Kelkar’s $ 500 billion revolution

We are on the verge of a revolution worth half a trillion dollars. After almost a decade of effort, India is about to move to a unified Goods and Services Tax (GST) to replace the current plethora of central and state indirect taxes. The Empowered Committee of State Finance Ministers is giving finishing touches to the GST, which is due to be implemented by April 1, 2010. You might ask, why should ordinary folk worry about arcane tax issues?

The answer comes from Vijay Kelkar, head of the Finance Commission and former Finance Secretary. He estimates that the value of the GST reform to India will be $ 500 billion, or almost half India’s GDP. Hence he calls the GST reform the biggest reform in India since industrial delicensing in 1991. Only time will tell whether his estimates are accurate. But if he proves even half right, he will be justified claiming that this is a silent revolution.

Kelkar came out with these estimates in his convocation address at the Indira Gandhi Institute of Development Research on February 6. He observed that in Canada, which is widely recognized as having a very good GST, Professor Hamilton used a computable general equilibrium model to estimate the impact of a well-functioning GST on the economy. He came up with an estimated benefit of 1.4% of GDP for Canada. Assuming the same level of benefit for India—an additional 1.4% of GDP— India, Kelkar says the positive gain will be $ 15 billion. Using a modest 3% discount rate, he then estimates the net present value of the reform to be worth $ 500 billion.

Moreover, says Kelkar, this incremental GDP would increase employment by 4-5 million. That represents a massive financial and human rate of return on a reform that is about to be achieved without any of the political economy storms and upheavals that usually make radical reform difficult.

Why will the GST improve the efficiency of the economy so much? Because it will restore rationality and ease of administration to an existing system riddled with multiple authorities, corruption, evasion and distortions because of a plethora of rates and exemptions levied by different states and the center. Manufacturing in India is hit badly by cascading taxes, to the point where India truly stands out in global comparisons. Capital goods bear an especially high rate of cascading tax, a serious distortion that holds back our growth.

Services in India were long untaxed, and today are still undertaxed, while some services escape taxation altogether. Services now constitute 55% of GDP, while manufacturing contributes around 24%. Service tax has plugged the tax gap to some extent. But clearly India needs a unified tax system covering both services and manufacturing, taxing only the value added at each stage. The tax needs to be levied at the destination point for maximum economic efficiency, compliance and ease of administration. And to the extent possible the GST rates should be uniform. Exports will be zero rated and hence escape indirect tax totally, in accordance with the international norm. Currently exporters are unable to get full refunds of sundry indirect taxes, handicapping them in the global market.

Kelkar lists four major channels through which GDP will improve after the introduction of a GST.

First, the current system fails to tax all goods and services. This failure leads to distortions and a misallocation of resources from maximum-efficiency areas to undertaxed areas. GST will maximize coverage of goods and services, and thus reduce distortions and improve output.

Second, the current unrefunded taxation of capital goods is a real curse on capital accumulation, hitting savings and investment. Kelkar believes that by ending such overtaxation, GST will make a huge long-term difference to outcomes.

Third, indirect taxes need to be levied at the destination point to be comprehensive and non-distorting. At any given price level and exchange rate, says Kelkar, violation of the destination principle puts local producers at an unwarranted disadvantage with outside producers. A destination-based GST will end the anomalies of the current system.

Fourth, differences in the tax bases of different states and the central government greatly increase the cost of doing business, and impose deadweight losses on the economy. “This is a league table in which we have constantly languished at the bottom,” says Kelkar. GST will go a long way towards reducing the current system’s red tape, delay, hassles, corruption, leakages and waste.

We can all agree with Kelkar that the potential gains from reform are high. It remains to be seen whether the full potential is realized. The immediate problems ahead relate to the finalisation of GST details by the Empowered Committee of State Finance Ministers. They will be tempted to have a large number of tax rates rates, and to have a large number of exceptions and exemptions. That, after all, is what enables politicians to develop patronage systems and collect kickbacks through changes in tax regime.

We can only hope, along with Kelkar, that the Empowered Committee will minimize the number of different tax rates, exemptions and exceptions to the GST. If the number becomes large, that could erode the functioning, effectiveness and economic gains of GST reform.

We must also hope that the State Finance Ministers will subsume other levies—octroi, entry tax, stamp duty—within GST. If such taxes are levied over and above GST, they will violate not only the simplicity of a comprehensive GST, they will also sabotage the aim of converting India into a true common market.

Cynics will say that nothing works well in India, so don’t expect GST to work very well either. The gains may be far less than Kelkar’s estimates. I share some of this cynicism. But let me add that precisely because India is so messy, the potential gains from GST must be much higher than in Canada. So perhaps we can reap a $ 500 billion bonanza after all.

What do you think?