A previous article, Sequencing in the construction of State capacity: Walk before you can run argues that in public administration, we should first reach for a modest objective, i.e. a low load, and build sound public administration systems, i.e. adequate load bearing capacity. Only after the systems have been proven to work at a low level of load should we consider increasing the load.
In building tax administration, the load is defined by (a) The tax rate and (b) The complexity of the tax in its very design - e.g. a sales tax is easier than an income tax. If the tax rate is low, the employee of the tax collection agency has a greater incentive to collect the tax. When the tax rate is high, there is a greater temptation to just take a bribe instead. If the tax system is simple, there is reduced discretion at the front line, and thus reduced rent-seeking.
In places like the UK, where there is high State capacity, income tax began at low income tax rates. When Pitt the Younger started the income tax in 1798, the peak rate was 10%. This gave them an opportunity to build sound tax administration under conditions of low load. Once this was done, the road to higher tax rates was available. In similar fashion, Singapore started with a GST rate of 4%, and then went up to 7%. The Japanese GST rate was also 3% at inception, and has now been moved up to 8%. In India, we never made the tax administration work at low rates of tax; premature load bearing was attempted by jumping to high tax rates without adequate load bearing capacity in the form of a well designed tax administration.
A standard debate in tax policy is about the choice between a low rate and a wide base versus higher rates applied on a smaller base. The traditional economics argument has been that the distortion associated with a tax goes up as the tax rate squared, so for a given level of tax revenue we are better off with a low rate and a wide base. A simple tax system with low rates will help lower the extremely large value for the Indian Marginal Cost of Public Funds. The argument presented here gives us one more perspective on the problem. Low tax rates are a low load from a public administration point of view; until load-bearing capacity has been created, it is unwise to subject the system to high load.
There is an interesting tension here between two different ways to make the load smaller. A lower rate requires a large base. The wider base involves a bigger tax administration machinery, and a larger number of transactions. A large number of transactions induces a greater load. But a higher tax rate changes what is at stake and increases the load substantially.
By this reasoning, the way forward on building a sound framework for tax administration is:
- First, design a very simple tax policy (e.g. a single rate comprehensive GST) with low discretion at the front line employees, so as to keep the load low. At first, set very low tax rates, to reshape the incentives of citizens and tax officials, to keep the load upon public administration low.
- Build and run a tax administration which is able to deliver sound tax revenues under these conditions. E.g. a 5% comprehensive VAT rate should generate VAT collections of near 3% of GDP. This requires sophisticated thinking about tax administration.
- Use independent private studies (e.g. comprehensive audits of some persons) and perception studies to measure the extent to which bribes are paid instead of tax.
- Only after this is working well, consider moving up to higher tax rates and/or a more complex tax policy.
Implications for GST design
How can a GST be designed so as to have low load? If we wanted to walk before we run, how would we design the GST?
- A low single rate of 12-15%. Multiple rates significantly increase the workload.
- A single rate and comprehensive base, which simplifies the workflow and reduces discretion and eliminates classification disputes.
- Centralised registration. State-wise registration administration work load, and compliance burden for taxpayers manifold - 36 times for those who have to register in all of the states and union territories.
- Automatic refunds of excess credits, without discretionary approval by officials.
- Eliminate the concept of self-supplies within a legal entity, as the number of transactions increases several fold if self-supplies are made taxable. No supply should be reckoned unless there is another person to whom a supply can be made.
- The system of penalties and assessments needs to be simple, with a bias in favour of low discretion and low penalties.
There has been a lot of focus on the `revenue neutral rate'. One twist on this is that the government is a significant buyer of goods and services. Thus the `budget neutral rate' would be a bit lower than the revenue neutral rate. This makes it possible for the rate to be lower when compared with the conventional analysis.
Single registration is a subject of some debate. Even when each state has its own GST law, it is very much possible to have single registration. The law would impose the tax on taxable supplies made in the state, allow input tax credits, and specify reporting obligations for information. These provisions will apply to any person registered in the country. There need not be the requirement of separate registration in each state. Computations of tax and reporting of the information could be on a single return with state-wise annexures. The key difference between state-wise and central registration would be that all of the state-wise compliances would be on a single registration portal, and the person will be treated as a single person (note that under the current Model law, each registration number is treated as belonging to a different person). This is how the Canadian GST operates, i.e., with single registration, but with multiple federal and provincial GST laws.
Does GST implementation require single control? We think single control is neither desirable nor feasible. Scrutiny and audits at the state level will necessarily require information on the dealer on a Pan India basis, which individual states would not have. Both the Centre and States would want to monitor compliance with their respective tax laws. If they want autonomy in administration of the GST, what is needed is a harmonisation agreement to avoid duplication of administrative effort and inconsistent policies across the country. For example, the governments should agree on a common rulings and interpretations authority, and common administration guidelines. A clean solution would be to have a common audit and scrutiny function that is jointly staffed by Centre and State officials. Some 12 States have already opted for a full-service model of GSTN, under which even scrutiny and audit would be done by GSTN.
The 122nd Amendment is a great step forward. It opens the possibility that India will become one country, one market. At present, tax administration in India works poorly. We do not know how to build a capable and uncorrupt tax administration. In the absence of this State capacity, we should start with a GST design that imposes a low load upon tax administration. Only after this is proven to work at high levels of probity and operational efficiency can we consider the possibility of going up to higher levels of load. This concept can be expanded to all of the GST in all of the States. To keep the load low, we need to expand the Prime Minister’s vision of One India, One Tax, to “One India, One Tax, One registration, and One Rate”.
Satya Poddar is a senior tax advisor with Ernst & Young in India. Ajay Shah is a researcher at the National Institute for Public Finance and Policy.