Since items in the 12% category account for only about 5% of total GST, the additional boost to consumption may not be significant, points out M Govinda Rao.
The Goods and Services Tax Council should be complimented for breaking the 'tyranny of status quo' by restructuring and reducing the number of GST rates.
Following the prime minister's Independence Day address, which promised a Diwali gift of lowering the tax burden, there were optimistic expectations of a reduced rate, a simpler structure, and greater ease of tax payments.
Credit goes to the Union finance minister, as chairperson of the GST Council, for persuading the members to unanimously adopt the decision to restructure the tax into two major rates by moving most items under the 12 per cent slab to the 5 per cent category, while also implementing measures to speed up registration and ensure faster refunds.
International experience shows that there is no 'one-size-fits-all' system of value added tax (VAT).
Each country adopts a variant of VAT, depending on political acceptability and convenience.
However, if some bad features, such as large-scale exemptions, too high or low thresholds, or multiple rates creep into its implementation, it is very difficult to remove them later.
However, if restructuring is done to reduce the tax burden, it gets universal acceptance.
Not surprisingly, the decision to reduce the number of rates has been welcomed by all.
While there was apprehension about revenue loss among the non-National Democratic Alliance-ruled states, the finance minister seems to have allayed their fears.
In any case, they too do not wish to be seen as obstructionists.
According to official estimates, the reform is expected to entail a revenue loss of about Rs 48,000 crore (Rs 480 billion) on an annualised basis for this financial year.
This works out to Rs 8,000 crore (Rs 80 billion) per month, which is not very high.
This is not surprising because consumption of those items that will now be taxed at 5 per cent is likely to expand to some extent, offsetting part of the loss, as most of the items in this category are expected to have reasonably high price elasticity of demand.
In any case, the revenue from items under the 12 per cent slab was about 5 per cent of the total, and reducing the rate will have only a marginal impact.
However, restricting the 28 per cent category to demerit goods -- particularly the reduction in rates on construction materials and automobiles and their parts -- is likely to make a dent in revenue.
Not surprisingly, the non-NDA ruled states have voiced apprehensions.
In some cases, this could affect their fiscal balance or capital expenditure, and it remains to be seen how they will adjust.
While reducing GST to two main rates is a significant measure, it is important to note that the system is still riddled with problems.
Ideally, a GST levied at a single rate, apart from exemptions, eliminates many administrative and compliance issues and reduces distortions.
It is no surprise that 81 per cent of the countries that have adopted VAT in one form or another since 2000 have preferred to levy the tax at a single rate.
Even after the elimination of the 12 per cent category to reduce the structure to two main rates, some of the problems will continue.
The large difference between 5 per cent and 18 per cent, besides incentivising lobbying to seek the lower rate, can lead to misclassification of the goods, often resulting in litigation.
There will be instances where the prevailing rates can create an inverted duty structure, particularly in items such as apparel, footwear, tractors, fertilisers, pharmaceuticals, and edible oil.
The issue becomes more severe in the case of a consumption-type VAT, where input tax credit is also allowed on capital goods and machinery purchases.
The distortions continue when the tax rates are bracketed according to the value of the commodity or service, or when the rate varies with end-use categories.
The reduction in the GST rate from 12 per cent to 5 per cent on a number of items is expected to provide a cushion against the adverse effects of the Trump tariffs on gross domestic product (GDP) growth by boosting private consumption.
GDP at constant prices in the first quarter recorded an impressive growth of 7.8 per cent, driven mainly by strong growth in private and government consumption expenditure and capital formation, aided by the front-loading of government capital expenditure.
It is hoped that the reduction in GST rates will provide an additional thrust to the private consumption engine needed to achieve the projected 6.5 per cent growth this year.
However, since items in the 12 per cent category account for only about 5 per cent of total GST, the additional boost to consumption may not be significant.
At the same time, it must be noted that the adverse effects of higher US tariffs will be on both net exports and foreign investments, and the only way to counter this is to seek alternative markets and undertake reforms to make the economy more competitive.
Similarly, the expectation that the reduction will reduce the inflation rate substantially to warrant a cut in the policy rate may also be questionable, for at present almost 50 per cent of the items that are in the consumer price index bundle are exempted from GST.
The most important tax reform needed at the present juncture to counter Trump tariffs is to make the economy more competitive.
In this context, the reform to expand the tax base to include petroleum products is important.
Presently, the cascading effect of taxes on petroleum products is very high and this increases the cost of transportation of goods and people.
In 2023-2024, cascading taxes at the Union level constituted 24.4 per cent of total domestic consumption taxes, while at the state level, domestic consumption taxes, excluding GST and state excise duties, constituted 34.4 per cent of consumption taxes.
Of course, the revenue loss factor outweighs any other consideration in this reform, but it is necessary to make a realistic estimate of the loss and initiate measures to limit it by pruning the list of exempted goods.
The inclusion of petroleum products in GST would help in taxing the transport sector much more comprehensively than at present.
Also, services such as legal fees, which are currently exempt, should be brought into the tax net to make it more comprehensive.
Similarly, the merit goods rate can be increased to 6 to 7 per cent.
However, this reform will not be easy to implement, since neither the Union nor the states would like to risk revenues, and the Union government is unlikely to take the lead because 85 per cent of the excise duty collected on petroleum products comes from cesses and additional excise duties, which are non-shareable.
But these are dire times, and it is necessary to think out of the box to inject greater competitiveness.
M Govinda Rao is chairman, Karnataka Regional Imbalances Redressal Committee. The views are personal
Feature Presentation: Aslam Hunani/Rediff
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