Dr. Devesh Kapur on the Indian Goods and Services Tax

Devesh Kapur is the Director of the Center for the Advanced Study at the University of Pennsylvania. He is Professor of Political Science at Penn, and holds the Madan Lal Sobti Chair for the Study of Contemporary India. Dr. Kapur has also served as the Associate Professor of Government at the University of Texas at Austin, and the Frederick Danziger Associate Professor of Government at Harvard. His research focuses on human capital, national and international public institutions, and the ways in which local-global linkages, especially international migration and international institutions, affect political and economic change in developing countries, especially India.

Devesh Kapur is the author of Diaspora, Democracy and Development: The Impact of International Migration from India on India, published by Princeton University Press in 2010, Defying the Odds: The Rise of Dalit Entrepreneurs (co-authored with D. Shyam Babu and Chandra Bhan Prasad), published in 2014 by Random House India, and The Other One Percent: Indians in America (co-authored with Sanjoy Chakravorty and Nirvikar Singh), published in 2016 by Oxford University Press. His latest edited works are Navigating the Labyrinth: Perspectives on India’s Higher Education (with Pratap Bhanu Mehta), published in 2017 by Orient BlackSwan, and Rethinking Public Institutions in India (with Pratap Bhanu Mehta and Milan Vaishnav), forthcoming in May 2017 by Oxford University Press.

In 2012, he received the ENMISA (Ethnicity, Nationalism, and Migration Section of International Studies Association) Distinguished Book Award for Diaspora, Democracy and Development: The Impact of International Migration from India on India. 

Dr. Kapur is the 2005 recipient of the Joseph R. Levenson Teaching Prize awarded to the best junior faculty, at Harvard College. He is a monthly contributor to the Business Standard. Professor Kapur holds a B. Tech in Chemical Engineering from the Institute of Technology, Banaras Hindu University; an M.S. in Chemical Engineering from the University of Minnesota; and a Ph.D. from the Woodrow Wilson School at Princeton. 

In June 2017 the Modi government introduced a major tax reform called the “Goods and Services Tax” (GST) which is a new form of consumption tax in India. It took fourteen years to adopt this reform. What does the new tax reform entail? Why is a tax on goods and services considered “historic” by some?

The concept of fiscal federalism is core to understanding the reform. In any federal system, there is an assignment of taxes at different levels of government, and there is an assignment of expenditures.

In the U.S., the income tax is a federal tax, whereas the property tax is a local tax. But, there are taxes on the range of goods for which you might have a state sales tax. Those taxes can vary from state to state. In most federal systems, the constitution assigns who can tax what. Hence, in the U.S., the primary income tax is levied by the federal government, not by the states. But when there are a range of taxes across goods and services across different geographical administrative areas, it can be complicated. When goods move across administrative borders, then the location where goods are produced and consumed becomes important for tax policy. An excise tax is imposed at the place of production while a sales tax is imposed at the point of consumption. Hence, the decision where to produce something can be driven less by economic efficiency and more by tax policy.  

This tax reform in India avoids what we call cascading taxes. For example, if an intermediate good sells for $10, and there is a 10% sales tax, the price paid by say a manufacturer would be $11. If this manufacturer buys five such inputs, assembles them and sells it to a consumer for $60 to which one adds a further 10% sales tax. Now of the total price paid – $66 – the final buyer is paying 10% tax on the 10% initial sales tax on each of the five inputs i.e. it’s a tax on taxes. The result is a cascading tax. To avoid this, many countries have a value added tax (VAT). This means that the tax is only on the value added to the cost of inputs. In the above example, the cost of inputs for the buyer is $55, the sales price is $ 60, so the value added is $5

A value added tax works against tax evasion, because in order for sellers to get the tax benefits, they have to show the cost of the inputs. So, the guy who sold goods to the final seller cannot hide what he received because the seller can get a tax credit only if he can show his cost of inputs.

Ideally, the VAT works when there is some uniformity in taxes across administrative jurisdictions. Imagine goods being made in California and being shipped to Nevada. If both states have very different tax rates, the company will decide to locate on just the other side of the border—not because it is economically efficient, but because the company will make more money because of differential tax rates.

When there is a large federal system, these multiple tax systems and rates in multiple administrative jurisdictions lead to huge economic inefficiencies because decisions about the location of production are not driven by economic considerations (i.e., cost of electricity, quality of infrastructure, cost of labor). They are driven essentially by tax shopping.

Having a uniform system of taxes in a federal system across different national units can make a very positive contribution to economic efficiency. In other words, it will improve internal trade. Many companies in India will set up multiple small plants because moving a good across state boundaries can result in higher taxes. So, companies will have many small, inefficient plants and warehouses in each state instead of one large plant or warehouse.

India essentially lacked a common market. The boundaries of the states were like boundaries of countries. Not exactly international boundaries, but the movement of goods and services across borders led to different taxes and these goods should have faced uniform tax rates to leverage India’s large internal market.

Everyone recognized this, but constitutionally the power to tax is shared between the federal and state governments. So, the only way the GST can work is if the states agree to give up their taxing power, to have one centralized tax applicable to all states, from which they are then guaranteed a share of the resulting tax pool. Its equivalent to pooling sovereignty, which has to overcome the classic problem of credible commitment. This required a huge degree of trust and negotiation, because a change to any tax system means there will be winners and losers. The states needed guarantees that when they give up their powers, their tax revenues would be protected. This is why it took this long to reach these compromises. It is called historic because it is amazing that they managed to achieve this agreement despite so many political parties representing different governments.

How does it align with the goals of the Modi government?

This constitutional amendment could only happen if all parties agreed. This began at the end of the last BJP-led NDA government in 2003-04, but most of the negotiations took place under the subsequent Congress-led UPA government. Right from the beginning, they did something politically savvy. The negotiations required meetings of the federal government and the finance ministers of all the states. The government decided that the Chairperson of the Committee of Finance Ministers would be led by the finance minister of a state ruled by an opposition party. This way, if agreement was reached within this empowered group of ministers representing the federal and states governments, then the opposition would have already agreed. Politically, this was very astute. As governments changed, all of India’s principal political parties were represented, which made this politically possible.

The agreement aligns with the goals of anyone who had come to power. It is not specific to the Modi government—if the Congress had been ruling, it would have aligned with its goals. Because of the protracted negotiations, the major political parties by and large were on board. If the Congress had come to power, this would have still happened—although maybe in a slightly different form.  

To that extent the reform aligns with the goals of any national government because it has been going on for so long. The country had to do this. It was a matter of when, not if.

There have been many problems with the implementation of the GST on the business side, with millions of businesses unable to file taxes. During the years of debate over this new tax regime, why were the challenges of implementation miscalculated?

When you are moving such a gargantuan system, there are bound to be problems. At its peak, there were around a million forms being filed every day. Major IT systems also hit glitches since there are millions of lines of code and this is something completely new to the public.

Because people always want to find a way to avoid taxes, they will complain. For example, there was a progressive tax on shoes. So, shoes would be sold one shoe at a time to avoid the higher tax of selling it as a pair, even though the price of the shoes together was the same. To illustrate, if  a pair of shoes that costs $150 and there is a progressive tax so that tax rate increases after $100 for the pair of shoes, then a shop would sell each shoe individually for $75 in order to apply the lower tax rate!

These glitches can only be known when they are worked out. Many of the frustrations come from companies that for a long time avoided taxes, and now they must pay taxes. But definitely some of it was because the system had glitches which took time to iron out.

Last year, the Modi government also introduced a new policy that strictly monitors large cash purchases and removed 84% of Indian currency from circulation. How did this policy and the GST affect domestic consumption?

Demonetization was intended to reduce the use of cash. When you use a lot of cash, you can avoid paying taxes because it is difficult to monitor it. Demonetization was intended to attack the scourge of black money, which is not accounted for and not declared to the tax authority. In retrospect, it was very disruptive and did not yield the desired results. This shock took the country 4 or 5 months to recover.

The GST was also disruptive, so the two in combination were even more disruptive both on the production side and on the consumption side. There are some estimates that say they affected GDP by .5%. The GST was not really an unanticipated shock, but because it was such a big change, it affected the economy like a shock. But, now the economy has recovered from both shocks, and so things have settled down.

How does the new value-added tax affect small-scale businesses?

There are three different types of small-scale business—microenterprises, small enterprises, and medium enterprises. These definitions are different from those in the U.S. Medium in India is small in the U.S., and small in India is micro in the U.S.

Small businesses often are not run by people who have the education to fill out and turn in the forms, so GST form filing cutoffs were raised to make it easier for small business owners. But when this happens, big companies will not purchase from small companies because they need to show from where they get their inputs to get their tax rebates. If small businesses cannot give tax numbers or receipts, then big companies will not purchase from them. So, small businesses are forced to come into the formal sector, because if they do not sell to the big businesses, then they have fewer options to grow. This process is moving businesses – especially B2B – from the informal to the formal sector.

Marcia Yang CMC '18Student Journalist

Featured Photo “The Revenue Secretary, Dr. Hasmukh Adhia, addresses a press conference on the Goods and Services Tax in New Delhi on July 4, 2017.”

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