India’s system of indirect taxation is notoriously fragmented. Since independence, the sales tax has grown to become the most important source of State financing, in part because it is the only major source of tax revenue constitutionally controlled by the States. At the same time, systems in different States have diverged to a great extent in scope, complexity, and rates. Most states have a large number of rates charged on different commodities, often depending on the type of manufacturer and identity of the buyer. Neighboring states will often have dramatically different tax systems. Trade between the states is regulated by the Centre under an entirely separate set of rules. We examine this complexity and provide some cross‐country comparisons in our first memo, Commodity Taxation in Bihar, 1994‐2012.
The current system has two major drawbacks. The first is its very complexity: it is costly for firms to understand the tax code well enough to be compliant, and for governments to administer it. More importantly, the current system encourages inefficient production in a number of ways. Firms restructure their supply chains to avoid taxes, often in ways that they wouldn’t otherwise do. Because the sales tax is sometimes charged twice on a given input at different stages in the production process, shorter, within‐firm production processes are encouraged. For these reasons, the Government of India has been moving towards a value added tax, known as the GST, for over a decade. In 2005, States started adopting a tax system known as the VAT, which significantly simplified the sales tax system and has some characteristics of a true VAT.
Our second memo, Distribution of the Commodity Tax Burden in Bihar, 1994‐ 2010, examines the shift from sales tax to VAT, and finds that the VAT reform of 2005 lowered rates, simplified the tax code, and brought rates closer to the national average. The code also became somewhat more progressive; the top decile now pays 30% more than the average taxpayer, rather than 8% more. Finally, in Rates, Redistribution and the GST, we consider different scenarios for the switch to GST. Across all plausible scenarios, the GST reform flattens the tax code. This is largely by design — the GST has a smaller number of tax rates, and taxes more commodities at the normal, middle rate of 20%. Those exemptions that do remain tend to be used equally by the rich and poor.