Many months ago, the Indian Government announced its intention to introduce a Goods and Services Tax (GST). Recently, I was asked whether such a complicated tax makes sense for India. My answer: it certainly does, provided that the Government ensures that it is as simple as possible for small businesses to collect.
In recent years, a reasonable consensus has emerged amongst economists about what constitutes a good tax and what constitutes a bad tax. There are many factors to take into account, but a country which wants to encourage economic growth will almost certainly be wise to minimise taxes which discourage investment and focus instead on taxes on the unimproved value of land and on consumption spending.
And a well-designed GST, or Value Added Tax as it is more commonly known in Europe, is now widely regarded as a very good tax on spending. That is particularly true in any country where tax evasion is a problem – which means almost every country! Why? Because, with GST levied at every stage from raw material to final consumer good, with the tax paid on inputs claimed as a credit against tax collected on sales, the tax tends to be self-policing. Evasion is not impossible, but it is much more difficult than is the case with most other taxes.
But there is a world of difference between a well-designed GST and the kind of GST found in far too many countries. Ideally, GST should be very easy for businesses to collect on behalf of the government. If it is complicated, and involves high compliance costs, the tax will be a brake on economic growth and many smaller companies will try to avoid being registered to collect GST.
The simplest GST has two characteristics. First it is one levied at the same rate on all goods and services, with no exemptions. This is very difficult for politicians to understand. They often confuse a GST with a sales tax. It is relatively easy to apply a sales tax to some goods and services but not to others. It is very much more difficult to apply a GST to some goods and services but not to others. That’s because when businesses seek to calculate the GST they have paid on their inputs – raw materials, components, rent, electricity, etc. – they have to separate out the inputs used in producing the goods and services subject to GST from those used in producing the goods and services which are exempt from GST because they are not permitted to claim back the GST paid on inputs used in producing exempt items. For some items, that will be an easy calculation, but for many others it will be anything but easy.
So the first reason to have no exemptions is that that vastly reduces the compliance costs involved in collecting the tax, and so reduces the adverse effects on economic growth. Moreover, while the natural temptation for political leaders is to exempt items which are particularly important to low income citizens – such as food and clothing – there is a tendency to forget that most of the money spent on food and clothing is not spent by low income people: it is spent by middle and high income people. So that in exempting items such as food and clothing an enormous amount of revenue is foregone for the sake of trying to protect those on the lowest income, people who can readily be protected from the impact of the tax by other means.
It is also true that once some goods and services are exempted from the tax, or are taxed at a lower rate, the political pressure to exempt other goods and services becomes very strong. If food and clothing are exempt, why not books, shoes, and medical supplies? In no time, there are more holes in the tax than in the average Swiss cheese, and compliance costs have gone through the roof.
The second key characteristic of a good GST is one which allows smaller businesses to account for the tax on a cash basis, without the need for accrual accounting or for the employment of professional accountants which accrual accounting often requires. Most small businesses in India – indeed in all countries – simply do not employ professional accountants, and introducing a tax which requires them to do so involves a very substantial compliance cost – or creates a big incentive to avoid registering for the tax. In New Zealand, any business with annual turnover of less than $2 million can account for GST on a cash basis, which makes complying with the tax extremely simple. My own family trust owns a small kiwifruit orchard with annual turnover substantially less than $2 million: I can do the GST return for the orchard in about 15 minutes twice a year.
As long as compliance costs are low – as they are when GST applies to everything at the same rate and cash accounting is an option for small businesses – even very small businesses will want to be registered for GST. That’s because many of their larger customers who will have to be registered for GST won’t want to buy from unregistered suppliers because it makes their own accounting so much more complicated.
The additional complication which the Indian Government faces in introducing a GST – which fortunately the New Zealand Government did not face – is that of course India is a vast country, with a federal system of government. To the extent that the introduction of GST is intended to substitute for a range of other taxes the challenge will be how to divvy up the revenue between the state and federal governments. It would enormously complicate the tax, and increase compliance costs in a way guaranteed to damage economic growth, if there were to be two levels of GST, one at the federal level and another at the state level.
Copyright © 2024 Don Brash.