrowing and through states’ self-adopted fiscal rules. Market discipline could be strengthened through reforms focusing in the near term on further liberalizing financial markets, improving the quality and timeliness of state fiscal data, ensuring sufficient fiscal flexibility for states to respond to fiscal shocks, and, over the medium term, on steps to strengthen no-bailout expectations.

The third chapter analyzes the structure and composition of FDI flows to India and factors underlying FDI flows across countries. FDI flows to India have increased significantly in recent years, partly benefiting from FDI liberalization and improved investor sentiment. Based on the empirical analysis, further investment liberalization, supply-side reforms, and infrastructure investment could help sustain FDI going forward.

The fourth chapter examines the nature, magnitude, and sources of resource misallocation across Indian states. As strict labor market regulations appear to be a major contributor to misallocation, further labor reforms will improve firm-level efficiency and productivity.

The final chapter takes stock of key issues in and identifies important reforms for India’s agricultural sector. Including based on the analysis, sustained inclusive growth requires agricultural sector reforms, which should focus on reducing supply-side constraints, building more integrated markets, boosting productivity, and addressing market distortions.

GST: Considerations for a Simpler Rate Structure1

The goods and services tax (GST) is a milestone reform in India’s tax policy, taking the important step of unifying and harmonizing numerous indirect taxes across all states of the federation and the central government. Yet, the GST has a complex structure with a relatively high number of rates (and exemptions), which could be simplified without sacrificing progressivity of the current GST and with potentially significant gains from lower compliance and administrative costs. A dual rate structure with a low standard rate and an additional higher rate on select items can be progressive and preserve revenue neutrality, while streamlining exemptions would further contribute to progressivity and reduce compliance and administrative costs.

A. Introduction

1. The introduction of the GST on July 1, 2017 was a critical and long-awaited reform to India’s indirect tax system. The GST subsumed numerous existing taxes at the center and states, including central excises and state valued-added taxes (VATs), the central service tax, countervailing and additional duties, and numerous levies such as on entertainment and gambling. The implementation of the GST led to the key step of harmonizing indirect tax rates on goods and services that previously differed across different states and the center, and brought services into the state tax net (earlier services were taxed only by the center and excluded from the state VAT).

2. India’s GST has a multiple rate structure, which is relatively rare among countries with a VAT. India belongs in a small group of (five) countries having four or more GST rates (four nonzero rates of 5 percent, 12 percent, 18 percent, and 28 percent; special low rates of 3 percent on gems and jewelry and 0.25 percent on rough diamonds; and a GST “cess” levied on demerit goods). In comparison, among 115 countries with VATs, 49 have a single rate, and 28 have two rates.2

3. The multiple rate structure in part reflects the demands of fitting multiple pre-GST tax rates on the same items. Rate fitment of items taxed differently under the previous excise and VAT regimes necessitated creation of in-between rates that would continue to yield revenue neutrality. For instance, a product taxed under a state VAT but zero-rated under excise taxes on the same good, say due to merit-good status, would need to be taxed at an intermediate rate under the new GST, to remain revenue-neutral.

4. The multiple rate structure and other features of India’s GST environment could give rise to high compliance and administrative costs. In general, high costs may stem from factors highlighted below, some of which may be relevant in the Indian context:

  • Legislative complexity (exclusions, exemptions, deductions, rate differences, frequency of changes, etc.);

  • Procedural requirements (such as the need for supplementary documentation);

  • Nature of the clientele—e.g., dealing with non-registrants; and

  • Verification costs—especially under high informality as exists in India.

5. There is a broad consensus among economists that fewer rates and exemptions reduce these costs (Owens et al. (2011), OECD Observer (2011)). Overall tax compliance costs can be quite high, ranging between 2–10 percent of revenue yields, as high as 2½ percent of GDP (Barbone et al. (2012)). The evidence on VAT compliance costs varies widely across countries (and methodologies). While evidence on GST compliance costs in India are scanty, anecdotal evidence suggests that for large firms, the cost has increased from negligible shares to 0.2 percent of total costs (excluding switch-over costs which are estimated to be around the same level), though there are economies from switching to a simpler tax structure particularly for inter-state commerce. It is also taken as well established in the literature that compliance costs are regressive.3 Another important benefit of a simpler rate structure is that it would reduce opportunities to lobby for lower rates among firms.

6. A simpler rate structure with fewer exemptions, however, would be less progressive. With the consumption basket of the rich taxed at higher rates than that of the poor, the GST as presently designed has an effective tax rate rising with household consumption. A revenue-neutral reduction in the number of rates would raise the effective rates for poorer households while reducing those for richer households. This is the key cost of moving to a simpler system.4

7. This chapter assesses the trade-offs in further simplifying India’s GST. We will estimate the change in the incidence of the GST across household consumption quintiles if a revenue-neutral shift was made to a single rate or a single rate supplemented by a high rate on certain items (Section B). While compliance costs are in general significant for taxes, GST/VAT compliance and administration costs are harder to generalize due to high variation in the evidence and with only nascent experience with the GST in India. However, we note the broad consensus on the desirability of a simpler GST structure. We also address some concerns on the impact for informal/small firms from moving to a single rate, and note caveats related to the analysis (Section C). A brief conclusion is offered in Section D. Data and methodological issues are addressed in the Appendix.

B. Incidence of the GST

“Can we have milk and Mercedes at the same rate?” – Prime Minister Modi.

8. The GST in its current design has a progressive incidence (Figure 1). The estimated total incidence includes both the direct incidence due to goods and services that are taxed and the indirect incidence that is due to the embedded input taxes on exempted goods (see Appendix for details). The estimated (average) effective GST rate on the lowest quintile of households by consumption expenditure, including both direct and indirect incidence, under the current GST rate structure (as of January 2018) is 9.0 percent. This rises only gradually to 9.6 percent for the fourth quintile and 10.5 percent for this topmost quintile.5

Figure 1.
Figure 1.

GST Incidence Under Current Structure

(By consumption quintile, in percent)

Citation: IMF Staff Country Reports 2018, 255; 10.5089/9781484373200.002.A001

Sources: Central Board of Excise and Customs; and Staff estimates. Rate structure as of January 10, 2018. All own-sector input supplies are assumed to be partly taxed.

9. Due to embedded input tax costs, exemptions have a regressive effect. A key finding from this exercise is that the indirect incidence of the current GST disproportionately burdens poorer households, undoing the objective behind having exemptions. The lowest quintile faces an additional 2.5 percent effective GST rate since exempt goods production cannot avail of input-tax crediting (and input tax costs are thus likely passed on to the final consumer). This indirect incidence regressively diminishes with higher consumption due to the lower share of exempt goods in the consumption basket of higher quintiles, falling to 1.7 percent for the highest quintile.

10. A revenue-neutral flat rate produces a flat GST incidence profile (Figure 2). In this exercise, a flat 10 percent GST rate (that produces about the same aggregate GST revenue on the given consumption profile), and the currently in-place set of exemptions, are simulated to generate the direct and indirect incidence profile. The direct incidence remains progressive, the difference across quintiles reflecting the difference in the weight of exempt goods in consumption. However, the indirect incidence due to exempt goods erodes the difference completely, and the total incidence is 10 percent for all.

Figure 2.
Figure 2.

GST Incidence Under Single Rate

(10% single rate and current exemptions; in percent)

Citation: IMF Staff Country Reports 2018, 255; 10.5089/9781484373200.002.A001

Sources: Central Board of Excise and Customs; and Staff estimates. Rate structure as of January 10, 2018. All own-sector input supplies are assumed to be partly taxed. Note that this simulation raises 99.4% of the revenue raised under the current GST structure.

11. A single rate thus causes the effective GST rate to rise significantly for the lower quintiles and fall for the highest. Such a profile is likely to pose political feasibility constraints. Therefore, we consider an alternative simulation where a single rate is supplemented with an additional (higher) rate to target the consumption of the higher quintiles. This enables a standard rate lower than 10 percent, helping to reduce the effective rate paid by lower quintiles.

12. A dual rate GST would be able to deliver a progressive incidence at little additional cost to poorer households. A revenue-neutral combination of a 9 percent standard rate and a 25 percent high rate (applied to items that in the current GST are taxed at 28 percent), while retaining the current set of exemptions, is simulated (Figure 3). The resulting profile of total GST incidence reveals a modestly progressive incidence. The total incidence on the lowest quintile is 9.6 percent, rising gradually to 10.1 percent for the highest quintile. Note that as usual, with the existing set of exemptions in place, the indirect effect erodes progressivity.

13. Other adjustments to such a dual rate system would help increase progressivity. Note that adjustments to the dual rate system could also be made to enhance its progressivity, with more selective application of the higher rate to exclude the consumption of poorer households as much as possible, and adjusting the top rate higher as required. In addition to more selective application of the high rate, eliminating exemptions would improve the progressivity of the tax by eliminating the regressive indirect incidence.

Figure 3.
Figure 3.

GST Incidence Under Dual Rate

(9% single rate + 25% top rate and current exemptions; in percent)

Citation: IMF Staff Country Reports 2018, 255; 10.5089/9781484373200.002.A001

Sources: Central Board of Excise and Customs; and Staff estimates. Rate structure as of January 10, 2018. All own-sector input supplies are assumed to be partly taxed. Note that this simulation raises 99.6% of the revenue raised under the current GST structure.

C. Caveats

14. There are important caveats/complications to address in the foregoing analysis.

  • The first relates to the possibility of under-reporting of consumption in the data used for this exercise, namely National Sample Survey’s (NSS) Household Consumption Expenditure data.6 Systematic under-reporting of expenditure on high valued items would yield a misleadingly low estimated progressivity under the current GST. However, this does not change the conclusion that a dual rate GST would still result in a progressive incidence, as even though the incidence on the rich would decline, it would likely be at a higher level than shown in the dual rate case, whereas it would be at a similar level for the poorer households assuming under-reporting of high valued consumption among these households is less prevalent.

  • A second relates to the costs of a uniform rate structure on small businesses. The concern is that an increase in the effective GST payable by small businesses under a uniform rate would have negative employment and output effects as such firms would be forced to exit. However, the resources released by exiting firms would likely be absorbed by firms that are able to grow, absorb the costs of a uniform tax rate, and expand their market share.

  • A final caveat relates to the treatment of firms outside the GST net. The analysis in Section B treats all household consumption as produced by firms in the GST net. In reality, only firms above a certain annual turnover threshold (INR 2 million or US$29,400) are required to register under the GST, and those with turnover between INR 2 million and INR 15 million (US$ 220,500) are required to pay a flat 1 percent tax but cannot charge the GST on sales nor avail of input tax credits. Thus, a potentially large number of small firms are excluded.7 The impact of GST-exempt firms on the estimated incidence in Section B is difficult to sort out empirically in the absence of detailed data on exempt firms’ supplies mapped to household consumption expenditure. However, we can sketch out some possibilities under different configurations of input consumption by exempt firms and the share of household consumption supplied by such firms:

    • Case 1: Exempt firms purchase inputs and pay GST on them (on which they cannot claim tax credits due to exempt status). In this case, the embedded tax costs will add to the indirect incidence of the consumer, qualitatively like the effect of exempt goods and services in the cases shown in Section B. The distribution of this additional indirect incidence would depend on the share of exempt firms’ output in household consumption expenditure across quintiles, which is hard to assess in the absence of detailed data. However, if we assume that exempt firms supply predominantly to poorer households, it would imply that the GST at present is less progressive than estimated due to the indirect incidence falling disproportionately on poorer households.

    • Case 2: Exempt firms have zero or minimal purchased inputs (an extreme assumption). Assuming households have a non-zero share of purchases from exempt producers, then the incidence under the current GST would be lower than estimated in Section B, as there would be no indirect incidence due to uncredited input tax costs. And, under the flat rate/dual rate scenarios, the incidence will be (i) lower than estimated if the share of exempt firm supply in household consumption is unchanged (or increases) relative to current shares or (ii) higher than estimated if the share declines.

D. Conclusions

15. Simplifying the GST is possible without imposing a significantly higher burden on the poor. For example, a dual rate structure with a low standard rate (and high rate on high-value consumption items) would still allow for progressivity, as would rationalizing exemptions by eliminating the regressive indirect incidence from unrefunded input tax costs.

16. There are likely significant benefits from lower costs of compliance and administration. The literature on VAT compliance costs shows that there is broad variation across countries; however, there is a consensus that compliance costs are regressive, and administrative costs increase with complexity. While evidence on India is nascent and remains to be assessed as experience with the GST is gained, anecdotal evidence from large firms indicates sizable increases in costs, which may be even more burdensome for smaller firms. Streamlined rates would also weaken incentives to lobby for lower rates.

17. These conclusions are broadly robust to the caveats. While data constraints preclude accurately assessing all the implications, the conclusions appear to hold under plausible cases.

Appendix I. Methodology

The main elements of the methodology are laid out below.

  • The GST subsumes central taxes (central excise, central service tax, counter-vailing duty, special additional duty, and additional surcharges and cesses), and state taxes (state VAT, central sales tax (levied by states), luxury tax, entertainment tax, entry tax, advertisement tax, purchase tax, and lotteries and gambling taxes).

  • With available information on the key pre-GST rates (in italics above), the pre-tax weight for goods and services in household consumption as reported in the NSS data (which is gross of pre-GST indirect taxes) is calculated. Item-wise GST rates are then mapped to these consumption weights, to calculate the effective GST rate for each household.

  • The effective rate includes both a direct incidence (weighted sum of non-exempt goods and services’ tax rates), and an indirect incidence (weighted sum of embedded input tax costs in exempt goods and services, which are not input-tax creditable, and thus are assumed to pass on fully to consumer prices, except for electricity and water).

  • The indirect incidence is estimated using input-output information, applying Leontieff-inverse coefficients to weight the share of a given input good/service in the output of a given (exempt) good/service. Goods excluded from the GST (such as fuels) are also treated as an exempt good for this exercise.

  • Revenue-neutral scenarios are then assessed on the same household consumption data by applying alternative tax (GST) rates on the goods and services, mapping as closely as possible to the items listed under the GST and the items recorded in household consumption expenditure.

Data

  • Household consumption expenditure: NSS 66th Round Consumption Expenditure Survey (2011–12), with more 100,000 households covering nearly 350 goods and services.

  • Rates of center and state taxes subsumed by GST, rates on GST: central and state government documents (World Bank), GST website.

  • Input structure of the Indian economy: Input-Output Tables of the Indian Economy 2007/08.

  • Concordance between rate schedules, consumption expenditure classification, and input structure classification: staff estimates.

References

  • Barbone, L., R. Bird, and J. Vazquez-Caro, 2012, “The Costs of VAT: A Review of the Literature,” International Center for Public Policy Working Paper 1222

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  • Government of India, 2015, Report on the Revenue Neutral Rate and Structure of Rates for the Goods and Services Tax, http://www.gstcouncil.gov.in/sites/default/files/CEA-rpt-rnr.pdf.

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  • Owens, J., P. Battiau, and A. Charlet, 2011, “VAT’s Next Half Century: Towards a Single-rate System?OECD Observer, 284, Q1 2011.

  • Sundaram, K. and S. Tendulkar, 2001, “Recent Debates on Database for Measurement of Poverty in India: Some Fresh Evidence,” Delhi School of Economics.

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  • Gupta, P., F. M. Blum, D. Jain, S.R. John, S. Seth, and A. Singhi, 2018, India Development Update: India’s Growth Story (English), Washington, D.C.: World Bank Group.

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1

Prepared by Adil Mohommad.

2

Source: World Bank India Development Update 2018.

3

“The regressivity of the compliance burden, especially for VATs, stems from the large diseconomies of scale involved in complying with tax requirements, together with the learning curve effect that militates strongly against small firms…” (Barbone et al. (2012)).

4

That said, it is noteworthy that since its implementation the GST rate structure has been streamlined to an extent, with most of items being moved out of the top 28 percent bracket (which would reduce the progressivity of the tax).

5

Estimates of the incidence in this Section are based on household consumption expenditure survey data, which yields lower GST standard rates than have been estimated using other data sources. For instance, see Report on the Revenue Neutral Rate and Structure of Rates for the Goods and Services Tax (GST) (December 2015), which shows estimates ranging from 11.6 percent to 17.7 percent for the revenue neutral rate.

6

For debates regarding the appropriateness of NSS data for setting the poverty line, see Sundaram and Tendulkar (2001) for instance.

7

According to the 2016 Economic Census of India, there are 58.5 million establishments in operation, of which 45.4 million are in non-agriculture (including the public sector). Currently 10.4 million firms are registered, of which 1.3 million are under the “composition scheme” (availing the flat tax but not the input tax credit).

India: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
  • View in gallery

    GST Incidence Under Current Structure

    (By consumption quintile, in percent)

  • View in gallery

    GST Incidence Under Single Rate

    (10% single rate and current exemptions; in percent)

  • View in gallery

    GST Incidence Under Dual Rate

    (9% single rate + 25% top rate and current exemptions; in percent)