Should commodity tax rates be uniform across regions in a heterogeneous country? Evidence from India

Abstract

With countries increasingly adopting the Goods and Services Tax (GST) as their system of commodity taxes replacing the myriad of sales, excise and other form of indirect taxes, there is a move towards the two features that characterize the GST: uniform tax rates across items and identical tax rates across regions. When India introduced the GST in 2017, it followed several other countries in departing from the first feature but in keeping with universal practice embraced the second feature. The chief motivation of this paper is to subject this latter feature to critical scrutiny. The study examines the four GST rates in India by comparing them with counterfactual evidence based on preference based optimal commodity tax rates estimated by taking into account regional diversity in prices and spending. The benchmarking suggests that the current top GST rates (12%, 16% and 28%) are much higher than can be justified by the optimal rates. The Indian evidence is also in favor of departing from the universal practice in GST of adopting a uniform tax across items. The paper makes a methodological contribution by proposing a procedure for calculating spatial prices that can be applied to a wide basket of items. The study provides evidence on the redistributive potential of indirect taxation by showing the progressive nature of the optimal commodity taxes. The latter result is of particular significance in developing countries where indirect taxes raise the greater share of revenue and provide an important policy tool for tackling increasing inequality. The study concludes with a list of policy lessons as the country seeks to make further changes to its GST. While there is a significant literature on harmonization of indirect taxes across countries that belong to a single economic grouping such as the EU, there is no such literature between regions within a large heterogeneous country. The present study on tax harmonization between the states in India attempts to fill this gap.