View: Clean up GST, to increase income tax collections

The Prime Minister has launched a tax reform programme that would further reduce the personal interaction between taxmen and taxpayers. This is meant to reduce the scope for rent-seeking and let people pay taxes without apprehension of being targeted for further investigations by tax authorities. This is welcome, but the way to increase direct tax collections really lies in cleaning up the indirect tax system, the Goods and Service Tax (GST) implemented jointly by the Centre and the states.
A direct tax is a tax that is borne by the entity on which the tax is levied, such as income tax and capital gains tax. An indirect tax is a tax that the entity on which the tax is levied can shift to someone else, so that the burden of the tax is borne by that someone else. All commodity taxes, such as the excise duty paid, for example, by refineries that produce petroleum products or alcohol, as the case may be, are indirect taxes, passed on to the end consumer, who fuels up at a petrol pump or raises a toast in the evening.

It is commonplace to say that only 3% of Indians pay tax. This is true if by tax we mean only direct tax (the latest figure is actually a little over 5%). Indirect taxes collectively account for two-thirds of all taxes collected by the Centre and the state governments. Direct taxes are just about a third of tax collections. Most indirect taxes have been folded into GST, those on petroleum products, alcohol, electricity and real estate being major escapees from the GST net.

The GST payable on say, a box of matches, is the same whether the buyer is the richest man in the country or a migrant worker. As a proportion of his income, that tax the rich man parts with is ridiculously small, compared with the proportion of income the same tax takes away from the migrant worker. This is why indirect taxes are said to be regressive. Developed countries collect a much higher share of their tax take as direct taxes, whereas India manages to push direct taxes only to a third of its total tax collection, while the bulk of tax collections come in the form of regressive indirect taxes.

How can India raise the share of direct taxes? Not by appealing to the well-off to honestly pay their tax, but by identifying the tax base that escapes taxation. That is achieved by cleaning up the GST system.

GST is a value added tax, meaning the tax is levied not on the gross price of a product sold by a company but on the value added by that company, after paying for its inputs such as raw materials, logistics, advertising, marketing, etc. The value added by a company in a period is the sum of the company’s gross profits, wages and salaries in that period. It is this non-obvious economic reality that makes the value of total output of an economy equivalent to national income.

This insight can lead to transparency as to taxable income and the number of employees any company has. Suppose a carton manufacturing company pays GST of Rs 18 crore at its applicable GST rate of 18%. So, the value added by the company is Rs 18 crore/0.18, that is Rs 100 crore. Suppose the company had been trying to disguise its profits and the number of workers on its rolls. Armed with the knowledge that the company’s value added is Rs 100 crore, the taxman can foil any attempt to show a profit lower than the actual. If profits are artificially lower, the company has to show how it paid such a huge bill on account of wages and salaries, and who these employees are.

Given this reality, companies would prefer to not pay GST. However, it is relatively difficult to evade GST, if the taxman diligently follows up the input trail. Suppose a garment maker in Surat buys fabric from a powerloom. The powerloom buys the yarn from a spinning company. The spinner has to procure the fibre from a fibre maker. Reliance and Bombay Dyeing are two large makers of polyester fibre. The taxman should go to bulk producers of polyester fibre and ask them to identify all their buyers. These, in turn, should be asked to identify all their buyers, and so on, down the chain to the garment maker. Some straightforward input-output norms can lead the taxman to identify all producers and the quantities they buy and sell. All of them can be made to pay GST to account for all their physical input and output quantities. GST leads to value added, which then yields gross profits, wages and salaries. Wages and salaries should be traceable to identifiable people and tax collected from those whose income crosses the tax threshold. Gross profits can lead to taxable net profits, leading to higher direct tax collections.

This entails some detective work, no doubt. But gumshoeing is not the tough part. The tough part is asking large companies like Reliance, in the case of petrochemicals, , Birla, in the case of aluminium, Tata or Jindal, in the case of steel, for full disclosure on their customers, accounting for 100% of their output. The next layer of producers and the one after that would tend to be influential at the state level. The point is to muster the political will to overcome their resistance to exposing their customers to the full glare of tax transparency. If, alongside, all GST exemptions can be removed and everything brought within the GST net, tax evasion would become very difficult. Companies that have to pay their tax in full would pay their lawyers and chartered accountants also on the basis of invoices that charge them GST on the service fee. The companies can set off the tax they pay against their tax dues and the lawyers and chartered accountants would have to take payment that is accounted for. India’s tax base can grow exponentially.

Honouring those who pay tax to boost tax collections is like looking for a lost key under the lamp post, on the ground that things are visible there, no matter if the key was lost somewhere else.