M Govinda Rao: Towards a dual GST - Reforms needed

The agreement by the Empowered Committee (EC) of State Finance Ministers to roll out a dual VAT at the Central and State levels is an extremely important step in the domestic trade tax reform in the country. Although very little is known at present about the details of the design and implementation mechanism and the final roadmap is expected to be announced on December 20, the agreement by the EC to adopt GST in April 2010 is a landmark decision.

However, this is only the beginning of the long and arduous road to the final destination. Indeed, the tax system reform involving the Centre and 35 states and Union Territories entails significant compromises and it is important to ensure that the process does not compromise the fundamentals of a sound tax system and federal principles. Although the dual VAT does not completely unify the tax structure and administration, this is perhaps the best feasible solution in the context of preserving the states' fiscal autonomy while harmonising the tax system. However, there are questions relating to the structure of the tax, the base and the rates, the administrative system and transitional issues.

Clearly, it is necessary to have the tax rate low, which means that the tax base must be broad. The prevailing statutory CENVAT rate of 16 per cent and 12.5 per cent state VAT does not give any indication on the revenue-neutral rate (RNR) due to the narrow coverage and multiple tax rates. The report of the Kelkar task force recommended the combined rate of 20 per cent but that was not worked out in any scientific manner.

While it is important to design the tax to be revenue-neutral, it is also important to realise that levying the tax at a high rate would only reduce compliance. In 2007-08, the estimated combined revenue from domestic indirect taxes from the Centre and states was 9.5 per cent of GDP or 11.6 per cent of NNP. By assuming the savings rate at 33 per cent, the combined burden of central and state domestic indirect taxes as a ratio of total consumption can be estimated at about 17 per cent. As all consumption, particularly government consumption, cannot be taxed, the RNR even with a comprehensive base will have to be higher than this figure. It is necessary to undertake detailed studies to estimate the RNR and hopefully, the EC will undertake them before a final decision is taken.

In any case, from the viewpoint of tax compliance, it would be inadvisable to have the combined burden of the tax more than 15 per cent. In fact, Thailand levied VAT at 7 per cent in 1992 even as the estimated RNR was 10 per cent and yet recovered the revenues besides sharply increasing the revenue productivity of income tax. Indeed, it is possible to levy the tax even at a lower rate to realise the present revenues. This would require the levy of separate excise on petroleum products (carbon tax) and on tobacco products and alcohol (sin taxes). In addition, it may be necessary to levy a separate excise on luxury items of consumption to keep the general VAT rate low.

Surely, the tax base must be comprehensive to include all goods and services except unprocessed food items and a few services as recommended by the service tax committee chaired by me in 2001. The tax should be levied at one rate by the Centre and another by the states. Indeed the states should have the autonomy to decide the rate, but to avoid tax competition the floor rate may be stipulated. Experience has shown that multiple rates designed for equity do not really serve the objective, but only add to administrative complexity and to increase the compliance cost. There are sectors difficult to tax, such as the financial sector and housing and a clear decision on the way to include them in the tax base is necessary.

Determining the base and rates is only one of the several important decisions to be taken. The transition to VAT involves significant reforms. At the central level the important reforms include unification of central CENVAT rates including the conversion of specific into ad valorem, extending service tax to all services with a small exempted list to convert CENVAT into a manufacturing stage VAT on goods and services as was recommended by the service tax committee in 2001. Hopefully, the forthcoming budget will take measures at least to unify the excise rates into one and extend the base of the service tax to make it a general tax from its present selective character and unify the rates of taxation on goods and services. Extending the service tax base would enable the Centre to reduce the CENVAT rate as well. Indeed, on petroleum and tobacco products, there can be a separate sumptuary excise. Of course, enabling the Centre to levy retail stage VAT can be done only after the Constitutional amendment.

The reforms at the state-level relate to the phasing out of central sales tax and the levy of service taxation. On the former, the EC has already decided to make the tax destination-based by transferring the tax collected on goods sold on inter-state sale to the destination state. In order to levy the GST at the state level it is important to give concurrent service tax powers to the states and given the difficulties in determining the place of performance in the case of services with inter-state spread, it would be necessary to agree upon the revenue accrual arrangements based on "place of supply rules" as in Canada.

The transition to the VAT regime requires considerable preparation and the EC will do well to set things in motion without any loss of time. There are considerable changes to be made in administrative organisation, legislation, returns, assessment, computerisation and information system, capacity building, adjudication, taxpayer services and transitional issues. It is extremely important to institute an effective mechanism to enforce decisions. The EC must be commended for leading the reform so far, but its record at enforcing the decisions taken has not been impressive. As the dual VAT is levied there will be a need for a permanent mechanism to resolve inter-state and Centre-state disputes.

The author is Director, NIPFP. Comments at mgr@nipfp.org.in