THE EQUITY-COMPLEXITY TRADE-OFF IN TAX POLICY: LESSONS FROM THE GOODS AND SERVICES TAX IN INDIA

Abstract

Developing countries often rely on consumption taxes, because these are broad, easy to administer, and harder to evade. However, the taxation system becomes inherently regressive. To counter this problem of the regressive nature of consumption taxes, there is a temptation among policymakers to address equity concerns through a multiplicity of rates, making the consumption tax system complex. Here, complexity is considered the by-product, or companion, to pursuing goals of equity. Complex tax systems, however, pose a different problem relating to equity. Assuming a minimum fixed cost of compliance imposed by a complex tax system, smaller firms and individuals face a much higher cost of compliance relative to larger firms and richer individuals. Oligarchic sectors dominated by a few large firms also find it easier to organize and lobby to get favorable rates compared to competitive sectors with small firms. Though complexity is considered a by-product of several equity-enhancing measures, the Indian experience with its Goods and Services Tax reform serves demonstrates the opposite, that there is a trade-off between equity and complexity.

I. Introduction

This essay explores the question of the equity-efficiency trade-off in taxation, using the cautionary tale of the Goods and Services Tax [hereafter GST] reform in India. Indirect taxes targeting consumption, like the GST, are broad, easy to administer, and harder to evade. Because the poor spend a larger proportion of their income on consumption, changing the system to a value added tax (VAT) like the GST can make the overall taxation system inherently regressive. ¹ To make the tax more equitable, policymakers create multiple rates and exceptions, with essentials at lower rates and luxury goods at higher rates. However, multiple rates and a complex tax structure result in high compliance costs, which can also be regressive. This is an important aspect to consider in the equity versus efficiency trade-off in tax systems.

The standard concerns for equity and efficiency in taxation have dominated the conversation for decades. The famous “leaky bucket” analogy—in which income redistribution from the top 5 percent to the bottom 20 percent of income earners, while desirable, never makes it in its entirety and is lost in transmission ²—is well-known. This trade-off is naturally context-dependent, and developed countries face quite different choices than developing countries. ³

There are many considerations of justice and equity in developing countries, in the creation of overall tax policy. Should the tax policy be focused on direct or indirect taxes, that is, should the policy tax labor or consumption? The problem is that consumption taxes tend to be regressive, while taxing labor, especially highly skilled labor, can distort the labor market, lead to “brain drain” or human capital flight, and set countries on a lower growth path.

Focusing only on consumption taxes, another aspect of equity today is to punish those producing and consuming “sin” goods like guns, alcohol, tobacco, fatty foods, and so on, to implement behavioral changes. On the other hand, consumption taxes also reward “green” goods like electric vehicles. These new goals are part of the larger goal of equity in society. However, this approach can also result in a regressive tax policy. Another issue is whether governments should tax wealth and property, or tax consumption and investment. Additionally, once we come to the specifics, like taxation on inheritance or on dividends, there is the additional temporal element—a trade-off between imposing costs or benefits on the present versus future generations.

In each of these spheres of tax policy, instead of identifying and implementing one specific policy that would lead to equity, over the decades, most governments attempt to target multiple goals packaged as equity. As a result, tax policies have increased in complexity, and such complexity is justified to further the goals of equity. Equity is a buffet of policies—in addition to progressive versus regressive tax, there are issues of real income distribution, in federal states—the additional question of equity between states, nudging consumers away from addictive goods, punishing sin goods, and encouraging green goods, encouraging local producers, and so on. The consequence of pursuing these equity enhancing goals is complexity in the taxation system. The trade-off between complexity and efficiency is clear. Complexity is a by-product of some equity goals pursued by policymakers. But there is also a trade-off between complexity and equity, especially in developing countries with weak state capacity.

Using the example of the GST reform implemented in India in 2017, I argue that complexity in tax policy can be regressive in developing countries. The cost of compliance is higher for smaller firms and low-income earners. There are three reasons complexity in the tax system like the GST is regressive: (1) the costs of compliance is regressive as smaller firms will spend a larger proportion of their income/revenue in compliance costs; (2) sectors that are oligarchic with few large firms will find it easier to collectivize and lobby for lower tax rates compared to sectors with a large number of competitive firms; and (3) if the government favors some sectors but wants to still remain revenue neutral, it will increase taxes imposed on other sectors, typically those sectors that are unorganized and have a large number of small competitive firms. These aspects are evident in the case of India’s GST, as I shall elaborate in this essay. Where the tax policy is complex because of a multiplicity of equity goals, governments may achieve neither equity nor efficiency.

The GST reform took almost a decade, as all Indian states needed to form consensus over giving up their individual taxes levied within the state and actually moving toward a uniform system of VAT. The Indian Constitution was amended to reflect the change. So, in addition to many federal and state taxes becoming a single GST, the effect of the GST was to turn India into one large free trade zone, with a single tax rate. It was marketed to citizens, businesses, investors, and multilaterals as the “Good and Simple Tax.”

However, by the time the reform was complete, it was neither good nor simple. Pursuing several different goals, all masked as increasing or furthering equity, the GST has furthered interest groups seeking rents, tax concessions, and privileges. As a result, India now has eight different GST rates—0 percent, 0.25 percent, 1.5 percent, 3 percent, 5 percent, 12 percent, 18 percent, and 28 percent, and twenty-one different cesses in addition to the GST. According to the World Bank India Development Update 2018, of the 115 countries with a GST regime, 40 countries use a single rate, and 28 countries use two rates. India is an exception along with Italy, Ghana, Pakistan, and Luxemburg—countries with four or more rates.

While the intention in India was to have a good and simple tax, the government gave up on an efficient single rate to ostensibly accommodate equity, levy higher tax rates on luxury goods, as well as punish producers of sin goods. This proliferation of rates makes India’s GST system extremely complex, and consequently, regressive.

In Section II, I describe the need for the GST in India, and how it was an attempt to improve the existing taxation system. In Section III, I detail how the process of bringing consensus for the reform also meant a proliferation of rates. In Section IV, I argue that complexity in GST also makes it regressive, and therefore, there is a trade-off between complexity and equity. In Section V, I conclude.

II. India’s Move to the Good and Simple Tax

Pre-GST, India’s tax system was ineffective, expensive, complex, and full of exceptions. The GST effectively subsumed almost all existing indirect taxes—Central Excise Duty, Service Tax, VAT, Central Sales Tax, entertainment tax, Octroi, luxury tax, many cesses/surcharges and various other state and central levies on goods and services. The exceptions alone, as estimated by Subramanian, ⁴ cost the government about 2.7 percent of GDP. While the VAT system in developing countries has been criticized, ⁵ there is widespread agreement that it is an improvement over the pre-2017 indirect taxation system in India. The original goal was to formulate a GST that would subsume all these different taxes into one single tax.

The advantage of shifting to the GST was threefold. The first advantage was in having a tax system that was easy to comply with. The union government alone had several indirect taxes —Central Sales Tax; Central Excise Duty; additional duties of excise levied under the Medicinal and Toiletries Preparation Act; additional duties of excise levied under Textiles and Textile Products; additional duties of customs (Countervailing Duties [CVD] and Special Additional Duties [SAD]); Service Tax; Surcharges; and Cesses. Simplifying this into a single tax would reduce compliance costs for individuals and firms, reduce administrative costs for the government, reduce tax and regulatory arbitrage, as well as increase tax buoyancy.

Second, unifying the state tax system and converting India into a single free trade zone with no differential levies while crossing state borders was a big advantage of switching to the GST. Every state set its rates for the following kinds of taxes: State Sales Tax or in some states the State VAT; Purchase Tax; State Entertainment Tax; Luxury Tax; Entry Tax (All Forms); Taxes on lottery, betting, and gambling; Surcharges and Cesses; and Taxes on advertisements. There are two aspects to indirect state taxes. First, unifying the taxes within each state would accrue the same benefits as unifying central taxes of reduced compliance costs, reduced arbitrage, and tax buoyancy. The second element of differential tax rates is the entry taxes imposed on interstate trade. Such tax rates essentially fragmented the Indian economy and created tariffs for interstate trade that did not exist for intrastate trade. In other words, India was a single country with freedom of movement, but it was not a single free trade zone.

This caused enormous logistical delays and imposed high costs on any activity that was conducted across states. For instance, goods transporting trucks in India drive 280 kilometers per day compared to 450 kilometers per day in Brazil and 800 kilometers per day in the United States. Only 40 percent of the total travel time is spent on driving, while checkpoints and other official stoppages take up almost one-quarter of total travel time. Eliminating differential tax rates and entry fees, and thereby checkpoints, would keep trucks moving almost six hours more per day, equivalent to an additional 164 kilometers. ⁶

Leemput ⁷ shows that interstate trade costs exceed intrastate trade costs by a factor of seven to sixteen. Bringing India’s interstate trade costs down to the U.S. level (that is, reducing by a factor of six) increases welfare by 15 percent, and eliminating intrastate trade frictions raises welfare by 5 percent. Seventy-two percent of all freight traffic in India moved on roads, and these border checkpoints imposed an enormous cost on Indian domestic trade. Unpredictability in freight transport requires manufacturers to hedge against possible delays by carrying higher levels of inventory. Including indirect effects on inventories and sales, logistics is 10 to 14 percent of the operating costs of manufacturing firms, by far the largest cost difference between them and services firms. Domestic freight performance is explained almost entirely by distance and state-border crossings. Adding two border crossings can add a week of uncertainty in shipments. ⁸ The World Bank estimated that about 20 to 30 percent of the overall costs of domestic transport are because of taxes and can be expected to reduce with the introduction of the GST and the elimination of border checkpoints. ⁹

The third advantage of switching to the GST was the potential to reduce corruption and tax evasion. Given the proliferation of rates and limited state capacity, India’s tax administration system is rife with corruption and Indian firms are notorious for evasion. However, the built-in governance processes that are part of the VAT system ensures that tax credits are only given when the tax liability is disclosed. In other words, the administrative cost of collecting the GST is reduced because of the self-policing incentive inherent to a VAT. In addition to incentive-aligned self-policing by firms, the GST has an additional dual monitoring structure—by the state government and by the union government. Hence, there is a greater probability that evasion will be detected.

The tax reform to switch to a single rate GST also received widespread support from economists within and outside government. Within the government, various committees addressed the question of the equity trade-off with a single rate GST. The Report of the Task Force on GST argued in favor of a single rate on the grounds of improving efficiency and reducing corruption. ¹⁰ The report also stated that a single GST rate “to the extent, it enhances economic efficiency, it will also create new opportunities for employment which would obviously benefit the relatively poorer section of the society and improve equity.” The Thirteenth Finance Commission Report also recommended a single positive rate on all goods and services and suggested that the government look to other welfare instruments to enhance equity.

For these three reasons, the GST reform in India had bipartisan support in Parliament, as well as support at the union government and state-level governments. In effect, this meant that most of the major political parties of India came together to implement the reform. But all the states, governed by different political parties, had to sign on to the reform and give up their ability to set their tax rates and decide based on the consensus formed in the GST Council. Since GST acts a trade treaty as much as a tax treaty—the benefits of a larger free trade zone with no differential tariffs and checkpoints were clear for all to see. Almost everyone anticipated that in the long run, states’ share in tax revenue would increase. However, in the short run, some states might also see a drop in the revenue under the new GST system. And since these benefits would take some time to materialize, the compensation structure was created to ensure that short term costs would not hamper long-run benefits. The union government promised to make up the shortfall in revenues under a compensation structure for the first five years of the reform.

III. The Road from Simple to Complex Is Paved with Good Intentions

The move to a GST in a federal system is no small feat. There is a constitutional trade-off in implementing the GST. States would lose some more fiscal/federal autonomy, in an already centripetal fiscal structure. But in return, states would gain a larger market—the key to long-run prosperity—and hence larger revenues. But to make this entire reform possible, Parliament had to pass a constitutional amendment (the One Hundred and First Amendment of the Constitution of India), as well as have half the states ratify the constitutional amendment, since it amended the entrenched clauses in the constitution. ¹¹

Once this was accomplished the first question was what goods and services would be included in the purview of the GST. That battle for a broad system covering all categories of goods and services was lost on multiple margins. Five areas were excluded from the GST altogether, because the states did not want to let go of control over revenues from these goods. Sale of land and real estate is notorious for the highest levels of corruption and tax evasion, but because so much of the land is either directly owned or controlled by political middlemen, including land and real estate in the GST, this area was a non-starter. Similarly, revenue from alcohol sales is one of the highest shares of state tax revenues and losing control over that was also politically difficult. This was further exacerbated by the fact that some states have complete prohibition over alcohol, while others consider it a sin good, and the third category of alcohol-producing states tax it at lower levels. Electricity, petrol, diesel, natural gas, and so forth were also left out of the GST system with separate taxes levied on them.

The other aspect of the reform, aside from consensus building, was the question of the tax rate. Various experts came up with different rates for a single GST. Consider the Report on the Revenue Neutral Rate and Structure of Rates for the Goods and Services Tax. ¹² The Revenue Neutral Rate is the single non-zero GST tax rate that would preserve the revenue at the levels before the GST reform. The report estimated a 15 percent single GST revenue-neutral rate. Most economists suggested a single rate, or at most two rates, mostly along these lines. There were differences in methodology, on the effect of the new GST system on the tax base and revenue collection in the short run, but the idea was largely the same, to ensure a single rate at or above the revenue-neutral rate. Kelkar and Shah estimated the lower end of that range, arguing that applying a single 10 percent rate on 70 percent of the economy would yield 7 percent of GDP as tax revenues. ¹³

The report ¹⁴ commissioned by the Ministry of Finance, anticipated the political considerations that were brewing. While the report strenuously recommended a single GST rate as a medium-term goal for India, it recommended a three-rate structure. First, a 12 percent GST for goods consumed by the poor; second, the standard GST rate applied to most goods at 17 to 18 percent; and third, demerit goods (luxury or sin goods) at 40 percent. There were a few roadblocks on the way to a single GST rate.

The main challenge in having a single GST rate across the country and all goods and services, was the perception of equity. The idea that a country with predominantly poor people would pay the same rate for their bread as the rich for their Mercedes, was politically and publicly untenable.

The problem was not just related to the GST, but more fundamental. In India, the share of direct taxes in total tax revenue, for both the union and state governments, is only 35 percent. Indirect taxes, now unified as the GST, are therefore inherently regressive because they tax consumption. The poor spend a larger share of their income, sometimes their entire income, on consumption relative to the rich, and therefore end up paying a larger proportion of their income in taxes relative to the rich. The rich, in India and across the world, tend to save a larger proportion of their income, which savings are not taxed. With GST imposed on most goods, and with higher tax rates, the inherently regressive nature of GST becomes more severe.

Right off the bat, there were two options under consideration—the first was to have a zero rate for essentials that the poor relied upon, and a high rate for everything else. But this would affect revenue collections, and having a single high rate, with everything else taxed at zero would deviate from revenue neutrality—perhaps the most important consideration for the union government. The alternative was to have a revenue-neutral rate for most goods and services and have very high rates for luxury goods.

There was a stable and persistent coalition pushing for the latter to create multiple rates, not unlike the bootleggers and Baptists lobbying for restrictions on sale of alcohol in the American south. ¹⁵ If the pro-poor in India were the baptists, then the bootleggers were not far behind. Thus, enormous pressure came from different sectoral lobbies.

This was already a deviation from the general prescription of economists who have argued for a simpler tax system even before the GST reform. This comes from a larger literature on efficient taxation and multiple tax rates. The Ramsey rule states that under certain assumptions, the excess burden of excise taxes is minimized when goods are taxed in inverse proportion to their elasticities of demand. However, once the knowledge problems and incentive problems faced by government actors are acknowledged, the multiplicity of rates because of the Ramsey rule may no longer be efficient.

James Buchanan noted that standard public finance assumes a benevolent dictator and that the standard analysis assumed different motivations for those in the public sector versus those in the private sector. ¹⁶ Buchanan uses the same behavioral assumptions for both private and state actors, that is, they are assumed to be utility maximizers who respond to the incentives they face and make use of the information available to them. State actors and decision makers who design taxes do not have sufficient information on demand elasticities to create a tax structure that conforms to the Ramsey rule, even if they want to. Armed with this kind of behavioral symmetry, and the incentives and information problems, the efficiency of multiple tax rates comes under question. Holcombe argues that if policy makers nominally try to implement the Ramsey rule, the incentives inherent in the political process will lead to non-optimal taxes and will result in a substantial number of rent-seeking losses while doing so. ¹⁷ This is also applicable to other kinds of taxes, including the GST in India.

In the context of import tariffs, Panagariya and Rodrik argue that while the case for uniform tariffs is not watertight, uniformity minimizes the pressures for favorable (higher) rates on some goods over others. ¹⁸ The commitment to a uniform tax rate introduces a free-rider problem for industries to lobby for lower rates for themselves (since such lower rates are then extended to everyone).

This process of rent seeking began to unfold in India as soon as the GST with multiple rates was announced. Given the proliferation of dozens of union and state rates and hundreds of exemptions over the decades in India, virtually every sector had some special tax concessions and provisions hard-won by lobbies. With a potential single rate GST and no exemptions, some goods and services would end up having their tax rate increase while other goods, especially luxury goods, would see the tax liability decrease. Every single lobby wants its tax burden to decrease and not increase. This is impossible with a single rate. All well-organized sectors suddenly tried to prove their essential status or their contribution to the poor—either by showing consumption patterns, or in case of luxury goods, by demonstrating employment or the supply of essential infrastructure to the economy, and so forth.

State actors also have incentives to increase the number of rates. There are two sets of pressures, favoring different groups, that end up in rate proliferation. The first is with respect to the lobbying efforts of various sectors, which tend to increase the number of rates and exceptions and decrease government revenues, since these lobbying efforts aim to decrease the tax rates for the benefit of those who are lobbying. However, there is an opposing pressure, which is to remain revenue neutral despite the lobbying efforts. To mitigate the impact of the concessions given to favored industries, state actors will increase the tax rate on those goods and services that are relatively inelastic in demand and belong to sectors that are relatively unorganized. Therefore, the kind of rent seeking and lobbying that leads to rate reduction for some special industries will also be accompanied by rate increases for other industries. Both pressures lead to frequent rate changes, increase in exceptions, and eventually rate proliferation.

Initially, most of the goods and services approaching the GST council (listed in Appendix I) managed to receive a rate reduction from the GST council. For instance, the 23rd GST council meeting reduced rates for over 150 goods and services from 28 percent to 18 percent with no clear guidelines or criteria of equity. However, in the last two to three years, as tax revenues have decreased, there is also a pressure to increase revenues or remain revenue neutral. This has come in two forms. The first is a rate increase for goods like woven fabrics, handmade matches, polythene sacks, caffeinated beverages, and so on. Some of these goods are made by small firms in the unorganized sector and cannot lobby for favorable rates. The other method has been to increase the number and percentage of cesses imposed on “sin” goods like tobacco listed in Appendix II, as they tend to have relatively inelastic demand.

In addition to equity concerns and rent-seeking pressures, a third reason for rate proliferation is the attempt to use the GST to bring about behavioral changes. First is by having high rates or “sin taxes” for goods like tobacco. And second is by providing lower and favorable rates to “green” or environmentally friendly goods. For sin goods, like tobacco, the GST rate is the highest, at 28 percent and in addition, cesses are imposed. These cesses on tobacco products range from an additional 5 percent to 204 percent depending on the type of tobacco product. (See Appendix II listing cesses.)

Equity goals also get complicated with sin goods. Beedi, considered the “poor man’s cigarette” is taxed at the highest rate, at 28 percent GST. However, unlike cigarettes, no additional cess is imposed on beedis. This has led critics to call for a cess on beedis to help reduce tobacco consumption among lower income groups. Adding a cess to beedis would make the GST more regressive; however, not adding the tobacco cess (intended to nudge behaviors that presumably improve health) will treat lower income groups unfavorably, by not trying to reduce beedi sales through the tax instrument.

Similarly, for green goods, electric vehicles and electric vehicle chargers were encouraged through a rate reduction, while SUVs and diesel vehicles saw an increase in the tax rate because of an added cess. However, diesel engines for tractors saw a rate decrease to encourage farmers, especially small farmers. Taxing diesel vehicles at a higher rate to meet “green goals” can also have regressive effects because it is an input in agriculture, and small commercial vehicles.

The trouble with this kind of lobbying is that the government had to follow through with consequences if the industries and firms at issue did not cater to the poor and tried to profit from the rate change. One bad idea led to the next, and the government announced that it would monitor the prices of goods and services before and after the tax rate reduction. To do this the government made provisions to set up an “Anti-profiteering Authority” to ensure that reduction in tax rates under the GST results in a decrease in prices of goods and services. ¹⁹

Finally, there was pressure either to have a single rate with a lot of exemptions, or alternatively, to have multiple rates applying to different goods, with the state carefully analyzing what kinds of goods qualify as essential, those used by the poor, luxury goods, sin goods, and so on. In the process, rates proliferated. From the original suggestion of a single non-zero revenue-neutral rate, the Indian GST system today has eight different rates. 0 percent, 0.25 percent (gemstones), 1.5 percent (diamonds), 3 percent (gold), 5 percent, 12 percent, 18 percent, and 28 percent.

Most items consumed by the poor are taxed at a low 5 percent or 12 percent rate. The government claimed that most of the goods in the Consumer Price Index (CPI) grouping were taxed at these lower rates, or, as in the case of food grains, are completely exempt. The attempt was to tax the bulk of goods at 18 percent and have luxury goods taxed at 28 percent.

However, this also did not end up with the most progressive tax structure. For instance, biscuits are taxed at 18 percent under the GST. Parle-G, a biscuit company that has existed for over a century in India, sells its smallest pack for five rupees (about seven USD cents). This seven-cent pack of biscuits is famous for being carbohydrate-rich, and poor people, who live on less than a dollar a day, often have a pack of Parle-G biscuits when they cannot afford a meal. This is taxed at 18 percent. The rationale is that not all biscuits are consumed by the poorest groups, and giving an exemption to a single firm, though well known in its service to the poor, would be against the ethos of the GST system.

On the other hand, gold jewelry, which is almost entirely held by the middle class or rich, is taxed at only 3 percent. The rationale there was different—it is easy to evade taxes with gold holdings. This rate is so obviously regressive that even reports by government economists and experts have pointed out the hypocrisy. But this rate also proliferated. Initially, gemstones were taxed at 3 percent, but in July 2017, the GST on gemstones was reduced to 0.25 percent. The ostensible reason was to make the Indian gemstone industry more competitive abroad. But the actual reasons were political. ²⁰ India’s demonetization had crippled its gold and diamond industry, concentrated in Gujarat, and after the demonetization disaster, allegedly Prime Minister Modi assured the sector that they would receive the GST concession in exchange for support in the election. This rate change happened in July 2017 with the state election in December 2017.

Whatever the ostensible and real reasons, poor people living on less than a dollar a day pay 18 percent on a seven-cent meal, while the rich buying gold and gemstones pay 3 percent and 0.25 percent respectively. This is a single example of well-organized industries getting special rates from the government.

If the government can reward well-organized industries that are lobbying it in exchange for favors, it can also punish industries that are not as well organized or have fallen out of favor, or sectors where the demand for goods is relatively inelastic. Several such goods and services, like woven fabrics, or handmade matches, and so forth, saw an increase in GST rates.

In the last six years since the implementation of the GST, there are hundreds of government notifications clarifying various aspects of the GST. I argue that complexity in tax policy can be regressive in developing countries. It is quite clear that various firms and interest groups are constantly seeking lower tax rates. Appendix I details all the GST Council meetings where rate changes were announced, and the specific rate change for the goods or services. This appendix alone is twice as long as the essay.

So, while there are “only” eight rates, there is a lot of movement of goods within four to five rate categories (0 percent, 5 percent, 12 percent, 18 percent, and 28 percent). Monopolistic and oligopolistic industries tend to be better organized and can better lobby their cause. As expected, larger firms benefit more from a proliferation of rates, because smaller and more competitive firms and industries may not be able to afford the cost of lobbying for lower rates.

IV. Complex Tax Systems are Regressive

Section III highlighted the efficiency problems caused by multiplicity of rates once informational constraints and political incentives are considered. However, once we account for informational constraints and political incentives, there are also equity problems caused by multiplicity of rates.

One might think eight different rates is not so bad, especially given that the alternative is a single rate with hundreds of exceptions. At least that is how the eight-rate “simple” tax was sold to Indians. The idea was that once there is a clear code of classifications, and people get enough time to get used to the new system, the GST system will subsist.

The government has a detailed list of classifications in the Harmonized System of Nomenclature (HSN)—an eight-digit code for goods classification—which tries to provide and stipulate a code for every conceivable product category. This was used over decades for the various indirect taxes and custom duties. One year into the GST regime, the HSN codebook for GST classification contained 18,306 entries in 438 pages. Even after doing such a detailed job (or maybe because of it), there is inevitable confusion. What happens when a good or service could fit in two different categories, and therefore be taxed at two different rates?

The Indian GST system encourages many to ask existential questions, “Is KitKat a biscuit or a chocolate?” is one such pertinent question, because biscuits were taxed at 18 percent while chocolates were taxed at 28 percent. Or should Pepsi’s Nimbooz be classified lemonade (taxed at 28 percent) or as pulp juice (taxed at 12 percent)? Most firms provide an in-house cafeteria, but most firms also have the food prepared outside the premises, often by a third party. Should they be taxed at 5 percent or 18 percent, because cafeteria service is taxed at 5 percent while outdoor catering is taxed at 18 percent? In each instance, members of the industry reached out to the finance ministry and the GST Council to clarify the matter, and lobby for the lower rate.

The opposite problem also exists with multiple rates and classifications, where variations of the same good are taxed under different rates. In 2017–18, there was a dispute over barfis (Indian milk-based sweets). Plain barfis were taxed at 5 percent, but barfis with dry fruits could be taxed at 12 percent, and chocolate barfis could be taxed at 28 percent. The GST Council had to clarify that chocolate barfis would be taxed at 5 percent as barfis and not as chocolate.

If one goes to the GST Council website, there are several hundred notifications, more than one for each day of the law’s existence. The union government alone has issued hundreds of such notifications since the implementation of the GST in 2017. Each of the twenty-eight states has, similarly, issued hundreds of notifications. There is a constant process of raising disputes and questions, and the government trying to clarify classifications and solve problems. And then there are the legal challenges in courts. And this is only about the current stock of goods and services in the economy. It does not account for new products and services that will surely enter the market in the future.

Some people blame the government for not doing a good enough job of detailing and specifying various classifications. It has done a remarkable job, but that is hardly the point. The problem is that it is an impossible task. No matter how detailed the classification codebook, there will be disputes and confusion, because we live in a wonderful world with interesting, complicated, customized goods and services with many dimensions that serve many needs.

The problem is that the finance ministry and the GST Council are asking the wrong question. The question is not how best to classify each good, but to realize the impossibility of successfully classifying each good. Therefore, it is best to do away with the need to classify each good. A single GST for all goods and services needs no classification system. All individuals and firms simply pay the same rate, and the government and the legal system can use valuable time and resources resolving other disputes and problems.

Often, the argument used against simplicity in the GST system is the lack of uniformity in the real world. The economy comprises different individuals and firms that come together in a beautiful dance coordinated by the price system. When the individuals and firms are so different, is it fair to treat them equally? After all, the entrepreneur owning a small sweetshop is not in the same position as the entrepreneur owning a luxury car showroom, and fairness demands that the rich pay higher taxes. To make the system just, barfis are taxed at 5 percent while luxury cars are taxed at 28 percent.

One of the main advantages of the GST system is that it provides an incentive for all members in the supply chain to ensure that taxes have been paid at each level. In cases where the supplier has not paid the tax or is exempt, the receiver pays the tax. However, the more complicated the tax classification and rate system, the harder it is to understand the tax burden of all the inputs. For instance, the Diwali holiday gift basket, ubiquitous in India, requires different sweets and dry fruits, and so on, as its inputs. If the barfi seller is unclear on whether he must classify a chocolate barfi as chocolate at 28 percent or as a barfi at 5 percent, then the seller creating the gift baskets is also affected. Either the barfi seller does not pay the tax, in which case it falls upon the gift basket sellers to figure out whether to pay 5 percent or 28 percent on the barfis and collect it from the barfi seller. Alternatively, the barfi seller pays the incorrect amount, affecting the tax payments and deductions of the gift basket seller. So, the more inputs required for any good or service, the higher the compliance burden created by the multiple GST rates. It is not enough to have clarity on one’s tax classification, but this extends to every single input. This can get extraordinarily messy and costly.

All this can only be resolved by having a single GST tax rate. If there is no confusion over the tax rate for different inputs, it will help the incentive mechanism built into the GST system work more smoothly.

The increase in high compliance costs due to complexity makes the GST regressive. Unfortunately, the intention to help the smaller and poorer firms by using multiple tax rates, often makes them worse off. Though 5 percent is a lower tax burden than 28 percent, the complicated GST system with its eight different tax rates and myriad exceptions, poses a disproportionately high compliance cost on the sweetshop. The burden to comply with the GST is very similar for both small and larger firms. And because the compliance requirements and, therefore, the costs are similar, a small firm pays a much larger proportion of its earnings to deal with compliance, relative to a large firm. In this sense, a complicated tax system is inherently regressive, because it forces the poor to spend a greater proportion of their earnings on compliance burdens imposed by the tax. Creating complex systems to maintain a progressive tax can perversely generate a regressive tax structure once compliance costs are considered.

It is the small firms, shops, and individual innovators and entrepreneurs who need simple rules the most. They need to use the scarce resources at their disposal to best serve their customers, instead of using those resources to pay professionals to help them understand complicated regulatory and tax requirements. The sweetshop owner potentially benefits more from simplicity than a luxury car business.

The GST compliance system has three parts. First, each taxpayer needs to figure out the classification and the rates applicable to their good or service. Second, each taxpayer must understand the classification and the rates applicable to their inputs. And then finally, the taxpayer must file returns and pay taxes. Each of these tasks is so complicated and costly under the present regime, that small firms and individual proprietors need to devote a significant proportion of their resources to understand and comply with the GST regime.

The classification system is quite clearly a mess, as briefly discussed above. Each taxpayer must navigate the 438-page long HSN code book (2017) with its 18,306 entries to identify which of the eight tax rates apply to the good or service in question. Any additional cess, sometimes levied by individual states, must also be added. This is no small task, and there are disputes and notifications that must be tracked almost daily in order to even calculate the criterion for the tax burden under the GST.

However, the compliance nightmare does not end there. Much has been said about the extremely cumbersome filing system, where taxpayers had to file monthly returns for union and for state GST. While a move has been made to reduce the frequency of filing returns and creating a more streamlined filing system, the process will be easier and cheaper with a single rate. If there is no confusion over the tax rate, more businesses are likely to file and submit vouchers on the GSTN on time, which means it is easier for sellers to match vouchers for their inputs and meet their tax and filing requirement with ease and on time.

Now comes the question of equity. For smaller firms, typically categorized as MSME (Micro, Small, and Medium Enterprises), there are three to four different aspects that raise compliance costs. First is that both small and large firms must spend similar resources to understand the HSN classification system to determine the tax rates applicable for their goods and all their inputs. Second, both small and large firms have the same number of tax filings per year. Third, the reverse invoice matching system to receive the input credit is similar for small and large firms, which means smaller firms, especially informal firms or those firms sourcing inputs from the informal sector, will have high costs of compliance with invoice matching. And finally, a larger proportion of the working capital is tied up for small (relative to large) firms, while waiting for input credit. Since the GST is not even six years old in India at the time of this writing, of which two years were during the COVID-19 pandemic, there are very few countrywide studies or estimates looking at the exact incidence of compliance costs on MSMEs.

Based on the experience of other developing countries, Emran and Stiglitz argue that “the regressive bias of compliance costs may be significant. A recent European Commission Staff working paper shows that the compliance costs of VAT are 2.6% of sales for small and medium firms, while it is only 0.02% of sales for large firms.” ²¹

In India, this sector is large—MSMEs’ contribute to a third of the GDP and almost half of all exports. The Finance Ministry’s 2019 report on MSMEs ²² admits that with the imposition of the GST “the compliance in terms of time, cost as well as energy is much higher for MSMEs vis-à-vis the bigger companies.” Instead of simplifying the system and reducing compliance costs, the Finance Ministry has instead announced a number of relaxations, exceptions, and benefits to MSMEs “necessary in order to help them cope with sudden increase/change in compliance challenges.” ²³

V. Conclusion

Equity and efficiency considerations in taxation are important everywhere, not just in developing countries. However, in developing countries, they take on different forms. One form discussed here is value added taxes on consumption, because they are broad, easy to administer in poorer countries, and harder to evade, the move becomes inherently regressive.

To counter this problem—the regressive nature of consumption taxes—countries start adding layers of equity-enhancing goals and tools. In the end, tax rates proliferate, making the entire system complex. Here, complexity is considered the by-product, or essential companion of equity.

Complex tax systems, however, pose problems of both inefficiency and equity. They are inherently regressive, because smaller firms and individuals face a much higher cost of compliance relative to larger firms and richer individuals. Complex tax systems are also prone to interest group capture, and monopolistic industries, with better organized lobbying, also end up at lower tax rates. And if the government favors some sectors but wants to remain revenue neutral, it will increase taxes imposed on other sectors, typically those that are unorganized and have a large number of small competitive firms, that are unable to get the reduced/favorable tax rates.

Though complexity is considered a by-product of a number of equity-enhancing goals, the Indian experience with its GST reform shows the opposite, that there is a trade-off between equity and complexity.