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India's Great Tax Tangle

Complexity and poor planning are bogging down one of the most important reforms in years.

Prime Minister Narendra Modi has touted the new tax.

Photographer: Ravi Choudhary/Hindustan Times/Getty Images

India's new indirect tax system, which for the first time tries to standardize most taxes across this vast country's many states, is proving to be even more difficult and disruptive to implement than first feared. That speaks to the unnecessary complexity the government's introduced into what should have been the simplest of laws.

QuickTake India's Aspirations

Here's what the goods-and-services tax, or GST, was supposed to be: a simple and low, India-wide tax rate that allowed businesses to claim credits for the taxes that they paid on their inputs. Economists seemed fairly confident -- with good reason -- of the results. First, the GST would bump up government revenue significantly as new products, services and producers entered the tax net. Second, it would reduce costs and increase efficiency, vastly increasing the competitiveness of Indian firms and making everything they produced cheaper. Third, it would make paying taxes so much easier that smaller companies would themselves seek to join the tax net, thereby increasing the size of India's "formal" economy and boosting small firms' chances for growth. And fourth, it would knit India's many states into a genuine single market.

As of now, it looks like only the fourth goal is being achieved. It isn't a small achievement, either. But nowhere in the world is one out of four a passing grade.

Consider government revenue. It looks to come in lower than expected because of complicated rules governing the transition between old and new tax systems, and because nobody really modelled the impact of a GST with eight -- yes, eight! -- different tax rates, topping out at 43 percent. The first month's numbers were poor: The government at first tom-tommed the $14 billion in revenue it received, and then was startled when India's taxpayers demanded credits worth $10 billion, far more than anyone expected. Government budgets across India are being remade on the fly; some state governments are panicked that not enough money will come in to keep their committed spending going.

That huge claim for credits might just be a one-off, a consequence of the transition between one rate and another. But it might also be to some extent a problem inherent in the system, if people are claiming input credit for tax at a higher rate than they pay on the eventual product. We simply don't know for sure -- and won't for awhile. Either way, the government can't be at all confident that the GST will permanently increase its revenue.

What about the second benefit, increased efficiency? Well, that's yet another problem. A well-designed indirect tax system would reduce compliance costs for companies. The GST doesn't; it's so complicated that even medium-sized companies are struggling to keep up with the rules, diverting resources that could have been devoted to productive activity. As for smaller companies, those who can't afford to hire a tax planner or get online daily may simply shut up shop. The government insists that its online payment system is easy to use. Unfortunately, few who have actually had to use it seem to agree, and it's their opinion that matters, not that of New Delhi bureaucrats.

Finally, yes, the GST is bringing some smaller firms into the tax net -- but not the way it should. Instead of companies and entrepreneurs looking at a simple, clean, low-tax system and choosing to opt in, they're being forced in willy-nilly by the biggest customers in their supply chain. Otherwise they may lose business to those who are part of the system and whose payments the customers can claim as refunds.

This is a clever part of the design of the GST -- the Indian government has essentially privatized tax enforcement -- but it's another hammer blow to the small businesses that drive India's growth and employment. Meanwhile, the smaller firms that do join up discover that they have to pay their taxes, but don't get their refunds for weeks, perhaps months. This drastically raises their working capital needs -- again increasing costs and reducing competitiveness.

Indian exporters are already complaining that around $10 billion worth of orders are "stuck" because of GST-related liquidity problems. This might become endemic across the economy unless the government gives up its insistence that refunds will only go out once everyone in a supply chain has dotted the Is and crossed the Ts on their paperwork. Officials don't seem eager to do that at all.

It's not too late for the government to reverse course and focus on returning to first principles. It needs to slash the number and level of tax rates, and to ensure people don't have to wait for refunds. It can only do that if it remembers the original motivation for the GST: to make paying taxes easier and reduce costs. In the multitude of last-minute, politically inspired changes to the GST, that basic economic logic has sadly been forgotten.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Mihir Sharma at m.s.sharma@gmail.com

    To contact the editor responsible for this story:
    Nisid Hajari at nhajari@bloomberg.net

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