Regional Inequality and Indirect Tax Reform in India

Abstract

This chapter discusses some aspects of regional inequality and disparity in India. In particular, four key issues related to this inequality are considered: the economic inequality across Indian states; the structure of vertical transfers; the lack of integration across various markets (with agricultural markets taken as an example) largely due to the existing regulations and indirect tax structure in the country; and the recently passed goods and services tax for rationalizing India’s indirect tax structure. The chapter closes with some policy options.

Appendix: Comment on Two Recent Structural Policy Changes

The right sequencing of economic policies, while unexceptionally important for the success of economic reform, is relatively neglected in popular discussion. For example, macroeconomic stabilization of a country with high inflation and sluggish output growth and an overvalued exchange rate would require that the correction to the exchange rate precede stabilization policy. Reversing this sequence would not yield the desired results.

A similar argument is relevant to the current debate in India on the efficacy of the policies of demonetarization and the implementation of the GST. Almost everyone seems to agree that GST is a good policy, but many criticize demonetization.¹⁸ An important point to understand here is that without demonetization, GST could not be a success. Demonetization has drastically reduced the size of the informal economy. As Emran and Stiglitz (2009) show, VAT (GST’s predecessor applied to goods only) applied in an economy with a large informal sector (like India’s) introduces a strong distortion between the formal and the informal sectors of the economy and, thereby, reduces welfare. This is in contrast to tariff reduction—another indirect tax reform—which reduces distortions between the home economy and the international economy and thereby could improve welfare.

As transactions could move into the informal economy, tax collections would not rise by much in response to the imposition of VAT. VAT was introduced into India on April 1, 2005 (ironically the same year as that in which the Emran–Stiglitz paper was published) and indirect tax revenues did not increase sharply in response to it. According to Ministry of Finance’s Indian Public Finance Statistics 2014–15 (http://dea.gov.in/sites/default/files/IPFStat201415.pdf), central and state indirect tax revenue as a percentage of GDP was 11.37% in 2005–06; 11.77% in 2006–07; 11.06% in 2007–08; 10.43% in 2008–09; 9.63% in 2009–10; and hovered between 10.53% (2010–11) and 11.57% (budget estimates for 2014–15). Hence, there was no jump in indirect tax collections after the imposition of VAT. This is despite the fact that the period to 2008–09 was one of very high economic growth in India. Clearly, the Emran–Stiglitz effect was operational.

It follows that it was essential to reduce sharply the size of India’s informal economy to make the GST a success. By this logic, demonetization should have occurred before the implementation of VAT in 2005.

The GST has many advantages—avoiding the cascading effects of taxes, removing disincentives against exports, creating a unified Indian market, to mention just a few. The last of these is of particular importance. With a unified indirect tax structure across the country, finally investors (domestic and foreign) have a strong incentive to be in India. With this in place, the most important reason for the potential slowing down of economic growth (sluggish private investment) will lose some of its bite, and economic growth should accelerate in the short to medium terms. As already noted , Van Leemput (2016) shows that India has much more to gain from internal liberalization than external liberalization. She estimates that if these internal trade barriers were to be reduced to the level of internal trade barriers in the USA, welfare in India would increase by 16% as opposed to only 7% for international trade liberalization. Hence, removing internal trade barriers is a major policy imperative for India. The GST has enabled the Indian economy to traverse a long distance in this direction. In addition, the Indian GST has the uniquely attractive feature that the shares of the central and state governments in the GST revenue are clearly delineated. This is very important, since some countries with long histories of GST along with a single-rate tax structure and unitary control have experienced disagreements about the disbursal of GST revenue when economic circumstances change. Regarding the speed of implantation of GST, there are compelling arguments why July 1 was the right time. The country could carry on the momentum of demonetization and capitalize on the sharply rising digitization of transactions. Two months is too short a period to judge the success of the GST. Most countries with more simplified GST structures than India’s have taken a year or more to adjust. By that token, the Indian GST is doing rather well.

There is no gainsaying the fact that, prior to November 2016, India had a very large informal economy. A key indicator of this was the overwhelmingly large proportion of transactions carried out using cash (the 2015 currency to GDP ratio was 12.51% for India, compared to 9.34% for China, 7.38% for the USA, 4.15% for Australia, 4.07% for the UK and 2.45% for Norway). In 2015, demand deposit as a proportion of currency was 0.6 in India, 20.97 in the UK, 5.27 in the Euro area and 3.94 in Australia. Thus, there was a heavy dependence on cash in India. Furthermore, India had a large parallel underground (or black economy) with malefic and dangerous overtones for the rest of the legitimate economy. The fact that large denomination currency notes were being counterfeited and put into circulation on a large scale, exacerbated the problem.

The gains from moving towards electronic modes of payment and away from cash are compelling. Electronic payments and transfers provide an easy audit trail for governments to tax individuals and businesses, and track illegal transactions such as money laundering, financing of crime, terrorism and drug smuggling. Some governments (e.g., Denmark) routinely discourage the use of currency notes (http://splinternews.com/the-government-of-denmark-wants-people-to-stop-using-ca-1793847623). Businesses too benefit from a move away from cash transactions to e-transactions, as there is evidence that people spend more when paying electronically.

Electronic means of payment provide greater security of transactions, despite the threat of cybercrime. Carrying large amounts of cash involves risks of its own and fuels government inefficiency and corruption. A report in Time magazine (http://business.time.com/2012/05/22/how-cash-keeps-poor-people-poor/) suggests that carrying out transactions by cash actually hurts the poor more than the rich, since it is harder to protect cash against theft, decay and natural disasters . Rogoff (2016) argues forcefully that reducing the role of cash in the economy also improves the efficacy of anti-recessionary monetary policy.

The government had prepared the population well for demonetization, shown by the sharp increase in Jan Dhan and other bank accounts (so that ordinary people would have an avenue to deposit their old ₹ 500 and ₹ 1000 notes and by announcing a generous amnesty scheme for tax dodgers well before November 2016. Once again, sequencing matters. The only people who would lose out from a move toward electronic payments would be those benefiting from illegal transactions in the cash economy.

Some people have argued that demonetization was a failure, since of the ₹ 15.44 trillion worth of crore currency denotified, all but ₹ 16 billion came back into the banking system. This argument is wrong. All bank deposits have enough information to identify the depositor. Large depositors can be pursued. A newspaper report on September 29, 2017 (http://economictimes.indiatimes.com/news/economy/policy/cbdt-chief-tells-tax-officers-to-target-rs-3-lakh-crore-unexplained-cash-deposits-during-note-ban/articleshow/60876158.cms) reports that the Central Board of Direct Taxes has discovered unexplained cash worth ₹ 3 trillion in bank accounts. Thus, all that the large proportion of denotified currency returning to bank accounts reveals is that the Indian banking system was working well.

While announcing its demonetization policy in November 2016, the GOI had inherited a serious problem. The value of notes to be disallowed accounted for a huge proportion of total currency value. The share of high-value notes rose from 36% of total notes in circulation in 2004 to over 80% in 2014, to about 86% at the time of demonetization. This clearly was the result of a flawed currency policy of the Reserve Bank of India. Ideally, the denominational composition of currency should be kept close to that being used in the modal cash transaction.