Notes on the GST roll-out

Two articles about India's impending Goods and Services Tax (GST) caught my attention.

1. Livemint explores the potential impact of GST on the country's massive informal sector. It points to the likely shift in activity from the informal to formal firms in sectors with high share of informality. 

It alludes to possible adverse impact on informal livelihoods, even as they are recovering from the effects of demonetisation. It writes, 

Many of the firms operating in this part of the economy make profits largely due to tax evasion and non-compliance with regulatory norms, which allows them to offer products at comparatively lower prices. However, in the GST-era, it will be a struggle for survival for such firms because they will be faced with taxes, lower margins and a sharp spike in the cost of compliance. Some firms in the unorganized sector may go under, while others could find their profits curtailed. To be sure, in some instances the two sets of companies cater to different customers, but there is always some overlap. And it is not just the manufacturers in the informal economy who will suffer but also the smaller dealers and wholesalers... The move to the new tax regime has the potential to cause immense disruption to the shadow economy that is the source of livelihood for many, although it is nobody’s case that firms that survive by flouting regulations and evade taxes continue to do so.

This theory of change of informality shrinking in any significant manner in response to GST goes contrary to historically observed trajectories of informality across countries. I have blogged on several occasions, in the context of the demonetisation, about the futility of trying to shrink the informal economy. See this, this, this, and this. 

Andrei Shleifer and Rafael La Porta have the most authoritative work on this,

Informality declines, although very slowly, with development. This is not to say that we oppose the structural policies such as simplification of registration or equalizing labor tax burdens across formal and informal sectors... These policies surely have desirable effects, but our reading of the evidence is that it is modernization, rather than structural policies, that shrinks informality... although avoidance of taxes and regulations is an important reason for informality, informal firms are too unproductive to thrive in the formal sector. Lowering registration costs neither brings many informal firms into the formal sector, nor unleashes economic growth... the informal economy is largely disconnected from the formal economy. Informal firms rarely transition to formality, and continue their existence, often for decades, without much growth or improvement... as countries grow and develop, the informal economy eventually shrinks and disappears. The formal economy comes to dominate economic life.

In simple terms, the policy focus should be on growing the formal sector than shrinking or nudging the informal sector. 

2. The GST will have a five-member National Anti-Profiteering Authority (NAPA) to look into cases of profiteering by firms not passing lower taxes to consumers, including power to deregister violating firms. Firstpost has a nice article which writes, 

Many other countries had... just one rate of GST across all goods and services. This naturally makes it easier to calculate the cost of inputs and taxes on them, set-offs, etc. Instead, what do we have in India? Multiple slabs with even the same product sometimes falling in different slabs. Not all the inputs going into a television set will be taxed at a same rate, the manufacturer will have to deal with multiple rates. The only person who will have a field day is the tax official and the worthies on the NAPA. Even in Malaysia, the anti-profiteering mechanism didn’t work too well and led to a large number of disputes and enormous litigation. Later the rules were eased and given up altogether after a year. The government then limited itself to appealing to businesses not to increase prices.

The point about easing regulations in response to emergent situations is instructive. It resonates with the adoption of minimum viable product approach in such complex roll-outs. Starting out with strict regulation is a strong signal of intent and can be valuable in shaping expectations and disciplining potential errant behaviours. The challenge though will be the ability to respond swiftly to the emerging scenarios. 

Unfortunately, it is here that Indian bureaucracy's decision paralysis is likely to hurt. Easing regulations will most certainly invite populist backlash with critics presenting it as favouring those profiteering. No logical analysis of the costs and benefits can take place in likely high-pitch media-mediated debates on such issues. Therefore, when faced with the choice of what is the right thing to do and the most politically correct thing to do, governments are most likely to incline to the latter. This deprives the government off one of the important levers to manage complex initiatives like  the GST.