PERSPECTIVES
Macroeconomic Aspects
of Goods and Services Tax
Arun Kumar
The introduction of the goods and
services tax may indeed be the
biggest reform of taxation so far,
but the proposal, as it stands, has
led to confusion. Certainly, the
myriad taxes producers face will
be simplified. But the benefit will
go to large-scale producers while
the small-scale ones will be at a
greater disadvantage than before.
The cascading effect will be
reduced but not eliminated. With
resort to revenue neutrality,
prices and costs will not decline.
A revenue neutral rate will,
however, be difficult to calculate
and will be controversial, given
the variety of taxes being
replaced. The adoption of a fixed
revenue neutral rate for all
stages of production and
distribution will lead to a rise
in the prices of basic and
intermediate goods, as also of
services, making the introduction
of GST inflationary, unless this
problem is specifically addressed.
Arun Kumar (arunkumar1000@hotmail.com)
is Sukhamoy Chakravarty Chair Professor at
the Centre for Economic Studies and Planning,
Jawaharlal Nehru University, New Delhi.
26
1 Introduction
T
he introduction of the goods and
services tax (GST) is billed as the
biggest reform in Indias taxation.
It is said to be a win-win situation for all
stakeholders. It is supposed to provide a
seamless, unified market for business,
raise gross domestic product (GDP) growth
by 1% to 2% and taxGDP ratio by 2%,
reduce cost of indigenous goods by
around 10%, impact the black economy
and lead to consolidation of manufactur-
ing to reap economies of scale. If correct,
this would be no small matter, given
that currently Indias rate of growth is
facing headwinds (if the controversial
revision of GDP figures is discounted)
with industry, exports and agriculture
not doing too well.
The Constitution amendment bill nec-
essary to implement GST is being op-
posed by the Congress Party and the
left, and states like Tamil Nadu and Odi-
sha. Is this just political opposition to
corner the Bharatiya Janata Party (BJP)-
led National Democratic Alliance (NDA)
or are there sound economic reasons for
why the nation needs to tread slowly on
such a massive and complicated exer-
cise? There is a divide between the pro-
ducing and the consuming states with
the former worried about losing revenue
and the latter gaining as the system
transits from a source to a destination-
based system. Finally, states are legiti-
mately worried that they may lose reve-
nue as a result of a shift from the present
system to a GST.
The GST raises many questions that
need answering. First, would the cascad-
ing effect be eliminated? Second, will
consumers benefit due to lower prices?
Third, will the ratio of indirect tax to
GDP rise? If so, how can prices fall?
Fourth, what would be the impact on the
large unorganised sector in the country
july 18, 2015
whose voice does not figure in the media
and is largely ignored by the political
class, except for paying lip service?
Fifth, the arguments being given in fa-
vour of GST are based on micro logic, but
does a macroeconomic analysis support
these contentions? Sixth, what impact
will the change have on the federal
structure of the country? Finally, would
the size of the black economy decline
due to introduction of GST?
2 Indirect Taxes:
A Macroeconomic Framework
Taxes can be direct or indirect. As the
names suggest, direct taxes fall directly
on incomes. As soon as they are earned,
they are liable to be taxed. The indirect
taxes fall on income through some acti-
vity. For instance, if one purchases a
good, the tax levied on it is paid. If one
does not purchase it, one is not liable to
pay the tax. So, indirect taxes can be
postponed while direct taxes (mostly)
cannot be.
Indirect taxes have been levied on the
act of production (excise duties), sale
(sales tax), transportation (octroi or entry
tax) and import (customs duties). There
have been other taxes, like on entertain-
ment, state cess, additional excise duty,
central sales tax and electricity duty. All
this makes for a complex web of taxes
which create difficulties for businesses
since they have to deal with multiple
agencies, forms and procedures.
Kalecki (1971) showed that indirect
taxes (since they are a prime cost) are
stagflationary, that is, ceteris paribus,
they lead to a rise in prices while output
stagnates (due to the impact on demand).
He also showed that, ceteris paribus,
direct taxes (these are not a prime cost)
have the opposite effectoutput rises
while prices remain unchanged. Thus,
macroeconomic analysis gives results that
are the opposite of what microeconomic
analysis suggests. The reason for this
difference lies in the assumptions made
in the two different theories. Macro-
economic analysis takes into account the
full circular flow of incomes and expen-
ditures while microeconomic analysis
does not do so and truncates the circular
vol l no 29 EPW Economic & Political Weekly

flow at some point. For instance, in the
latter case, the impact of a tax increase
on governments budget and conse-
quently on demand in the economy (due
to changes in the fiscal deficit, etc) is
left out.
Due to these differences in approach,
microeconomic analysis does not distin-
guish between direct and indirect taxes
and it is even argued that direct taxes
(income tax) may be replaced by indirect
taxes (value added tax (VAT)). Macro-
economic analysis suggests that this would
be a retrograde step for the economy.
In addition, indirect taxes tend to be
regressive while theoretically, if the black
economy is eliminated, direct taxes can
be progressive (Kumar 2013a). It is
shown that this is true even if luxuries
are taxed higher than necessities because
the definition of progressivity/regressiv-
ity is with respect to income and not
consumption.
If more of indirect taxes are collected
to raise resources and their share in GDP
rises, prices would rise and stagflationary
conditions would be strengthened. Thus,
if the argument is that GST would lead
to an increase in the indirect tax to GDP
ratio, then, the rate of inflation would
rise. If so, the argument that GST would
lead to a fall in prices and benefit the
consumers is not correct. Similarly, the
argument that the cost of indigenous
goods would fall is also not correct.
The black economy impacts both direct
and indirect taxes. Revenue collection
declines as the share of the black economy
increases and the tax to GDP ratio falls.
In India, as the share of the black econo-
my has risen, dependence on indirect
taxes has increased due to its greater
spread and increase in rates (Kumar
1999) resulting in the negative conse-
quences just spelt out. Would GST lead to
a decline in the black economy because
of better compliance and thereby lower
dependence on indirect taxes?
3 Indirect Taxes: Some Historical
and Definitional Aspects
Indirect taxes can be imposed in different
formsspecific, ad valorem and value
added. To begin with, most indirect taxes
were specific since they are easier to
implement. But they are not buoyant
Economic & Political Weekly EPW july 18, 2015
and, therefore, require periodic changes
in tax rates. Ad valorem taxes are buoyant
so that with inflation and/or a rise in the
value of the goods, the revenue automati-
cally rises, which is not the case with
specific taxes. There may be policy-related
reasons for changing the ad valorem tax
rates but not for lack of buoyancy. That
is why over time there was a shift from
specific to ad valorem taxes. But the
problem is that ad valorem taxes result
in a cascading effect which raises the
effective rate of indirect taxes (GOI 1978;
Kumar 1986; Purohit 1998).
Kumar (1986) showed that there are
two components of the cascading effect,
one, a tax on tax, and the other, a
profit on tax in a markup pricing
system. Thus, both profits and taxes
increase. Further, there are complications
due to multiplicity of indirect taxes. For
example, not only is there a cascading
effect within sales tax or excise duty but
also across taxes from sales tax to excise
duty and vice versa. More the number of
taxes, greater the cascading effect and
harder it is to calculate the impact of
these taxes on prices.
Further, the more basic a commodity,
the greater its cascading effect and impact
on prices of other goods. Essential items
of consumption, like food and clothing
for the poor, were exempt from taxes but
due to the cascading effect, they also
bore the effect of indirect taxes and their
prices were affected. For example, if duty
on diesel rises, the cost of transportation
rises and affects food prices. All this
affects exports since it is literally impos-
sible to calculate the effect of indirect
taxes on export prices and then neutralise
this effect by giving set-offs or subsidies.
This lowers a nations competitive position
vis--vis other nations.
GOI (1978) suggested that a move
to VAT would eliminate the cascading
effect. It should be noted that VAT is just
a way of calculating indirect tax. The
difficulty with the implementation of
this tax is that it is much more compli-
cated than the ad valorem tax. It requires
information on both revenue and costs
while ad valorem tax only requires the
former. The small-scale and unorganised
sector businesses do not keep detailed
data on costs since that adds to their
vol l no 29
PERSPECTIVES
costs. They use a lot of family labour and
own capital which is hard to factor into
costs. Thus, implementation of VAT for
such units is difficult. The unregistered
manufacturing sector in India accounted
for 48% of the manufacturing sector in
1978 and so it was understood that VAT
would be difficult to implement. Even
now, employment in this sector is close to
93.5% of the workforce even though the
output share has come down substan-
tially. Thus GOI (1978) suggested that
India should go for MANVAT (manufac-
turing VAT) which would be applicable
only to the manufacturing sector. But
even this was not feasible since the
manufacturing sector also had a large
unorganised sector. The share of the
unregistered manufacturing was 66%
in 195253 and it has come down to 28%
in 201213.
GOI (1985) suggested the implemen-
tation of MODVAT (modified VAT). Its
implementation was initiated in 1986
from those sectors (of manufacturing)
which purchased largely from within
the large-scale sector. This net was
expanded over the years to include
more and more goods.
The pressure for implementation of VAT
in the country increased after the new
economic policies (NEP) were launched
in 1991. GOI (1992) suggested that this
process be speeded up. The cross-condi-
tionalities of the World Banks structural
adjustment loan for the energy sector
also asked for the implementation of VAT
in the country. Big business, both multi-
national corporations (MNCs) and Indian
companies, saw an advantage in the
implementation of VAT since it would
benefit by the marginalisation of the
small-scale sector (Kumar 1986), which,
till then, benefited from reservation and
exemption from indirect taxes. Further,
due to an increase in scale economies
they would benefit from VAT while the
small-scale sector producing locally and
selling locally would not derive any ben-
efit from VAT. Thus, there was all-round
pressure to implement VAT in India.
Following these recommendations,
more and more commodities under
excise duty were moved to MODVAT and
then to CENVAT (central VAT) (introduced
in 2000). The states also moved the sales
27
PERSPECTIVES
tax to VAT and it was implemented
across the board in 2005. In the mean-
while, to increase the buoyancy of indi-
rect taxes, the centre introduced service
tax in 1994 which then added to the cas-
cading effect. The service tax net was
expanded over time to more and more
services. Thus, services tax showed the
highest buoyancy of all the indirect
taxes and consequently, the cascading
effect increased in spite of the introduc-
tion of CENVAT and VAT.
4 VAT: Cascading Effect, Revenue
Neutral Tax Rate and Prices
As argued above, calculation of the
amount of tax to be paid under VAT
requires knowledge of input costs and
revenue. This requires detailed account
keeping which is difficult for unorganised
and small businesses. The implementa-
tion of VAT calls for computerisation of
accounts which is expensive for small
and micro businesses. That is why these
businesses have been kept out of the
purview of implementation of VAT. Such
businesses were also assumed to be using
older technology and, therefore, they
were not competitive compared to the
large-scale units employing more modern
technology. However, for the same reason
they were also supposedly more labour-
intensive than the bigger units and,
therefore, in need of protection to keep
unemployment from rising. For these
reasons, they were exempt from indirect
taxes to give them a price advantage in
the market.
Unfortunately, in India, these exemp-
tions were often misused by the large-
scale units either by misdeclaration
or by using the small-scale sector to
produce their goods and rebrand them
as their own. For example, the use of
power looms by the large-scale cloth
manufacturers. The small and tiny sector
producing locally and selling locally was
also supposed to provide cheap and low-
quality goods selling at low prices for
the poor. That is another reason why
such units needed support in the form
of tax exemptions. However, as already
argued, indirect taxes have a cascading
effect from one to another good in
the chain of production. Thus, the
prices of commodities like hank yarn,
28
used in the production of cheap cloth
for the poor in the handloom sector,
which bore no excise duty, would in-
crease whenever their transport cost
went up because the road transport
prices went up due to tax increases. The
same is the case with food items that
bear no excise duty.
When one moves from ad valorem tax
to VAT, the base of the tax shrinks from
the value of the good to a portion of it,
the value added. Thus, there is a gap
between the value of output of a product
and the value added in it at that stage of
production. The more subsequent the
stage of production of a good in the pro-
duction chain, the larger the gap. So, at
a given tax rate, there is a higher loss of
revenue due to the shift from ad valor-
em to VAT (Kumar 1986).
If Oi is the value of output at a particular
stage of production on which an ad
valorem tax at the rate ti was applied
and if Vi is the value addition at this
stage of production and the VAT rate is Ti
then, earlier the government collected
Oi.ti as the tax, while now it would
collect Vi.Ti. Since Vi is smaller than Oi,
the tax collection at the old rate ti would
decline. Thus, if the same amount of tax
is to be collected, then the tax rate has
to rise and this is called the revenue
neutral rate (RNR, say, Ti). In other
words, Ti has to be greater than ti.
The RNR Ti can be calculated by equat-
ing the revenue, that is, Oi.ti = Vi.Ti. Ti =
Oi.ti /Vi. Since Oi /Vi > 1, Ti > ti.
The more subsequent the stage of pro-
duction i, the larger is Oi /Vi and, there-
fore, Ti has to be progressively higher
and higher compared to ti for revenue
neutrality. Thus, shifting to a constant
rate T at all stages of production would
not yield revenue neutrality at each
stage of production and it will have im-
plications for inflation (discussed later).
Suppose there was one ad valorem
rate t that was charged. Then Ti > t for
all stages of production and Ti will in-
crease later the stage of production i.
If revenue neutrality is achieved in the
aggregate by shifting from an average
ad valorem rate t to a constant VAT rate
T, then prices will change at all the inter-
mediate levels of production but the
final price will not change. T > Ti for the
july 18, 2015
initial stages of production and T < Ti
for the later stages of production.
Thus, prices will rise for the basic and
intermediate goods used in the initial
stages of production but will not fall
for the final good. This will lead to a
tendency for prices to rise. Further,
Singh (2006) showed that commodity
by commodity as MODVAT was implement-
ed, the buoyancy dropped since the rate
of tax declined and the base contracted.
This is the reason that the states fear
they would lose revenue.
The implication of revenue neutrality
is that even though the cascading effect
is reduced/eliminated, prices will not
fall (Kumar 1986) since neither the tax
collection falls nor does the profit fall,
and other costs remain unchanged.
Exporters will also not benefit for the
same reason. The objective of introduc-
tion of VAT cannot be to eliminate the
cascading effect but keep the prices
unchanged. If the economy is to benefit,
there should be a lowering of prices and
that requires that revenue neutrality be
given up.
Further, as GST covers more goods
and services and subsumes other taxes,
like luxury tax and cess, the RNR has to
be higher. If so, many of the prices will
rise rather than come down. For in-
stance, since services did not pay sales
tax and now they would have to pay the
revenue neutral tax rate calculated with
the inclusion of other taxes, their prices
would rise sharply.
Finally, the impact of VAT on the black
economy is uncertain. Wherever this tax
has been introduced in the world, it has
not led to the elimination of the black
economy. The logic given for why it
would lead to the elimination of the
black economy is that it forces producers
to declare costs and revenue. What is
revenue for the earlier stage of produc-
tion is the cost for the next stage. Thus,
under invoicing and over invoicing
which are used to generate black in-
comes (Kumar 2006) will get curtailed.
While this possibility always existed, it
is argued that this possibility will be
strengthened with computerisation as
the process would become automatic.
However, in India, mis-invoicing is not
just about prices but also quantity and
vol l no 29 EPW Economic & Political Weekly

misspecification of goods. For example,
an unblemished good may be declared
as seconds or scrap.
Further, in India, manipulation of
software and of documents is rampant
and does not pose a problem for ac-
countants and software experts. Fake
bills from small businesses and for over-
heads can be procured to show lower
value added. When PAN was introduced
for income tax and later the filing of
returns was computerised it was hoped
that black income generation would de-
cline but it does not seem to have had
that effect. Further, complexity is used
to generate black incomes and given the
complexity of GST, this process will con-
tinue. Where paper receipts may be
used, fake receipts may be generated.
5 Proposals and Implications
As discussed above, for a full and proper
implementation of VAT, to remove the
cascading effect, the entire chain of
production and distribution has to be
brought into the net of GST. If this is not
done, the cascading effect may be reduced
but will not be eliminated. The final
details of the implementation of GST and
the RNR will be finalised once the GST
council is set in place. One can however,
comment on the proposals as they have
been proposed at present.
The current proposal for GST may
have special provisions for petroleum,
tobacco and alcohol. These yield a lot of
revenue so the states and the centre
want special provisions for them. If this
does occur, the full chain of production
and distribution will not be covered
by GST so that the cascading effect will
continue. Since alcohol and tobacco are
more or less final products or intermediate
products, their cascading effect may be
small. However, the impact of petroleum
products not coming under GST would
be substantial.
Further, GST will replace sales tax
collected by the states and excise duty
and service tax collected by the centre.
Sales tax was collected by the Sales Tax
Department under the states while the
centre collected the other two taxes
under the Central Board of Excise and
Customs (CBEC). In the proposed scheme,
the two existing departments would
Economic & Political Weekly EPW july 18, 2015
continue to collect the GST which is
being split up into two components
the state GST and the central GST called
SGST and CGST, respectively. The set-off
for the tax paid at the previous stage
(called Input Tax CreditITC) will be
given separately within SGST and CGST
but not across from SGST to CGST or vice
versa. Further, there will be another
category of GST on interstate transactions
called integrated GST (IGST). Additional
duties of customs (called countervailing
dutiesCVD) will be a part of CGST but,
in addition, they will be treated as an
interstate transaction and bear the IGST.
Customs duties would be separate from
GST and so would an additional tax on
interstate movement of goods. Since
these will not be VATable, a cascading
effect would occur. Other points to
consider are:
(a) The RNR May Be High: An RNR of
27% with 14% for the centre and 13% for
the states is being discussed. This ap-
pears to be high, especially for services
which at present do not pay an equiva-
lent of a sales tax. What would be the
base of the GST?
Goods and services account for about
86% of the production in the economy.
But from this the exempt category, un-
organised sector and exports need to be
removed to calculate the base of GST.
However, imports need to be added. The
indirect tax collection at present is about
11% of GDP. Out of this customs duty need
to be removed, so for RNR, GST should
collect about 10% of GDP on a base of
around 50% of GDP or approximately a
20% RNR.
(b) SGST on Services: Prices of services
will rise since earlier they only bore the
service tax but now they will have to also
pay the SGST. Thus, the net for the states
would widen from goods to services also
so they should collect more taxes. How-
ever, this would be inflationary. Further,
since it is easier to mis-invoice services,
like that of a chartered accountant or a
doctor, higher taxes could lead to more
black income generation in such services.
(c) Differential Impact on Basics and
Final Goods: The RNR is an average
vol l no 29
PERSPECTIVES
rate, which, as discussed above, will imply
a higher tax rate than at present on the
initial stages of production and a lower
rate at later stages of production. Thus,
prices of basic and intermediate goods
will rise. However, prices of final goods
would remain unchanged since the total
tax collected at all the stages of produc-
tion put together would be unchanged.
This is likely to add to the inflationary
pressure in the economy because of the
greater impact of the rise in the prices of
basic and intermediate goods.
(d) Differential Impact on Producing
and Consuming States: In moving from
a source to a destination based tax, there
will be a differential impact of introduc-
tion of GST on the consuming and pro-
ducing states. Till now the sales tax was
collected by the state producing the
good but under GST it would be collected
by the state where consumption takes
place. This would be valid for interstate
movement of goods and is currently
covered under the central sales tax
which is to be eliminated. Thus, those
states which are the dominant producers
in the country would tend to lose reve-
nue. This is the fear of a state like Tamil
Nadu. This loss is proposed to be made
up using the collections from IGST.
(e) The Macroeconomic Conundrum:
To convince the states to accept GST, the
centre has argued that they would not
lose revenue. It has offered to compen-
sate them in case of a shortfall in their
revenue. But if the revenue shortfall
occurs it would be the case for both the
centre and the states since the base
would be common. So, the revenue of
the centre would fall even more if it
compensates the states and this would
lead to a higher revenue deficit and a
higher fiscal deficit in its budget.
In the present international climate, a
higher fiscal deficit is frowned upon by
the international agencies like, the cred-
it rating agencies and the International
Monetary Fund (IMF). The Indian govern-
ment has been bending over backwards
to keep the fiscal deficit under check by
cutting back on plan and capital expen-
ditures (Kumar 2013b). This is one of the
reasons that the rate of growth of the
29
PERSPECTIVES
economy has fallen since 2011. If the def-
icit increases due to the introduction of
GST, in the present circumstances, the
problem of pushing growth would in-
crease. The growth rate of the economy
could fall rather than increase as the
proponents of GST suggest.
If the revenue deficit is not to increase,
more revenue would have to be collected.
Since this cannot be done using indirect
taxes unless the rates are increased,
which, as pointed out earlier, is stagfla-
tionary, it would have to be collected
from direct taxes. Thus, the reform of
direct taxes is crucial. This could be
based on curbing the black economy.
However, this exercise cannot be a part
of the GST proposals and has to be
carried out separately.
The idea that GST will lead to more
investment and higher GDP is doubtful.
If demand stagnates, certainly more in-
vestment will not occur. At the macro
level, if GST raises the taxGDP ratio
and, therefore, prices go up, demand
will stagnate and investments will be
adversely affected.
(f) Impact on the Federal Structure:
Another important issue is of federalism
and the resource base of local bodies.
If the states lose revenue then the local
bodies will face a deeper revenue crunch.
At present, most local bodies are depend-
ent on transfers from state governments.
In the past, whenever the states have
faced a shortage of resources, transfers to
the local bodies have suffered cuts and
this impacts the availability of essential
services to citizens. In fact, most urban
areas present a picture of breakdown and
rural areas lack basic infrastructure.
The rates of taxes would be harmo-
nised across states. Given Indias federal
character, sales tax rates were fixed by
the states so that there was a variation
across states. No doubt this led to cer-
tain problems. People bought goods in
the states with lower tax rates (as in the
case of cars). The reason for the differ-
ences in rates was that different states
had different revenue needs and differ-
ent priorities. This is but natural given
the diversity of the nation. Under GST,
the rates of tax will be harmonised to
one common rate for all states. This
30
undermines the principle of federalism.
However, the rates will be determined
by a council with representation of all
states and the centre so that partly the
needs of federalism would be fulfilled.
6 Conclusions
The details of the implementation of
GST, like the tax rates and procedures,
will be worked out by the Inter-State
Council to be set up. Till then final com-
ments cannot be made on these issues.
However, the theoretical issues are clear
and this article has dealt with them.
The argument that GST will lead to a
seamless market is a hard sell. Interstate
movement of goods has been on the rise.
It is true that, at present, producers face
a myriad of taxes and this will be simpli-
fied by the introduction of GST. It is
argued here that the benefit will go to
the large-scale producers while the
small-scale ones will be at a greater dis-
advantage. Thus, the net effect of intro-
duction of GST on the economy needs to
be worked out and only the advantage to
the large-scale sector should not be the
basis of the argument.
It is argued that given the structure of
GST being adopted, the cascading effect
will be reduced but not eliminated. Fur-
ther with revenue neutrality, prices and
costs will not decline.
India has been moving from a simpler
ad valorem tax to a VAT with all its com-
plexity since 1986. Given the countrys
weak governance and the ingenuity of
Indias businessmen in circumventing
rules, it remains to be seen how effective
the much more complex switch to GST
will be. The RNR is going to be difficult
to calculate and will be controversial
given the variety of taxes being replaced.
Exemptions and exceptions proposed add
to the complexity. This may be the reason
why introduction of GST may not be able
to make a dent on the black economy.
Further, a fixed RNR for all stages of
production and distribution will lead to
a rise in prices of basics and intermedi-
ates and services so that the introduc-
tion of GST could be inflationary unless
the problem is specifically addressed.
The article points to an essential contra-
diction in the governments argument. If
the claim that the taxGDP ratio will rise
july 18, 2015
is correct, prices will go up and demand
will stagnate so that the growth rate
will not rise. If the taxGDP ratio falls
because the government implements
lower than RNR, then the assurance to
states that they would not lose revenue
cannot be fulfilled. If the central govern-
ment compensates the states for revenue
loss and if its revenue deficit is not to
rise, it would have to increase collection
of direct taxes. This would lead to a shift
from indirect to direct taxes, which is
welcome, but would need wider reform
for any meaningful change. In brief,
introduction of GST maybe the biggest
reform of taxation but it is wholly inade-
quate and the proposal as it stands has
led to confusion regarding many of the
issues of theory and practice.
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Kalecki, M (1971): Selected Essays on Dynamics of
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Kumar, A (1986): 1986-87 Budget: Signs of Growth
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