India’s Tax Reform Needs More Economics, Less Politics

Prime Minister Narendra Modi has often described the reform of India’s indirect taxes as his landmark achievement. In 2017, a patchwork of national, state- and local-level sales and excise levies were replaced by a single goods and services tax that economists claimed would increase government revenue while also being business friendly.

More than eight years on, it has become clear the GST hasn’t met expectations. The government recently announced that Modi’s right-hand man, Home Minister Amit Shah, would be put in charge of negotiations to fix it.

This is both good and bad news. It’s good news that Modi is willing to accept some reform of the GST is necessary — it isn’t common for populists to admit that something they did needs improving.

It’s also interesting that the home minister, who is the establishment’s go-to man for knotty political problems, has been put in charge. Shah has always been Modi’s enforcer, and has never run an economic ministry; but he has a reputation for getting things done. For example, the government tried and failed for years to privatize state-owned Air India, and only managed when Shah oversaw the process. It had nothing to do with his official portfolio — he just had the political stature to push through difficult changes.

The bad news, however, is that the GST reform doesn’t need those instincts. It would benefit from less politics and more economics. Partisan compromises caused the system to underperform in the first place.

Economists wanted India’s mess of indirect taxes to be replaced with a single, national value-added tax that would apply to all goods and services across the country and be evaluated by a single bureaucracy. Unfortunately, the constitution assigns state governments the right to impose indirect taxes, and not the federal authorities.

Officials in New Delhi eventually had to work out a messy compromise to get state governments on board. India doesn’t have one GST, but three — one for the central government, one for the states, and one for in-between transactions. Each of these has its own officials, tax forms, and filing requirements. Worse, instead of a single simple rate, the GST eventually went into effect with four, five, or even more slabs depending on what you included. Instead of applying to all goods and services, some big-ticket items — fuel, alcohol and electricity among them — were excluded.

As a result, the government never collected as much money from the new system as it hoped. It wasn’t until last year that actual indirect tax collections crossed 6% of GDP, the level they had been when the GST was introduced.

For businesses, some things have gotten easier — exporters get quick refunds on the taxes they pay, for example. But fraud has also exploded.

Almost 10% of the tax that’s collected is fraudulently claimed as refunds. Sometimes traders buy and submit counterfeit invoices for inputs that entitle them to tax credits. Other firms turn in bills that show goods being transferred from one company to another, their value being inflated every time — except these are all shell companies, and the goods in question don’t exist. They then claim input tax credits on these high, imaginary transactions. On one occasion, fraudsters registered 246 separate dummy firms that investigators had to untangle.

The multiple different tiers don’t help, either. Fraudsters can also mislabel goods to evade taxes. The honest have to deal with absurd acts of categorization. Last year, for example, officials “clarified” that sales of popcorn would be charged at a 5% rate, unless it was sold in a pre-labelled package, when it would be charged at 12% — except if it was caramel flavored, in which case the rate was 18%. The economist who had served as Modi’s advisor at the time the GST was introduced described this as a “national tragedy, violating the spirit of the Good and Simple Tax the GST was meant to be.”

The often-confusing nature of the system, as well as the poor digital infrastructure set up for payments and reporting, mean that smaller companies suffer disproportionately. Opposition politicians often claim that onerous GST requirements are driving small enterprises out of business. Not all big business is happy, either. Multinational companies can run afoul of complicated definitions of what counts as an exported service. Infosys Ltd. and some foreign airlines operating in India were hit with tax demands for billions of dollars last year based on an unusual interpretation of the code. (Infosys said in June that the demand had been withdrawn.)

The deviations from economic common sense that have marred the implementation of the GST are a consequence of political compromises. State governments are given a say in rates, and nobody has an incentive to simplify taxes, only to win populist medals by reducing the tax applicable to one good or another.

At the very least, one or two of the current tax bands need to be eliminated. Ideally, the entire system should be overhauled, and exemptions, such as for petroleum products, minimized. We should end up with a single tax, applied through a single form, and at a single rate for all transactions. If Shah listens to the economists, that’s what he will push through. But the chances are that he will listen to the politicians instead.