Why do different states of India have different tax rates?

Why do different states of India have different tax rates?

There are five major factors that affect tax rates, and that's why there are different rates in different states - 

1] Promoting goods of local importance

Consider the following examples - 

·         Thaalis are exempt from tax in Tamil Nadu

·         Uttar Pradesh is famous for Banarasi Saree, which is not taxed there

·         In Maharashtra, no VAT is levied on Solapuri Chaddars

This is just a few of a large number of goods that hold a special status in the respective states. And it is very logical. Many goods have a local importance; and hence the Government has the right to treat them specially; either to promote the local industry or to protect the tradition (or, usually, both)

2] To sync with the culture of that State

Here are some noteworthy differences - 

·         Gujarat has banned alcohol as a homage to Mahatma Gandhi who hails from that State.

·         In a similar manner, beef is prohibited in several states of India.

This differential treatment may be only a political gimmick, considering the population of states such as Maharashtra. Nevertheless, it should be understood that politics, mainly due to the demographics of the state, play a vital role in certain legislation policies of various states. 

3] Promote investment in the state

In addition to the differential VAT rates, even the Central Government provides selective exemptions based on the location. For instance, several goods manufactured in the following states are exempt from Central Excise Duty - 

·         Sikkim

·         Uttaranchal

·         Himachal Pradesh

If we get into the details of these exemptions, we shall understand that most of these exemptions are given to spur investment in these states. Here, the second point mentioned in the question becomes relevant (that lower tax increases investment, but let's discuss that later)

4] Higher revenue generation

It must be noted that high tax rates are not relevant only to deter investment. Sometimes, high tax rates are used to increase revenues. Take these classic cases - 

1.       In Tamil Nadu, tax rate on alcoholic bevarages exceed 200%

2.      On the other hand, Goa has these taxes as low as 20%

In Tamil Nadu, the high rate serves as a deterrent against addiction. However, in Goa, a high tax would mean a huge loss for revenue. Therefore, these differences can be understood in context of revenue. Well, now you know why is liquor so cheap in Goa?

Suffice to say that different states will react differently to tax rate changes. Therefore, governments manipulate these rates to suit their interests. 

5] The special case of petroleum products

There is no visible, convincing reason why different states should have different rates on petroleum products. And yet, different rates exist. This is the reason why petrol is cheaper in Delhi compared to Mumbai.

Petroleum has two major effects on the economy - 

·         It does not have any substitute. If you increase the tax rate on petrol, the public will be pissed off for a while; but will still refuel the tanks since they need to go to their offices

·         It has a cascading effect on all commodities. Everything travels from the factory to your home on petrol/diesel. Therefore, an increase in fuel price translates to an increase in all the other commodities.

If I was in the Government, I would be happy with the first point, since I can get more revenue by increasing the tax; but at the same time, I would be apprehensive regarding the second point. How respective states take this call depends on their own region. 

Bonus point: It may be noted that the petroleum problem is not likely to disappear anytime soon. Even after the introduction of GST, petroleum shall continue as it is, because GST on petroleum products has been deferred as per the latest bill. See - Why is GST not levied on petroleum and other fuels? 

 

Does increase in tax reduce investment?

We have already discussed this question in part while saying that tax rate increase is often carried out to increase revenue. This is mainly because some products are not as sensitive to tax rates as you would believe.

Hence, the answer you're looking for really depends on the tax elasticity of demand (See: Elasticity (economics) - Wikipedia)

Are different tax rates justified?

We have seen that there are a lot of factors which play a role in determining the tax rates of commodities. While all the above points make sense, there is still a reason why economists disagree with this policy. Here are the reasons:

1.       Differential tax rates don't sync well with the tax credit system. It disturbs the value chain, and therefore should be avoided

2.      It increases confusion - both for the businesses and the government. There is a risk of non-compliance

3.      Different tax rates create a location bias. Usually, only those states lower taxes who can afford to lose revenue - but those states don't really need extra investment as much as the underdeveloped states

Taxation is an art. It needs a genius mind to judge what to tweak for best results!

Happy Investing