Though the Goods and Services Tax (GST) is pretty much out of the window as far as this session of Parliament is concerned—and perhaps even later ones with the Congress party determined to block all reforms—as chief economic advisor Arvind Subramanian’s report points out, getting it through is critical for Make-in-India. Not just because, once there is a functional GST, you won’t need to have border check-posts across the country, but because the current system of taxation actively works against manufacturing in the country. And those who believe that tax exemptions can fix this are wrong since, as Subramanian committee’s report brings out so well, this only makes things worse (see table).

Much of the discussion around GST, including that by the Congress party, has centred around the so-called Revenue-Neutral-Rate (RNR), and lots of opprobrium has been poured on the National Institute of Public Finance and Policy (NIPFP) study that, reportedly, suggested a 27% RNR. That, of course, was seriously bad reporting since NIPFP never suggested this as the RNR—it suggested an 18% RNR, or thereabouts, but since India plans to have 2-3 rates, one of the rates it suggested was 27%. In fact, NIPFP’s revised RNR of 17.7% is not too different from Subramanian’s 15-15.5%—and this 15% rate, in turn, breaks up into a 12% lower rate, a 17% standard rate and a 40% higher rate. If you alter the lower rate or the top one, the standard one will also change.

Eventually, it all boils down to the assumptions you make, and how many sectors are exempted from the taxation. If you leave out petroleum, tobacco and alcohol, taxes across the country added up to R6.97 lakh crore in FY14, which means an RNR of 6.1% if you assume that all sectors of the economy are under the tax net, and pay their taxes in full.

But life is not that simple. If you remove health, education, financial intermediation and government services from taxable services, the potential tax base gets reduced to 59% of GDP and, if you add basic (unprocessed) foods to this, the number gets reduced to 55%. In which case, the RNR automatically rises to 11.1%, regardless of whether it was NIPFP that calculated the RNR or the IMF or Arvind Subramanian.A table in the report (Table 6) brings this out clearly—the IMF approach which uses GDP data, gets to a tax base of R59.9 lakh crore, and this yields an RNR of 11.6%. The NIPFP approach, based on indirect tax collections, yielded a much lower tax base of R39.4 lakh crore and therefore a higher RNR of 17.7%—Subramanian’s tax base of R44.2-46.2 lakh crore is lower than that of the 13th Finance Commission, and that is why his RNR of 15-15.5% is higher.

But why not use the right tax base, is the obvious question. The problem here is that there is no clarity of what goods are going to be exempt and, in any case, Indian data being what it is, it is difficult to reconcile most sets of data. The last Pay Commission, for instance, found there were 35,000 civilian defence employees based on the budget papers for FY14, 3.8 lakh according to the Directorate General of Employment and Training, and 4 lakh according to the Pay Commission itself. In any case, the RNR is not really the issue since, as more sectors come under its ambit, it will fall … indeed, if the lower rate is not too low and commodities like gold —bought by the better off—are taxed at slightly higher than the very low rate right now, overall rates will come down. It is only a matter of time.

What really matters, however, is the large exemptions that both the Centre and the states give today—these add up to around 2.7% of GDP—and the impact of the current system of taxation. The 2% central sales tax levied today, for instance, Subramanian points out, means a good faces an additional tax of 4% if, after an intermediate being produced in Maharashtra, it goes to Andhra Pradesh for conversion into a final good which, in turn, is sold in Tamil Nadu—for goods consumed in Chennai, it will be cheaper to import from South East Asia. This distortion, Subramanian estimates, affects at least half the trade flows between states —for the rest, branch transfers are a help, but the tax savings through this have to be offset by the increased costs of warehousing and logistics. This, of course, is the reason why the 1% tax proposed by the BJP-ruled states as part of the GST regime was a bad idea.

Another set of issues that need to be dealt with immediately are those arising from the special additional duties (SAD) and countervailing duties (CVD) on imports. Both duties, on the face of things, are levied to offset the imposition of excise duty on domestic goods. But, according to the Subramanian report, “CVD/SAD exemptions act perversely to favour foreign production over domestically produced goods; that is, they provide negative protection for Indian manufacturing”. While the details can be seen from the table, the short point is that when even local manufactured goods are given an excise exemption—naturally, there will be no CVD either—imports are a cheaper option.This is something not appreciated by most, but is an important issue that policymakers need to keep in mind.

When, for instance, the real estate sector is exempted from taxes, there is an effective tax on it since the taxes paid on the inputs —such as steel and cement—are also not rebated; while the average tax rate on cereals is 2.3%, the committee points out, the effective tax rate is 4.8%. That, and not just the losses to the exchequer, is the reason for doing away with all exemptions—instead of helping Make-in-India, they militate against it.