Microeconomics of Goods and Service
Tax (GST)
It took 70 years for the largest
democracy in the world to move into a direction of economic integration by
adopting the Goods and Service tax on 1st July 2017. The idea of GST
was first introduced in the parliament in 2000 by the then PM Shri Atal Bihari
Vajpyee and was recommended for implementation in 2004 by Shri Vijay Kelkar,
chairman of tax reform task force. However, it took almost 16 years to complete
its journey from conceptualization to institutionalization in the Indian
constitution with the assent of President on the One Hundred and First
Constitutional Amendment Act, 2016. After the adoption by the J&K
legislative council on 5th July, this tax regime has replaced the Value
Added Tax (VAT) system across the country.
One hundred and first
constitutional amendment act (2016) was enacted almost after 12 years of due
consideration of both houses of parliament and all the state assemblies, as
this legislation required the states and center to give up their respective
individual power of taxation to a newly constituted GST council which consists
of representatives of all the State Governments and Union Territories along
with Central Government. GST is considered to be a game changer for the Indian
economy as it has completely changed the way taxes will be levied, collected,
and distributed consistently across the nation. Not only it has economic
significance, but also political significance as it alters the characteristics
of federal economy in which states have concurrent or exclusive power to tax
goods in accordance with Indian constitution. Since the changes with the
introduction of GST has impacted every economic agent of the economic sphere of
the country, be it individual or firm, this paper attempts to analyze its
microeconomics aspect.
GST And It's Composition
Like VAT, Goods and Services Tax
(GST) is also an indirect tax which will be levied on the final value (market
value) of the goods and services provided, right from manufacturer to consumer.
Since input credit for the GST paid for intermediate goods and services are
allowed, the tax turns out to be on value addition at each stage. With its
implementation, it has subsumed many different kind of indirect taxes levied by
central or state governments. The following tables represents the significant
indirect taxes that were subsumed in GST:
TABLE 1: DIFFERENT TYPES OF
INDIRECT TAXES SUBSUMED IN GST
|
Central Taxes
|
State Taxes
|
|
Central Value Added
Tax/Sales Tax
|
State Value Added
Tax/Sales Tax
|
|
Central Excise Duty
|
Entertainment Tax
(other than the tax levied by the local bodies),
Central Sales Tax (levied by
the Center and collected by the States)
|
|
Additional Excise
Duty
|
Octroi and Entry tax
|
|
Service Tax
|
Purchase Tax
|
|
Additional Customs
Duty commonly known as Countervailing Duty (CVD)
|
Luxury tax
|
|
Special Additional Duty
of Customs (SAD)
|
Taxes on lottery,
betting and gambling
|
In India, GST has been implemented
with dual structure – Center GST (CGST) and State GST (SGST). Under the
constitutional provisions, taxation powers were distributed among center and
states in order to have federal character for India as a union of states. Since
the introduction of GST was supposed to subsume many taxes from the center and
state list defined in the constitution, a GST council was constituted which
have the power to levy taxes, decides rates, and then distribute the proportion
of GST between center and states. This GST council is representative body of
all the States, Union Territories (UT), and Union government with respective
finance minister as its de-facto member. The GST council has to decide the overall
GST rate and then divide it into CGST and SGST which is currently fixed at
equal proportion. For example, if a good is taxed at 18% under the GST rule,
the CGST and SGST would be 9% each. The GST is a consumption based tax which
means that the state where goods and services will be finally consumed, will be
getting the tax credited in their consolidated funds. Under the current
arrangement, the SGST will be directly credited to the State government and
CGST and IGST (IGST is levied on inter-state trade of goods and services) will
be credited to Union government. The GST council decided to levy five different
rates for goods and services in order to maintain the equity feature of
taxation policy in which necessity goods and services consumed by poor should
be taxed at smaller rates than the tax rate on luxury goods and services. The
following table presents the different rates under the GST rule:
TABLE 2: GST RATES BY PRODUCT
CATEGORY
|
Exempt (0%)
|
Low Rate (3%)
|
Low Rate (5%)
|
Standard Rate (12%)
|
Standard Rate (18%)
|
High Rate (28%)
|
High Rate (28% with Cess)
|
|
Agricultural goods
|
Silver, Gold, and
diamonds
|
Necessity goods
|
Consumer Goods
|
Consumer Goods
|
Luxury goods and
consumer durables
|
Luxury and De-Merits
Goods
|
The rational for having multiple
rates under GST is justified under the economics principle of taxation. Basic
goods or services should have lower tax rate than the luxury goods since luxury
goods are consumed by well-off consumers. However, the current distribution of
goods and services under existing GST rates does not follow this principle
strictly as some of the goods and services consumed by even weakest section of
society have been placed in relatively higher rate. For example, service tax on
telecommunication services has increased from 15% under previous taxation
system to 18% under GST. Given that the weaker section also uses mobile phones,
this increase will definitely pinch their small pockets.
One significant feature of the GST
is the allowance of input credit for the taxes already paid at previous
transaction. The following picture represents tax calculation under pre GST and
post GST scenarios:
FIGURE 1: TAX CALCULATION UNDER
PRE AND POST GST SYSTEM
The system of input credit will
result in avoidance of tax cascading effect i.e. taxing the same goods and
services multiple times making the goods or services much dearer than what it
should have been. The inbuilt system of input tax credit starting from the
manufacturer to final consumer is also a self-regulating mechanism of tax
compliance in which each trading agent has its own incentive to declare the
actual amount rather than underestimating the invoice value for avoiding or
under-reporting taxes. Therefore, the current GST mechanism will also help in
curbing black money generated in the economy and enhance the overall
transparency in the tax administration.
Behavioral Analysis of Producer under GST
Given the wider macroeconomic
implication of the GST implementation, the question that needs to be analyzed
is “how a firm or a producer of any good or services would behave under the new
taxation regime”. In a market economy with perfect competition, producer takes
the prices as given and then produces the amount of quantity where his marginal
cost equals price (price is also the marginal revenue for this kind of firm).
Introduction / increase in taxes increases the price, lowers the quantity
demanded, shift the supply curve of the firm to the left and therefore, reduce
the quantity produced. The two figures provided below exhibits the short run
and long run impact of introduction of taxes on the price and quantity.
FIGURE 1: SHORT RUN IMPACT FIGURE 2: LONG RUN IMPACT
If this simplest microeconomics
theory is applied to the firm behavior, the most important factor that needs to
be determined to predict the firm behavior in terms of output produced, should
be change in prices due to changing taxation system and power of firm to shift
the tax incidence towards consumer.
The change in prices can be two
fold – direct and indirect. Direct change in prices depends on the new GST tax
rate which have either resulted in higher or lower tax rate in comparison to
the existing effective taxes. Indirect changes will be depending on the change
in prices of intermediate goods and services. If the input prices of a good or
service get reduced, it will result in cost reduction for the firm which should
be reflected in the final price of the goods or services being produced. The
final price of the goods and services depends on the direction of direct and
indirect change. If direct and indirect price changes are in the same
direction, the final price should definitely be reduced increasing the demand
and thus quantity produces by the firm and hence, should be increasing its
overall profit. However, direct and indirect changes may be in opposite
direction, in which case the final price movements will be dependent on
magnitude of direct and indirect price changes. For simplicity, let us analyze
only the final movement of prices where it can either increase or decrease.
In the first case of increase in
prices, the firm will anticipate relative shrink in demand and then produce the
quantity where the demand meets supply at the new prices. Overall, the
reduction in quantity will reduce the producer’s revenue and profitability in
the short as well as long run. However, the cost of tax compliance on the
individual firm is also set to reduce with replacement of so many central and
state taxes with single tax rate structure. Use of technology in the tax return
filing is supposed to be one time investment and is being facilitated by
central government, thus reducing the overall cost of tax compliance. This will
lower the marginal and total cost curve of the firm and therefore, new
equilibrium should result in increase in quantity produced. The net effect on
the output is dependent on the quantum of change in marginal cost curve.
In the second case of decrease in
prices, producers will react to the increased demand and hence will increase
the production. In this scenario, there will be definite increase in output and
consumption which will add up to GDP values. In addition, the lowered prices
makes the good more competitive in the international market and thus, have the
potential to increase the export and have a positive impact on balance of
payments.
Firm’s behavior will also be
dependent on elasticity of demand curve. If the goods or services produced by a
firm are having inelastic demand, firms have the power to pass on the tax
burden to final consumer. In such cases, producer’s surplus will not decrease
to the same amount as it would have been with a good or services having elastic
demand curve. If we take the same example of telecommunication services, higher
service rate charged under GST can be passed on to customer as
telecommunication services demand is relatively inelastic. It is highly
unlikely that the marginal increase in prices for calling or data services will
result in people stopping or reducing its usage.
In terms of tax compliance by an
individual firm, the current GST has a mechanism to incentivize reporting of
actual invoice value rather than under-reporting for the motive of tax
avoidance. In the current system, any mismatch in the invoice of the goods and
services, especially in Business to Business (B2B), will punish the defaulter
by disallowing the input credit. Therefore, the equilibrium in tax compliance
can be compared to Nash equilibrium where each economic agent is expected to
maximize their gains independent of each other leading to the maximum social
welfare. Wholesalers or retailers will report their actual invoice value in
order to get credit for the tax amount already paid at the time of their
purchase.
The rationalization of multiple
taxes under GST should result in improving the ease of doing business in the
economy. Now the firm needs to comply with only dual GST tax regime replacing
the older system of tax compliance with multiple indirect taxes of center and
state government separately. Tax compliance for inter-state goods and services
was even more complicated. Therefore, improvement in ease of doing business and
reduction in cost under GST regime will also induce firms to expand or
diversify in the long run in order to maximize its profit and reduce its
underlying risk, assuming that there will be growth in demand due to structural
economic reform and growing population. With ease of entry and exit (exit ease
has been enhanced with the bankruptcy bill[1]),
firms can choose to enter the market resulting in higher competition and higher
efficiency which is a stated goal under market mechanism of capital economy.
Behavioral Analysis of Consumer under GST
It is widely argued that the
introduction of GST in the Indian Economy is expected to increase the consumer
welfare in the long run through reduction in prices. The prices are expected to
reduce as a result of reduction in tax cascading effect, direct reduction in
prices, or increased market competition with new firms entering into production
system due to improved index of ease of doing business. Therefore, it is
important to analyze the changes in consumption behavior in the short and long
run with introduction of GST.
To assess the change in consumer
behavior, consumption basket should be known for consumers with significantly
different income. The consumption behavior of low income group differs
significantly with consumption behavior of middle or high income group. Lower
income people spends more on necessities than on luxury goods. The below graph
provides a picture on consumption bundle at national level and urban level:
From the figure above, it can be assumed
that urban and rural consumption pattern across income quantile bands are
similar. Therefore for the present analysis, we shall concentrate only on India
level consumption trend.
Bottom 20% population spends
almost 58% of their consumption expenditure on food items whereas top 20%
population spends only 40%. Among the non-food expenditure, education
expenditure is highest in top 20% income group while health expenditure is highest
among bottom 20%. Highest expenses on health services among poorest section of
the society indicates that the quality of food intake is inferior and the same
is reinforced with the data which clearly shows that the cereal and its
substitute constitute highest proportion of food expenses for bottom 20%
population. With the implementation of GST, the prices of these commodities are
expected to change which will further induce changes in consumer behavior. The change
in consumption behavior with following consumption baskets are given below.
Food: - Within the food category, cereals and cereals substitute are zero
rated in the GST system. These were also exempted under the previous regime and
therefore, no change in prices are expected. Poorest section spends more than
20% of their income on these food items which is also one-third of their total
food expenditure. Fresh fruits and vegetables are also zero rated and hence
will be within the reach of poorest section. GST on processed food items ranges
from 5% to 28% which will result in increase in final prices as many of these
food items were earlier exempted or having lower rate. For example, preserved
vegetable will have 18% GST against 0% in previous regime and frozen meat will
have 12% GST against 6% earlier. Increase in prices of these food items may
force some of the not so well off families to shift to inferior goods. However,
these will be short run impact as increase in prices may not be significant in
long run due to avoidance of tax cascading effect. Also, consumer preference and
their future economic condition are supposed to be driving factor in the long
run.
Education: - Since pre GST and post GST rates on most of the stationary items
(books, notebooks, pen, pencils, etc.) are same, GST introduction is not
supposed to alter consumption behavior towards education.
Health Services: - The overall prices in the health services industry will be
declining as the tax rates pre and post GST are mostly unchanged or have been
lowered. Given the reduction in prices, consumption expenditure may reduce.
This will help the poorest population of the society the most.
Entertainment: - The percentage of consumption expenditure for entertainment is
highest among the top 20% population. The entertainment goods and services are
most likely to gain as the taxes are lower than the pre GST regime. The
entertainment tax which was a state tax earlier varied from 0% to 60% is now
kept under the 28% bracket. However, there are some exceptions. Few of the
states were having zero entertainment tax due to which the ticket price of
movies were within the reach of poorest. For example, poor population of Tamil
Nadu is a huge consumer of cinemas tickets who will have to pay more to watch movies
on screen leaving them relatively worse off. Same stands for Amusement parks
for which there is an increase in overall tax rate. Consumption behavior may
change for bottom 20% population in those states where prices are likely to go
up.
Conveyance: - GST implementation is not supposed to alter the consumption
pattern for conveyance as it is mostly demand driven. Prices are also not
expected to change as fuel, which is most important component of variable cost
in transportation sector, are kept out of GST regime. The cost of vehicles are
already coming down with GST which will increase the supply and therefore, put
a downward pressure on the expenditure incurred by a consumer for his
conveyance.
Clothing and Footwear: - Low cost clothing and footwear has been placed in 5% GST rate
which is expected to reduce price whereas remaining types are placed in 18% GST
rate resulting in increased prices. The consumption expenditure percent across
income quantiles for clothing and footwear is highest in bottom 20% and
therefore, differential pricing is justified. GST will benefit the lower income
population due to price reduction and is likely to increase its disposable
income which can be utilized for further consumption. However, increase in
prices of good quality goods may change the consumption pattern of median
population and even force some of not so well off families to shift to inferior
quality clothes and footwear.
Other Expenses: - Given that the other expenses category is highest in top 20%
population, it may be assumed that the expenses are mostly on non-basic or
luxury goods which is put into higher tax brackets. The consumption pattern for
this category is not expected to change in the high income group whereas it may
change significantly for the bottom 20%. Increase in service charges under GST
will make the services little costlier and will be pinching the budget of lower
and middle income consumer group. For example, increase in service charges for
telecommunication services which is widely used by bottom 20% of the population
will leave them with less disposable income.
Overall, the consumption behavior
of a consumer is not expected to change significantly in the short run as the
rates which has been introduced are mostly similar. Expected reduction in
prices on few commodities may get offset with rise on some of the goods and
services. However in the long run, macroeconomic impacts of GST may induce
consumers to change their consumption pattern. The facts can only be verified
once data starts accumulating on the consumption behavior as well as
macroeconomic indicators.
Road forward
Given these expected change in
microeconomic behavior of producer and consumer, the road ahead would be to
lower the overall cost in the economy. Avoidance of tax cascading will help in
this direction. However to realize the full potential of the GST
implementation, investment is required in human capital and technology. By
design, GST's architecture is using cutting edge information technology. For
example, in many states, even registering for a TIN/ VAT used to involve
unwritten costs of bribery and multiple rounds to offices. However, for GST
registration, one can apply online with all details and the GST number is
allocated within three days without necessity to visit any office. Similarly,
under GST regime, most of tax related queries will be asked electronically for
which answers are also to be filed in electronic form. Producers and consumers
has to be imparted with knowledge and awareness about GST which will help in
reduction of tax compliance cost. However, the tax compliance cost would likely
to be higher for smaller firms. Therefore, policy intervention may be needed to
reduce the cost for these firms and induce them to adopt newer technology. Use
of technology will help producers to enhance efficiency in supply chain
management (inputs, transportation, inventory, tax credits, etc.) and lower their
cost which can be passed on to consumers. Other benefits on cost will be
accruing due to reduction in transportation time. Earlier, carriages had to
wait for long duration at state borders for entry tax payment. With GST, such
waiting time has been eliminated. This is much more economically beneficial for
commodities with short life such as food products, fruits, vegetables etc.
Success of GST would also be on the infrastructure development which enhances
the transportation, storage, and distribution network of goods and services.
Firming up the institution like Goods and Service Tax Network (GSTN) would be
indispensable in this regard.
In current form, the GST regimes
are also half way to the ideal scenario. Multiple rates (more than three)
increases the compliance cost. Exemptions of many goods are resulting in leakage
from the taxation system. Most importantly, the distribution of goods and
services in different tax rate slabs are not rationalized. For example, printed
books are zero rated, geometry boxes are taxed at 5%, pencil sharpeners at 12%,
and notebooks at 18%. No rational seems to be justifying these goods at
different rates. These goods are complimentary in nature, belongs to education
related category, and are also consumed by poorest population. The success of
GST is dependent on removing the imperfectness from the current regime and move
towards the ideal GST with few tax slab and minimal exemption. The learning
from current implementation must be utilized to move in that direction.
Conclusion
GST has certainly helped in
economic integration of India as a consumer has to pay same tax rate on his/her
consumption basket across India. A producer has to pay one tax rather than
paying multiple taxes to center and states separately. Change in tax rate on
goods and services will certainly have an impact on production and consumption
behavior. However, the quantum of change depends on other external factors such
as elasticity of demand, macroeconomic factors, technology upgrades, etc. India
will have to wait and watch to evaluate the impact of such a major economic
reform in taxation system. But, the odds are in favor of positive impact given
the wider economic reforms are simultaneously carried out along with effective
implementation of new GST system.
References
[1] http://www.mca.gov.in/MinistryV2/insolvency+and+bankruptcy+code.html
 |
Shishu RanjanEconomist and Banker |
Comments
Post a Comment