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Op-ed

America Could Turn to India for Inspiration on Tax Reform

by Arvind Subramanian, Peterson Institute for International Economics

Op-ed in the Business Standard
February 24, 2010

© Business Standard


Bemoaning the state of the Indian public sector and its inability to deliver essential services is a hardy perennial of intellectual discussions. Academic reputations can be built, and tenure at universities such as Harvard obtained, it seems, by documenting the entrails of the Delhi car licensing system. All this is fair enough because the caricature—of bumbling bureaucrats, venal politicians, and bizarre, byzantine processes for decision making—often approximates the reality. But India and the Indian public process can surprise, even wow, the careful observers. One such surprise—an unambiguous success of Indian institutions—must be the future introduction of the goods and services tax (GST), a major piece of tax reform that would be the envy of mature democracies such as the United States.

The coming budget, to be presented later this week, may insufficiently address India's key fiscal challenge: reducing the vulnerability in its public finances. And vulnerable they are as a recent working paper by Petia Topalova and Dan Nyberg of the IMF highlights. Amongst the BRIC—the supposed club of aspiring big powers comprising Brazil, Russia, India, and China—India's ratio of government debt to GDP (exceeding 80 percent) is the highest. The Chinese state is not only stronger than the Indian in implementation capacity but also in fiscal firepower with debt of less than 20 percent of GDP.

Amongst a wider group of emerging-market countries too, India's fiscal performance has been relatively weak in recent years: during the global boom years, 2003–08, India's public indebtedness improved much less than the average emerging market country, and that despite the fact that it posted much higher rates of economic growth. In the years leading up to the crisis, when the economy was growing at 9 percent and revenues were buoyant, India squandered a golden opportunity to set its fiscal house in permanent order. A modest budget for the coming year risks repeating this mistake.

But the grounds for fiscal optimism lie elsewhere. They lie in the future implementation of the broad-based GST, which could generate additional annual revenues of about 1.5 percent of GDP, create an Indian common market, and solve some structural tax problems. If implemented, and complemented with spending restraint, a path for medium-term fiscal adjustment could be within reach. This path is far from certain. Any number of shocks could cause departures from it: stymied privatization, higher world prices of oil—which would increase consumer subsidies—and more fiscal populism, generally. But the GST offers hope.

The question is: How is India managing to pull off such a major tax reform under such inhospitable conditions? Its tax administration is not exactly of the quality in advanced economies (Europe or the United States) and would seem unequal to the challenge of implementing a new and complicated tax such as the GST. Moreover, in a federal structure such as India's, with overlapping constitutional responsibilities between the Centre and the states, and varying interests and capacities across states, the GST is mind-bogglingly difficult to design, let alone implement. Above all, generating a modicum of consensus across political parties at the Centre and the states around an issue that affects so many voters and citizens would seem impossible, especially in such a messy, raucous, and fractured democracy such as India's. And yet, a successful GST is attainable.

The key to the GST effort goes back to a remarkable combination of shrewdness and statesmanship on the part of Yashwant Sinha, the finance minister in the Bharatiya Janata Party (BJP)–led government in 2001. Recognizing that successful implementation of value–added tax (VAT) would be impossible without buy-in from the states, he created an "empowered committee" comprising the finance ministers of all the states. The masterstroke was to appoint West Bengal Finance Minister Asim Dasgupta of the Communist Party (CPM)—a party then strongly opposed to the policies of the BJP—to chair this committee. This was management not by delegation but by delegation to the political adversary.

But it worked. One important reason was that the states, rather than the Centre, were driving the process which created a sense of participation and ownership that would have been hard to achieve otherwise. Not just West Bengal but other states—including Tamil Nadu, which has always been assertive about states' rights—developed a stake in the process and contributed constructively.

Yashwant Sinha's successful experiment was followed by his successor P Chidambaram, who then retained the empowered committee, calling upon it to design and help implement the next stage of tax reform, namely the implementation of the GST. This committee has been the GST's midwife. It is almost as if India now has a permanent process—indeed a new and functioning institution because the empowered committee is registered under the Societies Act and even has quasi-legal status—for addressing tax matters that will involve the Centre and the states.

This process may yet come up short. It may also be difficult to extend it to other policy areas. But in one important respect, the GST experience may have wider implications. The house that India's founding fathers built was a federal structure with a strong Centre. But the de-monopolization of political power at the Centre and the growth of regional parties have de facto made India more politically decentralized. The GST experiment suggests that the move away from a strong Centre federalism need not entail a threatening centripetalism but could instead lead to a cooperative federalism that is perhaps India's future.

Many factors explain the Indian economic transformation. But it is hard to believe that India's economic possibility frontiers have not been determined by India's institutions. What the GST story indicates is that for all of India's flaws and deficiencies—captured in the constant why-can't-we-be-more-like-China lament—there remains the ability, fragile and episodic though it may be, to build good institutions, especially if old ones become dysfunctional. The spirit of institution building that formed the core of the Gandhi-Nehru-Patel enterprise remains etched in India's collective DNA. Polarized and paralyzed America—which will badly need tax reform to get its fiscal house in order—could turn to India for inspiration.