M Govinda Rao: Budget Blues - 2007

We can expect some significant reform initiatives in the direct and indirect tax systems.

As the budget time approaches, expectations are ubiquitous. Experts indulge in what the finance minister should do and speculate on what he may. The common man is always hoping for increase in the threshold, reduction in the rates of taxes. The businessman and industrialist would like to see greater room for manoeuvre through additional tax preferences and lower rates and the withdrawal of three irritant taxes""the fringe benefits tax, securities transaction tax and cash withdrawal tax. Economists would like to see continuation of fiscal correction and larger allocation to infrastructure. Every important constituency would want larger allocations. Surely, the finance minister at this time is the most hassled man. On the one hand, he has to signal further reforms, continue tax reform in terms of broadening the base, reducing the rates and simplifying the tax system and, on the other hand, make allocations to satisfy coalition partners and various constituencies. He has to balance populism associated with structural reforms.

Fortunately, the high revenue productivity of direct taxes has provided some breathing space. The tax information network (TIN) has proved to be a boon. Also, despite fears of escalating expenditures on various schemes, allocations to various of those seem to be well under control. Of course, the oil sector deficit could be a disturbing factor. On the whole, probably, the fiscal and revenue deficits for 2006-07 would conform to the budgeted estimates and as a ratio of GDP, may well be lower, thanks to the higher GDP.

In the prevailing environment, it seems that there is not much the finance minister can do to rationalise the expenditures. There is little manoeuvrability in regard to food and fertiliser subsidies. The subsidy bill on fertilisers has ballooned to over Rs 34,000 crore and on domestically produced urea alone, the subsidy is at an all-time high of Rs 15,000 crore. The main reason for this is the sharp increase in the cost of feedstock. Of course, there is something terribly wrong with the pricing policy of urea, as also reluctance not to increase the selling price. Foodgrains have been imported at prices higher than the domestic price and that would have added to the subsidy bill. Even if some rationalisation of subsidies is to be attempted, perhaps, it may be prudent to do this outside the Budget to avoid the glare. The Pay Commission may recommend an interim relief, which could burgeon spending on salaries and pensions. The Budget has to meet the larger outlay for the first year of the 11th Plan as well.

Perhaps, we can expect some significant reform initiatives in the direct and indirect tax systems. The Kelkar initiative on TIN and the consequent sharp increase in the buoyancy of direct taxes have demonstrated the dictum that in developing countries "tax administration is tax policy". However, there is a long way to go in improving the information system for excise duties. This will, if professionally done, bring in rich dividends and also prepare the stage for a proper goods and services tax (GST). Indeed, proper coordination and sharing information between the direct and indirect tax departments as also between the central and state tax departments must be initiated. This may not be an issue that would receive much attention in the Budget, but nevertheless, should be an important reform agenda.

On the GST front, it would be useful to set a clear roadmap, but in the absence of clarity and agreement between the Centre and states, the reform will continue in an ad hoc manner, as in the past. It would, however, be useful to be clear about the overall burden of GST and the tax room for the Centre and states. The FRBM report suggested the overall tax burden to 20 per cent with tax room for the Centre and states at 12 per cent and 8 per cent, respectively. Indeed, if we do not expand tax preferences, and if we can create an efficient information system, tax compliance can improve significantly to enable a lower rate of GST. It appears that a combined rate of 15 per cent seems to be reasonable with the Centre and states levying the tax at 7.5 per cent. In fact, the exemptions to small-scale industry and area-based exemptions have been a cause of low productivity of the excise tax system. Add to this is the huge loss inflicted by the special economic zones. We cannot think of a reasonable rate structure unless we do away with these preferences. In any case, the present Budget will do well to extend service tax to cover all services (with a small exemption list) and unify the CENVAT and service tax rates, say, at 14 per cent. Transforming selective taxes to a general tax was recommended by the Expert Group on Service Taxation in 2001 and was reiterated by the Kelkar task force as well as the FRBM reports.

The passage to the CST abolition in VAT reform seems to be long-winded and the decision to reduce the levy to only 3 per cent is disappointing. The expectation was that the CST would be halved in the first year to reduce the transaction cost significantly. There has been much discussion on the issue of compensation and here again the decision to assign the revenue from about 70 services to the states is disappointing, first, because, the states will get only revenue and not revenue powers and second, from the viewpoint of transition to VAT, input tax on these cannot be credited and, to that extent, cascading will continue. Besides, this will complicate the tax structure. It is important to assign general tax powers to evolve a proper state VAT. This would require a specification of rules of appropriation in regard to the services with inter-state scope.

On central taxation itself, not much can be expected. However, given the high buoyancy of direct taxes, the finance minister may take the courage to remove the surcharges on the high income tax payers. Observers will continue to lament on the unholy trinity of taxes""the fringe benefit tax, the securities transaction tax and the cash withdrawal tax, but they seem to have a long life.

The author is Director, National Institute of Public Finance and Policy. Comments at mgr@nipfp.org.in