GS Notes

6. Economics Notes 17

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Elaborate Notes

Integrated Goods and Services Tax (IGST)

  • Constitutional Basis: The Integrated Goods and Services Tax (IGST) is governed by Article 269A of the Indian Constitution, which was introduced by the 101st Constitutional Amendment Act, 2016. This article specifically deals with the levy and collection of Goods and Services Tax in the course of inter-state trade or commerce.
  • Mechanism: IGST is levied by the Central Government on all inter-state supplies of goods and services. It is designed to ensure a seamless flow of input tax credit across state borders. In essence, it is not a separate tax but a mechanism to coordinate the State GST (SGST) and Central GST (CGST) systems. The tax is levied at the destination state, upholding the ‘destination principle’ of GST.
  • Apportionment of Proceeds: A crucial feature of IGST, as stipulated in Article 269A, is that the collected proceeds are not deposited into the Consolidated Fund of India in the first instance. They are held in a separate IGST account. The GST Council, a constitutional body established under Article 279A, recommends the principles for the apportionment of the IGST revenue between the Union and the States. After the ‘destination’ state is identified and the input credits are settled, the appropriate share is transferred to the respective state’s and the Centre’s accounts. This mechanism prevents the funds from being locked up in the Consolidated Fund, which would require parliamentary appropriation for every settlement.

Cess and Surcharge

  • Constitutional Framework: Article 270 of the Constitution outlines the ‘divisible pool’ of taxes, which are taxes levied and collected by the Union but shared with the States as per the recommendations of the Finance Commission. However, the article explicitly excludes cess and surcharge from this pool. This means the revenue collected from any cess or surcharge belongs exclusively to the Central Government. Article 271 specifically empowers the Parliament to levy a surcharge on any tax mentioned in Article 269 and 270 for the purposes of the Union.

  • Cess:

    • Definition and Purpose: A cess is a tax levied for a specific, pre-defined purpose. The revenue generated from a cess is earmarked for that particular purpose and, in principle, cannot be used for any other expenditure. This concept is rooted in the idea of targeted funding for national priorities.
    • Historical Examples:
      • Education Cess & Secondary and Higher Education Cess: Levied on direct taxes to fund Sarva Shiksha Abhiyan and Mid-Day Meal schemes. These were subsumed into a new Health and Education Cess of 4% in the Union Budget 2018.
      • Swachh Bharat Cess (2015): A 0.5% cess on all taxable services to fund the Swachh Bharat Abhiyan. It was later subsumed into GST.
      • Krishi Kalyan Cess (2016): A 0.5% cess on taxable services to finance initiatives for the improvement of agriculture. It was also subsumed into GST.
    • Administration: The proceeds are supposed to be transferred to a dedicated non-lapsable fund in the Public Account of India. However, reports by the Comptroller and Auditor General (CAG) have frequently pointed out issues such as non-transfer or short-transfer of cess proceeds to the designated funds, and their subsequent underutilization.

  • Surcharge:

    • Definition and Purpose: A surcharge is defined as a ‘tax on tax’. It is levied as a percentage of the existing tax liability. The primary rationale for levying a surcharge, especially on income tax, is to ensure a higher tax contribution from high-income individuals and highly profitable corporations, thereby addressing income inequality and furthering the principle of progressive taxation.
    • Application: In India, a surcharge is levied on individuals with an annual income exceeding ₹50 lakh. The rates are tiered, increasing for higher income brackets. It is also levied on domestic and foreign companies based on their profit levels.
    • Distinction from Cess: Unlike a cess, the revenue from a surcharge is not earmarked for a specific purpose and can be used by the Central Government for any of its general expenditures.

  • Key Differences Summarised:

    FeatureCessSurcharge
    Constitutional BasisExcluded from divisible pool under Art. 270.Specifically mentioned in Art. 271; excluded from divisible pool under Art. 270.
    PurposeLevied for a specific, pre-defined purpose (e.g., education, health).No specific purpose; augments general revenue of the Union. Often used for fiscal consolidation.
    Sharing with StatesNot shared with states.Not shared with states.
    Calculation BaseLevied on tax liability, often including surcharge. E.g., Health & Education Cess is on (Income Tax + Surcharge).Levied directly on the tax liability before cess is applied.

Concepts Related to Taxation

  • Cascading Effect:

    • Definition: This refers to the phenomenon of ‘tax on tax’ within a production and distribution chain. It occurs when a tax is levied on a good at a stage of production, and the tax paid becomes part of the cost of the good for the next stage. The subsequent stage then levies its tax on the new, higher cost base (which includes the earlier tax).
    • Example: A manufacturer makes a good for ₹100 and pays a 10% excise duty (₹10). The cost for the wholesaler is now ₹110. The wholesaler adds a 10% profit (₹11), making the price ₹121. If a 10% sales tax is now applied, it is on ₹121, not the original ₹100. This inflates the final price for the consumer.
    • Historical Context: This was a major flaw in the pre-GST indirect tax system in India, which included Central Excise Duty, Service Tax, and State Sales Tax/VAT without full cross-sectoral credit. The introduction of MANVAT (1986) and later CENVAT (2000) were early attempts to mitigate this, but GST was the comprehensive solution.

  • Tax Evasion vs. Tax Avoidance:

    • Tax Evasion: This is the illegal and deliberate non-payment or under-payment of taxes. It involves fraudulent activities like concealing income, inflating expenses, or maintaining false accounts. It is a criminal offense punishable by penalties and imprisonment under laws like the Income Tax Act, 1961.
    • Tax Avoidance: This involves legally arranging one’s financial affairs to minimize tax liability by taking advantage of loopholes and ambiguities in the tax laws. It operates within the letter of the law but against its spirit.
      • Example (Vodafone Case): In 2007, Vodafone acquired Hutchison Essar’s Indian operations. The transaction was structured offshore: a Netherlands-based Vodafone company bought a Cayman Islands-based company that controlled the Indian assets. Vodafone argued that no tax was due in India as the transaction occurred between two foreign entities. The Supreme Court of India ruled in Vodafone’s favour in 2012. The Indian government responded by retrospectively amending the Income Tax Act to tax such indirect transfers. This led to a long legal battle, which India eventually lost in international arbitration in 2020. This case highlights the fine line between tax planning and aggressive tax avoidance.
      • Government Response: To counter sophisticated tax avoidance, India introduced the General Anti-Avoidance Rules (GAAR), which came into effect from April 1, 2017. GAAR empowers tax authorities to deny tax benefits on transactions that are deemed to have been entered into with the sole purpose of avoiding tax.

  • Transfer Pricing:

    • Definition: Transfer pricing refers to the setting of prices for goods and services sold between related legal entities within an enterprise. For instance, if a subsidiary company sells goods to a parent company, the cost of those goods is the transfer price.
    • Mechanism of Abuse: Multinational Corporations (MNCs) can manipulate transfer prices to shift profits from high-tax jurisdictions to low-tax jurisdictions (tax havens). For example, a subsidiary in India (high-tax) might sell its product at an artificially low price to an associated enterprise in Ireland (low-tax), thereby booking minimal profit in India and maximizing it in Ireland.
    • Regulatory Principle: Tax authorities globally, including in India, mandate that all intra-group transactions must adhere to the Arm’s Length Principle (ALP). This principle, endorsed by the Organisation for Economic Co-operation and Development (OECD), requires that the price should be the same as it would have been if the parties were unrelated and acting independently.

  • Base Erosion and Profit Shifting (BEPS):

    • Definition: BEPS is a broader term that encompasses various tax planning strategies, including transfer mispricing, used by MNCs to exploit gaps and mismatches in tax rules. The aim is to make profits ‘disappear’ for tax purposes or to shift them to locations where there is little or no real economic activity but the taxes are low, resulting in little or no overall corporate tax being paid.
    • International Response: The OECD/G20 BEPS Project was initiated in 2013 to address this challenge. It has delivered 15 “Actions” to equip governments with domestic and international instruments to tackle BEPS. Key outcomes include country-by-country reporting, limiting interest deductions, and preventing treaty abuse. A more recent development is the Two-Pillar Solution, which includes a global minimum corporate tax rate to ensure large MNCs pay a minimum level of tax regardless of where they are headquartered or operate.

  • Tax Buoyancy and Tax Elasticity:

    • Tax Buoyancy: This measures the total responsiveness of tax revenue to changes in Gross Domestic Product (GDP). It is calculated as the ratio of the percentage change in tax revenues to the percentage change in GDP.
      • Formula: Tax Buoyancy = (% Change in Tax Revenue) / (% Change in GDP)
      • Interpretation: A tax buoyancy greater than 1 is considered healthy, as it indicates that tax revenues are growing at a faster rate than the national income. This growth includes both automatic increases (due to economic growth) and the effects of discretionary changes (e.g., changes in tax rates, expansion of the tax base).
    • Tax Elasticity: This measures the inherent responsiveness of tax revenue to changes in GDP, after removing the effects of discretionary tax policy changes. It reflects the efficiency and structure of the tax system itself.
      • Formula: Tax Elasticity = (% Change in Adjusted Tax Revenue) / (% Change in GDP)
      • Interpretation: It isolates the “automatic” response of tax collection to economic growth. A high tax elasticity implies that the tax system is well-structured to capture revenue from economic growth without frequent rate hikes.
    • Example Distinction: If GDP grows by 10% and tax revenue grows by 20%, the tax buoyancy is 2.0. However, if 10% of that revenue growth was due to a new tax being introduced (a discretionary change) and only 10% was due to the automatic increase from the growing economy, then the tax elasticity would be (10% / 10%) = 1.0.

Methodology of Taxing

  • Based on Equity: The principle of equity in taxation, as articulated by economist Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations (1776), suggests that citizens should contribute to the state in proportion to their respective abilities.

    • Progressive Tax: The tax rate increases as the taxable amount (the base) increases. This system places a greater burden on those who have a higher ability to pay. India’s personal income tax system is a prime example, with its slab rates increasing from 0% to 30% as income rises. This is considered a key tool for reducing income inequality.
    • Proportional Tax: The tax rate remains constant, regardless of the size of the tax base. The absolute amount of tax paid increases with the base, but the percentage remains the same. Corporate tax in India is largely proportional, though surcharges at higher profit levels introduce a mildly progressive element.
    • Regressive Tax: The tax rate decreases as the tax base increases. In effect, it takes a larger percentage of income from low-income earners than from high-income earners. Most indirect taxes, like GST, are considered regressive. For example, a 5% tax on a basic commodity like soap constitutes a much larger proportion of a poor person’s monthly income compared to a wealthy person’s income.

  • Based on Valuation:

    • Ad-valorem Tax: This tax is levied as a percentage of the value of the good or service (“ad-valorem” is Latin for “according to value”). Most modern taxes, including GST and customs duties on many items, are ad-valorem. Their revenue automatically increases with inflation and rising prices, making them more buoyant.
    • Specific Tax: This tax is levied as a fixed amount per physical unit of the good, such as per kilogram, per litre, or per item, regardless of its price. For example, the excise duty on petroleum products in India has a significant specific component. This tax is easier to administer but is not responsive to price changes, and its real value can be eroded by inflation.

Classification of Taxes

  • Direct vs. Indirect Tax: This classification is based on whether the tax burden can be shifted.

    • Direct Tax: The ‘impact’ (initial point of taxation) and the ‘incidence’ (ultimate financial burden) fall on the same person or entity. The taxpayer cannot legally shift the burden to someone else. Examples: Income Tax, Corporate Tax, Wealth Tax (abolished in 2015).
    • Indirect Tax: The ‘impact’ and ‘incidence’ fall on different persons. The person who pays the tax to the government (e.g., a retailer) can shift the burden to the final consumer by including it in the price of the good or service. Examples: Goods and Services Tax (GST), Customs Duty, Excise Duty.

  • Value Added Tax (VAT):

    • Concept: VAT is a multi-point tax levied on the value added at each stage of production and distribution. It is designed to tax only the final consumption, and its key feature is the system of input tax credit, which eliminates the cascading effect.
    • Evolution in India:
      1. MANVAT (1986): Introduced by Finance Minister V.P. Singh, the Modified Value Added Tax was a limited form of VAT on select inputs to reduce the cascading effect of Central Excise Duty at the manufacturing stage.
      2. MODVAT: The scope of MANVAT was expanded over the years and it was renamed MODVAT.
      3. CENVAT (2000): The Central Value Added Tax further reformed the system by integrating taxes on goods (excise) and services (service tax) at the central level, allowing for cross-utilization of credits.
      4. State-level VAT (2005): States replaced their cascading Sales Tax regimes with a state-level VAT system, based on the recommendations of the Asim Dasgupta Committee.
      5. GST (2017): The Goods and Services Tax subsumed CENVAT, Service Tax, State VAT, and numerous other indirect taxes into a single, comprehensive tax. This created a unified national market and a seamless chain of input tax credits, finally and comprehensively addressing the cascading effect.

Prelims Pointers

  • Article 269A: Governs the levy and collection of IGST on inter-state trade.
  • Article 270: Defines the divisible pool of taxes to be shared between the Centre and States. It excludes cess and surcharge.
  • Article 271: Empowers Parliament to levy a surcharge for the purposes of the Union.
  • Article 279A: Provides for the constitution of the GST Council.
  • Cess: A tax for a specific purpose; proceeds are not shared with states. Example: Health and Education Cess.
  • Surcharge: A ‘tax on tax’ levied on existing tax liability; proceeds are not shared with states.
  • Cascading Effect: The phenomenon of ‘tax on tax’ in a multi-stage production system, which inflates final prices. GST was introduced to eliminate this.
  • Tax Evasion: Illegal non-payment of tax. It is a criminal offense.
  • Tax Avoidance: Using legal loopholes to reduce tax liability.
  • Vodafone Case: A famous case related to tax avoidance through an offshore transaction.
  • GAAR (General Anti-Avoidance Rules): A statutory provision to counter aggressive tax avoidance.
  • Transfer Pricing: Pricing of transactions between related entities of a multinational corporation.
  • Arm’s Length Principle (ALP): The international standard for transfer pricing, requiring transactions to be at market rates.
  • BEPS (Base Erosion and Profit Shifting): Tax planning strategies by MNCs to shift profits to low-tax jurisdictions. It is an initiative of the OECD/G20.
  • Tax Buoyancy: Measures responsiveness of tax revenue to GDP growth, including discretionary policy changes. Formula: %Δ Tax Revenue / %Δ GDP.
  • Tax Elasticity: Measures responsiveness of tax revenue to GDP growth, excluding discretionary policy changes.
  • Progressive Tax: Tax rate increases with the tax base (e.g., Income Tax).
  • Proportional Tax: Tax rate is constant regardless of the tax base (e.g., Corporate Tax).
  • Regressive Tax: Tax takes a larger percentage of income from low-income earners (e.g., Indirect Taxes like GST).
  • Ad-valorem Tax: Tax levied as a percentage of the value of the good.
  • Specific Tax: Tax levied as a fixed amount per unit of the good.
  • Direct Tax: Impact and incidence of tax are on the same person.
  • Indirect Tax: Impact and incidence of tax are on different persons (burden can be shifted).
  • Evolution of VAT in India: MANVAT (1986) → MODVAT → CENVAT (2000) → State VAT (2005) → GST (2017).

Mains Insights

1. Cess and Surcharge vs. Fiscal Federalism (GS Paper II):

  • Cause-Effect Relationship: The Union government’s increasing reliance on cesses and surcharges directly reduces the size of the divisible pool of taxes available for sharing with the states. This undermines the spirit of cooperative federalism and fiscal devolution recommended by successive Finance Commissions.
  • Debate & Viewpoints:
    • Centre’s View: Cesses are necessary for targeted funding of national priorities and social sector schemes, ensuring funds are not diverted. Surcharges are a tool for fiscal consolidation and making the tax system more progressive.
    • States’ View: This is a mechanism to bypass the constitutional scheme of revenue sharing. It curtails the fiscal autonomy of states and makes them more dependent on central grants. The 15th Finance Commission noted with concern that the share of cesses and surcharges in the Centre’s gross tax revenue has been increasing, and suggested mechanisms to bring them within a transparent fiscal framework.
  • Analytical Insight: While constitutionally permissible, the excessive use of these instruments can strain Centre-State financial relations and contradicts the move towards greater fiscal decentralization.

2. Tax Policy and Socio-Economic Equity (GS Paper III):

  • Indirect Taxes and Inequality: India’s tax revenue composition has a high share of indirect taxes, which are inherently regressive. This means they disproportionately burden the poor, who spend a larger fraction of their income on consumption. This can exacerbate income inequality and work against the goal of inclusive growth.
  • Balancing Act in GST: The GST regime attempts to mitigate this regressive nature through a multi-slab structure: essential goods are exempted or placed in the lowest slab (5%), while luxury goods are in the highest slab (28%). However, the debate continues on whether this structure is complex and whether further rationalization is needed to enhance equity.
  • Policy Implication: A long-term goal for a welfare state should be to increase the proportion of direct taxes in the total tax kitty, as they are more equitable and progressive. This requires widening the tax base and improving compliance.

3. Tax Evasion, Avoidance, and Ethical Governance (GS Paper IV):

  • Ethical Dimension: Tax evasion is both illegal and unethical, as it is a breach of the social contract between a citizen and the state. Tax avoidance, while legally permissible, raises ethical questions. Is it ethical for a corporation to use complex legal structures to pay minimal tax in a country where it earns substantial profits and uses public infrastructure? This deprives the nation of revenue needed for public services.
  • Role of GAAR: The introduction of GAAR reflects a shift from a purely legalistic interpretation to one that considers the ‘substance’ and ‘intent’ of a transaction. It represents an ethical stance by the state against arrangements designed solely to defeat the purpose of tax law.
  • Corporate Social Responsibility (CSR): Paying a fair share of taxes can be viewed as a fundamental component of CSR. Aggressive tax avoidance is often seen as being in conflict with the principles of ethical corporate citizenship.

4. Globalization and National Tax Sovereignty (GS Paper III):

  • The Challenge: Globalization and the digital economy have enabled MNCs to exploit mismatches between different countries’ tax systems through BEPS and transfer pricing. This erodes the tax base of developing countries like India and challenges their tax sovereignty.
  • International Cooperation: Unilateral measures (like a digital services tax or ‘Google tax’) can lead to trade disputes. Therefore, multilateral solutions are essential. The OECD/G20 BEPS framework and the ongoing negotiations for a Global Minimum Corporate Tax are crucial steps.
  • India’s Stance: India has been a strong advocate for these global initiatives, as they aim to create a level playing field and ensure that MNCs pay tax where economic activities are performed and value is created. The success of these initiatives is vital for protecting India’s revenue base in an increasingly integrated global economy.

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