Friday, 14 November 2014

Understanding Revenue Neutral Taxation

You might have heard that, GST Rates will be decided on the principle of Revenue neutrality.
Today, we are going to understand what exactly is 

The true definition of revenue neutrality if you ask, it will be:
  • A condition of fiscal policy making in which any increase or decrease in tax revenues be achieved with a commensurate increase or decrease in tax revenues.For example, a proposal to decrease taxes for one economic group must include a mechanism to increase tax revenues from another source in order to offset the revenue decrease.
  • Taxing procedure that allows the government to still receive the same amount of money despite changes in tax laws. The government may lower taxes for one particular group of people, but raise taxes for another group. This allows the revenue that they receive to remain unchanged (neutral).

In Our case, GST sense, it will be imposing some taxation and to remove few other taxation in a way that, there is no loss of revenue to government. The purpose if to simplify the taxation structure at the same time take care that, there is no loss of revenue to government as GST will be a major overhaul in the Indirect taxation in India.
Let's take an example, Govt collects 10Rs from Excise on 100Rs manufactured, 12Rs from Service Tax on 100Rs Services provided, 15 from Sales Tax on 100Rs of Sales. So, total amount collected is 37 (10+12+15) on 300 Rs of activity. If we were asked to calculate a revenue neutral rate for a new taxation which replaces these 3 taxation, we will calculate it to 12.33% (37/300). This way even if the govt looses revenue from abolishing the 3 taxes, it would earn exactly the same from new tax. This is revenue neutral taxation, or call it a revenue neutral tax rate.

National Institute of Public Finance and Policy (NIPFP) is tasked with recommending a revenue neutral tax rate for the goods and services tax. The NIPFP website lists the below description for work they do.
Tax Policy and tax administration has been among the core areas of interest in the Institute. The Institute was and continues to be at the forefront of research on tax policies in India. The Chelliah Committee Report, which formed the basis for economic reform initiatives in the early nineties, was supported by work at the Institute. The debate on introduction and design of State-level Value Added Tax in India was anchored around a study by the Institute on Reform of Domestic Trade Taxes in India. One of the first systematic studies on Unaccounted Incomes in India was undertaken at the Institute in 1982. The team at the Institute has been consistently providing policy inputs through research papers on issues relating to tax policy reforms in India.  In recent times, the focus areas of research have been understanding unaccounted incomes in India, issues in the design of GST for India, evaluation of major tax incentives and analysis of state specific tax regimes for identifying mechanisms for augmenting revenues.

Now let's discuss some technicality. Below is a publication by NIPFP discussing
Revenue Implications of GST and Estimation of Revenue Neutral Rate: A State Wise Analysis
Publication date - Jan, 2013
Report submitted to the Empowered Committee of State Finance Ministers
R. Kavita Rao, Pinaki Chakraborty,
The study was undertaken at the request of the Empowered Committee of State Finance Ministers to assess the state specific GST tax base and corresponding revenue neutral rates. As a part of this study, state wise possible revenue loss/gain in the event of introduction of GST was also done.

Full details can be found here

A few summarized para from this publication.

An exercise of this nature requires an estimation of correct base for GST which in any form of taxation is the key for the measurement of tax potential. Theoretically, the applicable base of GST depends on a number of factors related to its design, e.g., whether it is origin or destination based, of the income or consumption type, implemented with a credit invoice or subtraction method and contains many or few exemptions. As discussed, the proposed GST will be destination based, consumption type system implemented with a credit invoice method, like the present VAT.

The starting point for the estimation of base is the gross domestic product of an economy, in the case of states, the gross state domestic product, since it represents the sum total of the value added in the production of goods and services within a state economy. However, for a destination based consumption type GST, the legitimate question that arises is whether final consumption expenditure, which represents the sum total of value added of domestic consumption is not a more direct starting point in estimating the base. Though at the outset it appears to be correct, in practice, it depends to a large extent on the scope and the nature of exemptions under consideration. For a destination based consumption type of GST levied comprehensively with no exemptions, the base is simply the final consumption on goods and services, which may not be possible in the real life situation. Like in the case of goods, even in the proposed GST regime, there are many services that would be exempted from the service taxation.
Generally, there are three alternative methods of estimating base of GST, viz., GDP adjusted for exports and imports, the consumption expenditure and the taxable turnover of goods and services. GDP adjusted for external sector transactions would represent the total expenditure on private consumption, government consumption, fixed capital formation and changes in business inventories. The estimated GDP adjusted for the value of services of exempted sector, government wages, fixed capital formation and net consumption abroad would precisely define the GST base. Although GDP data is available from the national account statistics, it is very difficult to get disaggregated data on exempted sectors and on value of goods and services to be excluded from GST base. Use of GDP, thus as GST base becomes problematic even at the national level GST calculation. It becomes even more difficult in the case of states as there is no reliable data available on exports and imports from and to the states apart from the items to be excluded from the estimation of GST base within the exempted sector from the state GSDP. In many states it has been argued that a substantial portion of the IT services are exported out of the state and this is not available for taxation. However, we do not have reliable data on state level IT export.

Another alternative, which can be used as the base of GST, is consumption expenditure on goods and services. The consumption expenditure data is available at the state level as well as at all India level. The state specific consumption expenditure data can be used as a proxy for GST base. The aggregate private consumption expenditure data for the country as a whole is provided by the National Accounts Statistics (NAS). State wise consumption expenditure data is also available from national sample survey on 5 yearly bases. This method of estimating GST base is called consumption expenditure approach. However, the consumption expenditure method is not free from limitations, primarily due to the non-availability of data on exempted commodity consumption and exemption of dealers with turnover below the taxable limit. Given these limitations, it is difficult to estimate the GST revenues of individual states through consumption expenditure approach.
Another limitation of the National Sample Survey consumption expenditure data is that it suffers from the problem of underestimation of consumption expenditure for both goods and services when compared with the private final consumption expenditure provided in the national accounts statistics. In fact, as per the 61st round (2004-05) consumption expenditure survey, the total private final consumption expenditure was Rs. 931415 crore, and as per the National Accounts Statistics, the same was Rs. 1873729 crore. In other words, NSS estimates of private final consumption expenditure was 49.7 percent lower than the NAS estimates. Given this gross underestimation of base by the NSS consumption expenditure survey, we have not used it. Also the listing of goods and services in the NSS schedule is quite different from the actual taxable base of goods and services. Also as the consumption expenditure data reflects household consumption, relying on it for the purpose of tax base would be erroneous. There exist issues of concordance between the two estimates of consumption based on their methodologies. While NSS is a household survey and their estimates of private consumptions are based on only household information and does not include consumptions of the private non-profit organisations serving the households, NAS on the other hand is derived from a commodity flow approach.

It is possible to estimate GST revenues through "tax turnover" method. Advantage of tax turnover method is that it is based on the data of taxable turnover of goods available with the respective sales tax department of states on goods. As under GST, like in VAT, tax paid on input by a VAT registered dealer would have to be rebated, one has to estimate the inputs eligible for input tax rebate from the tax turnover data. It is also to be noted that inputs eligible for credit will be the taxable inputs alone. Thus, one has to determine not only the input component from the taxable turnover, but also the structure of input used, viz., taxable input and non-taxable/exempted inputs. Another issue that requires attention is the quantification of locally produced inputs and the use of imported inputs within the taxable inputs as they are treated differently in current VAT regime.
In case of goods, as it is well known, taxable goods produced within a state is sold via (i) local sales, (ii) taxable inter-state sales, (iii) consignment/branch transfers and (iv) international exports. We have not been able to obtain the VAT data available with individual sales tax department on turnover in a short span of time and also there are major data issues on taxation of goods specific turnover in many states. Thus, we have used the alternative approach to arrive at turnover of goods. We have used weighted average tax rates for the estimation of taxable turnover from the data on tax collected under VAT excluding those which would not form part of the GST, viz., liquor, diesel, petrol and ATF.

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