Modi’s Tackling Tax Reform

05.18.15

Modi’s Tackling Tax Reform

05.18.15
Associated PressAssociated Press

By Krishna Balan for Global Risk Insights

Described as potentially the biggest change in Indian taxation since independence, the Goods and Services Tax (GST) aims to simplify the colossally complex Indian tax system. Prime Minister Narendra Modi’s proposition aims to replace local taxation with a uniform federal tax, creating a single accessible market with the revenue losses to local bodies being offset by federal funds.

Modi’s government hopes that this tax reform will help reverse India’s fiscal troubles, which currently boast the lowest tax to GDP ration in the world. The reforms aim to increase overall revenue and mitigate against back alley taxation and evasion.

It is hoped that this long overdue formalization, alongside helping move India towards the powerhouse it’s long promised to be, will allow the government to cut its budget deficit and bolster social spending. Additionally, the tax efficiency’s effect on manufacturing should light a fire under the ‘Make in India’ campaign, a move to reduce the isolation between India’s producing and consuming states.

This redesign to nationally uniform taxation is something that has a precedent for success. It has been implemented across the commonwealth, in countries such as Canada and New Zealand, under the title of VAT. These countries, however, are developed and not subject to limiting infrastructure and corruption.

India’s closest equivalent would be Malaysia, where a similar system was recently rolled out; if there is any hope for success, India should use this neighbour’s experiences as a testing ground. While vastly different in scale, there are undoubtedly invaluable lessons to be learnt.

Risks to tax reform

There are, however, notable downside risks to the proposed changes – with these still under consideration, Modi’s April 2016 target for a full roll-out is questionable. Most recently, in a sequence of stalls, May 12th saw India’s opposing congress party succeed in delaying parliamentary action and compelling a review of the proposition to two separate parliamentary panels. The endurance of the GST proposition is not helped by the fact that it is being tied in with a land acquisition bill that carries heavy opposition.

It is clear, however, where investor sentiment lays, with the stall in parliament causing a more than 2 percent drop in shares. Speaking to CNBC, analysts at ANZ described the move to defer the bill as ‘unfortunate and ill-timed,’ but said the delay ‘was not a derailment’ and that GST ‘will see the light of day.’ The bill itself does have bipartisan support, but on this occasion, Congress was not ready to vote for it without a review by parliamentary panel.

Furthermore, the bill requires approval from over half of India’s 29 member states, alongside parliamentary backing. This most recent setback has fueled existing doubts over Modi’s ability to meet his own April 2016 deadline.

It’s not just political partisanship that is driving doubters of Modi’s reform; there are several other potential risks. Most prominent of these are concerns that Finance Minister Arun Jaitley’s conjecture that GST would boost GDP growth by 1-2 percent could potentially be flawed – his figures are reliant upon limited or no increases in the net tax burden for businesses over time.

If the government uses GST as a fiscal revenue booster, India could become a less competitive country in attracting business, with a potentially larger tax burden for foreign companies under the new system. This would in turn have a negative impact on previously competent state governments, reducing their taxable base and overall tax revenue.

The proposition as a whole assumes that the central government is less corrupt than local governments, and that centralized controls will be exercised more responsibly. While Modi has a clean, anti-corruption global image, there’s no guarantee that future governments will be the same.

In combatting corruption concerns, the current parliamentary reviews should seek to legislate the capacity of federal governments to control GST rates. Currently, there is a provision for states to block moves, but usually the party governing the centre also has multi-state power, leaving the ultimate decision authority with the Finance Minister.

A further problem arises in Modi’s self-imposed timeline of April 2016. With the bill facing one roadblock after another, the likelihood of an on-time completion is remote. This creates uncertainty for foreign companies, with the potential for retrospective taxation.

If the full roll out is pushed to 2017 or 2018, foreign firms could find themselves hit with a bill dating back to 2016. As such, many foreign firms are understandably approaching investment and expansion in India with caution. To steady the ship and put an end to speculation, Modi’s government needs to make clear its stance on timelines and implementation.

The proposition has, however, received high praise in most quarters, and is gradually building momentum. Should Modi’s government successfully oversee the revolution, it will serve as a beacon of modern India, and will further underline how it’s economically progressive, reform-minded government sets it apart from other emerging markets.

Suresh Prabhu, India’s Railway Minister, stated recently that ‘the comprehensive indirect tax reform will make India the single largest market in the world.’ There’s no doubt that, if successful, GST implementation could be the catalyst for a profound change in the Indian outlook, both for those on the inside and those on the outside looking in.

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