[Goods and Services Tax] Part 2: GST explained

Hello everyone. In the previous part, we discussed the system of indirect taxation prevalent before 1^st of July. In this part, we will see what changes the GST system brings to the table. I strongly recommend that you read the first part before proceeding. 

What is GST?

GST has been defined as any tax on supply of goods and services other than on alcohol for human consumption. It has three important properties:

- It has a one nation-one tax structure. This means it will subsume many indirect taxes like VAT, CST, Excise, Service tax, etc.

- It is a destination based tax. This means the taxing authority is the place where goods are supplied to and not where the sale originates.

- It has a VAT like structure. This means that taxes paid at previous stages will be available as setoff at the subsequent stage.

Normally when you (the consumer) buy something, you will see two components of GST – Central and State. This is because when a sale is made within a State (say Tamil Nadu), GST will be shared between Center and the State. In case the sale takes place across two States, IGST (Integrated GST) will be levied.

Under CGST, the present central taxes of Central Excise Duty, Central Sales Tax CST, Service Tax, Additional excise duties, etc. will be subsumed. Please keep in mind that the revenue collected under CGST is for the Centre. Similarly, under SGST, the indirect taxes at the state level will be subsumed. These include VAT, luxury tax, entertainment tax, taxes on lottery, etc. The revenue collected under SGST is for the state government. IGST is charged on the movement of Goods and services across the states. For e.g. if the goods move from Tamil Nadu to Kerala, IGST will be levied. The revenue collected from IGST is shared by the state government and central government as per the rates fixed by the authorities. In order to ensure smooth operations, the goods & services to be taxed as well as other essential design features of the GST would have to be common between the Center and the States.

GST and its administration

GST will be administered by the GST council. It will be the apex policy making body consisting of Central and State ministers in charge of the finance. The Council will make recommendations on model GST laws, its rates, place of supply rules and any other matters relating to GST. It has been alleged in the past that GST will lead to surrender of financial sovereignty of States to the Center. This is misrepresentation of truth. Yes, the states earlier had the right to tax transactions in their territory. Now it is both center and the states through the GST council which will levy taxes. They have not surrendered their sovereignty rather both the center and states have ‘pooled their sovereignty’ together to streamline and better manage the taxation of goods and services in India. The Centre will levy IGST on inter-state supply of goods and services. States will have the right to levy GST on intra-state transactions. Petroleum and petroleum products, i.e., crude, high speed diesel, motor spirit, aviation turbine fuel and natural gas, shall be subject to GST from a date to be notified by the GST Council. Still they are under the earlier system. It has also been decided that the Area upto 12 nautical miles will be under Central administration. However, States can collect tax on economic activities carried therein. Stamp duties which are levied on legal agreements by states, will continue to be levied separately.

So what are the expected Benefits of GST?

The main benefit that is expected is that it will be a simple and efficient taxation system. This should encourage tax compliance.  Besides, GST will also help in creating a wider tax base. This is necessary for lowering tax rates. In the current system, since compliance is low, the honest tax payer pays not only his own share, but also of the evader.

Elimination of multiple taxes and their cascading effects will lead to a reduction in price, provided the tax rates do not increase. The system of input tax credit (ITC) which allows for offsetting of all indirect taxes paid at earlier stage is the biggest reform. Earlier, since central and state taxes were completely isolated from each other and were administered separately, there was no scope of offsetting taxes paid to the center or state against the other. (Refer to the illustration in part 1). Harmonization of center and state tax administrations would also reduce duplication of efforts and cut red-tape. Additionally, the new automated system of GSTN would reduce errors and ease up the return filing procedure.

Challenges in the current system

Most important one is the multiple slabs of GST rates. In the current model, there are 4 rates of 5%, 12%, 18% and 28%. Besides, there are number of items such as raw agricultural produce which is zero rated and some luxury goods and those with negative externalities which attract a cess over and above the rate of 28%. This has made the system highly complicated. A silent drawback of this system is that of lobbying. Many producers or service providers, especially in the food processing sector would want their products to be zero rated or so. This may give rise to unscrupulous classifications in order to escape taxation. One more drawback of the earlier system which GST does not address adequately is the number of compliance forms to be submitted to the authorities. Certainly the compliance and registration for firms operating in multiple states has become easier, but not to the extent expected. For example, a firm operating in say 20 states will still have to submit like 400 odd documents, although most of them would be automated. So there is still scope of improvement here.

Concept of Revenue Neutral rate

It is the tax rate that allows the government to receive the same amount of revenue despite the change in tax laws. Currently, the total incidence of indirect tax in most of the states is about 30%, which includes 12% excise, 14% VAT and other taxes, depending on the good. Under the GST regime, if the average incidence of taxation comes out to be, say 20%, the government will lose out on revenue. Moreover, there with the system of input tax credit (ITC), any tax paid at earlier stage will be offset at a later stage, i.e. one can claim a return of tax from the government if one presents the invoice (similar to the concept of VAT which I have discussed in Part 1). This will also lead to reduction in revenue collection for the government. Therefore, the effort was to make sure that tax rates are such that revenue of the government does not decrease. The average GST rate which ensures this is called revenue neutral rate. It is the rate at which tax revenue will remain the same, despite allowing input credits, exemptions, etc.

Now calculating RNR is not the same as simply adding the current state and central taxes together. For example, having a combined tax rate of say 30% (~12% of center and ~18% of states) would be considered too high. As such, there would be less incentive for people to comply at such a high rate. Therefore, RNR should be such that it inspires compliance as well. It should thus take into account the expected benefits such as widening of tax base in its calculation.

Ideally, one would have wanted only one rate in GST which is RNR. We have ended up having multiple. The rationale was – combine all the taxes levied and put the goods into those tax slabs which are closest to their existing rates. Political compulsions of competitive populism have forced such absurdities like different rates for rasmalai, gol-gappe and samosa. Eating in an AC restaurant attracts higher rate than a non-AC one. Morning shows of bhai ki movies which cost less than Rs. 100 will attract lesser tax rate as compared to evening shows. Same movie, same hall, same bullshit. Socialist hangover.

GST on international trade- Imports and Exports

Since GST is a destination based tax, exports would be zero-rated as the sale is not made in India. Zero rated does not mean exempt. They will be eligible for full duty drawback. Of course they will have to pay customs duty. Please note customs duty is not part of GST. Imports would attract tax in the same manner as domestic goods and services. They will be subjected to a basic customs duty when they enter the territory of India. After that, they will be subjected to IGST.

At last let us compare the GST system with the existing system through the same illustration which we took in the previous video. The bat was sold from UP to a wholesaler in Maharashtra, say Nagpur, who sold it to a showroom in Mumbai for selling to a final consumer. Assume cost of manufacturing the bat to be 100 rupees with each party in the transaction wanting to earn a profit of 100 rupees. Further assume a GST of 10% (CGST and SGST of 5% each) and an IGST of 10%.

First, the manufacturer sells it to the wholesaler for Rs. 200+taxes. Since it is an interstate sale, IGST @10% is levied. Hence the cost for the wholesaler is 220 rupees. Next, the retailer in Mumbai purchases the bat for Rs. 320 + taxes. Tax in this case will be 5% CGST and 5%SGST, i.e. Rs. 32. Now this will be offset against the tax already paid, i.e. 20 rupees. Therefore tax paid is 32-20, equals 12 rupees. Thus, the retailer purchases it for 320+12=332 rupees. Finally, the consumer will pay Rs. 432+taxes. Again, 5%SGST and 5%CGST will be levied and offset by the tax already paid. Hence, the tax incidence is 43.2 minus 20 minus 12, i.e. Rs. 11. Hence the final cost to the consumer is 432+11, equals 443 rupees. 

Tax under new regime:

Tax under old regime:

As can be clearly seen, the bat which cost Rs. 477 in the previous regime will cost only Rs. 443 in the current regime, assuming the tax rates remain the same. This is possible only because of this offsetting mechanism - central and state taxes being offset against each other.

I hope that with this illustration, your conceptual understanding of GST is clearer. If you have any doubts, do let me know and I will try to address them.

Thank you very much. Cheers!

[Goods and Services Tax] Part 1: Past system of indirect taxation

The Goods and services tax has come into effect from 1^st July 2017 after the relevant bills were passed in the Parliament and the State legislatures. In this post, I will try to decipher GST and address some complexities associated with it. For that, we will also have to look at the indirect tax system which we have recently overhauled. This will be of great help to understand why we actually need GST and what its potential benefits are. Only then will we be in a better position to understand GST in detail.

So what was system of indirect taxes in India before 1^st July 2017?

Indirect taxes are those in which the burden of paying the tax can be shifted. This means that the entity responsible for paying the tax to the government does not actually bear the tax on itself, rather charges it from the final consumer. Currently, both the central and state governments levy indirect taxes on different goods. Central Indirect taxes include excise, customs, central sales tax, CENVAT, etc. State level indirect taxes are sales tax (Or VAT), entertainment tax, etc. Goods may be taxed according to their value, dimensions or quantity, etc.

The producer pays excise duty to the center on production. On selling to the wholesaler, he pays VAT to the state government, if the wholesaler is located in the same state or a CST to the central government otherwise. The wholesaler makes some profit while selling to the retailer, and pays the tax on his sale in the same manner. Finally, the retailer sells it to consumer after making a profit, collects the VAT from the consumer and pays it to the state government. And since all these are indirect taxes, they are ultimately borne by the consumer.

Note that if the sale is from one state to another, the state government cannot levy a sales tax on this sale as this will distort the free movement of goods in course of inter-state trade. This is a constitutional requirement. In order to compensate the selling state for loss of sales tax, the central government levies a Central Sales tax and transfers the entire amount to the selling state.

Since 2005, sales tax in the states is levied in form of Value added Tax. This reform was meant to check the evasion of taxes and correct the double taxation system. The term 'value addition' implies the increase in value of goods and services at each stage of production or transfer. VAT is a multi-stage tax with the provision to allow 'Input tax credit (ITC)' on tax at an earlier stage, which can be appropriated against the VAT liability on subsequent sale. This input tax credit means setting off the amount of tax paid on inputs by the dealer against the tax to be paid at the output stage.  In case the good is a final good, this value added can simply be considered as the profit which everyone in the supply chain is making.

Let us take an illustration. Assume that the rate of excise duty, CST and VAT is 10% each. Also assume each person in the supply chain wants to make a profit of 100 rupees. Now, suppose a cricket bat was manufactured in Meerut (UP) sold to a wholesaler in Nagpur, Maharashtra, who sells it to retailer in Mumbai. 1^st, an excise duty of Rs. 10 is paid by the producer to the central government. Next, the producer charges a Central Sales tax on Rs. 210 @10% from the wholesaler and pays it to Central government, which pays the entire amount to the UP government. Next, the wholesaler, who has brought it for Rs. 210+21, equals 231, makes 100 rupees profit and charges Rs. 331 +tax @10%, which is Rs.33. He pays this to the Maharashtra government. Finally, the retailer, who has bought it for Rs. 331+33, equals 364, earns a profit of rs. 100 and sells it to the consumer for Rs. 464 + tax, which is 10% of 464 minus the tax already paid, which is Rs. 33. Hence the consumer finally gets it for Rs. 464 + 46-33=477 rupees.

Now, this existing system of indirect taxes has number of problems: 

-  It adds to cost of the products, leaving them uncompetitive, especially in course of inter-state trade

- There are number of local level levies such as entry tax and octroi

- There is time delay and complexity in administration due to multiple authorities which collect taxes.

These problems result in increased costs – monetary as well as human, and therefore the system does not inspire compliance. As such, there is tendency to evade taxes. Key to increasing tax revenues of the country is to incentivize people to comply with the tax laws. Simplifying the indirect tax system holds the key here.

From what we have seen above, it is clear what should the basic objectives of new tax architecture be:

- It should be easy to administer as well as easy to comply. For that, it must be able to combine all the central and state taxes together into one single tax.

- It should make evasion difficult.

- If any kind of indirect tax has been paid on a certain value to any authority, that value should not be taxed again. In other words, Central and state level taxes should be able to be offset against each other.

- The shares of central and state governments must be clearly defined in order to minimize disputes.

With these drawbacks in mind, we will see how the GST system tries to address them in the next part.