governance, political economy, institutional development and economic regulation

Hasmukh Adhia Masterclass

Muscular tactics are paying-off in the Income Tax system. The number of assesses went up by an astounding 25 percent from 37 million in March 2016 to 46 million, by March 2017 and to 63 million by mid-July 2017. The linking of Aadhar-PAN card to bank accounts; the campaign against cash and now the GST, together create desirable institutional incentives for individuals and business to bank their transactions. This provides the “push” factor for enlarging the income tax base of potential assesses.

Transformative GST  

The GST is even better designed to provide desirable incentives for enlarging the indirect tax base. Unlike, Income Tax where “push” factors compel assesses to pay tax on the income revealed via bank transactions, the GST uniquely also has “pull” factors for better tax compliance. The biggest being the facility to set-off GST paid on purchases against GST payable on sale, which reduces the net tax payable. This induces both buyers and sellers to bank their transactions – which is also good for income tax collections.

Transformative, as the GST is, glitches have inadvertently crept in, which go against the grain of positive incentives to prefer banked to cash transactions; increase value addition and boost tax revenues.

But design glitches remain

One such, relates to small service providers with annual revenues of up to Rs 2 million. Those providing services within the state are exempt from both registration and payment of GST up to this limit. But the moment they provide a service across the state borders or to a client abroad, they are compelled to get a GST registration; submit the mandatory three returns per month and much worse, pay GST on their entire revenue stream.

Killing the small cross-border service provider

Individual IT professionals writing code or designing websites routinely get contracted over the internet to provide services to overseas clients or to clients across state borders. Each contract may be as low as Rs 20,000. But all these professionals will need to get registered and incur the transaction cost on submitting monthly GST returns. For these small service providers, the price points are highly competitive. It is unlikely that clients will be willing to part with the 18 percent GST for out of state providers. They will be pushed to get registered and pay the GST themselves or absorb the tax in the price they charge with the GST paid on the purchase by the client.

The net result will be that out- of-state small service providers will become uncompetitive and may stop seeking work outside their states, reducing competition. GST which was meant to create a Pan Indian national market will instead, end up creating intra-state silos for small service providers.

The negative impact is fiscally marginal but it rankles

This design flaw will also impact income tax revenue. Service providers whose annual billing reaches Rs 1.6 million within a state, will refuse out-of-state work of less than Rs 0.5 million because, by increasing their out-of-state billing by up to Rs 0.4 million they end up paying the entire incremental amount as GST.

If 2 million small service providers, ranging from civil contractors, designers to business consultants, refuse additional work due to this reason, the government loses Rs 18 billion as income tax. This calculation assumes a tax rate of 20 percent and the underlying taxable income lost at one half of the amount of work refused.

Protection for local service providers breeds inefficiency

The “infant industry” proposition can be used to justify discouraging cross border services and thereby encouraging small local service providers to ramp up their capacity and fill the gap. This may well be true. But it rankles against the pan-Indian tax framework objective of promoting efficiency and competition. It is also, against the logic of digital India which is meant to enable seamless work across state and international borders.

Whence the pan-Indian market and digital India?

Admittedly lost income tax revenue of Rs 18 billion is small change, in an income tax kitty of around Rs 4 trillion. But it is personally frustrating for small service providers who can see the cross-border opportunity to expand their business but are blocked by the “deadweight” amount of Rs 0.4 million of billing, which equals the GST they would pay by increasing their billing to Rs 2 million, if some part of it coming from cross border contracts.

Have a common GST exemption limit irrespective of location of the client

Is there a way of getting away from this flawed design? Yes, there is. The first option is to extend a common GST exemption limit to all service provision, irrespective of whether it is within state, across state borders or overseas. This immediately removes the “deadweight” of GST becoming payable, the moment a cross border transaction, no matter how small, is made.

Tax only the incremental revenue above the GST exemption limit

However, this still leaves the problem of expanding billing above Rs 2 million and thereby losing the exemption from GST on the initial Rs 2 million. Adopting the principle of taxing only the incremental amount, as used in the Income Tax, can effectively avoid the perverse incentive for opting for cash based transactions to avoid losing the tax exemption above a billing of Rs 2 million, till billing expands substantially beyond Rs 2.4 million, at which point it would neutralize the additional GST paid and yield a net income increase for the supplier.

Harmonise tax exemptions under IT and GST to reduce reduce the compliance cost 

The best option is to harmonize the exemption limits under GST and income tax. The current income tax regime presumes taxable income at 50 percent of billing, unless shown otherwise. A billing of Rs 0.5 million corresponds to a net taxable income of Rs 0.25 million which is also the maximum limit for income exempt from income tax. Hence the exemption limit for GST could be reduced to Rs 0.5 million from the existing limit of Rs 2 million. But rolling back exemptions is tough. Alternatively, the exemption limit in Income Tax could be increased to Rs 1 million. Enhancing the income tax exemption limit is the preferred option.

The number of income tax assesses increased by 25 percent in 2016-17 over the previous year. In comparison the revenue from Income Tax increased by 18.4 percent. Tax yields are lagging increase in assesses. Efficient tax collection practices would point towards focusing on high value targets rather than cluttering up the system with marginal yield assesses until tax filing systems are vastly more simplified and easy to follow for the average citizen.

This article is also available at http://blogs.timesofindia.indiatimes.com/opinion-india/end-perverse-incentives-for-small-service-providers-in-gst/

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