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Posts tagged ‘GST’

“Demonetisation” as a morality play

The politics around “demonetisation” — a misused term for what happened on November 8, 2016 — has taken centerstage in the run-up to the Assembly elections in Himachal Pradesh (that voted yesterday) and Gujarat (which goes to the polls in December). Finance minister Arun Jaitley has added “morality” to the cluster of objectives, that seemingly justified compulsorily replacing 86 per cent of our currency with new notes over a short period of just two months last year.

Whose morality?

Morality is a slippery slope to tread in public affairs. It’s certainly an individual virtue, but at a societal level it’s difficult to define. Consider the moral conundrums that arise while enforcing a law which doesn’t have widespread local acceptance. Rebels with a cause see themselves as morally-elevated outliers. Not so long ago, our freedom fighters were feted for disrupting the peace, assassination or damaging public property. Even today in areas like Kashmir or the Maoist belt in central India, it’s tough to apportion the balance of morality between those who violate the law and others who seek to enforce it.

Our Constitution, quite properly, is silent about “morality”. A quasi-moral concept of “socialism” was introduced in 1976 into the preamble, by former PM Indira Gandhi, as a populist measure. But it sits incongruously with the otherwise liberal slant of the document.

Corruption is patently immoral as it saps national wealth. Measures to fight corruption are part of public dharma. The real issue is: was demonetisation essential to end corruption?

Demonetisation to identify counterfeit money like using a hammer to kill a bug

If the objective was to weed out counterfeit money, which can fund terrorism or even legal transactions, there was no need to impose a tight timeframe of two months. This is what caused widespread panic and disruption. It would have been enough to alert the public to the menace; provide markets (banks already have them) with testing devices to weed out “compromised” notes over time. This is an ongoing activity, that all central banks do routinely, because any note (besides crypto currencies) can be counterfeited.

Better policing can identify & capture the stocks of black cash

If the objective was to capture the stocks of “black” money, held as cash, in one fell swoop, this was better done by making known “havens” of “black” cash — apparently entire warehouses — unsafe for storage through effective enforcement, coupled with strong incentives to come clean. Note that “black” money hasn’t gone away.

Black money was generated even as the notes were being replaced

Demonetisation can do very little to stop generation of black money. The government knows this. It intends to use “big data” for surveillance of potential evaders; embed governance systems with enhanced oversight and enhance transparency. Only improved technology and perpetual, intensive oversight can starve this hydra.

Was it political?

Not least the timing of the move, just before the elections in Uttar Pradesh, India’s most populous state, which sends the largest number of members to the Rajya Sabha, where the BJP didn’t have a majority, could indicate the compulsion to play to the gallery. If this was the motive it worked very well politically — not least, because UP is a poor state with low governance indicators and high levels of inequality. Hitting the rich is a tested populist strategy, perfected by former PM Indira Gandhi, and still held dear by our antiquated Communist parties.

Would Gandhiji have approved?

But demonetisation doesn’t align with Mahatma Gandhi’s precept that “means matter as much as ends”. Hitting tangentially at corruption, at the cost of scorching even the law-abiding, is unacceptable. Anti-corruption measures which ignore the social and economic collateral cost of implementation are suspect. The State has an asymmetric, fiduciary relationship of trust with citizens. Did it live up to its dharma of insulating the honest from State-induced actions intended to harm the corrupt?

Some positives – nudged people towards digital and banked transactions

Undoubtedly, demonetisation did accelerate a shift towards banked transactions and boosted digital payments. Both outcomes are winners. But it’s also true that it put a temporary brake on economic growth by disrupting business and inducing job losses, mostly in the informal sector, where workers and the self-employed are less well paid, and less well-endowed to absorb the cost of a disruption.

Means matter as much as ends

Seemingly desirable steps to make the system honest can have grossly inequitable outcomes, which Gandhiji would have termed “immoral”. It’s possible to reduce corruption by replacing income-tax with a “head tax”. Citizens are more easily identifiable than their income, so very few would be able to escape this tax. If a “head tax” were to replace income-tax, each citizen would pay Rs 3,600 per year. But consider, for 40 per cent of the population, which is vulnerable to poverty, the head tax would be a minimum 12 per cent of even the poverty level income of $1.90 per day. Currently, even an income of Rs 10 lakhs (Rs 1 million), or 22 times the poverty level income, attracts a low effective tax rate. Protecting the weak is cumbersome. It creates tax escape routes, which need to be plugged with minimum collateral damage to the weak and the honest.

GST the first efficient, corruption buster

The good news is that the Narendra Modi government has got it bang-on with its second major corruption-busting initiative: the Goods and Services Tax (GST). Implemented from July 1, 2017, it has also disrupted business and compounded job losses, arising from the shutting down of businesses, which relied on the illegal competitive advantage of avoiding tax. GST is a potent standalone, medium-term winner. This expectation mitigates the interim economic “amorality” arising from the collateral harm to innocent workers and suppliers to such businesses. The proactivity of the GST Council in correcting mistakes and acknowledging errors has only deepened its credibility and conveyed a sense of responsible stewardship. This is welcome.

Compensate for the distress & dislocation

cashless

Demonetisation was misguided even if it had “moral” end-objectives. One-fifth of our population, which suffered the most, is in the income segment of Rs 50,000 to Rs 5 lakhs (0.5 million) per year, being workers and those self-employed in the informal sector. They have still not been compensated. Hopefully, the finance minister will apply some balm in his 2018-19 Budget and bring this tragic “morality play” to a happy end.

Adapted from the author’s opinion piece in The Asian Age, November 10, 2017 http://www.asianage.com/opinion/columnists/101117/end-morality-play-its-a-misfit-in-eco-policy.html#vuukle-emotevuukle_div

Rooting out perverse incentives in GST

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/

Fix the “market” for political power

Indian army

Citizens expect governments to intervene when the markets fail. The market for Diplomacy failed last month at Doklam. If the Chinese Army is to be stopped well north of the tri-junction between India, Bhutan and Tibet/China, then only the Indian forces, funded by taxes, can do the job. This is a satisfactory arrangement for all Indian and Bhutanese citizens, who otherwise may be hard-pressed to secure their territory.

When State failure fails to fix the underlying market failure

But not all government actions have an obvious rationale. Demonetisation was unleashed in November 2016 to end black money. Few believe that this objective has been achieved. Black money is not an outcome of market failure. It is an outcome of governmental failure to tax income effectively; control corruption or control crime. Poor governance only encourages the generation of black money, which then requires another intervention to root out black money. Economist Shanta Devarajan of the World Bank, in New Delhi last week for the NCAER annual India Policy Forum <http://www.ncaer.org/event_details.php?EID=184>  believes such iterative interventions are ineffective in improving the quality of governance, and can reduce the legitimacy of governments. Far better instead to rethink how to deal with the underlying market failure – in this case the “market” for political power.

Poor tax administration

So why do governments tax ineffectively? Most commonly, multiple objectives in the tax policy are to blame. The sale of loose groundnuts — the ordinary person’s food — may be tax-free but packed groundnuts, even if unprocessed, are taxed. This creates a five per cent tax differential for arbitrage between the two categories, which are difficult to administer separately. A single rate of tax levied on a non-evadable tax base is the most effective. But consider that this would be akin to the colonial “poll or head tax” — levied on each person uniformly. Effective, but terribly inequitable.

The killer “app” for instant equity – Universal Basic Income- how effective?

Admittedly, mechanisms like transfer of a basic income to the poor can neutralise such an inequity. But transfer of a similar amount of cash, to each poor person, itself creates huge inequities, even among the 40 per cent population vulnerable to poverty. Transferring differential amounts, depending on need, attracts the same inefficiencies as trying to administer progressive tax rates fairly.

The big 2Cs – Corruption and Crime

Why is corruption or crime so hard to control in India? If citizens feel that political power can be acquired by subverting the “popular” vote, it reduces their faith in the power of their vote. It also delegitimises the government and undermines its ability to rule, in the eyes of those who voted against the government. Bihar faced this conundrum for two decades.

It does not help that, in India, governments can be formed even with a minority of the total votes cast in elections, so long as each elected member of the ruling party gets more votes than the next candidate. This first-past-the-post system fractionalises politics. It encourages parties to form coalition governments, which are unable to discipline errant behaviour by their constituents. This “coalition dharma” fosters crime and corruption.

Are laws aligned with context?

An alternative explanation for pervasive crime or corruption is that laws are out of sync with local customs. And not enough has been done to change social behaviour beyond legislating transformative rights and duties. Ending open defecation — a prime driver to reduce the vulnerability of women to crime — is one such example. The benefits from ending open defecation are dependent on collective action. One reason why we did not do more earlier could be that the political incentives are perverse. They favour exaggerating, rather than bridging, the social cleavages of caste and religion, which inhibit collective, progressive decision making.

Feudal governance patterns breed poor accountability

Low public accountability and lackadaisical collective action can also be traced to the continuation of feudal traditions of governance and poorly distributed income growth. Richer citizens are more resilient to State encroachment of their rights and less dependent on State largesse. Luckily, over the past three decades, we have become less poor, better educated and more aware of our rights versus the State.

But the extent of inequality remains significant as does the infrastructure deficit across rich and poor areas. The privileged crust is thinner than a hand-tossed Neapolitan pizza — possibly just 10 per cent of the population. The rest seethe in forlorn frustration. Can we get away from this low-level equilibrium? Yes, we can by fixing the market for political power.

End the perverse incentives in our political architecture 

Our political architecture is riddled with perverse incentives which  constrain the will to reform. Here are four changes which are overdue – deepening decentralisation; enhancing state government autonomy; enhancing the representativeness of the legislatures and regulating political parties better.

First, bridge the trust deficit and distance between citizens and the State. Empower state governments versus the Union government and local government versus state governments. Hopefully, the 15th Finance Commission will carry forward the trend of forcing the Centre to devolve functions and Central taxes to states and directly to local governments based on performance criteria.

Second, cut the colonial fat; abolish the titular but unedifying position of state governors. These are unelected nominees of the Union government exercising oversight over elected state governments. Transfer this role to the President, who is elected. This will level the playing field between states and the Centre versus the presidency.

Third, make Parliament and state Assemblies more representative. Sharply reduce the size of constituencies. Only directly-elected members should be eligible to become Prime Minister or chief minister. A candidate should be able to contest an election for only one seat at a time. The winner must secure a simple majority of the available votes and two-thirds of the votes cast. Municipalities must be headed by elected mayors.

Fourth, the functioning and finances of recognised political parties must be made transparent. Inner-party elections must conform to common but effective guidelines. The Election Commission must be empowered to determine constituency boundaries and diversified beyond the administration, to include citizen representatives and the judiciary with the chief election commissioner chosen specifically.

Use the GST process of risk-free consensual decision making

GST became a reality as a process of cooperative federalism was followed led by the finance minister. Reforming the market for political power could benefit from a similar approach.

Adapted from the author’s article in The Asian Age, July 19, 2017 http://www.asianage.com/opinion/columnists/190717/power-structure-needs-reform.html

Can GST make Hasmukh Adhia smile?

Hasmukh

Hasmukh Adhia, India’s revenue secretary, is finance minister Arun Jaitley’s chief aide for rolling out the Goods and Services Tax. Contrary to his first name, he never smiles, at least not in public. But even he can now take a break and smile. The GST juggernaut is careening ahead. In just over a week, India would have leapfrogged into the league of economies which have walked the talk on rationalising indirect taxes.

Noose tightens on black money generation

card pay

Photo credit: Imagesbazar.com

So what will Mr Jaitley and the GST Council have achieved on July 1, 2017? First, this collegial team of finance ministers, across the Central and state governments, would have fired the first, potent salvo against black money. Demonetisation; tax raids; getting back overseas black money caches — all pale in significance, compared to the institutional impact of GST. Consider, that the most vocal protests against GST have come from dry fruit traders, cloth merchants and jewellery makers. These businesses have been traditionally cash heavy. Of course, the intrepid evader will still have tax leak holes left open. Agriculture, food items and the business in booze remain yawning gaps in the tax revenue security architecture. But the message is loud and clear: the rope is shortening. So watch out!

Lower net indirect tax, lower prices to spur demand

shopping

Photo credit: Imagesbazar.com 

Second, the massive discounts being offered on pre-GST clearance of the stock of consumer durables suggests that prices of these goods will reduce. An entity, empowered to investigate and ensure that net tax reduction benefits are passed on by manufacturers and dealers to consumers, is in the offing. The history of such clunky, intrusive executive action is not encouraging. Due to information asymmetry, determining the cost breakdown of products externally, is invariably inefficient. Either the enforcement agents get compromised or they end up harassing manufacturers and suppliers for trifling results.

But in truth, it really doesn’t matter. Inflation levels are at historic lows — below three per cent per annum; the monsoon is progressing well and global demand remains damp. Babus and their counterparts in the public sector — around 18 million households — have all either been given or will soon get pay revisions. They are itching to spend the windfall.

Clunky “inspector raj” to check price rise – a bad idea

Even if the entire tax rationalisation bonanza is retained by manufacturers and dealers, it will still generate surpluses for private investment — in debt servicing, realty and equity markets. Improving the revenue steam of corporate India is vital for getting over the gargantuan NPA problem, which is bad cholesterol for growth. The good news is that most product markets are competitive. Digital marketers have cut retail margins to the bone. Even the market for services is hyper competitive — think telecom. This makes it tough for corporates to retain extra normal profits.

SMEs & Trade pay the price for becoming accountable – high compliance cost

Also, undeniably, tax rationalisation has come at a cost. The actual transaction cost, for business, to comply with digital GST processes is unknown. But GST provides a huge opportunity to India’s IT developers to innovate low-cost compliance and oversight options — particularly for value segments produced by small and medium industries. These could be perfected at home and marketed worldwide as context-specific solutions for developing countries. In 2013, at a conference in Washington, the World Bank president asked Nandan Nilekani why he wasn’t rolling out Aadhaar across the globe? Mr Nilekani responded that he was too busy at home and had no time left for solving the problems of the world. This single statement projected India’s enormous domestic, digital market potential far better than the glossies, which international consultants and governments routinely produce touting themselves. These digital opportunities have multiplied by several degrees with GST.

Multiple rates align with multiple objectives 

Third, the agreed-upon somewhat clunky architecture for GST reflects compromises made to achieve the twin overriding concerns — protecting the poor and ensuring fiscal neutrality for all governments. In the absence of a direct cash transfer framework, continuing tax exemptions on mass consumption goods and services is a reasonable policy option. Given the federal structure and the plurality of our polity, there never was an option to the consensual approach adopted by the GST Council. Meeting the revenue concerns of state governments has inevitably led to six GST rates. The highest rate of 28 per cent is designed to be used for neutralising any revenue loss for state governments.

Multiple rates result in efficiency loss due to tax leakage from misclassification of goods to a lower tax rate. A good example is the amorphous classification of a storage battery as a computer peripheral (lower tax rate) versus use for backup lighting needs (higher tax rate). Multiple rates also increase the accounting load for keeping track of tax credits and debits. But the economic benefits from early implementation of a less than perfect solution far outweigh the opportunity lost from a prolonged wait for the BJP to come to power in all the states, thereby enabling a best practice single rate template to be imposed from above, China style.

Fourth, GST is good for jobs. It gives a boost to “Make in India” by withdrawing the tax advantage for imported manufacturers. Importers pay Central state tax at four per cent as special additional customs duty. But domestic products are taxed at the rates of state sales tax, which are generally higher. This disadvantage for domestic production will vanish with GST. Imports, in addition to customs duty, will pay additional customs duty at the GST rate applicable for domestic products.

Flexible implementation arrangements – to muddle through the knots

Finally, the finance minister has consistently adopted a firm but nuanced, practical stance on the implementation schedule. Recognising that small-scale industry and traders are lagging in preparations, he has agreed to defer the filing of returns by two months. Assurances have also been given that the GST rates could be adjusted if the net tax burden gets distorted or gets unbearable. A government that is open to negotiating beneficial outcomes for all stakeholders and still retains the will to keep the national interest foremost is quite clearly operating at the tax-related good governance frontier. Smile, please.

Adapted from the author’s article in the Asian Age , June 23, 2017 http://www.asianage.com/opinion/columnists/230617/its-time-to-smile-gst-to-usher-in-a-new-era.html

Jaitley black money

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