Optimal Taxation in a Federation and GST in India

Optimal tax models, starting from Ramsey (1927), are often studied using a single government. However, there are several countries which are federations and in that multiple levels of government have fiscal authority, which masks the heterogeneity across states. In this paper we study a federation with two states and a federal government. We first find that the optimal tax design indicates tax smoothing across the states and consumption smoothing across states and time. Moreover, optimal consumption is found to be independent of the tax rates. We also find that all governments cannot have zero borrowing simultaneously. Then we characterize two equilibria, one where both federal and state governments impose taxes and two, where only the federal government imposes tax. We find that in the first equilibrium, states potentially impose different tax rates, but consumption across states are the same. In an equilibrium with a single federal tax, consumption is smooth across time, but may not be equal across states. However, aggregate consumption in the economy is greater in the second equilibrium. India has adopted a nationwide GST system, moving away from multiple taxation. So, we then calibrate the model to Indian data and find the revenue neutral tax rates. We find that the highest revenue neutral tax rate is 20.1% and the median rate is 11.4%. Using the calibrated indirect tax rates in a regression analysis, we find that tax rates at the state level is negatively related to the growth rate of the state. So, after the implementation of GST in India, some states may see a higher level of consumption tax rate in the state and hence, a fall in growth rate.