Chapter - V

DATA ANALYSIS

India’s Current Model

A) India currently has a mixed system of taxation of goods and services; it is not “classic”

VAT or GST system although the taxes on g oods are described as “VAT” at both Central and

State level on goods and it has adopted value added tax principle with input tax credit mechanism

for taxation of goods and services.

B) Until introduction of Modvat (now CENVAT) Scheme in 1986 in Central Excise Duty

that duty was an origin based single point taxation system on manufacture of goods with some

exceptions where set off scheme was used to reduce cascading effect of taxes. At that time, at

State level, variety of schemes were used like origin based single point system, multi point system

with set off, last point (retail level) system and so on. This was, again, not standard even within a

state. States adopted different systems for different commodities too. Even now, with introduction

of State VAT, there is combination of origin based (Central Sales Tax)and destination based multi

point system of taxation.CENVAT is only at manufacturing level and does not go upto retail level.

C) Similarly, there was no union level tax on services till introduction of Service Tax in

1994 although, there was and there continues selective levy by States of Service Tax on specified

services like entertainment tax, electricity duty. Even now, Union Service Tax is not

comprehensive; it is levied on large number of select services and there is no comprehensive

Service Tax at State Level. The “VAT” at Union as well as State Level is on goods only except

that at the Union level there is input tax credit mechanism between CENVAT and Service Tax.

Principal differences between the current structure and classic VAT are:

Two separate VAT systems operate simultaneously at two levels, Centre and State, and tax paid

under one is not available as set off (input tax credit) against the other Tax on services and on

goods is under separate legislations at Centre Level. There is no comprehensive taxation of

services at the State level – few services are taxe d under separate enactments. Imports in the

country are not subjected to VAT

Current structure of indirect taxes is, thus, in a sense, dual one where tax on activity of
manufacture and provision of services is collected by Union Government and that on sale of goods
is collected by State Governments.

D) Finance Commission determines the overall and individual share of states in the taxes
collected by Union. The overall share of states in taxes at present is 30.5 % of the total taxes
collected by Union Government from all taxes i.e. direct and indirect.

Fiscal Autonomy and Harmonization

An important consideration in the design of reform options is the degree of fiscal

autonomy of the Centre and the States. It goes without saying that the power to govern and to

raise revenues go together. The Constitution of India lays down a clear division of powers

between the Centre and the States, including the power to levy taxes. Should the Centre and the

States then have complete autonomy in levying and collecting the taxes within the parameters
specified in the Constitution, or should they voluntarily or otherwise conform to certain common

principles or constraints? Should they collectively agree to have their individual taxes consolidated

into a single national tax, the revenues from which get shared in some agreed manner among the

constituent units? Such a system would have much to commend itself from the perspectives of

economic efficiency and the establishment of a common market with in India. Indeed, such

political-economy compromises have been adopted by China and Australia. China moved to a

centralized VAT with revenue sharing with the provinces — ensuring that provinces got as much

revenues as under the prior arrangements, plus a share of the increment. In Australia, the GST is a

single national levy and all the GST revenues collected by the center are returned to the states.

However, such a compromise is unlikely to find much favor with the States in India, as is already

revealed in their preference for the Dual GST.

To give political substance to the federal structure in India, the States (as well as the

Centre) are likely to insist that they have certain autonomy in exercise of their taxation powers.

Full autonomy would mean that:

• retain the power to enact the tax,

• enjoy the risks and rewards of ‘ownership’ of the tax (i.e., not be insulated from

fluctuations in revenue collections),

• be accountable to their constituents, and

• be able to use the tax as an instrument of social or economic policy.

 Notwithstanding the above, there is a clear recognition of the need for harmonization of the

Centre and State Taxes. Fiscal autonomy is important to allow the Centre and the States to set the

tax rates according to their revenue needs. Harmonization of tax laws and administrative

procedures is needed to simplify compliance and enforcement. It is also necessary to ensure that

inter-state differences in policies and procedures do not generate additional economic distortions.

An important question then is the desired degree of harmonization and the mechanism for

achieving it.

The elements of harmonization can be divided into three broad sets: tax rates, tax base and

tax infrastructure, i.e., the administration and compliance system. The first two elements could be

viewed as important levers on which States would want to have some degree of control to achieve

their social, economic, and fiscal policy objectives. However, the experience of other countries as

well as the sub-national governments suggests that changes to the GST base are not a suitable

instrument for social and economic policy (as discussed in greater detail in a later section in

considering the treatment of food). While the tax base is a subject of intense debates at the time the

tax is introduced, changes in the base after its introduction have been infrequent. This has

especially been the case where the tax was initially levied on a broad and comprehensive base.

Where the tax was initially levied on a narrow base, subsequent changes in the base have then

been felt necessary to minimize anomalies, distortions, and revenue leakages created by the

narrow base. Achieving such changes once the tax has been brought in, however logical, is

invariably politically contention because of vested interests. It is thus important to get the structure

right at the outset, as the base (and quite often the rate) cannot be easily changed, ex post facto.
 The VAT in the European Union is an example reflecting these policy considerations. The

base for the EU VAT is uniform, as codified in the EU Directive, which is binding in all Member

States. There are important variations in the base, but these are essentially in the form of

derogations granted for the arrangements existing at the time of introduction of the tax, and were

intended to be temporary (though this has not always been the case). The tax rates are specified as

floor rates (with some provision for reduced rates and maximum rates), below which Member

States cannot set their rates.

Administration and compliance is an area where the need for harmonization is the greatest,

and where Centre-State or inter-state variations are unlikely to serve any social or economic policy

objective. This includes items such as the taxpayer registration system, taxpayer identification

numbers, tax forms, tax reporting periods and procedures, invoice requirements, cross-border trade

information systems and IT systems. Harmonization of these elements would result in significant

savings in costs of implementing the GST (by avoiding duplication of effort in each government),

as well as recurring savings in compliance costs. Harmonization would also permit sharing of

information among governments, which is essential for effective monitoring of cross-border

transactions. A common set of tax identifier numbers across states and the central government is a

key element in the efficient exchange of information.

Harmonization of tax laws is also critical. Variation in the wording and structure of tax

provisions can be an unnecessary source of confusion and complexity, which can be avoided by

having the Centre and the States adopt a common GST law. An alternative is to agree on the key
common elements if separate laws are chosen. Some of the critical elements for harmonization

include common time and place of supply rules, as well as common rules for recovery of input tax,

valuation of supplies and invoicing requirements. There would then be merit in harmonizing the

system of tax interpretations and rulings as well (e.g., about classification of goods and services,

determination of what constitutes taxable consideration, and definition of export and import).

These considerations suggest that harmonization of virtually all major areas of GST law

and administration would be desirable. There is merit in keeping even the GST rate(s) uniform, at

least during the initial years until the infrastructure for the new system is fully developed (see

Ahmad, Poddar et al, 2008 for the GCC proposals). Harmonized laws would mean lower

compliance costs for taxpayers and may also improve the efficiency of fiscal controls.

The Central Sales Tax (CST) in India provides a very useful for model for such

harmonization. The CST is a state-level tax, applied to inter-state sales of goods, based on the

origin principle. The tax law (including the base, rates, and the procedures) is enacted by

Parliament, but the States collect and keep the tax. It is a perfect example of absolute

harmonization, with the States enjoying the risks and rewards of ownership of the tax.

It is worth emphasizing that harmonization should not be viewed as constraining the fiscal

autonomy of the Centre or the States. Rather, this is a framework that facilitates more efficient

exercise of taxation powers, and all jurisdictions would be worse off without harmonization. This

was the case under the previous State sales tax system, under which inter-
state tax rate wars became a race to the bottom. Even today, they all suffer because of lack of

harmonization of information and technology architectures, as a result of which they are unable to

share information on inter-state trade. Harmonization should allow greater exploitation of the

benefits of a common market.

Question 1 : What is the justification of GST ?

Answer : There was a burden of “tax on tax” in the pre-exist ing Central excise duty of the

Government of India and sales tax system of the State Governments. The introduction of Central

VAT (CENVAT) has removed the cascading burden of “t ax on tax” to a good extent by providing

a mechanism of “set off” for tax paid on inputs and services up to the stage of production, and has

been an improvement over the pre-existing Central excise duty. Similarly, the introduction of VAT

in the States has removed the cascading effect by giving set-off for tax paid on inputs as well as

tax paid on previous purchases and has again been an improvement over the previous sales tax

regime. But both the CENVAT and the State VAT have certain incompleteness. The

incompleteness in CENVAT is that it has yet not been extended to include chain of value addition

in the distributive trade below the stage of production. It has also not included several Central

taxes, such as Additional Excise Duties, Additional Customs Duty, Surcharges etc. in the overall

framework of CENVAT, and thus kept the benefits of comprehensive input tax and service tax set-

off out of the reach of manufacturers/dealers. The introduction of GST will not only include

comprehensively more indirect Central taxes and integrate goods and services taxes for set-off

relief, but also capture certain value addition in the distributive trade. Similarly, in the present

State-level VAT scheme, CENVAT load on the goods has not yet been removed and the cascading

effect of that part of tax burden has remained

unrelieved. Moreover, there are several taxes in the States, such as, Luxury Tax, Entertainment

Tax, etc. which have still not been subsumed in the VAT. Further, there has also not been any

integration of VAT on goods with tax on services at the State level with removal of cascading

effect of service tax. In addition, although the burden of Central Sales Tax (CST) on inter-State

movement of goods has been lessened with reduction of CST rate from 4% to 2%, this burden has

also not been fully phased out. With the introduction of GST at the State level, the additional

burden of CENVAT and services tax would be comprehensively removed, and a continuous chain

of set-off from the original producer’s point and service provider’s point up to there tailer’s level

would be established which would eliminate the burden of all cascading effects, including the

burden of CENVAT and service tax. This is the essence of GST. Also, major Central and State

taxes will get subsumed into GST which will reduce the multiplicity of taxes, and thus bring down

the compliance cost. With GST, the burden of CST will also be phased out. Thus GST is not

simply VAT plus service tax, but a major improvement over the previous system of VAT and

disjointed services tax – a justified step forward.

Question 2. What is GST? How does it work ?

Answer : As already mentioned in answer to Question 1, GST is a tax on goods and services with

comprehensive and continuous chain of set-off benefits from the producer’s point and service

provider’s point up to the retailer’s level . It is essentially a tax only on value addition at each

stage, and a supplier at each stage is permitted to set-off, through a tax credit mechanism, the GST

paid on the purchase of goods and services as available for set-off on the GST to be paid on the

supply of goods and services. The final consumer will thus bear only the GST charged by the last

dealer in the supply chain, with set-off benefits at all the previous stages. The
illustration shown below indicates, in terms of a hypothetical example with a manufacturer, one

whole seller and one retailer, how GST will work. Let us suppose that GST rate is 10%, with them

manufacturer making value addition of Rs.30 on his purchases worth Rs.100 of input of goods and

services used in the manufacturing process. The manufacturer will then pay net GST of Rs. 3 after

setting-off Rs. 10as GST paid on his inputs (i.e. Input Tax Credit) from gross GST of Rs. 13. The

manufacturer sells the goods to the whole seller. When the whole seller sells the same goods after

making value addition of (say), Rs.20, he pays net GST of only Rs. 2, after setting-off of Input Tax

Credit of Rs. 13 from the gross GST of Rs. 15 to the manufacturer. Similarly, when a retailer sells

the same goods after a value addition of (say)Rs. 10, he pays net GST of only Re.1, after setting-

offRs.15 from his gross GST of Rs. 16 paid to whole seller. Thus, the manufacturer, whole seller

and retailer have to pay only Rs. 6 (= Rs. 3+Rs. 2+Re. 1) as GST on the value addition along the

entire value chain from the producer to the retailer, after setting-off GST paid at the earlier stages.

The overall burden of GST on the goods is thus much less.

Question 3 : How can the burden of tax, in general, fall under GST ?

Answer : As already mentioned in Answer to Question 1, the present forms of CENVAT and State

VAT have remained incomplete in removing fully the cascading burden of taxes already paid at

earlier stages. Besides, there are several other taxes, which both the Central Government and the

State Government levy on production, manufacture and distributive trade, where no set-off is

available in the form of input tax credit. These taxes add to the cost of goods and services through

“tax on tax” which the final consumer has t o bear. Since, with the introduction of GST, all the

cascading effects of CENVAT and service tax would be removed with a continuous chain
of set-off from the producer’s point to the retailer’s point, other major Central and State taxes

would be subsumed in GST and CST will also be phased out, the final net burden of tax on goods,

under GST would, in general, fall. Since there would be a transparent and complete chain of set-

offs, this will help widening the coverage of tax base and improve tax compliance. This may lead

to higher generation of revenues which may in turn lead to the possibility of lowering of average

tax burden.

Question 4 : How will GST benefit industry, trade and agriculture ?

Answer : As mentioned in Answer to Question 3,the GST will give more relief to industry, trade

and agriculture through a more comprehensive and wider coverage of input tax set-off and service

tax set-off, subsuming of several Central and State taxes in the GST and phasing out of CST. The

transparent and complete chain of set-offs which will result in widening of tax base and better tax

compliance may also lead to lowering of tax burden on an average dealer in industry, trade and

agriculture.

Question 5 : How will GST benefit the exporters?

Answer : The subsuming of major Central and State taxes in GST, complete and comprehensive

setoff of input goods and services and phasing out of Central Sales Tax (CST) would reduce the

cost of locally manufactured goods and services. This will increase the competitiveness of Indian

goods and services in the international market and give boost to Indian exports. The uniformity in

tax rates and procedures across the country will also go a long way in reducing the compliance

cost.
Question 6 : How will GST benefit the small entrepreneurs and small traders?

Answer : The present threshold prescribed indifferent State VAT Acts below which VAT is not

applicable varies from State to State. The existing threshold of goods under State VAT is Rs. 5

lakhs for a majority of bigger States and a lower threshold for North Eastern States and Special

Category States. A uniform State GST threshold across States is desirable and, therefore, the

Empowered Committee has recommended that a threshold of gross annual turnover of Rs. 10 lakh

both for goods and services for all the States and Union Territories may be adopted with adequate

compensation for the States (particularly, the States in North-Eastern Region and Special Category

States) where lower threshold had prevailed in the VAT regime. Keeping in view the interest of

small traders and small scale industries and to avoid dual control, the States considered that the

threshold for Central GST for goods may be kept at Rs.1.5 crore and the threshold for services

should also be appropriately high. This raising of threshold will protect the interest of small

traders. A Composition scheme for small traders and businesses has also been envisaged under

GST as will be detailed in Answer to Question 14. Both these features of GST will adequately

protect the interests of small traders and small scale industries.

Question 7 : How will GST benefit the common consumers?

Answer : As already mentioned in Answer to Question 3, with the introduction of GST, all the

cascading effects of CENVAT and service tax will be more comprehensively removed with a

continuous chain of set-off from the producer’s point to the retailer’s point than what was possible

under the prevailing CENVAT and VAT regime. Certain major Central and State taxes will also

be subsumed in GST and CST will be phased out. Other things remaining the same, the burden of

tax on goods would, in general, fall under GST and that would benefit the consumers.
Question 8 : What are the salient features of the proposed GST model?

Answer : The salient features of the proposed model are as follows:

(i) Consistent with the federal structure of the country, the GST will have two components:

one levied by the Centre (hereinafter referred to as Central GST), and the other levied by the States

(hereinafter referred to as State GST).This dual GST model would be implemented through

multiple statutes (one for CGST and SGST statute for every State). However, the basic features of

law such as chargeability, definition of taxable event and taxable person, measure of levy

including valuation provisions, basis of classification etc. would be uniform across these statutes

as far as practicable.

(ii) The Central GST and the State GST would be applicable to all transactions of goods and

services except the exempted goods and services, goods which are outside the purview of GST and

the transactions which are below the prescribed threshold limits.

(iii) The Central GST and State GST are to be paid to the accounts of the Centre and the States

separately.

(iv) Since the Central GST and State GST are to be treated separately, in general, taxes paid

against the Central GST shall be allowed to be taken as input tax credit (ITC) for the Central GST

and could be utilized only against the payment of Central GST. The same principle will be

applicable for the State GST.

(v) Cross utilisation of ITC between the Central GST and the State GST would, in general, not

be allowed.

(vi) To the extent feasible, uniform procedure for collection of both Central GST and State

GST would be prescribed in the respective legislation for Central GST and State GST.

(vii) The administration of the Central GST would be with the Centre and for State GST with

the States.

(viii) The taxpayer would need to submit periodical returns to both the Central GST authority

and to the concerned State GST authorities.

(ix) Each taxpayer would be allotted a PAN linked taxpayer identification number with a total

of 13/15 digits. This would bring the GSTPAN-linked system in line with the prevailing PAN-

based system for Income tax facilitating data exchange and taxpayer Compliance. The exact

design would be worked out in consultation with the Income-Tax Department.

(x) Keeping in mind the need of tax payers convenience, functions such as assessment,

enforcement, scrutiny and audit would be undertaken by the authority which is collecting the tax,

with information sharing between the Centre and the States.

Question 9 : Why is Dual GST required ?

Answer : India is a federal country where both the Centre and the States have been assigned the

powers to levy and collect taxes through appropriate legislation. Both the levels of Government

have distinct responsibilities to perform according to the division of powers prescribed in the

Constitution for which they need to raise resources. A dual GST will, therefore, be in keeping with

the Constitutional requirement of fiscal federalism.

Question 10 : How would a particular transaction of goods and services be taxed

simultaneously under Central GST(CGST) and State GST (SGST)?

Answer : The Central GST and the State GST would be levied simultaneously on every

transaction of supply of goods and services except the exempted goods and services, goods which

are outside the purview of GST and the transactions which are below the prescribed threshold

limits. Further, both would be levied on the same price or value unlike State VAT which is levied

on the value of the goods inclusive of CENVAT. While the location of the supplier and the

recipient within the country is immaterial for the purpose of CGST, SGST would be chargeable

only when the supplier and the recipient are both located within the State.

Illustration I : Suppose hypothetically that the rate of CGST is 10% and that of SGST is 10%.

When a wholesale dealer of steel in Uttar Pradesh supplies steel bars and rods to a construction

company which is also located within the same State for, say Rs. 100, the dealer would charge

CGST of Rs. 10 and SGST of Rs. 10 in addition to the basic price of the goods. He would be

required to deposit the CGST component into a Central Government account while the SGST

portion into the account of the Concerned State Government. Of course, he need not actually pay
Rs. 20 (Rs. 10 + Rs. 10 ) in cash as he would been titled to set-off this liability against the CGST

or SGST paid on his purchases (say, inputs). But for paying CGST he would be allowed to use

only the credit of CGST paid on his purchases while for SGST he can utilize the credit of SGST

alone. In other words, CGST credit cannot, in general, be used for payment of SGST. Nor can

SGST credit be used for payment of CGST.

Illustration II: Suppose, again hypothetically, that the rate of CGST is 10% and that of SGST is

10%.When an advertising company located in Mumbai supplies advertising services to a company

manufacturing soap also located within the State of Maharashtra for, let us say Rs. 100, the ad

company would charge CGST of Rs. 10 as well as SGST of Rs. 10 to the basic value of the

service. He would be required to deposit the CGST component into a Central Government account

while the SGST portion into the account of the concerned State Government. Of course, he need

not again actually pay Rs. 20 (Rs.10+Rs. 10) in cash as it would be entitled to set-off this liability

against the CGST or SGST paid on his purchase (say, of inputs such as stationery, office

equipment, services of an artist etc). But for paying CGST he would be allowed to use only the

credit of CGST paid on its purchase while for SGST he can utilise the credit of SGST alone. In

other words, CGST credit cannot, in general, be used for payment of SGST. Nor can SGST credit

be used for payment of CGST.

Question 11 : Which Central and State taxes are proposed to be subsumed under GST ?

Answer : The various Central, State and Local levies were examined to identify their possibility of

being subsumed under GST. While identifying, the following principles were kept in mind:
(i) Taxes or levies to be subsumed should be primarily in the nature of indirect taxes,

either on the supply of goods or on the supply of services.

(ii) Taxes or levies to be subsumed should be part of the transaction chain which

commences with import/ manufacture/ production of goods or provision of services

at one end and the consumption of goods and services at the other.

(iii) The subsumation should result in free flow of tax credit in intra and inter-State

levels.

(iv) The taxes, levies and fees that are not specifically related to supply of goods &

services should not be subsumed under GST.

(v) Revenue fairness for both the Union and the States individually would need to be

attempted. On application of the above principles, the Empowered Committee has

recommended that the following Central Taxes should be, to begin with, subsumed

under the Goods and Services Tax:

(i) Central Excise Duty

(ii) Additional Excise Duties

(iii) The Excise Duty levied under the Medicinal and Toiletries Preparation Act

(iv) Service Tax

(iv) Additional Customs Duty, commonly known as Countervailing Duty

(CVD)

(v) Special Additional Duty of Customs - 4% (SAD)

(vi) Surcharges, and

(vii) Cesses.
 The following State taxes and levies would be, to begin with, subsumed under

GST:

(i) VAT / Sales tax

(ii) Entertainment tax (unless it is levied by the local bodies).

(iii) Luxury tax

(iv) Taxes on lottery, betting and gambling.

(iv) State Cesses and Surcharges in so far as they relate to supply of goods and

services.

(v) Entry tax not in lieu of Octroi.

Purchase tax: Some of the States felt that they are getting substantial revenue from

Purchase Tax and, therefore, it should not be subsumed under GST while majority of the States

were of the view that no such exemptions should be given. The difficulties of the food grain

producing States was appreciated as substantial revenue is being earned by them from Purchase

Tax and it was, therefore, felt that in case Purchase Tax has to be subsumed then adequate and

continuing compensation has to be provided to such States. This issue is being discussed in

consultation with the Government of India.

Tax on items containing Alcohol: Alcoholic beverages would be kept out of the purview

of GST. Sales Tax/ VAT could be continued to be levied on alcoholic beverages as per the

existing practice. In case it has been made Vatable by some States, there is no objection to that.

Excise Duty, which is presently levied by the States may not also be affected.
 Tax on Tobacco products: Tobacco products would be subjected to GST with ITC.

Centre may be allowed to levy excise duty on tobacco products over and above GST with ITC.

Tax on Petroleum Products: As far as petroleum products are concerned, it was decided

that the basket of petroleum products, i.e. crude, motor spirit (including ATF) and HSD would be

kept outside GST as is the prevailing practice in India. Sales Tax could continue to be levied by

the States on these products with prevailing floor rate. Similarly, Centre could also continue its

levies. A final view whether Natural Gas should be kept outside the GST will be taken after

further deliberations.

Taxation of Services : As indicated earlier, both the Centre and the States will have

concurrent power to levy tax on goods and services. In the case of States, the principle for taxation

of intra-State and inter-State has already been formulated by the Working Group of Principal

Secretaries/ Secretaries of Finance/ Taxation and Commissioners of Trade Taxes with senior

representatives of Department of Revenue, Government of India. For inter-State transactions an

innovative model of Integrated GST will be adopted by appropriately aligning and integrating

CGST and IGST.

Question 12 : What is the rate structure proposed under GST ?

Answer : The Empowered Committee has decided to adopt a two-rate structure –a lower rate for

necessary items and items of basic importance and a standard rate for goods in general. There will

also be a special rate for precious metals and a list of exempted items. For upholding of
special needs of each State as well as a balanced approach to federal flexibility, it is being

discussed whether the exempted list under VAT regime including Goods of Local Importance may

be retained in the exempted list under State GST in the initial years. It is also being discussed

whether the Government of India may adopt, to begin with, a similar approach towards exempted

list under the CGST. For CGST relating to goods, the States considered that the Government of

India might also have a two-rate structure, with conformity in the levels of rate with the SGST. For

taxation of services, there may be a single rate for both CGST and SGST. The exact value of the

SGST and CGS Trates, including the rate for services, will be made known duly in course of

appropriate legislative actions.

Question 13: What is the concept of providing threshold exemption for GST?

Answer : Threshold exemption is built into a tax regime to keep small traders out of tax net.

This has three-fold objectives:

a) It is difficult to administer small traders and cost of administering of such traders is very

high in comparison to the tax paid by them.

b) The compliance cost and compliance effort would be saved for such small traders.

c) Small traders get relative advantage over large enterprises on account of lower tax

incidence. The present threshold prescribed in different State VAT Acts below which VAT

is not applicable varies from State to State. A uniform State GST threshold across States is

desirable and, therefore, as already mentioned in Answer to Question 6, it has

 been considered that a threshold of gross annual turn over of Rs. 10 lakh both for goods

and services for all the States and Union Territories might be adopted with adequate

compensation for the States (particularly, the States in North-Eastern Region and Special

Category States) where lower threshold had prevailed in the VAT regime. Keeping in

view the interest of small traders and small scale industries and to avoid dual

control, the States also considered that the threshold for Central GST for goods may be

kept Rs.1.5 Crore and the threshold for services should also be appropriately high.

Question 14 : What is the scope of composition and compounding scheme under GST?

Answer : As already mentioned in Answer to Question 6, a Composition / Compounding Scheme

will be an important feature of GST to protect the interests of small traders and small scale

industries. The Composition/ Compounding scheme for the purpose of GST should have an upper

ceiling on gross annual turnover and a floor tax rate with respect to gross annual turnover. In

particular there will be a Compounding cut-off at Rs. 50 lakhs of the gross annual turnover and the

floor rate of 0.5% across the States. The scheme would allow option for GST registration for

dealers with turnover below the compounding cut-off.

Question 15 : How will imports be taxed under GST ?

Answer : With Constitutional Amendments, both CGST and SGST will be levied on import of

goods and services into the country. The incidence of tax will follow the destination principle and

the tax revenue in case of SGST will accrue to the State where the imported goods and
services are consumed. Full and complete set-off will be available on the GST paid on import on

goods and services.

Question 16 : Will cross utilization of credits between goods and services be allowed under

GST regime?

Answer : Cross utilization of credit of CGST between goods and services would be allowed.

Similarly, the facility of cross utilization of credit will be available in case of SGST. However, the

cross utilization of CGST and SGST would generally not be allowed except in the case of inter-

State supply of goods and services under the IGST model which is explained in answer to the next

question.

Question 17 : How will be Inter-State Transactions of Goods and Services be taxed under

GST in terms of IGST method ?

Answer : The Empowered Committee has accepted the recommendation for adoption of IGST

model for taxation of inter-State transaction of Goods and Services. The scope of IGST Model is

that Centre would levy IGST which would be CGST plus SGST on all inter-State transactions of

taxable goods and services. The inter-State seller will pay IGST on value addition after adjusting

available credit of IGST, CGST, and SGST on his purchases. The Exporting State will transfer to

the Centre the credit of SGST used in payment of IGST. The Importing dealer will claim credit of

IGST while discharging his output tax liability in his own State. The Centre will transfer to the

importing State the credit of IGST used in payment of SGST. The relevant information is also

submitted to the Central Agency which will act as a clearing house mechanism, verify the
claim sand inform the respective governments to transfer the funds. The major advantages of

IGST Model are:

a) Maintenance of uninterrupted ITC chain on inter-State transactions.

b) No upfront payment of tax or substantial blockage of funds for the inter-State seller or

buyer.

c) No refund claim in exporting State, as ITC is used up while paying the tax.

d) Self monitoring model.

e) Level of computerisation is limited to inter-State dealers and Central and State

Governments should be able to computerise their processes expeditiously.

f) As all inter-State dealers will be e-registered and correspondence with them will be bye-

mail, the compliance level will improve substantially.

g) Model can take ‘Business to Business’ as well as ‘Business to Consumer’ transactions into

account.

Question 18 : Why does introduction of GST require a Constitutional Amendment? Answer

: The Constitution provides for delineation of power to tax between the Centre and States. While

the Centre is empowered to tax services and goods up to the production stage, the States have the

power to tax sale of goods. The States do not have the powers to levy a tax on supply of services

while the Centre does not have power to levy tax on the sale of goods. Thus, the Constitution does

not vest express power either in the Central or State Government to levy a tax on the ‘supply of

goods and services’. Moreover , the Constitution also does not empower the States to impose tax

on imports. Therefore, it is essential to have Constitutional Amendments for

empowering the Centre to levy tax on sale of goods and States for levy of service tax and tax on

imports and other consequential issues. As part of the exercise on Constitutional Amendment,

there would be a special attention to the formulation of a mechanism for upholding the need for a

harmonious structure for GST along with the concern for the powers of the Centre and the States

in a federal structure.

Question 19: How are the legislative steps being taken for CGST and SGST ?

Answer : A Joint Working Group has recently been constituted (September 30, 2009) comprising

of the officials of the Central and State Governments to prepare, in a time-bound manner a draft

legislation for Constitutional Amendment.

Question 20: How will the rules for administration of CGST and SGST be framed? Answer :

The Joint Working Group, as mentioned above, has also been entrusted the task of preparing draft

legislation for CGST, a suitable Model Legislation for SGST and rules and procedures for CGST

and SGST. Simultaneous steps have also been initiated for drafting of legislation for IGST and

rules and procedures. As a part of this exercise, the Working Group will also address to the issues

of dispute resolution and advance ruling.

The systematic attempt to evolve a tax system in independent India started with the

implementation of the report of the Taxation Enquiry Commission (India, 1953). In fact, this is the

first comprehensive attempt to review the tax system. This provided the backdrop for the

generation of resources for the Second Five Year Plan (1956-60), and was required to fulfill a

variety of objectives such as raising the level of savings and investment, effecting resource
transfer from private to public sector and achieving a desired state of redistribution. It was a

comprehensive attempt to design the tax system for the country and covered central, state as well

as local taxes.

Since then, there have been a number of attempts, most of them partial, to remedy various

aspects of the tax system. Given that in the early 1950s the level of saving was just about 10 per

cent of GDP, the expenditure tax was levied on the recommendation of Kaldor Committee (India,

1956) as a measure to curb consumption. However, this had to be withdrawn in 1957-58 as it did

not generate the expected revenues. With the adoption of planned development strategy in a mixed

economy framework, raising more resources and achieving the desired state of redistribution

became an obsession and this caused the policy makers to design the income tax system with

confiscatory marginal rates. The consequent disincentives and high rate of return on tax evasion,

low probability of detection and the ineffective legal system that failed to impose penalty within a

reasonable time period, led the Direct Taxes Enquiry Committee (India, 1971) to recommend

significant reduction in marginal tax rates. On the indirect taxes side, a major simplification

exercise was attempted by the Indirect Taxes Enquiry Committee (India, 1977), though its

implementation was not initiated until 1986. Systematic and comprehensive attempts to reform the

tax system at the central level started only after market based economic reforms were initiated in

1991. The Tax Reforms Committee (India, 1991) laid out a framework and a roadmap for reform

of direct and indirect taxes as a part of the structural reform process, following the unprecedented

economic crisis. The paradigm of reform adopted by the TRC was in keeping with the best

practice approach of broadening the base, lowering marginal tax rates, reducing rate

differentiation, simplifying the tax structure and adopting measures to make the
administration and enforcement more effective. The reforms were to bring about revenue

neutrality in the short term and enhance revenue productivity in the medium and long term. The

overall thrust of the TRC was to (i) decrease the share of trade taxes in total tax revenue; (ii)

increase the share of domestic consumption taxes by transforming the domestic excises into VAT

and (iii) increase the relative contribution of direct taxes.

The important proposals put forward by the TRC included reduction in the rates of all

major taxes, i.e., customs, individual and corporate income taxes and excises to reasonable levels,

maintain progressivity but not such as to induce evasion. The TRC recommended a number of

measures to broaden the base of all the taxes by minimizing exemptions and concessions, drastic

simplification of laws and procedures, building a proper information system and computerisation

of tax returns, and revamping and modernisation of administrative and enforcement machinery. It

also recommended that the taxes on domestic production should be fully converted into a value

added tax, and it should be extended to the wholesale level in agreement with the States, with

additional revenues beyond post-manufacturing stage passed on to the State governments. The

analytical basis for the reform in the new millennium was provided by task force reports on the

reform of direct and indirect taxes (India, 2002) and the report of the task force on the

implementation of the Fiscal Responsibility of Budget Management Act, 2003 (India, 2004). In

many ways the reform since 1991, with emphasis on simplicity and efficiency make marked

departure from the past. In fact, the task force reports build on the recommendations of the TRC.
Reform of Direct Taxes

At the central level, the income tax was evolved as a principal instrument to bring about

redistribution until mid 1970s. Thus, in 1973-74, the personal income tax had eleven tax slabs with

rates monotonically rising from 10 per cent to 85 per cent. When the surcharge of 15 per cent was

taken into account, the highest marginal rate for persons above Rs. 200,000 income was 97.5 per

cent. Combined with the highest wealth tax rate of 5 per cent, the total tax payable at the highest

bracket was more than 100 per cent. In the case of company taxation, the classical system of

taxation involved the taxation of the profits in the hands of the company and the dividends in the

hands of the shareholders. The distinction was made for widely held companies and different types

of closely held companies and the tax rate varied from the base rate of 45 per cent to 65 percent in

the case of some widely held companies. Although nominal rates were high, the effective rates

were substantially lower due to generous tax preferences such as depreciation and investment

allowance. In fact some companies were able to make use of generous tax preferences to bring

down tax liability to zero.

The Direct Taxes Enquiry Committee (India, 1971) attributed the large scale tax evasion to

the confiscatory tax rates and in keeping with its recommendation marginal rates were reduced to

77 per cent including the surcharge. The highest marginal rate was further brought down to 66 per

cent and the highest wealth tax rate was reduced from 5 per cent to 2.5 per cent in 1976-

77. However in 1979-80, the surcharge on income tax was increased as also the wealth tax rates

reached the maximum of 5 per cent. The major simplification and rationalisation initiative,
however, was in 1985-86 when the number of tax slabs were reduced from eight to four and the

highest marginal tax rate was brought down to 50 per cent and wealth tax rates to 2.5 per cent.

The last wave of reforms in personal income taxation was initiated on the basis of the

recommendations of the Tax Reform Committee (India, 1991). The tax rates were considerably

simplified to have three slabs beginning with a rate of 20 per cent, a middle rate of 30 per cent and

the maximum rate of 40 per cent in 1992-93. The financial assets were excluded from wealth tax

and the maximum marginal rate was reduced to one percent. Further reduction came in 1997-98

when, the three slab rates were brought down further to 10-20-30 per cent. In subsequent years,

exigencies of revenue have led to adding surcharge and a two per cent primary education cess on

all taxes. In the case of corporate taxation too, the basic rate was brought down to 50 per cent, and

rates applicable to different categories of closely held companies were unified at 55 per cent.

Following the recommendations of TRC, the distinction between closely held and widely held

companies was done away with and the tax rates were unified at 40 per cent in 1993-

94. In 1997-98, when personal income tax rate was reduced, the company rate was brought down

to 35 per cent and the levy of 10 per cent dividend tax was shifted from individuals to companies.

The subsequent years have seen lack of direction in the measures adopted. The dividends tax rate

was increased to 20 per cent in 2000-01, reduced again to 10 per cent in 2001-

2 along with reversal to the classical system of taxing it in the hands of the shareholders and the

policy was reversed once again in 2003-04 with the levy of the tax on the company.

A major problem with this is the generous tax preferences. In the case of personal income

tax The Advisory Group on Tax Policy and Tax Administration lists the incentives in 25
pages of its report (India, 2001, pp. 125-150) and the Task Force on Tax Policy ad Tax

administration also makes a detailed list of these concessions. These include incentives and

concessions for savings, for housing, retirement benefits, investment in and returns from certain

type financial assets, investments in retirement schemes and income of charitable trusts. There are

a variety of tax preferences that have not only distorted the after tax rates of return on various

types of investments in unintended ways but also has significantly eroded the tax base.

The major tax preferences in the case of corporate tax were investment allowance and

depreciation allowance. In addition, tax incentives were also provided for locating in backward

areas. The result of these preferences were that there evolved a set of companies which planned

their activities to take full advantage of the generous concessions to fully avoid the tax. This form

of tax avoidance by ‘zero-tax’ companies was s ought to be eliminated by introducing the

Minimum Alternative Tax (MAT) in 1997-98. Even as companies can take advantage of the tax

preferences, they are required to pay a minimum of 30 per cent tax on their book profits. In

subsequent years, a provision has been incorporated to allow these companies paying a MAT to

take partial credit of MAT against income tax liabilities in following years.

Reform of Indirect taxes : Union Excise Duties:

The structure of excise duties by the middle of 1970s was complex and highly

distortionary. Tax structure of tax was a mix of specific and ad valorem, and on the latter alone

there were 24 different rates varying from 2 to 100 per cent (excluding tobacco and petroleum

products which were taxed at higher rates). In effect, this was a manufacturers’ sales tax

administered on the basis of goods cleared from the godowns. “Cascading” from the tax resulted
not merely from its pre-retail nature but also because it was levied on inputs, capital goods as well

as final consumer goods. The tax system was complex and opaque and the detailed analysis by

Ahmad and Stern (1983) showed significant variation in the effective rates. The report of Indirect

Tax Enquiry Committee (India, 1977) recommended that conversion of specific duties into ad

valorem, unification of tax rates and introduction of input tax credit to convert the tax into a

manufacturing stage value added tax (MANVAT), but it was not implemented until 1986-

87. Then, all of a sudden, the value added tax was implemented in a modified form

(MODVAT). This was a strange combination of taxation based on physical verification of goods

with provision of input tax credit.

The coverage of the credit mechanism too evolved over time - starting with a few

commodities, it covered all commodities and incorporated comprehensive credit in by 1996-97.

Not surprisingly this piecemeal and gradualist approach led to decline in the tax-GDP ratio after

reforms. Further reform impetus on Excise duties came with the implementation of there

commendations of the TRC. The measures included gradual unification of rates, greater reliance

on account based administration. In 1999-00, almost 11 tax rates were merged into three with a

handful of “luxury” items subject to two non-vatabl e additional rates (6 and 16 per cent). These

were further merged into a single rate in 2000-01 to be called a Central VAT (CenVAT), along

with three special additional excises (8 per cent, 16 per cent and 24 per cent) for a few

commodities.
Customs Duties:

Contrary to the general patterns seen in low income countries where international trade

taxes contribute bulk of the revenues, revenue from this source was not very large in the initial

years of independent India (Chelliah, 1986) due to quantitative restrictions on imports. Further,

high and differentiated tariffs and setting the rates varying with the stage of production (lower

rates on inputs and higher rates on finished goods) and income elasticity of demand resulted in not

only high and varying effective rate of protection, but also premium for inefficiency and

unintended distortions in the allocation of resources.

By the middle of 1980s, the tariff rates were extremely high and the structure complex.

The Long Term Fiscal Policy (LTFP) presented in the Parliament in 1984-85 emphasised the need

to reduce tariffs, have fewer rates and greater uniformity and reduce and eventually eliminate

quantitative restrictions on imports. However, for reasons of revenue, the tariffs were raised and

the weighted average rate increased from 38 per cent in 1980-81 to 87 per cent in 1989-90 (India,

1991). Further, although dismantling of quantitative restrictions began in the latter half of the

1980s, tariffs were kept at high levels. Thus, by 1990-91, the tariff structure was highly complex

varying from 0 to 400 per cent, Over 10 per cent of imports were subject to more than 120 per

cent. Wide ranging exemptions granted by issuing notifications made the system complex and was

a reflection of the influence of various special interest groups on the tax policy.
 The recommendation of TRC in regard to the reform of important duties was the weakest.

It recommended tariff rates of 5, 10, 15, 20, 25, 30 and 50 to be achieved by 1997-98. The tariff

rate was to vary directly with the stage of processing of commodities, and among final consumer

goods, with income elasticity of demand (higher rates on luxuries). Excessive rate differentiation

(seven rates) and setting degree of protection depending on the stage of processing has been

criticised by Joshi and Little (1996, p. 74) when they state, “….this is a

totally unprincipled principle, for it has no foundation in economic principles”. The proposed tariff

structure would have caused high differences in effective rates and provided higher degree of

protection to inessential commodities.

The reform of import duties in earnestness actually started in 1991-92 when all duties

above 150 per cent were reduced to this level to be called the “peak” rate, which was brought

down in the next four years to 50 per cent by 1995-96. Along with relaxation of quantitative

restrictions on imports and exchange rate depreciation, the change in the tariffs constituted a major

change in the foreign trade regime in the country.

Service Tax

An interesting aspect of the assignment system in India is that except in the case of a few

specified services assigned to the states such as entertainment tax, passengers and goods tax and

electricity duty, the services were not specifically assigned either to the centre or to states. This

violated the principle of neutrality in taxing consumption as it discriminated against the goods. As

services are relatively more income elastic, the tax system was also rendered less progressive.
Even more important argument for taxing services is to enable a coordinated calibration of a

consumption tax system on goods and services as in the production chain, services enter into

goods and vice-versa.

The introduction of tax on services at the central level began in 1994-95 with three services

namely, non-life insurance, stock brokerage and telecommunications. The list was expanded in

succeeding years to include over 80 services at present. Although initially taxed at 7 per cent the

rate was increased to 10 per cent in 2002-03. The Expert Group on Taxation of Services (India,

2001) recommended the extension of the tax to all services along with the provision of input tax

credit for both goods and services and subsequently, integration with the central VAT (CENVAT)

on goods. However, the government is yet to implement general taxation of services though, input

tax credit for goods entering into services and vice versa has been extended.

State level tax reforms:

Tax reforms at the state level have not coincided with those at the centre. While individual

state governments tried to appoint committees from time to time and reform their tax structures,

there was no systematic attempt to streamline the reform process even after 1991 when market

oriented reforms were introduced. Most of the reform attempts were ad hoc and were guided by

exigencies of revenue rather than attempts to modernize the tax system. Indeed, systematic studies

were commissioned to show their reform orientation, but the recommendations were hardly

implemented. The pace of tax reforms in the States accelerated in

the latter half of the 1990s with increasing pressures on their budgets and, in some cases, due to

the conditionalities imposed by multilateral lending agencies or to meet the targets set by the

medium term fiscal reforms facility. The major landmark in tax reform at the state level was in

simplifying and rationalizing the sales tax system the introduction of value added tax in 21 states

from April 1, 2005.

Recent Reforms in the tax system

The recent reforms are, in fact, a continuation of the reforms initiated in 1991. In this

sense, tax reform in India has been gradual and although not always consistent from year to year,

the overall direction has been to broaden the tax bases, reduce the rates, reduce rate differentiation

and make the tax system simple and transparent.

As regards the personal income taxes, the rates of personal income tax have remained

stable since 1997-98. Thus, the three rates of personal income tax at 10, 20 and 30 per cent have

continued till date with some changes in the associated tax brackets. The surcharge at the rate of 5

per cent of the tax payable imposed in the wake of the Kargil war in 2002-03 on all income tax

assesses was discontinued in 2003-04, but a separate surcharge of 10 pert cent of the tax payable

was imposed on all tax payees having taxable income above Rs. 0.85 million, which was raised to

Rs. 1 million in the budget of 2005-06. Although the exemption limit remained at Rs. 50000 since

1998-99, the generous standard deduction, exemption of dividend and interest on government

securities up to specified limits effectively increased the threshold substantially. The 2005-06

budgets raised the exemption limit to Rs. 100,000 and marginal changes were made
in the tax brackets. The exemption limit for women was increased to Rs. 135,000 and for senior

citizens, Rs. 150,000. Alongside increasing the exemption limit, the standard deduction was

abolished. In addition, savings in superannuating schemes up to Rs. 100,000 was made deductible

from the taxable income.

Reforms in State tax systems:

The most important reform initiative in the case of the States is the replacement of the

cascading type sales tax with the state level VAT. While significant progress has been made in

converting central excise duties into a manufacturing stage VAT, the reform in the states’ sales tax

systems has lagged behind. This is critical for minimizing distortions, for they contribute over 60

per cent of states’ tax revenues and to evolve a coordinated consumption tax system in the country.

A systematic discussion on coordinated consumption tax system was initiated in the Report

on Reform of Domestic Trade Taxes in India prepared by the NIPFP (1994). The report favoured

the conversion of the prevailing sales taxes to VAT parallel to the central manufacturing stage

VAT. There are a number of arguments for replacing the prevailing state sales tax with destination

based VAT. Therefore, the decision to transform the states’ sales tax systems into a destination

based retail stage VAT from April, 2005 is opportune. However, the reform in April, 2005 is only

a transitional measure; it extends the sales tax up to the retail stage with credit allowed of taxes

paid on purchases for all intra-state purchases. Inter-state sales tax will continue to be levied until

it is phased out in the next two years.

 The VAT reform adopted in April 2005, levies the tax at two rates namely, 4% and 12.5%

(except for bullion and specie and precious metals, which are taxed at 1%). Basic necessities

(about 75 items) are exempted. Petrol and diesel (which contribute about 40% of sales tax) are

kept outside the VAT regime and a floor rate of 20% sales tax will be levied on them. All dealers

up to Rs. 500,000 are exempted. Those with the turnover above Rs. 500,000 but below Rs. 5

million will be required to pay the simplified tax at 2 per cent of the turnover, but they do not

constitute a part of the VAT chain unless they voluntarily register and pay the tax at the prescribed

rates. The regular VAT dealers are those above Rs. 5 million turnover and they are required to

register for VAT. They may, however, voluntarily register as regular VAT dealers. As mentioned

earlier, the tax credit mechanism operates in full only in the case of intra-state sale. In inter-state

transactions, the exporting state is supposed to give input tax credit for purchases made locally,

against the collection of CST. .The tax credit of CST in the importing state, or other mechanisms

of zero-rating of inter-state sales, will be extended after two years when the CST in its present

form will be phased out. In the mean time, information system for inter-state trade will be built up

and ICICI Infotech has been contracted to undertake the task.

ACHEVEMENTS AND CHALLENGES AHEAD, AFTER TAX SYSTEM REFORM IN

INDIA:

(“Just as it is impossible not to taste honey or po ison that one may find at the tip of one’s tongue,

so it is impossible for one dealing with the government funds not to taste, at least a little bit, of the

King’s wealth.” . . . . . . . . . Kautily a, Arthashastra).

 Reforming the tax system is critical to achieve fiscal consolidation, minimize distortions in

the economy and to create stable and predictable market environment for the markets to function.

Not surprisingly, the wave of tax reforms across the world that began in the mid 1980s accelerated

in the 1990s motivated by a number of factors. In many developing countries, tax policy was used

as the principal instrument to correct fiscal imbalances (Ahmad and Stern, 1991). In others, the

transition from centralized planning to market required wide ranging tax reforms. Besides

efficiency considerations, these tax reforms had to address the issue of replacing public enterprise

profits with taxes as a principal source of revenue and aligning tax policy to the development

strategy. An important reason, however, was inter nationalisation of economic activities. The

sharp reduction in tariffs accompanying globalisation required that an appropriate source of

revenue to replace this had to be found. On the other, globalisation emphasised the need to

minimise both efficiency and compliance costs of the tax system. The reforms in Indian tax system

in some respects are unique. Unlike most developing countries which were guided in their tax

reforms by multilateral agencies, Indian tax reforms have borne the domestic brand largely in

response to changes in the development strategy over time while keeping in tune with the

institutional arrangements in the country. Thus, even when the government sought assistance from

multilateral financial institutions, the recommendations of these institutions did not directly

translate into an agenda for tax reform. Despite this, the tax system reforms were broadly in

conformity with international trends and advice proffered by the expert groups and was in tune

with international best practices. Over the years, tax policy in the country has evolved in response

to the development strategy and its changes. In the initial years, the tax policy was directed to

increase the level of savings, transfer available savings for investment as envisaged by plan

strategy and the need to ensure a fair distribution of incomes, to

correct inequalities arising from the oligopolistic market structure created by the co-existence of

private and public sector and the existence of other instruments of planning such as licensing

system, exchange control, administered price determination (Bagchi and Nayak, 1994). The role of

history and institutions in the country was also important in shaping the tax system. Indeed, the

assignment system in the federal polity has impacted on the tax structure and administration. This

has also made encompassing, comprehensive and coordinated tax reforms difficult. The system of

planning also introduced selectivity and discretion in tax structure and its implementation. This

eroded the tax base further, created special interest groups and introduced ‘negotiated settlement’

in the tax system. Again, i n a closed economy, inefficiencies did not matter and relative price

distortions and disincentives did not warrant much consideration in the calibration of tax policy.

The Indian tax reform experience can provide useful lessons for many countries due to the

largeness of the country with multilevel fiscal framework, uniqueness of the reform experience

and difficulties in calibrating reforms due to institutional constraints. These, by themselves, are

important enough reasons for a detailed analysis of the tax system in India. Unfortunately, unlike

in many developed countries where major tax reform initiatives were followed by detailed analysis

of their impact, there are no serious studies analysing the economic impact of tax reforms in India.

This research analyses the Indian tax system involving its structure as well as operations.

In section 2, the evolution of Indian tax system and the impact of historical and institutional

factors in shaping Indian tax policy are discussed. The trends in tax revenue are presented therein

and these point towards a relative stagnancy and deceleration in tax revenues at both Central and

State levels.
 I have analyzed the reasons for the stagnancy in revenues at Central and State levels. This

is followed by an exploratory discussion on the possible efficiency and equity implications of tax

system. The final section presents directions for further reforms.

Trends in Indian Tax Revenues

This section presents an analysis of the trends in tax revenue in India. The paper focuses on

the changes in the level and composition of tax revenue since 1991 when systematic reforms were

set in motion. The analysis shows that despite initiating systematic reforms, the revenue

productivity of the tax system has not shown appreciable increase and the decline the tax ratio due

to reduction in customs duty could not be compensated by internal indirect taxes. The trends in tax

revenue in India show four distinct phases (Rao, 2000) (Table 1; Figure 1). In the first, there was a

steady increase in the tax-GDP ratio from 6.3 per cent in 1950-51 to 16.1 per cent in 1987-88. In

the initial years of planning, increase in tax ratio was necessitated by the need to finance large

public sector plans. Thus, the tax ratio increased from a mere 6.3 per cent in 1950-51 to 10.4 per

cent in 1970-71 and further to 13.8 per cent in 1980-81. The increase continued until it peaked to

16.1 per cent in 1987- 88 (Figure 1). The buoyancy of the tax in later years of the phase was

fuelled by the economy attaining a higher growth path and progressive substitution of quantitative

restrictions with tariffs following initial attempts at liberalisation in the late 1980s.

The second phase started with the economic recession following the severe draught of

1987 and was marked by stagnancy in revenues until 1992-93. However, triggered by the pay
revision of government employees, expenditure-GDP ratio increased significantly after 1988-89

and this caused serious fiscal imbalances leading to the unprecedented economic crisis in 1991

(Table 2). The subsequent adoption of stabilization of structural adjustment program led to sharp

reduction in import duties. Thus, in the third phase, the tax ratio declined from 15.8 per cent in

1991-92 to the lowest level of 13.4 per cent in 1997-98 and fluctuated around 13-14 per cent until

2001-02 even as the deficits continued to be high. The subsequent period has seen attempts to

increase the tax ratio to mainly to contain the level of deficits. Thus, tax – GDP ratio increased by

over one percentage point in the tax ratio to 15.2 per cent in 2003-04 (revised estimates for the

Centre and budget estimates for the states). The aggregate tax –GDP ratio is yet to reach the levels

that prevailed before systematic tax reforms were initiated in 1991.

Interestingly, the trends in tax ratios of direct and indirect taxes follow different paths. In

the case of the former, the tax ratio remained virtually stagnant throughout the forty year period

from 1950 to 1990 at a little over 2 per cent of GDP. Thereafter, coinciding with the reforms

marked by significant reduction in the tax rates and simplification of the tax structure, the direct

taxes increased sharply to over 4 per cent in 2003-04 and expected to be at about 4.5 per cent in

2004-05. In contrast, much of the increase in the tax ratio during the first 40 years of planned

development in India came from indirect taxes, which as a proportion of GDP increased by over

three times from 4 per cent in 1950-51 to 13.5 per cent in 1991-92. However, in the subsequent

period, it declined to about 10.6 per cent before recovering to a little over 11 per cent. The decline

in the tax ratio in recent years was mainly due to lower buoyancy of indirect taxes.
 Interestingly, fluctuations in the tax ratio are seen mainly at the central level. Central

revenues constitute about 60 per cent of the total tax revenues and therefore, fluctuations in central

tax ratio impacts significantly on the aggregate tax ratio.

The tax ratios at both central and state levels increased sharply during the period from

1950-51 to 1985-86. Thereafter, the tax ratio at the state level was stagnant at about 5.5 per cent

until 2001-02 and then increased marginally to 6 per cent in 2003-04. In contrast, the central tax

ratio continued to increase and peaked in 1987-88 to remain at that level until the fiscal crisis of

1991-92. In subsequent years, there was a sharp decline until 2001-02 followed by recovery to the

pre-1991 level in 2004-05 (revised estimates). Within the central level, the share of direct taxes

increased from 20 per cent in 1990-91 to over 43 per cent in 2004-05. As mentioned earlier, the

increase in the tax ratio until the end of the 1980s was due to indirect taxes, but in subsequent

years increase in direct taxes arrested the sharp decline indirect taxes.

Analysis of Central Taxes

As mentioned earlier, over 60 per cent of aggregate tax collections in the country is

effected at the central level as all broad based taxes excluding the sales tax has been assigned to it.

Further, since the trends in central taxes have been decisive in determining the overall trends and

therefore, it is useful to examine these in greater detail.

Bird (1993), after observing tax reforms in many countries states, “…fiscal crisis has been

proven to be the mother of tax reform” and Ind ian experience fits into this. However, unlike

reforms undertaken in response to crises which are often ad hoc and are done to meet
immediate exigencies of revenue, tax reform in India was undertaken after a detailed analysis.

Interestingly, contrary to expectations, the period after the introduction of reforms has seen decline

in the tax-GDP ratio from 10.3 per cent in 1991-92 to 8.2 percent in 2001-02 at the central level,

before it recovered to about 10 per cent in 2004-05.

This has prompted many to ask whether the tax reforms caused the decline in the tax-GDP

ratio. The contrary view can be that the ratio declined in spite of the reforms. The disaggregated

analysis of the trends in central tax revenue presented in table 3 (Figure 3) shows that sharpest

decline in the tax –GDP ratio was in indirect taxes – both customs duties and central excise duty.

The former declined by about 1.8 percentage points from 3.6 per cent in 1991-92 to 1.8 per cent in

2004-05 and the decline in the latter was by one percentage point from 4.3 per cent to 3.3 per cent

during the period. Interestingly, the tax ratio from both the taxes declined up to 2001-02 and have

stabilized at that level and indicators are that while the customs may continue to decline as tariff

levels are further brought down, the tax ratio from internal indirect taxes are likely to increase if

reforms towards improving the coverage of service tax and its integration with CenVAT is

undertaken and significant improvement in tax administration is achieved.

In contrast to indirect taxes, there has been a significant increase in the revenue from direct

taxes. In fact, since the reforms were introduced, the direct tax-GDP ratio more than doubled from

about 2 per cent in 1991-92 to 4.3 per cent in 2004-05. The increase was seen both in personal

income and corporate income taxes, the tax-GDP ratio in the latter increasing by
more than three times from 0.9 per cent in 1991-92 to 2.7 per cent in 2004-05. The revenue from

personal income tax increased from 0.9 per cent to 1.6 per cent during the period.

The decline in the share of customs revenue is certainly to be expected when the tariff rates

are significantly brought down in the wake of external liberalisation. In fact, the decline could

have been even faster but for the hesitancy on the part of the Finance Ministry to reduce the tariffs

even more, mainly due to the demands of the domestic industry. To some extent it was expected

that increasing imports due to liberalization will offset the effect of rate reduction. However,

increase in imports after liberalization (Panagariya, 2005) was not enough to balance the revenues.

The declining trend in excise duties throughout the 1980s was due to the fact that the rate structure

assumed when input tax credit was allowed was perhaps not revenue neutral. Continued

exemption of small scale sector and widespread use of area based exemptions are other important

reasons for the decline in the excise duties. In addition, due to poor information system, it was

possible to claim excessive input tax credit.

Since 1997-98, it is also seen that over 75 per cent of the increase in the GDP is

attributable to the growth in the services sector, and the manufacturing sector has been relatively

stagnant, implying an automatic reduction in the ratio of taxes on manufacturing base as a

percentage of total GDP. In contrast to indirect taxes, the revenue from direct taxes has shown a

steady increase. Revenues from both personal income tax and corporate income tax have increased

over the years. The major reason attributed for the increase is the improved tax compliance arising

from reduction in marginal tax rates. Of course, there is some independent

evidence on the improvement in tax compliance since 1991 (Das-Gupta and Mookherjee, 1997,

Das-Gupta, 2002).

Analysis of the Trends and Economic Impact of the Tax System

In this section, the observed trends in different central and state taxes is explained in

greater detail and the possible efficiency and equity implications of different taxes is analysed.

Specifically, the analysis seeks to raise a number of questions. These include, has tax compliance

improved over the years in response to reduction in marginal tax rates? What other factors

influence revenue productivity of the tax system? What are the efficiency and equity implications

of the tax system?

Personal Income Tax (PIT):

As shown in the previous section, the revenue productivity of the personal income tax has

improved after comprehensive tax reform was initiated in 1991. Interestingly, increase in revenue

productivity was seen even as the growth of GDP itself decelerated.

Therefore, it is natural to attribute the increase in revenue productivity to improvement in

tax compliance arising from reduction in marginal tax rates in 1991-92 and 1996-97. While it is

inappropriate to explore the statistical significance of the relation between the effective tax rates

and the PIT collections as a proportion to GDP, given the small size of the sample, such an

exercise does give a flavour of the sign of the coefficient. Interestingly, the relation appears to be
negative, whichever be the reference income group considered, i.e., the decline in the tax rate is

associated with an increase in the income tax collections as a ratio of GDP, suggesting some

applicability of the Laffer curve. In fact, Dasgupta and Mookherjee (1997) draws some tentative,

but important conclusion of improved compliance of the tax system. In a more recent analysis

Das- Gupta (2002) based on 16 different structural, administrative and institutional indicators

concludes that the performance of the tax system has shown improvement: tax compliance has

indeed improved after the reduction in marginal tax rates. While the association between tax rates

and improvement in tax performance is indisputable, it is not appropriate to attribute improvement

in revenue productivity of the personal income tax since 1996-97 solely or even mainly to

reduction in the marginal rate of tax. The information presented in Table 5 shows that the main

reason for the increase in revenues is the extending the scope of tax deduction at source. The

proportion of tax deducted at source (TDS) actually declined from 42 per cent to 22 per cent of

total revenue collections in 1994-95, but increased to over 50 per cent in 1996-97 and further to 67

per cent in 2001-02 before declining marginally to 64 per cent in 2003-04. This again is not due to

extension of TDS to other incomes, but simply to the increase in the salary component of TDS.

The TDS in salaries in 1992-93 constituted only 25 per cent of the total TDS, and it increased to

50 per cent in 1999-2000 before declining to 41 per cent, as TDS from payments to non-residents

and to contractors increased substantially.

Thus, the trend in TDS suggests that the improved compliance is largely explained in terms

of improved coverage or greater effectiveness of TDS as a tool for collecting taxes. It is important

to understand the impact of reduction in the marginal tax rate and reduction in the number of rate

categories since 1991-92 on the overall progressivity of the tax system. We have
tried to work out the impact of changes in the rate structure on the effective tax rates faced by

different income groups over time. This is important since, given indirect taxes are often argued to

be lacking in progressivity, the job of delivering progressivity to the tax system is often assigned

to personal income tax. Detailed analysis of effective tax rate on individuals belonging to different

income levels shows that the effective tax rates among income tax payers have been converging

over the years indicating reduction in progressivity among income tax payers. However, from this

it should not be inferred that progressivity has declined and overall equity in the tax system has

worsened over the years. Surely in 2003-04, as many as 28.8 million people pay income tax as

compared to 3.9 million in 1989-90 and the tax paid by them now has doubled from less than one

per cent of GDP to 2 per cent of GDP. The increase in the number of taxpayers indicates

improvement in horizontal equity and the fact that larger proportion of incomes are subject to tax

now represents improvement in vertical equity as well (Rao and Rao, 2005).

Corporate Income Tax:

As mentioned earlier, of the four major taxes considered, the revenue from the corporation

tax grew at the fastest rate during the 1990s. As a ratio of GDP, the revenue from the tax increased

by three times from 0.9 per cent in 1990-91 to 2.7 per cent in 2003-04. This happened in spite of

reduction in the rates. The reforms, as discussed earlier, comprised of doing away with the

distinction between closely held and widely held companies, reduction in the marginal tax rates to

align it with the top marginal tax rate of personal income tax, rationalising tax preferences –

investment allowance and deprecia tion allowance to considerable extent. In

addition, the introduction of MAT has also contributed to the revenues. It would be instructive to

analyse the contribution of different sectors to corporation tax revenue. The analysis of data in the

sector-wise contribution of corporation tax from the prowess database which accounts for about

two-thirds of the corporate tax collections shows that the manufacturing sector in 2004-05 paid

about 40 per cent of the tax. Within this sector, the petroleum sector contributed the bulk (12.5 per

cent) followed by chemicals (6.5) and basic metal industry (6.1). In contrast, the contribution of

textiles is just about 0.5 per cent. In fact, in 1994-95 industries such as chemicals, machinery,

transport equipment contributed overwhelming proportion of corporation tax, but their share

declined sharply over the years (Rao and Rao, 2005). Another important issue examined here

refers to the contribution of the public sector enterprises to the corporation tax. Curiously, after

liberalization, the share of public enterprises has increased considerably over the years. In the

initial stages of liberalization, the share actually fell from 23 per cent in 1990-91 to 19 per cent in

1994- 95, but thereafter, it increased to 38 per cent in 2002-03. In other words, over 50 per cent of

the corporation tax in 2003-04 was collected from public enterprises (Rao and Rao, 2005). This

may partly be due to their lack of elaborate tax planning to minimise the incidence of taxes unlike

the private sector.

Union Excise Duties :

Declining tax-GDP ratio of Union excise duties is truly a matter of concern. The reforms in

union excise duties rather than improving the revenue productivity have led to its decline over the

years. Although during the last few years the revenue-GDP ratio from the tax has been stagnant at

3.3 per cent, it is significantly lower than the ratio in 1991-92 (4.1 per cent). Not only
that the revenue productivity of Union excise duty has declined over the years, even the

composition shows increase in revenue concentration particularly towards commodities which

would be used in further production. Independent operation of excise and sales tax systems and

confining the tax to goods and to the manufacturing stage alone does not remove cascading and

final products in the manufacturing stage are not necessarily final consumer goods. The

commodity wise revenue collections from Union excise duty bring out efficiency and equity

implications of the tax system. One of the most important features is the commodity concentration.

Just five groups of commodities namely petroleum products, chemicals, basic metals, transport

vehicles and electrical and electronic goods together contribute to 75 per cent of total revenue

collections from excise duty. It is normally expected that over the years, with diversification in

manufacturing, the commodity concentration in excise duty should reduce. Contrarily, the

commodity concentration has only increased over the years with a single group, petroleum

products contributing to over 40 per cent of the union excise duty collections, with more than three

times increase in share over a 13 year period. This imposes disproportion tax burden on different

sectors of the economy. Besides, this type of commodity concentration does not allow objective

calibration of policies in regard to excise duties as the Finance Ministry would not like to lose

revenue from this lucrative source.

Another important feature excise duties is that overwhelming proportion of the duties is

collected from commodity groups which are in the nature of intermediate products. Besides

petroleum products, a significant proportion of which is used in transportation of goods and

persons involved in or related to other manufacturing, the taxes on all goods serving as inputs to

service providers, especially of services used as inputs to manufacturing activities, contribute to

cascading and add to the production cost. Transport vehicles and related industries are another

such industry. These are a source of significant inefficiency in the system. This also makes it

difficult to speculate on the distribution of tax burden in terms of different income classes as it is

difficult to speculate on the effect of the tax on different manufacturing enterprises and its effects

on employment and incomes.

A striking feature of the excise duty is that like corporation tax, a predominant proportion

- almost 42 per cent of total collection is paid by public sector enterprises. Also, this component of

revenue has wide fluctuations from year to year. It reached the highest share of 53 per cent in

1999-2000, and the lowest in 2001-02 at just about 30 per cent. The fluctuations are due to the

fluctuations in administered prices on items such as steel, coal, minerals and ores and petroleum

products. The last one also varies with international prices. In other words, the revenue from

excise duties, which constitutes an important source of revenue, is fluctuates widely depending

upon pricing and output decisions of the government and given the significant dependence on this

sector, the ability of the PSUs to forge an independent pricing policy too could be compromised. .

Customs Duties :

The most important and in many ways far reaching reforms have been in the case of

customs tariffs. Since 1991, imports subject to quantitative restrictions constituted 90 per cent of

total imports, and these restrictions have been virtually done away with. The import weighted

tariff rates have been reduced from 72 per cent in 1990 to 15 per cent at present. The peak rate
of import duty too has been brought down from over 150 per cent in 1991 to less than 20 per cent

at present (Virmani et. al, 2004).

From efficiency point of view, differentiating tax rates varying with the stage of production

continues to be a problem. The rates on raw materials and intermediate goods continue to be lower

than those on consumer goods and capital goods and even the recent task for ce on Reform of

Indirect Taxes (India, 2002) has followed the same principle. The commodity group wise analysis

of customs shows that despite external liberalisation, almost 60 per cent of the duty comes from

only three commodity groups namely, machinery (26.6 per cent), petroleum products (21 per cent)

and chemicals (11 per cent). Further, overwhelming proportion (over 75 per cent) of the duty is

collected from either machinery or basic inputs or intermediate goods. Thus, liberalisation,

contrary to the fear, has not led to massive inflow of consumer goods (Rao and Rao, 2005). This

also implies that reducing the duties further and imparting greater uniformity would be beneficial

to the economy (Virmani et. al. 2004).

Towards Further Reforms in the Tax System:

In the last few years, reforming the central tax system has received considerable focus. The

Advisory Group on Tax Policy and Administration for the Tenth Plan (India, 2001) and the Kelkar

Task Force (KTF) reports on Direct and Indirect Taxes (India, 2002) and more recently the KTF

on the implementation of the FRBM Act (India, 2004) have comprehensively examined the tax

system and made important recommendations to reform. While there are differences relating to

some of the specific recommendations as compared to the TRC, there is broad

agreement on the direction and thrust of reforms and on the emphasis placed on the reform of tax

administration.

Reform of central taxes:

The reforms with regard to personal income tax will involve further simplification of the

tax system. This includes withdrawal of tax exemptions and concessions given for specified

activities, abolition of surcharge and further simplification of the tax. In fact, there is considerable

virtue in having a single tax rate with an exemption limit as many transitional economies have

found. The ability of income tax system to bring about significant redistribution through tax policy

is limited and it is increasingly being realized that equity should focus on increasing the incomes

of the poor rather than reducing the incomes of the rich and this objective is better achieved by

expenditures on human development and not through the tax system (Harberger, 2003, Bird and

Zolt, 2005). Yet, moving towards a single rate of tax may not be politically feasible at this

juncture. On the corporation tax, base broadening involves getting rid of the tax preferences.

In particular, the exemption for profits from exports, free trade zones, technology parks,

area based exemptions for backward area development, for infrastructure should be phased out.

Similarly, the present rate of depreciation allowance, even after the reduction in 2005-06 is quite

generous and needs to be reduced to more realistic levels and the rate should be aligned with that

of marginal tax rate on personal income tax. There has been a lot of flip flop in regard to
taxation of dividends from one year to another. The most satisfactory solution in this regard is to

have partial integration of the tax with personal income tax.

With regard to import duties, the reform will have to move in the direction of further

reduction and unification of the rates. As most non-agricultural tariffs fall between zero and 15 per

cent, a uniform tariff of 10 per cent would considerably simplify and rationalise the systems

(Acharya, 2005). Equally important is the need to get rid of plethora of exemptions and

concessional treatment to various categories including project imports. In fact, a minimum tariff of

5 per cent on all exempted items would rationalize the duty structure and help the cause of revenue

as well. Wide ranging exemption is a problem also with excise duties. Therefore, one of the most

important base-broadening measures should be to reduce the exemptions. In particular, the

exemptions given to small scale industry has not only eroded the tax base but has inhibited the

growth of firms into an economic scale. Similarly, various exemptions given to project imports

have significantly eroded the tax base. Another important reform area is to fully integrate the

CENVAT with the taxation of services (India, 2001).

Evolving Coordinated consumption tax system:

One of the most important reforms needed in indirect tax system is to evolve a coordinated

consumption tax system for the country (Rao, 1998). This is necessary to ensure that the tax

burden is distributed fairly between different sectors and between goods and services. The reform

should also improve the revenue productivity, minimize relative price distortions and above all,

ensure a common market in the country. This involves coordinated calibration of

reforms at central, state and local levels. At the centre, as mentioned above, the first step is to

evolve a manufacturing stage VAT on goods and services. At the state level, converting the sales

tax into VAT should be completed by allowing input tax credit not only for intra-state sales and

purchases but also for inter-state transactions. Also, appropriate mechanisms will have to be found

for enabling the states to levy the tax on services and integrating it with the VAT on goods, so as

to arrive a comprehensive VAT. An important problem in this regard is devising a system for

taxation of services with an inter-state coverage. The local level indirect tax reform relates to the

abolition of octroi. There is no place for octroi in any modern tax system. The problem however, is

of finding an appropriate substitute. In every country, property tax is a mainstay of local body

finances and reform in this area should help in raising revenue productivity. Yet, this may not

suffice. In this situation, the better option is to allow the local bodies to piggyback on the VAT

collections in urban local body jurisdictions. This way, it will avoid cascading of the tax and

minimise exportation of tax burden by the urban local bodies to non-residents.

Reform in tax administration:

In India, the poor state of tax administration has been a major reason for low levels of

compliance and high compliance cost. A major aspect of this is the virtual absence of data on both

direct and indirect taxes even at the central level. Not only that this rendered proper analysis of

taxes to provide adequate analytical background to calibrate changes in tax structure, but also it

made proper enforcement of the tax difficult. Thus the changes in the tax structure had to be made

in an ad hoc manner.
 The consequence of this has been the high compliance cost. The only estimate of

compliance cost by Das-Gupta (2004a, 2004b) of both personal income and corporation tax shows

that in the case of personal income tax it is as high as 49 per cent of personal income tax

collections and in the case of corporate tax, between 6 and 15 per cent of the tax paid, with the

bulk being legal costs of compliance. While these estimates should be taken with a note of caution,

the important point to note is that the compliance cost of collecting taxes in India is extremely

high. High compliance cost combined with poor state information system has led to continued

interface of taxpayers with officials, negotiated payment of taxes, corruption and rent seeking and

low levels of tax compliance. An important indication of the poor information system is that even

as the coverage of TDS was extended over the years, information was not assembled even to check

whether those deducting the tax at source actually filed the returns. As the CAG report for 2003-04

states, of the 0.63 million returns to be filed by TDS assesses, only 0.50 million or were filed or

more than 40 percent of the TDS assesses did not file the returns. Even this is vast improvement

over the previous year when 80 per cent of the TDS assesses did not file the returns. The recent

initiatives on building the computerised information system in direct taxes follow from the

recommendations of the KTF. The Central Board of Direct taxes (CBDT) outsourced the function

of issuing permanent account numbers (PAN). The Tax Information Network (TIN) has been

established by the National Securities Depository Limited (NSDL). The initial phase has focused

on ensuring that TDS assesses do infact file the returns, and matching and cross-checking the

information from banking and financial institutions to ensure that the taxes paid according to the

returns are in fact credited into government accounts

in the banks. The Online Tax Accounting System (OLTAS) was operationalised in July 2004. This

has helped expedite the number of refunds from 2.6 million in 2002-03 to 5.6 million in 2003-04.

Not surprisingly, in the last four years revenue from direct taxes increased at over 20 per cent per

year. Similar initiatives have been taken in regard to indirect taxes as well. The customs e-

commerce gateway (ICEGATE), Customs Electronic Data Interchange system (ICES) have helped

to improve the information system and speed up the clearance processes. In 2003-04, ICES

handled about 4 million declarations in automated customs locations which constituted about 75

per cent of India’s international trade. Progress has been made in building capacity in modern

audit systems and computerised risk assessment with assistance from Canadian International

Development Agency (CIDA).

Another critical element in tax administration is the networking of the information from

various sources. As mentioned earlier, systems have to be evolved to put together information

received from various sources to quantify the possible tax implications from them in a judicially

acceptable manner to improve tax enforcement. In the first instance, the information networking

should get the data from various sources such as banks and financial institutions on various

assesses. In the second, there must be meaningful exchange of information between the direct and

indirect tax administrations. In the third, it is necessary to exchange information between central

and state taxes. Building computerised information system will help to improve enforcement of

taxes.
 Table No. 1

Year Revenue Fiscal Primary Debt Tax Ratio Tax Tax Transfer
Deficit * Deficit Deficit stock (Centre) Ratio Ratio to States
(Centre) (Centre)* States (Total)
1981-82 (-)0.60 6.4 4.1 46.4 9.4 4.9 14.3

1985-86 1.8 8.8 5.7 51.9 10.6 5.3 15.6

1990-91 4.2 9.3 4.9 61.4 10.1 5.3 15.4 4.9

1995-96 3.2 6.5 1.6 60.1 9.4 5.4 14.8 4.3

1996-97 3.6 6.3 1.1 58.0 9.5 5.2 14.7 4.3

1997-98 4.2 7.2 2.0 56.5 9.1 5.3 14.5 4.9

1998-99 6.4 9.0 3.6 58.6 8.3 5.1 13.4 3.7

1999-00 6.3 9.5 3.8 58.9 8.9 5.3 14.2 3.8

2000-01 6.5 9.2 3.3 61.5 9.0 5.6 14.6 3.9

2001-02 6.9 9.6 3.4 63.2 8.2 5.6 13.8 3.8

2002-03 6.7 9.9 3.4 69.5 8.8 5.9 14.6 3.8

2003-04 5.8 9.2 2.9 72.4 9.2 6.0 15.2

Note RE: Revised estimates.

Source : 1. Public Finance Statistics, Ministry of Finance, Government of India

2. Annual Report, Reserve bank of India, 2002-03
 Table No. 2
Trends in Tax Revenue in India
(Per Cent of GDP)
Centre States Total
Direct Indirect Total Direct Indirect Total Direct Indirect Total
1950-51 1.8 2.3 4.1 0.6 1.7 2.2 2.3 4.0 6.3
1960-61 1.7 3.5 5.2 0.6 2.0 2.7 2.3 5.5 7.9
1970-71 1.9 5.1 7.0 0.3 3.1 3.4 2.2 8.2 10.4
1980-81 2.1 7.1 9.2 0.2 4.4 4.6 2.3 11.5 13.8
1985-86 2.0 8.3 10.3 0.2 5.0 5.3 2.2 13.3 15.6
1987-88 1.9 8.7 10.6 0.2 5.2 5.4 2.1 14.0 16.1
1990-91 1.9 8.2 10.1 0.2 5.1 5.3 2.2 13.3 15.4
1991-92 2.4 8.0 10.3 0.2 5.3 5.5 2.6 13.3 15.8
1995-96 2.8 6.5 9.4 0.2 5.2 5.4 3.0 11.7 14.8
2000-01 3.3 5.8 9.0 0.2 5.4 5.6 3.4 11.2 14.6
2001-02 3.0 5.2 8.2 0.2 5.4 5.6 3.2 10.6 13.8
2002-03 3.4 5.4 8.8 0.2 5.7 5.6 3.5 11.1 14.6
2003-04 3.8 5.4 9.2 0.2 5.8 5.9 4.0 11.2 15.2
2004-05# 4.3 5.6 9.9 Na Na Na Na Na Na

Note: * Actual for the centre and revised estimate for States. # Revised estimates for Centre.
n.a. Not available
Source: Public Finance Statistics, 2003-04, Ministry of Finance, Government of India
 Table No. 3
Level and composition of Central Tax Revenue

PIT CIT Direct Custom Excise Indirect Total GDP

Tax
Per Cent of GDP
1985-86 1.0 1.1 2.1 3.6 4.9 8.8 10.9 100
1990-91 0.9 0.9 2.0 3.6 4.3 8.2 10.9 100
1995-96 1.3 1.4 2.8 3.0 3.4 6.5 9.4 100
2000-01 1.5 1.7 3.3 2.3 3.3 5.8 9.0 100
2001-02 1.4 1.6 3.0 1.8 3.2 5.2 8.2 100
2002-03 1.5 1.9 3.4 1.8 3.3 5.4 8.8 100
2003-04 1.5 2.3 3.8 1.8 3.3 5.4 9.2 100
2004-05 1.6 2.7 4.3 1.8 3.3 5.6 9.9 100
2005-06 1.9 3.1 5.0 1.5 3.5 5.5 10.5 100
Per Cent of Total Tax Revenue
1985-86 9.2 10.1 19.3 33.0 45.0 80.7 100
1990-91 9.3 9.3 19.2 35.9 45.0 80.8
1995-96 14.0 14.8 30.2 32.1 42.6 69.8
2000-01 16.8 18.9 36.2 25.2 36.1 63.8
2001-02 17.1 19.6 37.0 21.5 36.3 63.0
2002-03 17.0 21.3 38.4 20.7 38.8 64.5
2003-04 16.3 25.0 41.3 19.1 38.1 61.3
2004-05 16.6 27.1 43.9 18.4 35.7 56.1
*
2005-06 17.9 29.9 47.9 14.4 32.9 52.1
#

Note: * Revised Estimates Budget estimates, Source Estimate of Revenues, Central Budget
(various years)
 Table No. 4
Trends in State Level Taxes

Years Direct Sales State Stamps Taxes on Other Total Total

Taxes* Tax Excise and transport indirect indirect taxes
Duty registration taxes taxes
1985-86

1990-91 0.2 3.2 0.9 0.4 0.5 0.3 5.1 5.5

1995-96 0.2 3.0 0.7 0.5 0.4 0.5 5.2 5.4

1996-96 0.2 3.2 0.7 0.5 0.4 0.3 5.1 5.2

1997-98 0.1 3.2 0.8 0.5 0.4 0.3 5.2 5.4

1998-99 0.1 3.1 0.8 0.4 0.4 0.3 5.0 5.1

1999-00 0.1 3.2 0.8 0.4 0.4 0.3 5.2 5.3

2000-01 0.2 3.5 0.8 0.4 0.4 0.4 5.4 5.7

2001-02 0.2 3.4 0.8 0.5 0.5 0.4 5.4 5.7

2002-03 0.2 3.5 0.8 0.6 0.5 0.3 5.7 5.9

2003-04 0.2 3.6 0.8 0.5 0.6 0.3 5.8 6.0

Source: Public Finance Statistics, Ministry of Finance, Government of India

 Table No. 5
Contribution of TDS to Revenue, personal Income Tax

Tax Deduction at Advance Tax (%) Gross collections Refunds (Rs

source (%) (Rs. Crore) crore)
1990-91 41.75 36.00 6188.37 827.74

1991-92 48.22 33.29 7523.97 794.79

1992-93 42.91 33.45 9060.79 1165.44

1993-94 19.65 51.77 14106.25 4045.96

1994-95 22.18 56.87 17178.72 3357.76

1995-96 22.21 50.01 22949.61 6462.48

1996-97 50.87 27.30 20042.48 1808.49

1997-98 50.87 24.10 19270.19 2169.60

1998-99 52.44 23.59 22411.98 2171.83

1999-00 53.69 24.58 28684.29 3029.79

2000-01 63.22 20.89 35162.61 3398.63

2001-02 67.10 19.23 35358.00 3354.00

2002-03 65.55 20.26 42119 5253

2003-04 64.03 20.01 48454 7067

Source: Report of the comptroller and Auditor General (Direct Taxes) (Various years),
Government of India, 2005
***
Level, Composition and trends in state taxes

Table 4 presents the trends in states’ tax revenues. It is seen from the table that the revenue

from state taxes as a ratio of GDP was virtually stagnant throughout the 1990s fluctuating around

5 to 5.7 per cent. In fact, from 1994-95, the tax ratio declined to bottom out at 5.1 per cent in

1998-99, the year in which the states had to revise the pay scales exacerbating their fiscal

problems. In subsequent years, there has been a steady improvement in the tax ratio to touch 6 per

cent in 2003-04. Of the different state taxes, sales tax is predominant and constitutes about 60 per

cent of total state tax revenues. Therefore, not surprisingly, the overall trend in states’ tax ratio

follows closely the trends in sales tax revenue. The revenue from sales tax after reaching a low of

3.1 per cent in 1998-99, has increased marginally to 3.5 per cent in 2000-01. It has remained at

that level thereafter. Any attempt to improve the revenue productivity of states’ tax system has to

deal with the reform of sales taxes. Therefore, the recent move towards destination based VAT is

extremely important. State excise duty is a sumptuary tax on alcoholic products. On this, there has

always been a problem of balancing regulatory and revenue considerations. The major components

of the tax come from arrack, country liquor and ‘India Made Foreign Liquor’ (IMFL) including

beer. The duty collected is by way of license fee on the sale/auction of vends and taxes on

consumption. The problem in regard to country liquor is the brewing and consumption of illicit

liquor. This has not only caused loss of revenue, but has been an important health hazard. As

regards IMFL, in one of the states it was estimated that actual evasion of the tax may be as high as

three times the revenue collected (Karnataka, 2001). The way to deal with this problem has more

to do with strengthening the tax administration and information system and less to do with the

structure of the tax.

 The principal source of stamp duties and registration fees is from the sale of immovable

property transactions. The most important problem afflicting this tax is Under valuation of the

value of the property transacted. A part of the reason for this lies in the high rates of tax.

Undervaluation of immovable property is aided by the lack of organised market. Development of

organised market for urban immovable property transactions is hindered by the high rate of stamp

duties and registration fees and other policies such as rent control act and urban land ceiling act. In

fact, until recently, the tax rates were as high as 12 to 15 per cent on the value of transactions

(NIPFP, 1996). Many of the states which reduced the rates have found the typical working of the

“Laffer curve” phenomenon and have s tarted reforms to reduce the rates in this direction. In

Karnataka for example, the tax rate was reduced from 16 per cent in 2001-02 to 8 per cent in 2002-

03 and witnessed 30 per cent growth of revenue from stamp duties during the period.

At the local level there are two taxes of some significance. These are the taxes on property

and in some states, Octroi levied by urban local bodies. The major problem with urban property

taxes, like in the case of registration fees is undervaluation. Alternative models of reform – of

using the capital value or rental value for valuing the property have been suggested. The ultimate

reform depends on the development of organised property. In most cases the recommendations

suggested have been to use the guided value determined in some independent manner. As regards

Octroi, this check-post based levy is not only impeding internal trade and violating the principle of

common market, but also is a source of corruption and rent seeking.

How GST Will Work?

Generally, the dealers registered under GST (Manufacturers, Wholesalers and retailers and

service providers) charge GST on the price of goods and services from their customers and claim

credits for the GST included in the price of their own purchases of goods and services used by

them. While GST is paid at each step in the supply chain of goods and services, the paying dealers

don’t actually bear the burden of the tax because GST is an indirect tax and ultimate burden of the

GST has to be taken by the last customer. This is because they include GST in the price of the

goods and services they sell and can claim credits for the most GST included in the price of goods

and services they buy. The cost of GST is borne by the final consumer, who can’t claim GST

credits, i.e. input credit of the tax paid. The GST can be divided into following sections to

understand it better:

a. Charging Tax:

The dealers registered under GST (Manufacturers, Wholesalers and Retailers and Service

Providers) are required to charge GST at the specified rate of tax on goods and services that they

supply to customers. The GST payable is included in the price paid by the recipient of the goods

and services. The supplier must deposit this amount of GST with the Government.

b. Getting Credit of GST:

If the recipient of goods or services is a registered dealer (Manufacturers, Wholesalers

and Retailers and Service Providers), he will normally be able to claim a credit for the amount of

GST, he has paid, provided he holds a proper tax invoice. This “input tax credit” is set off
against any GST (Out Put), which the dealer charges on goods and services, which he supplies, to

his customers.

c. Ultimate Burden of Tax on Last Customer:

The net effect is that dealers charge GST but do not keep it, and pay GST but get a credit

for it. This means that they act essentially as collecting agents for the Government. The ultimate

burden of the tax falls on the last and final consumer of the goods and services, as this person gets

no credit for the GST paid by him to his sellers or service providers.

d. Registration:

Dealers will have to register for GST. These dealers will include the suppliers,

manufacturers, service providers, wholesalers and retailers. If a dealer is not registered, he

normally cannot charge GST and cannot claim credit for the GST he pays and further cannot issue

a tax invoice.

e. Tax Period:

The tax period will have to be decided by the respective law and normally it is monthly

and/or quarterly. On a particular tax period, which is applicable to the dealer concerned, the dealer

has to deposit the tax if his output credit is more than the input credit after considering the opening

balance, if any, of the input credit.

f. Refunds:

If for a tax period the input credit of a dealer is more than the output credit then he is

eligible for refund subject to the provisions of law applicable in this respect. The excess may be

carried forward to next period or may be refunded immediately depending upon the provision of

law.

g. Exempted Goods and Services:

Certain goods and services may be declared as exempted goods and services and in that

case the input credit cannot be claimed on the GST paid for purchasing the raw material in this

respect or GST paid on services used for providing such goods and services.

h. Zero Rated Goods and Services:

Generally, export of goods and services are zero-rated and in that case the GST paid by

the exporters of these goods and services is refunded. This is the basic difference between Zero

rated goods and services and exempted goods and services.

i. Tax Invoice:

Tax invoice is the basic and important document in the GST and a dealer registered under

GST can issue a tax invoice and on the basis of this invoice the credit (Input) can be claimed.

Normally a tax invoice must bear the name of supplying dealer, his tax identification nos., address

and tax invoice nos. coupled with the name and address of the purchasing dealer, his tax

identification nos., address and description of goods sold or service provided. The working of GST

with respect to manufacturer, dealer and consumer can be seen in the illustrations given on
next page: The manufacturers will get the input credit of all the taxes paid by them on the raw

material and also on the services. Let us assume the rate of GST at 16% and a plastic

manufacturing company has consumed the following goods and services while producing the

goods, which they are able to sell at Rs. 100 lakh plus tax: -

Now the “Output Tax” i.e. the tax charged from the purchaser is as under:

The next tax payable by Manufacture is as under;-

 If the goods are sold to a trader by this manufacturer and the trader also used some of the

services amounting to Rs. 5 lakh on which he has paid service tax amounting to Rs. 0.80 lakh, then

his input tax is as under:

Now the dealer sold the goods to the consumers by adding his profit of Rs. 10 lakh and in

that case his output tax will be as under:

The net tax payable by the dealer is as under :-

 Now through this system we have presumed that the goods of Rs. 115 lakh are sold to the

customers then the Government in that case has got the tax in the following form:

See, this is exactly equal to the amount that has to be borne and ultimately paid by the last

customer on Rs.115 lakh @ 16% i.e. Rs. 18.40 lakh. Apparently the system is very much similar

to the present system of VAT but the implementation of this system will certainly have some

unique problems compared to VAT. In a very simple manner the overall system of GST can be

seen as under with the help of this table:

 The Net GST payable by the Manufacturer and Trader can be seen as under with the help

of Figure 4:

Fig. 4: Showing the output credit, input credit and Net tax payable by the Manufacturer and the
Dealer.
 The Net component of Tax to the consumer can be seen in Figure 5:

Fig.5: Showing how the tax borne by the ultimate consumer is deposited by various dealers at

different stages.

Systems of GST

Internationally, there are three systems in vogue:

(a) Invoice System

(b) Payment System

(c) Hybrid System

(a) Invoice System: In the invoice system, the GST (Input) is claimed on the basis of invoice

and it is claimed when the invoice is received, it is immaterial whether payment is made or not.

Further the GST (Output) is accounted for when invoice is raised. Here also the time of receipt of
payment is immaterial. One may treat it as mercantile system of accounting. In India the present

system of sales tax on goods is an invoice system of VAT and here it is immaterial whether the tax

payer is following the cash basis of accounting or mercantile basis of accounting. The advantage

of invoice system is that the input credit can be claimed without making the payment. The

disadvantage of the invoice system is that the GST has to be paid without receiving the payment.

(b) Payment System: In the payment system of GST, the GST (Input) is claimed when the

payment for purchases is made and the GST (Output) is accounted for when the payment is made.

In this system, it is immaterial whether the assesses is maintaining the accounts on cash basis or

not. The advantage of cash invoice system is that the Tax (output) need not be deposited until the

payment for the goods and/or services is received. The disadvantage of the payment system is that

the GST (input) cannot be claimed without making the payment. The Taxes on services in India

are based on this payment system since service tax is payable on receipt basis and further Cenvat

credit is only allowable when payment of the service is made. In some countries, this system is

also adopted for small traders to keep them away from the complexities of the Invoice system,

which is purely a mercantile system.

(c) Hybrid System: In hybrid system the GST (Input) is claimed on the basis of invoice and

GST (Output) is accounted for on the basis of payment, if allowed by the law. In some countries

the dealers have to put their option for this system or for a reversal of this system before adopting

the same. These three systems can be summarised as under:

 It always depends on the law of the country, which decides the system of GST to be

followed by the dealers.

GST and Present System of VAT

In principle, there is no difference between present tax structure under VAT and GST as

far as the tax on goods is concerned because GST is also a form of VAT on Goods and services.

Here at present the sales tax, with an exception of CST, is a VAT system and in case of service tax

the system also has the Cenvat credit system hence both sales tax and service tax are under VAT

system in our country. At present the goods and services are taxed separately but in GST the

difference will be vanished. The overall system of GST is very much similar to the VAT, which

can be considered as first step towards GST. Let us see the VAT implementation schedule of

various states:
 All the states have their own VAT Laws comprising VAT acts and VAT rules and the acts

and rules are formulated on the basis of “Whit e Paper on VAT” issued by the empowered

committee of states’ Finance Ministers on VAT headed by Asim Das Gupta, the Finance Minister

of West Bengal. Due to the fact that the taxpayers are already using the Vat able sales tax and

service tax system there may be a possibility that GST will be a matter of settlement between the

Centre and the states and like VAT, the possibility of any resistance from the taxpayers is

somewhat less.
Service Tax

In our country, the goods are taxable since long but the same cannot be said for services. Till 1994

there was no tax on services and this tax was introduced by the then Finance Minister and present

Prime Minister Shri. Manmohan Singh. The logic behind this tax was “When goods are taxable

why not Service?” It is also a central tax and along with central excise it is governed on the system

VAT and the service tax suffered and paid can be claimed as Cenvat credit against central excise

and service tax or vice versa. There is no separate Service Tax Act and Service Tax Department in

India and taxes on services in our country are governed by some of the provisions of Finance Act

– 1994 and Service Tax Ru les – 1994 and the department concerned is Central Excise department.

In our country the whole service sector is not taken under the service tax net and instead a

selective approach is adopted. In 1994 only three services were brought under service tax net and

the number has been increasing every year since then. Today, the number of services under the

service tax net is touching almost 100.

Rate of Service Tax

The rates of service tax at various stages oftime have been as under:

When GST will be introduced, the service tax provisions as contained in Finance Act –

1994 and Service Tax Rules – 1994 will be replaced by the provisions of a Central Goods and

Service Tax Act and Rules.

GST and Income Tax

GST is basically an indirect tax but since the last burden of this tax is borne by the ultimate

consumer hence for a consumer it is a tax on him. If a person pays income tax of Rs. 10,000 on his

income and Rs. 2500 on services and goods consumed by him the total burden of tax on him is Rs.

12500 during the year. Now in some countries the GST has been made deductible from the income

tax of the ultimate consumer but this has been done only on experimental basis and only in the

case of small income group assesses. If this approach is adopted in India, then the person

mentioned above will get the credit of Rs.2500.00 and have to pay income tax of Rs.7500.00
only to make his total tax in tune of Rs.10000. However, this is a very remote possibility in our

country.

It is Essentially a Centralised System

The GST will work only as a centralised taxation system with collection of all the Tax going to the

Central Government and then shared by the states. And this will be a big problem when GST will

be introduced in India because the country has the federal system of economy in which the states

also have the power to collect tax and that is the main base of their economic autonomy. How this

system will work in a centralised system can only be understood from the announcement of the

Finance Minister, so let us once again see the relevant portion of the speech.“It is my sense that

there is a large conse nsus that the country should move towards a National Level Goods and

Service Tax (GST) that should be shared between the Centre and the States.”This particular

peculiarity of the GST has made it totally different from the VAT and this can only be a national

level tax and can be successfully managed by the central power and the total collection of the same

can be shared by the states. VAT has also been \ introduced in our country without abolishing the

CST (Central Sales Tax) and even lowering the CST rates have been postponed several times. The

basic reason behind this has been that some of the states collecting major share of CST are not

ready to compromise with their economic autonomy. VAT principally is also a central tax but in

our country it has been introduced with some compromises and states have agreed on it, though

with some initial hesitation, because their economic autonomy was not touched. There is

psychological difference between the collection of Tax by the states themselves and sharing the

centrally collected tax.

The State Economy and GST

At present the Tax structure of the country is as under:

When GST will be introduced it will replace the Central excise, services tax, VAT and

CST. Till date the Centre has the monopoly power of the tax on services and states have the power

to tax the sale of goods. Now the states will have to surrender their power to tax the goods and

share the central tax and certainly this will be a very tough bargain for them. The states are

demanding that they should be given power to tax the services also but in GST they will actually

lose their power to tax even the goods. The tax will be collected at Central level and then it will be

shared by the states. The Budget (Estimates) for the Year 2005-2006of 13 states are being

presented herewith and it will give an indication how these states may react when the actual steps

will be taken to implement GST because some of the states are collecting their own taxes to

support their economy very well but the same thing cannot be said for the others. There is clear

financial and economic disparity in the country. These reactions from the states will depend on

how the GST will curtail their power to tax and how this curtailment will affect their economy and

autonomy.
 The larger the own collection of tax, the more difficult it will be for the states to accept

the GST. This will be a major hurdle, which the Central Government will have to cross while

introducing the GST.