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May 2, 2017 | 09:15 GMT

7 mins read

The Way to Solve India's Tax Problems

Modi's Tax Reform Push
(PRAKASH SINGH/AFP/Getty Images)
Forecast Highlights

  • India's new Goods and Services Tax (GST) marks a significant step toward achieving the country's long-held goal of economic liberalization.
  • Such a sweeping reform is destined to create controversy, and disagreements have already broken out over several aspects of the GST's implementation.
  • Nevertheless, the ruling party's growing power bodes well for the tax reform's long-term success.

India is a nation of a thousand divides. But if the country's recent progress in reforming its tax code is any indication, it may be slowly overcoming its penchant for political fragmentation. On March 29, the lower house of the Indian Parliament passed a new Goods and Services Tax (GST) intended to broaden the country's tax base, boost the government's revenue and increase the Indian tax-to-GDP ratio. The comprehensive measure is merely the latest sign that Indian Prime Minister Narendra Modi's attempts to consolidate power are beginning to bear fruit, providing the clout he needs to push through policies that have otherwise stalled in the face of lawmakers' squabbles.

The Legacy of the License Raj

The GST, a levy applied to all production stages of goods and services consumed in India, is only one part of a decadeslong project to liberalize the Indian economy. Initiated in the 1980s, the effort gained momentum in 1991 when India's balance of payments crisis came to head just as the inspiration for its planned economy — the Soviet Union — collapsed. After securing an emergency loan from the International Monetary Fund, New Delhi moved quickly to dismantle the country's elaborate and overbearing system of regulations, business licenses and bureaucratic red tape known as the "license raj."

Tax reforms were a crucial part of this overhaul. The government hoped that by imposing a fiscal policy that prioritized savings and investment, it could breathe new life into an economy struggling to ensure that its output outpaced a rapidly expanding population. And in some ways New Delhi was right: Its structural adjustments bolstered economic growth, and the country's corporate services sector reaped the rewards.

Even so, the legacy of India's convoluted tax system lived on. Holdover issues such as cascading (double taxation), low compliance rates, a small tax base and the uneven distribution of taxation powers between the central and state governments continue to hobble the Indian economy to this day — problems the GST is meant to stamp out once and for all.

The Solution: Simplicity

The primary goals of the GST are twofold: to simplify the Indian tax code and heal the rifts it has created. As it stands, a raft of indirect taxes at the central and state levels have led to cascading, a problem that arises when a buyer pays a tax on the total value of a purchase, despite the good having already been taxed at earlier stages in the supply chain. In effect, this creates a system of double taxation.

The GST will replace this complicated collection of taxes with a single value-added tax and an accompanying system of tax credits, in which each buyer in the supply chain receives a credit for taxes previously paid on the items in question, thereby reducing the buyer's tax burden. Since claiming these credits would require documentation from earlier sellers, the new system also creates a self-policing mechanism that will promote better compliance with the nation's tax laws among Indian companies. And thanks to multiple stages of documentation, tax authorities will have more complete information to consult. This, in turn, will help to formalize India's economy through the construction of a modern, efficient and digitized tax system. Better compliance will also generate more revenue for the government in New Delhi, which hopes to bump up India's current tax-to-GDP ratio of 16 percent to levels seen in other emerging markets. (South Africa, China and Turkey boast ratios of 26, 28 and 21 percent respectively.)

India Tax Reform Infographic

Simplification is certainly important, but it isn't an end unto itself. The unity it enables in the Indian market, however, is. Goods in India are currently subject to a complex division of taxes at the central and state levels. For instance, New Delhi can legally levy taxes on the manufacture of goods and services, but states can tax only the sale of the former. Moreover, goods that cross state borders are slapped with a 2 percent surcharge and are ineligible for tax credits, a setup that has discouraged trade among Indian states and undermined supply chain efficiency. (Even if it is more efficient to build plants in several states, for example, a non-refundable tax on interstate trade can result in the clustering of facilities in a single state.)

The new tax bill aims to address these problems. Under the GST's Integrated Goods and Services Tax, which regulates financial transactions among states, buyers in importing states can claim tax credits. In theory, this should bolster the Indian manufacturing industry by driving interstate commerce. Furthermore, a constitutional amendment that the Modi administration pushed through Parliament in August 2016 permits states to tax services in addition to goods.

The Path Forward Is Clearer Than Ever

Of course, in a country as big as India, ambitious initiatives like the GST will never please everyone — a reality that has led to the downfall of many reform attempts before it. Disputes have already broken out over several points of the GST, including the need for a four-tier tax rate instead of a single-tier structure, confusion over how products are distributed among the proposed tiers, and the exclusion of petroleum and alcohol (both major revenue generators). This is to say nothing of the legislative hurdles the tax bill must still overcome, such as the requirement that each Indian province pass a state-level GST before the central government's July 1 implementation deadline. The GST council, moreover, has yet to decide how the new tax revenue will be split between the central and state governments.

Then there's the digital infrastructure underpinning the new system to consider. The overhaul will require governments and businesses alike to transition to an online system of tax administration called the GST Network, which is bound to result in setbacks as each side adapts to the unfamiliar scheme. What's more, tax reform is only one piece of a larger package of measures that India will need to implement to achieve its economic goals, such as boosting the country's meager GDP per capita through manufacturing-led growth and eradicating the mass poverty India inherited upon gaining its independence in 1947.

Yet despite these many challenges, progress is being made. Modi's success in passing much-needed but long-stalled measures like the GST can be largely attributed to the power amassing beneath him as voter sentiment swings in his favor. The rightward shift underway in Indian politics, symbolized in the victory Modi's Bharatiya Janata Party (BJP) secured in Uttar Pradesh state elections earlier this year, is granting the prime minister the influence he needs to force through sweeping change — and improve his own prospects for re-election. After all, it was the BJP's majority in the lower house of Parliament that enabled the administration to pass the August constitutional amendment simplifying the division of taxation powers between central and state governments.

Modi will doubtless encounter pitfalls in putting the GST into practice. Any leader would in enacting massive, nationwide policies across a country India's size. But the powerful prime minister, backed by a congressional majority, stands a better chance than his predecessors in spurring the country forward in its long, halting journey toward economic reform.

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