GST and Its Failures: Explained

Arun Kumar

GST has been in operation since July 1, 2017. In the six years that have elapsed, has it fulfilled the promises that its proponents had vociferously claimed for it. It was billed as the second freedom since it was supposed to unify the `fragmented’ Indian market. That was the parallel drawn with 1947 which brought together the states to form India as a union of states.

Promised Gains from GST

GST was supposed to benefit the people by, increasing GDP by 1 to 2 per cent, reducing inflation, curbing the black economy, increasing tax collection leading to better public services, creating ease of doing business leading to increased investment, removing cascading effect of taxes, etc. With all the hype, no negative notes were discussed.

GST under discussion since the late 1990s finally got implemented in July 2017 after agreement was reached across political parties and states in 2016. Several prosperous states were reluctant to join GST since it is a last point tax which would be disadvantageous to them. They were brought on board with the promise that their revenue would be protected with a guaranteed 14% increase over the base of 2015. They were to be compensated for any revenue shortfall.

Liquor for human consumption and petroleum goods are cash cows for the Centre and the states. To bring states on board, they were kept out of GST so that in case of need they could be milked for extra revenue. This came in handy for the Centre and the states during the pandemic.

The states agreed to give up their power of fixing rates in favour of a common tax rate for the country. This dents federalism. A GST council was set up consisting of all the Finance Ministers of the states and headed by the Union Finance Minister. Decisions on the rules and the rates were to be taken by voting with each state having the same weight in the Council. But the rules of functioning of the Council were drafted in such a way that the Centre could exercise a veto on any proposal it did not like. Further, it could influence the smaller states to vote with it to get proposals implemented even if some of the bigger states opposed them.

The agreement between the Centre and the states was hailed as ‘Cooperative Federalism’. In fact, suggestions have been made to set up other Centre-States councils on matters like, subsidies and expenditures. This idea is being propounded so that the Centre can get greater control on more of the states’ budgetary provisions. That it would reduce states’ autonomy and further dent federalism is hardly a concern for the Centre.

It was stated that 17 indirect taxes were being replaced by 1 tax, cascading effect of indirect taxes would be removed, rates would be set so as to ensure revenue neutrality, entry into states would be eased with the abolition of check posts at state borders and so on. It was argued that e-waybill would make it easier to track movements of goods and ease transportation. GST requires computerization and that was expected to lead to digitization of the economy and better tax compliance.

It was also said that GST is applicable in 160 nations with the earliest being France in 1954, so why not in India? But, what may work in some country may not work in another country? USA does not have GST and Malaysia had withdrawn GST in 2018. Further, hardly any country has the full GST — most including India have a half-way house – which leads to its own problems.

Complex Structure

GST is a very complex tax applicable on supply of goods and services. The definition of supply itself is complicated leading to daily new cases in the courts. Further, it is calculated as Value Added Tax which requires suppliers to compile information on all input and outputs.

  1. Input Tax Credit

The system works with the input tax credit (ITC). Businesses require inputs to produce anything. For instance, to produce a simple steel utensil, steel is bought and to produce that pig iron is purchased and that requires iron ore. In between, at each stage, chemicals, energy, transportation, accountant services, marketing, finance and so on are required. Each of these have a tax levied on them. Earlier there were the sales taxes, excise duties and services tax. If something was imported there were customs duties to be paid. Tax at each stage raised the price the buyer if input had to pay. This was the cascading effect of taxes. It leads to a higher effective tax rate than the announced tax rate. Hence it was inflationary.

Value Added Tax is supposed to remove the cascading effect. In India the way it worked was that the tax paid on the inputs was set off against the tax that the producer had to pay. This is the input tax credit. So, the producer is only supposed to pay the tax on the value she/he is adding to the product made. Slowly, since the late 1990s, the governments had moved to levying Sales tax, Excise duty and Service Tax as VAT using the input tax credit mechanism.

But cascading effect continued since there was no input credit across taxes – service tax, excise tax and sales tax. So on the production of pig iron in the above example, no ITC was available on sales tax paid or the service tax paid for transportation or accounting services, etc. So, while cascading effect was removed within a tax it continued across taxes. This cascading effect across taxes was sought to be removed via GST which brought all indirect taxes on a common GST platform. Under GST ITC becomes available for all the indirect taxes paid. This was supposed to lower the effective tax on any item and lower the prices and the rate of inflation.

2. Revenue Neutral Tax Rate

But, if the effective rate comes down, government revenue gets reduced and that raises the deficit in the budget. States would also have a bigger problem of meeting their needs. Hence there was talk of a `revenue neutral tax’. That is, under GST the rate of tax levied should keep the overall tax revenue unchanged. This raised much controversy since different rates of taxes were required.

The controversy was deeper than imagined at the beginning since different kinds of goods and services required different rates and not one common tax rate as envisaged under ideal GST.

Indirect taxes are inflationary since they are like prime costs for business.
Different rates were required since indirect tax lead to price increase and it was felt that the poor would be adversely impacted. As the former FM, Mr. Jetley said, a Mercedez car and a hawai chappal cannot have the same tax rate. Indirect taxes are regressive so a common rate of tax will make the system more regressive.

To reduce regressivity, common items of mass consumption have been exempted from GST. Many government essential public services, like, education and water supply are exempted. Legal services are also exempted. Many essential items are kept at 5% tax rate while luxury items are at 28% and the sin goods have a cess on top. There are special rates for precious items. Such multiplicity of taxes has made GST complex and that enables tax evasion.

Further, even items that do not pay GST end up paying some part of it since goods need to be transported, etc. As diesel, trucks, batteries, etc., pay GST, the price of wheat which is exempt from GST also ends up paying a part of the GST. Cascading effect also partly continues.

A large number of fake companies have sprung up which provide fake ITC to evade taxes. The government has stated that Rs.30,000 crore of tax has been evaded. The actual would be many times more since only about 3% of the evasion is usually detected.

3. Impact on Unorganized Sector 

For the huge unorganized sector in India, keeping track of input and output is difficult and they cannot afford to computerize. So, under GST, the unorganized sector with turnover of up to Rs.50 lakh is exempted and above that up to a turnover of up to Rs.1.5 crore, they are under the composition scheme with a flat 1% tax. But they neither get ITC nor can they offer ITC to their buyers. Thus, they face a disadvantage viz.-a-viz. the organized sector which benefits from ITC. This is in addition to the complexity introduced in the economy due to implementation of GST.

The organized sector benefits from lower costs due to ITC. Their effective selling price also is less since they can offer ITC to their purchaser. Since the revenue neutral rate has to be kept high and the unorganized sector does not get ITC, their cost rises compared to earlier and they have to raise their price if the same profit is to be earned. The organized sector is unaffected since they get the ITC for the higher tax paid. The result is that the organized sector prices become lower than the price charged by the unorganized sector.

The result is a shift in demand from the unorganized sector to the organized sector. This is being reported from leather goods, pressure cooker, luggage industry, FMCG, etc.. The result has been a decline in the unorganized sector with many units closing down and workers becoming unemployed. The organized sector being highly mechanized and automated provides few jobs.

Assessment of Performance

It was expected that GST as a last point tax would benefit the poorer states which are the consuming states. It was hoped this would reduce inter-state inequality. The opposite has happened since the unorganized sector is concentrated in the poorer states. As this sector has declined, it has led to a greater adverse impact on the poorer states than on the richer states.
Implementation of GST did not result in a lower inflation rate or an increase in the rate of growth of the economy or a check on the black economy. Of course, many factors, not just the indirect tax rate, impact these variables. For instance, demonetization was a major shock just 8 months before the launch of GST and it had damaged the economy severely. Post GST, even the official rate of growth of the economy fell from 8% to around 3% just before the pandemic hit the economy. If the adverse impact on the unorganized sector could be independently measured, the actual rate of growth would have been close to zero per cent. India has not been the fastest growing large economy in the world as officially claimed.

  • Tax Revenue
  • Revenue collection from GST has been on the rise. In 2017-18, the starting year, monthly GST collection was Rs.79,898 crore per month. Since that was a disturbed year and there were teething problems let us start with 2018-19 when the monthly collections had reached Rs.98,114 crores. Now the figure has even touched around Rs.1.8 lakh crore but the average for 2022-23 is Rs.1.51 lakh crore. This is an increase of 53.5% in 5 years. Does this constitute a success of GST with better compliance and less black income generation? Even a growth of 14%, promised to the states, GST collection should have increased by 92% over 5 years.
  • GVA at current prices in 2018-19, was Rs.172 lakh crore and in 2022-23 it is supposed to have reached Rs.247 lakh crore — an increase of 44% in 5 years. Thus GST collection has grown faster than the GVA. It appears that compliance has improved.
  • But the corporate sector has grown much faster than the rest of the economy. As per the RBI sample of companies in Q1 of 2020-21, production grew 71.1%, in Q4 of 2021-22 at 22.2% and in Q1 of 2022-23 by 39.7%. This is far greater than the growth in GVA of about 8% per annum. Since most of the GST is collected from big businesses and their associates, the increase in collection of GST should have also been far greater than 53.5% in 5 years.
  • Another indication is that in 2017-18, e-commerce grew 41% (of course, on a small base) and in the pandemic year at 40% plus. Last year it is supposed to have grown at around 20%. This is much higher than the growth in GVA. It is another indication of the growth of the organized sector at the expense of the unorganized sector, like, the neighbourhood shops.
  • The implication of the above is that the claim of better compliance in the economy, especially, the organized sector, is incorrect. The detection of large scale ITC fraud and detection of fake companies shows that tax evasion is substantial. This loss of revenue not only impacts the national budget but also means less resources available to the states.

Conclusion

Some key official promises of benefits from GST have been discussed here and clearly they have not materialized. Namely, GDP growth has declined, inflation rate has not fallen and the black economy continues to thrive. The cost has fallen on the vast unorganized sector which is the major employer in the economy. The overall economy had slowed down even before the pandemic. The backward states which were expected to benefit have not, due to the decline in the unorganized sector.

All this is a result of the GST being unsuited to the highly complex and differentiated Indian economy. Because GST exists in other countries cannot be the reason why India should go for it. The complexity has been amplified by the attempt to tackle many issues with one instrument, the GST. All this has made GST a half-way house, structurally flawed, not promoted ease of doing business and therefore led to a stagnant investment rate and slow growth.

An alternative simpler GST is possible but the government is not willing to admit failure. Further, while GST has not benefitted the country, the bigger challenge is to fiscal federalism which has been dented and which will have long term consequences. It needs to be tested if GST also falls foul of the basic structure doctrine?

This article was first published in the Mainstreamweekly as The Unfulfilled Promises of a Structurally Flawed GST: Assessing its Impact During Six Years of its Operation on 22 July, 2023.

Read more articles by the author: GST and Its Undelivered Promises