Given the fact that Prime Minister Narendra Modi has a degree in Entire Political Science and not in Entire Economic Science, it is only to be expected that he is a bit weak in monetary and fiscal policy. He has now admitted as much in a recent interview given to Zee TV, where he has asked that his performance as the leader of his Government should not be evaluated just on the basis of the sorry implementation of the Demonetisation of high-value notes and the Goods and Services Tax (GST). While one can excuse Modi for his ignorance in economic matters, the same license cannot be extended to the bevvy of economists who are among his staff who should be advising him about the right monetary and fiscal measures to take instead of kowtowing to his absurd dictates regarding something that he knows very little about. Despite both demonetisation and the design of the GST flying in the face of established monetary and fiscal policy, none of the economists and bureaucrats had the guts to tell Modi that these would fail miserably. This, in short, is the problem with governance in this country in every sphere, from agriculture to industry to water management including sanitation to education to health, that the political and administrative practice is irrational and so incompetent!
Let us start with demonetisation. What is the most important lesson that we have learnt from this exercise? It is that those in the habit of accumulating black money will try and game the system rather than let go of their illegal hordes. This is what happened. Huge amounts of black money were deposited regardless of the warnings from the Government that they would be tracked and indicted later for depositing the demonetised notes in excess of the limits prescribed. So almost all the money was deposited and now the Income Tax Department is saddled with the Herculean task of sending notices to these 18 lakh depositors of unaccounted money and proceeding against them. Most have not responded to the email notices that have been sent to them and not filed income tax returns that account for the deposits they have made. Due to the lack of staff, the Income Tax Department scrutinises in detail the returns of only a few thousand assessees every year and so it can easily be imagined how difficult it will be for it to scrutinise these 18 lakh depositors. Since email notices have not garnered much response, now written notices have to be sent and then staff have to be deployed to scrutinise the books of all these people. There has been an increase in the number of income tax assessees and the income tax deposited but this has been of the same order of increase as in earlier years and so it can safely be assumed that unearthing the black money deposited is going to be a long haul. All this at a huge cost to the economy in general and to poor people in particular.
Given this tendency of the black people of this country, who are incidentally also the top 1% economically, to game the system, one would have thought that the Government would have designed a GST that would have prevented such gaming. But no, once again there was great fanfare, as with the announcement of demonetisation and a worthless and unworkable GST was launched. Modi in his eagerness to copy Nehru’s freedom at midnight speech, delivered another one at a specially called midnight session of parliament, declaring that he was freeing the economy of the country from the tyranny of multiple indirect taxes!!! But what actually happened is another sordid story altogether.
The lynchpin of the GST is the input tax credit system. I had described this in my first post on GST before it was launched, in which I had predicted that the faulty way in which the GST had been designed, it was bound to fail and I will repeat it here as without understanding this, one cannot appreciate the monumental blunder that has been committed!
In the above graphic we ignore for the time being the tax that the manufacturer has paid on the goods and services procured by him and assume they are a part of his selling price of Rs 100. He adds Rs 5 for GST at 5 per cent and sells the product to the wholesaler for Rs 105 and uploads the invoice for the same to the Goods and Service Tax Network (GSTN), the internet based software that is to keep all the tax data, with which he is registered. Every month the manufacturer pays the total tax that he has collected from his sales in accordance with the invoices he has uploaded on to the GSTN to the tax authorities. The wholesaler on his part sells the product to the retailer at Rs 120 and adds Rs 6 for GST at 5 per cent. Since he has already paid Rs 5 of the tax to the manufacturer he can claim the input tax credit from the invoice that has been uploaded onto GSTN by the manufacturer and will pay only the net GST to the tax authorities. The wholesaler too uploads the invoice onto the GSTN. The retailer sells the product for Rs 160 and adds a tax of Rs 8 at 5 per cent when selling to the consumer, who, thus, pays the full tax. The retailer too pays only the net GST to the tax authorities after uploading the invoice of sale to the consumer onto the GSTN.
In theory the manufacturer, wholesaler and retailer will all demand that not only they get tax paid invoices from their vendors but that these are also uploaded onto the GSTN and the taxes paid in time by those who sell to them because otherwise they will not be able to claim input tax credits and will have to pay the whole GST themselves. At the same time the Government benefits because the input tax credit chain ensures that each and every transaction is tracked and taxes paid on it. Not only does this broaden the indirect tax base but also by completely tracking the income and expenditure of business entities, gives the Government a correct picture of the net incomes earned by them and so increases the direct tax base considerably as incomes cannot be concealed to evade tax while at the same time by making the tax payment system more or less automatic, the indirect tax bureaucracy can be freed to monitor the direct tax system which will now be augmented due to better indirect tax reporting. More importantly by unifying the separate Central and State indirect tax systems and simplifying them, the flow of economic activities would be smoothened bringing down the overall taxation and complexities of the economic system.
However, for the input tax credit system to work smoothly, it is essential that there be only one or at the most two tax rates. This is because of the fact that with multiple tax rates, there is a need to classify goods and services which are to be taxed differently and this leads to complexities in the filing of computerised returns which in turn mean that small businesses below a certain threshold of turnover have to be exempted from registering in the GSTN altogether because they will not be able to comply with the complicated procedures and a considerable number of others below a slightly higher threshold will have to be exempted from filing the returns known as GSTRs and instead will have to pay a composition tax on their total turnover. Originally as conceived, there were three returns to be filed every month. GSTR1 for the previous month was to be filed first by the 10th of the following month giving the details of all the invoices of purchase and sale of various items and the taxes paid or collected on them. Once this was done then all assessees could compare their returns with those of their suppliers and buyers to see whether all the returns matched and file GSTR2 by the 20th of the month, indicating those items of return that were not matching and also getting in touch with the suppliers and customers to rectify the anomalies. Finally, once all the returns were matched and the input tax credits availed, then the final return along with the tax to be paid was to be filed by the last day of the month. There was a penalty of Rs 200 per day to be paid if the returns were not filed and taxes not paid by the stipulated date.
Unfortunately, things went awry from the first month after launch itself!! The main reason was that the complicated Harmonised System of Nomenclature (HSN) used in the excise duty regime earlier was retained in the GST regime. HSN was introduced by the World Customs Organisation to have a standard format of classification for goods which are traded internationally and have different tariffs so that international trade is smooth. This was adopted by the Central Board of Customs and Excise in India both for the customs duties and the excise duties so as to harmonise both duties across different goods. However, in the new GST system, which by design has a much lesser number of taxes by categories rather than goods, this was not necessary as even if there were effectively ten different tax slabs with exemptions and cesses, instead of detailed classification of each type of good only the broad categories of taxation in which the goods fell could have been named. Similarly, for services too, the Services Account Code with detailed classification of services was retained even though there were just two rates of GST for services. What this did was it complicated hugely the returns filing process as each invoice had to mention the correct HSN or SAC number of the good or service sold and the tax that had been collected on it by the vendor divided into State GST, Central GST and Interstate GST. If there was a mistake then the return would not be accepted by the GSTN and if there was an anomaly in filing between actual sale and the return, then the GSTR1 of one business would not tally with that filed by another business with which it had transacted. Moreover, since the GST was introduced hastily without proper beta testing of the GSTN software, the system had innumerable glitches and often crashed. Also due to even further complications, the electronic waybill system which was to replace the earlier system of paper transport challans which used to be carried by the transporting vehicles was not ready due to the unpreparedness of the GSTN software. So while the earlier transport challans and border checking of transport vehicles were removed, the e-way bills and their checking through handheld devices were not operational.
Therefore, in the first month itself the three-stage filing system had to be put in abeyance and in great hurry an ad hoc system of filing of a hastily devised GSTR3b was introduced in which businesses only had to file self-assessed returns of the overall buying and selling they had done and not the detailed invoices with their goods and services, HSN and SAC codes, amounts and taxes and pay the net tax as calculated by the businesses on the basis of this self assessment. This ad hoc measure was necessary as otherwise taxes would not be paid since the originally designed return filing system had failed and this would greatly jeopardise the finances of the central and state governments.
The provision to exempt businesses with turnover less than Rs 20 lakhs (Rs 10 lakhs in the North East) from registering in GSTN and to exempt businesses with a turnover less than Rs 1.5 crore (Rs 75 lakhs in the North East and Himachal Pradesh) from filing the GSTRs and instead avail of the composition scheme, provided loopholes for businesses to evade taxes and these were necessitated precisely because of the bad design of the GST. Even though the introduction of the reverse charge mechanism, which required businesses registered in GST to pay the GST on behalf of their vendors who were not registered on GST, theoretically created a pressure system that would bring in smaller businesses into the tax net as they would find their business going to bigger businesses, in effect because of the badly designed GST this did not happen as the input tax chain did not take off in the first place.
This precipitate fall in GST collection was also due to a parallel reduction in taxes on various goods and services as protests against the high and often irrational and conflicting taxes gained ground. Especially so in the run-up to the Gujarat assembly elections when the Government had to backtrack not only on tax rates but also on the filing of GSTR1 which was put in abeyance for the current financial year, thus completely freeing businesses from truly reporting their turnover. The Government then frantically began taking punitive measures as predictions were that there would be a considerable shortfall in tax collection if things went on like this and it increased the heat on businesses and so the GST collection for December 2017 has shown a slight increase to Rs 86,703 crores but is still highly deficient.
The only person within the Government who has spoken some sense throughout is Arvind Subramanian, the Chief Economic Advisor to the Government of India. From the beginning, he has been saying that there should be a single revenue neutral GST tax rate of around 15-16% and he has repeated this in the recently released Annual Economic Survey.