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What You Should Know About India’s Largest Modern Tax Reform

By: Emily Potosky

On August 3, the upper house of India’s parliament approved a constitutional amendment, officially known as the Constitution (One Hundred and Twenty-Second Amendment) Bill, 2014, proposing a new taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system called the goods and services tax (GST). The GST is a value-added tax (VAT)A Value-Added Tax (VAT) is a consumption tax assessed on the value added in each production stage of a good or service. Every business along the value chain receives a tax credit for the VAT already paid. The end consumer does not, making it a tax on final consumption. that will replace most of India’s indirect taxAn indirect tax is imposed on one person or group, like manufacturers, then shifted to a different payer, usually the consumer. Unlike direct taxes, indirect taxes are levied on goods and services, not individual payers, and collected by the retailer or manufacturer. Sales and Value-Added Taxes (VATs) are two examples of indirect taxes. es levied on goods and services by the central and state governments. Indirect taxA direct tax is levied on individuals and organizations and cannot be shifted to another payer. Often with a direct tax, such as the personal income tax, tax rates increase as the taxpayer’s ability to pay increases, resulting in what’s called a progressive tax. es refer to taxes collected by an intermediate party from the person who ultimately pays the tax. An example would be a sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. , excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. , or goods and services tax, where the store collects the tax, but the tax is often paid by the consumer through higher prices. Proponents of the GST expect the tax to boost economic growth by up to 2 percentage points due to greater tax compliance, reduction in cost, and simplification of the tax system.

The current tax system in India is economically inefficient, violates the neutrality principle, and is notoriously complicated. The World Bank rates India 157th out of 189 countries for ease of doing business. Currently, the effective tax burden on various goods and services throughout India varies by both location and product because a good is often taxed multiple times at different rates through various indirect taxes. This leads to an estimated 25 to 40 percent increase in the cost of goods and services. Parliament aims to alleviate this cascading tax problem by replacing almost all indirect taxes with the GST. The exact GST rate has not been decided, but most estimates range between 15 and 18 percent.

Indirect Taxes Replaced by GST

Taxes levied by the Central Government

Taxes levied by State Governments

  • Central Excise Duty
  • Excise Duties on Medicinal and Toilet Preparations (perfume, hygiene products, etc.)
  • Additional Duties of Excise (textiles, textile products, and goods of special importance)
  • Additional Duties of Customs (CVD)
  • Special Additional Duty of Customs (SAD)
  • Service Tax
  • Other taxes and surcharges related to the supply of goods and services
  • State VAT
  • Central Sales Tax
  • Purchase Tax
  • Luxury Tax
  • All Forms of the Entry Tax
  • Entertainment Tax (state, not local)
  • Taxes on Advertisements
  • Taxes on Lotteries, Betting, and Gambling
  • Other taxes and surcharges at the state level

Indirect Taxes Not Replaced by GST

  • Taxes on petroleum products
  • Entertainment and amusement taxes levied at local levels
  • Alcohol and liquor taxes
  • Stamp duty and customs duty
  • Tax on the consumption and sale of electricity

It is difficult for India to implement tax reform because under Article 265 of the Constitution, "No tax shall be levied or collected except by the authority of law." A law must be passed at either the state or national level in order to enact any tax reform, regardless of importance. The GST will not be implemented right away, because the bill must be passed in the lower house, then ratified by at least half of India’s 29 states. In addition, another bill must be introduced detailing the structure of the tax, which will include a central and a state GST. Regardless, this is the country’s biggest tax reform since 1947, and it has been in the making since 2000.

In order for the GST bill to pass, several amendments were proposed, including creation of a method for dispute resolution, and striking down the provision providing a small tax on interstate trade. An especially interesting amendment addresses the reduction in state revenue, a key concern of state governments about adopting the GST. In the amendment, the central government promised to provide the state governments with compensation for lost tax revenue for up to five years.

India faces many economic challenges. It is comprised of 29 states and seven union territories, all heterogeneous in terms of per capita GDP, population, urban development, and even culture. In addition, India has a very large untaxed informal sector. It is estimated at $780 billion, or about 40 percent of India’s official gross domestic product, and employs more than 90 percent of India’s workforce. The simplicity of the GST helps alleviate some of the geographic problems. Moreover, the structure of the GST encourages voluntary compliance, which helps capture some of the missing revenue from the informal sector.

While there will be winners and losers from the implementation of the GST, as certain industries will be paying a higher effective tax rate, the GST seems like it will be a positive reform for India. It simplifies the current tax system, lessens compliance costs, reduces the final price of goods and services for consumers, and promotes economic growth in India.

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