Trial-and-Error Taxation Causes Costly Consequences - A Cess That Cost Rs. 50,000 Crore

Raman Swamy

Students appearing for competitive exams like CAT, MAT, XAT and NMAT are often encouraged to find quick solutions of quadratic equations by the ‘Trial and Error’ method.  Coaching class tutors tell them - Make a guess, try something, if it does not work, guess again.  After some time your guesses will become more educated, you will make fewer errors and you will require fewer trials to arrive at the correct solution.

However, what is good for students trying to grasp the basic concepts of algebra, geometry and trigonometry can be quite disastrous for Governments in power entrusted with the task of formulating policy in a complex market economy.  

GST is not CAT, MAT, XAT.   There is no justification for adopting a Trial and Error strategy when forcibly enforcing a new tax regime on a marketplace where a billion people carry out ten billion transactions every single day. 

Every wrong guess will have consequences.  Every error will be costly and painful for citizens and businesses.  

On Tuesday, the Government’s trial-and-error method of implementing the new GST rates had a consequence.  Investors lost Rs. 50,000 crore in trade in ITC, the premier blue-chip conglomerate -- all because the GST Council suddenly imposed a new Cess on cigarettes.   

The reason?  A classic error, an oversight or guesswork gone awry, call it whatever you wish.     

Under GST, cigarettes fall in the highest 28 percent bracket and attract an additional cess depending on their length.  But – and here is the catch -- the effective levy is 8 percent lower than earlier.  This is because under GST the earlier “Additional Excise Duty” has been dropped and is no longer levied.

Naturally enough, there was much rejoicing among cigarette manufacturers, retailers and consumers.   Companies like ITC and Godfrey Phillips got huge windfall gains.   There was even a prospect that the tax benefit could be passed on to the consumers and cigarette prices may fall.  

The celebrations have proved to be short-lived and premature.  There was no way the Tax authorities were going to allow the makers of cigarettes – on which Finance Ministers have invariably imposed ever-rising ‘Sin Tax’ -- to get away with making a profit out of the new tax reform.

Hence, the hike announced on Monday on the Compensation Cess on cigarettes.   While the 28 percent GST rate will remain and so will the 5 percent ad valorem tax, the additional Cess will change as per the length of the cigarettes to ensure that the total effective tax rate does is not smaller than earlier.

For the anti-smoking lobby and for puritans at large, this belated correction makes moral sense.  But from the policy perspective this smacks of shoddy homework and resort to the Trial-Error-Correction syndrome.   

The impact of the sudden announcement of additional cess --  made incidentally by the Finance Minister after a video-conference meeting of the GST Council on Monday --  was that on Tuesday morning the stock markets crashed.

ITC shares in particular led the way down with a tumble of 15 percent.  The company’s total market capitalisation on the BSE contracted by almost Rs 50,000 crores within a few hours of trading.

So what, the anti-smoking lobby might say, they deserve it for selling cancer-causing products and ruining the health of the younger generation.   What does it matter anyway, some others ask,  the stock market keeps going up and down every day and has nothing to do with the real economy.

Granted there is merit in both such viewpoints.  But the reality is that ITC holds a weightage of 7.2 percent in Sensex.  When ITC stocks plummet, the entire market index falls.

That is what happened.  On Tuesday, the market got spooked.   It led to the biggest fall of the year 2017.   Sensex lost 364 point in a single day. 

Somewhere along the line this does matter.  Under market capitalism, many things are interlinked.  

For instance, foreign portfolio investors (FPIs) are among the major stakeholders in ITC.  So is the insurance giant LIC.   FPIs hold 20 percent stake in ITC and LIC holds 16.25 percent.  Also, banks and other financial have nearly 10 percent stake.   Losses, even if notional and temporary, were suffered by all these parties.   In addition, many small players, the retail investors,  would have incurred crippling blows to their finances, some even wiped out.

Moreover, even though ITC has the image of being a cigarette maker,  things have changed in recent years.   The company has diversified to an astonishing extent.  Today, it is a one of India's mightiest multi-business enterprises with a market capitalisation of 45 billion US dollar and an annual turnover of 8 billion dollars.

ITC’s portfolio spans over a wide spectrum --   Fast Moving Consumer Goods (FMCG), Hotels, Specialty Papers, Packaging, Agri-Business, and Information Technology.   In other words,  it is not just making cigarettes, the poisonous weed stick.  

When ITC gets such a heavy hit on the stock market, as it did today, its other businesses also feel the spasms of pain.  That affects and impacts the real economy.  

Taxmen and Ministers ought to know this more than the lay public.  Trial and Error methods are best left to seekers of knowledge in educational institutions.  The real economy requires experts who know what they are doing, not experimental economists who make guesses, make errors and try again.

Jul 20, 2017