Haseeb A Drabu: Compensating VAT

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The new deadline for the introduction of a state level value added taxation (VAT) regime is April 1, 2005. Prior to this, the empowered committee on VAT had set a deadline twice, the last one being April 2003, which could not be met.

If the committee fails to meet the deadline it has set itself this time around, not only will its credibility be totally eroded, it will delay the move to a better system by another couple of years.

The fact that most states are eager to move to the new regime as soon as their "neighbouring" states do, points to the fact that there still are some niggling doubts and insecurities associated with the move. The biggest of these relates to loss of revenue emanating from the Laffer curve response to change in tax and tax regime.

The finance minister's belief "" there will be no loss of revenue "" on which his compensation promise is based is not shared by most states. The only evidence that is giving many state governments some comfort is the Haryana experiment which is, by all accounts, doing very well.

Whether the April 1, 2005 deadline is met and whether all states move to the VAT regime together will be clear next month when the contours of the compensation package will be worked out and announced by the finance ministry.

So it is of utmost importance to work out a fair and balanced compensation scheme that not only meets the actual loss of revenue of states in the transition period but also doesn't penalise the states that implement the system well and manage not to have a loss of revenue. In other words, it has to be a compensation cum incentive package.

There are three basic issues in working out a compensation package. First, is the measurement of loss, if any. Second, is the principle and criteria for compensation and third, the methods and institutional mechanism of compensation.

The measurement of loss has to be done technically by assessing the normative and trend revenues of a state and comparing it with the actuals achieved by the state. The difference between the two in individual taxes, if amounting to a break in trend, will be the loss due to a change in the tax regime.

The two basic principles of compensation should be to debar all those states from compensation, which don't move to VAT by April, 2005. Second, quantum of compensation should not be open ended and the eligibility for getting compensation should be limited to a period of three to five years.

The criteria of compensation should be based on two things; first the ability of a state to absorb the shock and second, the extent of fiscal stress that the state is under. A cross-classification of the two, will yield a number of categories of states.

Of these, the "high-income low-fiscal stress" states should get the lowest compensation. At the other end of the spectrum there will be states that are "low-income high-fiscal stress".

These states should get the maximum assistance. The compensation for the rest should be calibrated on the basis of where they lie on the "ability-stress" curve.

The special category states should be kept out of this for the simple reason that whatever their negative balance from current revenues "" which will ultimately get affected by the loss of tax revenue "" is funded by the Planning Commission before a plan size is decided.

Finally, the issue is of the institutional mechanism for assessing and granting compensation. Instead of the Centre doing this as all states and the empowered committee is suggesting, it will be best done through the aegis of the Twelfth Finance Commission (TFC).

There are a number of advantages in this approach. First, the TFC, a neutral institution, is just about completing its assessment of the finances of all states and knows what their normative revenue position is. So it is best equipped to assess fiscal stress.

Second its recommendation will be in operation from April 1, 2005 for five years which should be the outer limit for the compensation.

Finally, it has estimated the total revenue and resource position of the Centre and states and will be able to find resources for a "compensation cum incentive pool" without excessively burdening the Centre or squeezing the states.

The TFC would also be able to tie in the compensation with a whole lot of other criteria, like the incentives for states which implement the system well. There will thus be vertical as well as horizontal or inter-state compensation issues that can be dealt with in an impartial and equitable manner.

haseebd@business-standard.com