Wednesday, August 24, 2016

GST and Tax Competition

In the last post on GST, Adithya Reddy highlighted some speeches by members of the Constituent Assembly. Two of those are germane to our present discussion. One is by Mr. Mahavir Tyagi: “Because there is no ceiling limit on this sales tax, they can go on raising the tax …My point is that if we do not fix a limit, the provincial Governments would go on taxing”. The other is by Mr. Ramaswamy Mudaliar, who said: “as far as possible, it (sales tax) should be uniform… in all the provinces. You will be killing the goose if you go on increasing the sales tax”.
These statements are puzzling. If certain taxes are left to the states, one would expect taxes to be driven down, due to constant competition among the different states to attract investment. One explanation would be the closed nature of the economy at the time – states did not have to strongly compete with lower taxes to attract private firms.
Under the proposed GST regime, the indirect tax rate(s) will be set by one central authority, the GST Council comprising of the finance ministers of the Union and the States. The GST Council does have any internal competitive pressures to anchor the tax rate. As this piece by Prashant Perumal argues, this centralisation is (theoretically) likely to lead to higher tax rates.
Whether tax competition is ‘good’ or not, is a subject of debate amongst economists and policymakers. Tax competition leads to a race towards the bottom, with governments forced to cut taxes for wealthy investors (especially corporate taxes) whilst compromising on subsidies and redistribution (Vivek Dehejia’s piece presents a brief overview of this debate). This has led to calls for cooperation among governments to limit the harmful effects of such competition. For instance, member states of the EU (a monetary union with each member state having independent fiscal policy) have agreed to a ‘Code of Conduct’ for business taxation. The agreement acknowledges both the positive and negative effects of tax competition, and aims to restrict the latter through cooperation and collaboration.
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