The truck stops here

A fix for India's indirect-tax system is overdue but it may fall short of the ideal

TRADE negotiators were dismayed when in July India scuppered a chance to make modest progress on a global trade deal. Perhaps they hoped for too much. For years India has failed to sign a free-trade agreement even with itself. A recent report from the World Bank said bureaucracy related to tax-collection at state borders is a big reason why India's long-distance truckers are parked 60% of the time. A proposal to address this by rationalising the myriad state and central-government levies into a harmonised goods-and-service tax, or GST, has been around since at least 2007. But grubby politics has put paid to the idea—until now.

The present mess is rooted in the division of fiscal power in India's constitution, says Indira Rajaraman, an economist. To ensure balance the central government was granted the right to tax the production of goods; the states could tax their consumption. The drafters ignored services but as they became more important to the economy, their taxation became the preserve of the centre. From the outset India has suffered the problem of “cascades” of tax on tax. The centre slaps an excise at the factory gate; the states compound that with a tax at the point of sale.

The problem has become bigger as new levies have proliferated. The centre imposes a tax on goods that are sold across state borders. States collect taxes on entertainment and betting. There are separate levies on transport, electricity and cars. Rates vary from state to state, adding to the complexity. This creates a big burden on businesses that sell across borders. It is in part why India's manufacturing has a small share of GDP compared with other emerging markets, says Vijay Kelkar, a former chairman of the finance commission, which mediates between the centre and states on tax issues.

How should the mess be cleared up? An ideal tax system would have three elements: it should be progressive, with the better-off shouldering more of the burden; it should not influence choices over what to produce or consume; and it should be simple. Mr Kelkar's commission sketched out a GST that conforms to these principles. It would be levied at a uniform rate on all sales, including of property and financial services, with exceptions only for unprocessed food, schooling, health care and some public services. A sin-tax surcharge to the main GST rate would apply to petrol, tobacco and alcohol. With a broad tax base the GST rate could be as low as 12%—5% for the centre and 7% for the states. The properties of a value-added tax would apply so that taxes on inputs could be claimed back.

The government must secure the agreement of India's 29 states to the reform. If there is to be a common rate, the states must give up their much-prized power over taxes. Many fret about the possibility of lost income. Indirect taxes are 45% of the centre's tax-take but 80% of state revenue, says Morgan Stanley, a bank. There are already worrying signs that, to placate the states, the GST in its final form will deviate from the ideal. The exclusion of land sales would raise the rate by 2-3 percentage points, reckons Satya Poddar of EY, a consultancy. Alcohol may also be out and petrol may be given a special status. But the more exemptions there are, the more the GST will resemble what it is supposed to replace. At issue is whether, as Mr Poddar puts it, the GST will be a game-changer or merely a name-changer?