Production responses and tax evasion with limited state capacity

Policy brief 11 Oct 2019 State

Authors

In India, indirect taxes represent 85% of state tax revenue. Historically, its highly decentralised system of commodity taxation has led to production inefficiencies.
Our research is on the effect of India switching from a sales tax to a value added tax (VAT) in the 2000s. We focus on two margins of response: Output and tax evasion near registration thresholds.
We reflect on the implementation challenges of the reform in light of India’s limited state capacity and recommend future adjustments.
The reform occurred gradually: Like the previous and highly criticised tax system, the VAT reform maintained its product and state-specific tax rates.
The switch to VAT reduced tax cascading, lowered tax rates, and created enforcement opportunities and challenges for the government.
The reform saw little evidence of bunching, except at the very largest tax thresholds. Large production efficiency gains were made in the manufacturing sector.
Recent reforms saw the transition to a centralised goods and services tax (GST), but some features of the prior decentralised regime remain: The existing system remains more complex that other countries, has higher tax rates on some goods, and requires substantial compliance costs.
Addressing these concerns is subject to the same political concerns that plagued prior reforms.
The government needs to work toward standardising the system across states and products, while being mindful that persistent reforms increase compliance costs.