Along with State and the Union governments, allow local governments to get a share of the Goods and Services Tax, linked to the performance of the local economy.
Why bring cities and towns into a national tax setup?
The links between city government and city economy are weak and broken in India.
All economic activity is eventually ‘local’, with an individual or a business consuming goods and services. Cities, towns and villages are natural economic units that provide goods and services to resident individuals and businesses – allowing each entity to pursue their own economic activity.
Take a Bangalore restaurant which may have a turnover of a few crore rupees and employs 25-30 people. The restaurant may benefit (or suffer) from the investment climate and rule of law upheld by the Karnataka and Indian governments. But more directly, the restaurant lives or dies by the health and safety inspections done locally, by their business registrations, and by the quality of water, electricity and transport provided in Bangalore.
However, there are weak-to-no incentives for local governments to care about local economic activity. Ideally, a city mayor or a village administration should benefit immensely when new jobs are created, and more economic value is generated locally. This should influence performance in elections. However, Indian cities and towns get weak direct incentives from helping create more business activity in a city.
If more jobs and economic activity are generated in a city, local services like transport, water and electricity are consumed more. Property rates go up because of greater demand for real estate. However, none of these translate to more taxes for the city government. Most city services like buses and water and electricity are heavily subsidised, so governments do not end up earning more when the demand for both go up. Property taxes in India are disconnected from market prices of real estate, and aren’t updated frequently enough. So even when property rates go up, taxes lag behind.
Starting now, all businesses will be paying one GST — Goods and Services Tax, based on the goods and services that they consume, and the value they add to it. Under the current setup, cities, towns and villages don’t get a penny directly. All the GST collected is split between States governments and the Government of India. They can hope to receive grants and project funding from states and New Delhi, which often come with patronage.
What will the reform achieve?
If cities and towns were to get a small piece of the GST ‘action’ based on what taxes were collected locally, this could transform city governments’ connection with the city economy. If a city’s residents become more prosperous, it means that they can spend more at local restaurants and movie theatres. If the local government positively and tangibly benefits from this, they will be incentivised to help their residents rather than get in the way.
What is the cost of inaction?
Cities, towns and village governments will continue to be poor in India. Even as the cities themselves grow richer, city governments will remain relatively poor, and dependent on the largesse of State and Union governments.
City governments will also continue to focus on basic services at best, and rarely engage businesses positively.
Local governments are also likely to go back to regressive taxes that provide them some fiscal independence. They will remain oblivious to their role in promoting economic growth and prosperity for all Indians.
How can the reform be achieved?
City governments from across states can start forming interest groups that persuade the Finance Ministry and the GST council to take note of the need for a local share of GST. They can start by asking for 1 or 2 percentage points of the total GST collected, directly linked to the economic activity happening locally.
The GST administration can work towards a tax system that takes in the location where the consumption of goods and services is taking place. Even if it takes a couple of years, the GST administration can develop a tax system that does not increase the cost of compliance greatly, nor the cost of administering the tax.
A note of caution
It is important to ensure that in order to give local governments a share of the GST revenues, the overall tax rates should not be increased. Nor should more rates be introduced. State and Union governments can always choose to reduce the grants that they give to local bodies, and allow them to gain more from their share of the GST. This way, not only do local governments have more money to spend, but that money is directly linked to the economic performance of the local city or village.