India’s enormous market—a caged tiger—will now be unleashed,” said Anand Mahindra, chairman of the automobile manufacturer Mahindra & Mahindra Ltd., about the passage of a historic tax bill last week. At present, the country’s 29 states essentially dictate their own individual tax codes, a confounding system that has long tripped up inter-state commerce. But to the world’s surprise—not least India’s—this disorder could finally be coming to an end. After more than a decade of protracted negotiations, intense shuttle diplomacy, and close combat with vested interests, both houses of parliament unanimously passed the landmark Goods and Services Tax (GST) bill in a move analysts have called, “one of India’s most significant and ambitious reforms ever attempted.” At its core, the GST will replace a bevy of state and federal taxes with a single, unified tax on goods and services, bringing the country closer than ever before to a common market.  

A COMMON OPERATING SYSTEM

The journey to this momentous agreement began 25 years ago this summer. India’s economy was in shambles and the country was suffering a massive balance-of-payments crisis. Staring down the unthinkable prospect of bankruptcy, India adopted a sweeping set of market-friendly economic reforms that dismantled the “License Raj,” a suffocating thicket of licenses and regulations. Although many vestiges of this “Raj” remain, the reforms of the 1990s successfully ended the practice of industrial licensing, curbed the public sector’s role in the economy, opened India’s markets up to the world, and substantially unshackled India’s states from control by New Delhi, paving the way for them to shape their own economic destinies to a greater extent that ever before.

In this process, some Indians gained more than others. Inequality between—and within—states rose to new levels. Overall, in the quarter-century after the reforms, India experienced unprecedented rates of economic growth and lifted hundreds of millions out of extreme poverty. Private entrepreneurship took off, trade surged, and the first few chapters of the “Incredible India” story were written.

Still, the reforms did not fix the opaque rules governing how the central government coordinates revenue collection with the states, or how states would deal with cross-border transactions. These issues are hardly novel, but it was the very success of India’s liberal reforms that brought to the fore the head-spinning patchwork of central and state taxes and levies that befuddled consumers, stymied entrepreneurs, and encouraged the growth of the informal economy. Trucks carrying goods across state lines often wasted hours—even days—stalled at checkpoints. Firms faced a “cascading burden of ‘tax on tax’,” as businesses had to pay duties at each level in the supply chain, cutting into their profit margins. Unsurprisingly, the resulting complexity created incentives for tax evasion and deprived governments of much-needed revenue—all of which counteracted the very point of mandating the levies in the first place. 

The promise of the GST is that it will provide a common operating system through which the states—and New Delhi—can harmonize the current maze of indirect taxes on goods and services, such as jurisdiction-specific excise, value added, luxury, and entry taxes. The GST will levy a tax on the value-added at each stage of production, but it will also provide for offsetting tax credits for every purchase from the point of manufacture to the point of consumption. Under a “destination-based” rather than “production-based” tax, consumers are only responsible for the tax levied by the last actor in the supply chain. This intricate system will be managed through a single online interface for tax registration, compliance, and credits.

To be sure, there is a difference between the current GST and the pristine version that India had once envisioned. States successfully lobbied to keep key revenue-generators, such as alcohol, petroleum (at least for now), and real estate, outside of the GST net. In addition, there may be as many as three separate rates, rather than a single unified one, to allow for differential taxes on goods whose consumption the government wants to discourage, such as tobacco, or encourage, such as food. Whereas early studies of India’s tax system, which were premised on a “flawless” GST, estimated that the new tax would boost gross domestic product growth by nearly two percentage points, a more recent study puts the projected increase at half that amount.

As imperfect as it is, the current GST will not only align India’s taxation of goods and services with the practices of most nations, but it will also provide both domestic and international firms the uniformity and the predictability they need to do business. Although a Mumbai-based entrepreneur selling goods in Chennai will still have to negotiate India’s patchy infrastructure, he or she will no longer have to navigate differing tax rates in half-a-dozen states.

For their part, consumers will face a transparent tax on the value of goods and services they purchase, which will reduce prices over the medium term as firms reap the benefits of a reduced tax burden and pass on the savings. State governments also stand to gain enormously because businesses will have a built-in incentive to apply for tax credits on any materials they purchase because they will only receive such credits if their suppliers paid taxes on their inputs. So a wholesaler who buys shoes from a shoe manufacturer will only be able to claim a tax credit on its purchases if the manufacturer can prove it paid taxes on the raw materials that it originally purchased. As a consequence of this “self-policing,” tax compliance will increase and the black economy will shrink.

A POLITICAL TIGHTROPE

For all the dazzling, potential benefits of a GST, the new regime still faces daunting political hurdles. Now that both houses of parliament have acted, a two-thirds majority of at least half of India’s state legislatures must ratify the law. Next, a GST Council—comprised of central and state government representatives—will need to be established; this body will be responsible for drafting a model GST law that parliament and all of the states must pass. Crucially, the council must set the all-important “revenue neutral rate,” or the tax rate which preserves the current level of revenue enjoyed by the center and the states.

This decision will require cautious balancing. If the rate is set too high, the ruling Bharatiya Janata Party (BJP) could be pilloried as the party of high taxes. A high tax rate would also encourage further non-compliance and raise prices. Conversely, if the rate is set too low, states will find it difficult to balance their books. The central government has offset this concern by promising to cover states’ revenue losses for the first five years, but that could derail New Delhi’s ambitious plan to reduce the fiscal deficit

Even assuming speedy legislative action and a reasonable compromise on the GST rate, the path ahead is riddled with landmines. Businesses will have to incur costs to adjust to the new regime, which will be especially high for smaller firms that have never paid taxes or lack the technology and expertise to adapt. The government will have to train new tax collectors and implement a massive new online tax system. In fact, leading economists suspect that there could be adverse consequences to both growth and inflation in the short term until these teething pains subside. To further muddy the waters, legal experts are already warning of future lawsuits over the constitutionality of the GST, since it alters the basic federal–state structure outlined in India’s founding document by reallocating taxation powers.

MODI-MENTUM?

Both the government and major opposition parties are attuned to the short-term costs and the long-term benefits of the tax revamp. When the Congress Party was in power, it mooted a GST bill as early as 2006. The BJP, then in opposition, found creative ways of obstructing progress despite a broad consensus that the idea was a good one. Prime Minister Narendra Modi, who was chief minister of the state of Gujarat at the time, argued vociferously against the tax because of concerns that his state—an industrial powerhouse—would lose revenue.

But now Modi occupies a much higher seat of power and Congress legislators no longer fill the treasury benches. Having played hardball with the government for two years, the increasingly isolated Congress eventually signed onto the deal. Although it handed Modi a major victory, the party hopes that the prime minister will be forced to absorb the short-term adjustment costs and that it can revive its fortunes by the next general election in 2019, when it can reap the long-term economic benefits.

Still, Modi, stung by the criticism that his government has not done enough to reshape India’s economic landscape, has notched a legislative accomplishment that even his harshest critics can’t easily dismiss. The triumph gives his government newfound momentum at exactly the right time. Early campaigning has already started for January’s regional elections in the pivotal state of Uttar Pradesh, home to 200 million Indians. Due to the timing and political importance of the poll, many will interpret it as a mid-term verdict on the Modi government itself. The prime minister and his party arrive at the battle armed with a shiny new political weapon, one that will herald a better tomorrow but take time to deliver rewards. To paraphrase a common Indian refrain: the country’s future is bright—it’s the present that is cloudy.

This article was originally published by Foreign Affairs.