Asian giants plot big indirect tax reforms

April 26, 2013

Two of the largest economies in Asia — India and Japan — are on the cusp of introducing significant indirect tax reforms.

India proposes to replace the current indirect taxes with a reasonably comprehensive goods and services tax (GST). The aim is to boost efficiency. Meanwhile, the Japanese VAT reform focuses on additional revenue generation.

GST in India

India proposes to introduce a dual GST to be levied concurrently by the Central and State governments, with the standard features of a classical VAT. The GST could provide significant impetus to industry and economic growth.

However, its implementation has seen long delays due to strong differences between the Central and State governments about the GST design and other issues. The GST would rationalize and simplify the consumption tax structure at both Central and State levels.

It would replace almost all indirect taxes, minimize exemptions and do away with the current multiplicity of taxes. By ensuring a smooth flow of input tax credit, it would eliminate the cascading of taxes that add to the burden of taxpayers.

Since the GST would be levied uniformly on all supplies of goods and services throughout the supply chain, it would make the supply chain tax neutral irrespective of the nature of the product or distribution chain.

The decisions of individual businesses about inventory and distribution management could thus be determined on the basis of operational efficiency rather than tax considerations.

The GST would also lead to uniform treatment of domestic and exported goods. It would substantially reduce competitive distortions between competing products. Most importantly, it would facilitate the integration of India as a seamless common market by removing the current fiscal barriers and ensuring the free flow of goods from the point of origin to final consumption.

For government, the GST would simplify compliance and yield greater revenues. And, for the overall economy, GST is expected to bring significant macroeconomic dividends by removing current distortions that inhibit businesses and investment

VAT in Japan

Japan has a comprehensive VAT, which in many ways is one of the better models of GST. The Japanese VAT is applied to a comprehensive base, with the notable exception of financial services, and it has a single rate. Even though Japan does not require invoices to support input tax credit claims, it has enjoyed high compliance, thanks to the low rate of tax (3% at inception and 5% currently).

The policy discussions in Japan have been focused on the tax rates to meet the rising revenue needs. Japan’s gross public debt in the last two decades has more than tripled to almost 200% of gross domestic product (GDP). The main factors behind the rising debt have been the steady rise in social security spending due to an aging population and weak economic growth.

This is evident from Japan’s tax-to-GDP ratio of 27.6%, which is among the lowest in the OECD countries.

Given the grim fiscal situation, the IMF recommended a gradual increase in the VAT rate from the existing 5% to 15% over the medium term to restore Japan’s fiscal health. It was felt that an increase in VAT rate was likely to be less distortive than other taxes.

Also, since Japan has a relatively simple tax with a broad base, low rate and strong compliance, it would be efficient and easy to administer. VAT was perceived as more suited to addressing the fiscal pressures of an aging society because it would provide a robust source of revenue as private consumption and spending grow and as the population ages. Japan has previously raised its VAT rate from 3% to 5%.

In August 2012, it passed a bill for increasing the VAT rate in two phases – from 5% to 8% from April 2014 and then from 8% to 10% from October 2015. This doubling of the VAT rate was not without controversy and came with a clause that the new, higher rate may be suspended if the “comprehensive economic condition is not appropriate for the tax hike.”

One of the key concerns was the burden of the rise on lower-income households, which may require the imposing of a lower rate for “necessities.” Creating a lower or special rate would reduce the revenue productivity that makes the VAT rate increase the most compelling instrument for containing the deficit.

Conclusions

India could learn from Japan’s VAT system, which has a low tax rate and strong record of compliance. Japan has withstood political pressures for multiple VAT rates, which invariably lead to a higher standard rate. In the next few months, it will be interesting to watch how the two economies tackle the multiple pressures of reform.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

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