Giving states a share in service tax

India's indirect tax system, comprising both the federal and state taxes, is inherently complex in nature. Apart from the complexity created through the multiplicity of taxes that are inherent in this structure, the aggregate incidence of indirect taxes is also exceedingly high thereby impacting aggregate consumption. Independently, the fact that these taxes are not offsets against each other results in cascading, thereby exacerbating the problem with attendant consequences on inflation.

The introduction of the value-added tax (VAT) has, therefore, indeed been a paradigm shift in the Indian indirect tax structure and perhaps the most remarkable fiscal reform since Independence. However, there still remains inconsistency relating to the manner of operation of the VAT on goods and services. As the VAT on goods is a state levy and the VAT on services, i.e. the service tax, is a central levy, and there is no agreed distinction between goods and services, the very problem of treatment of a particular transaction as both a supply of goods and a provision of service poses a considerable challenge to integrating the indirect taxation of goods and services. It is in this context that the discussion surrounding the ability of the states to tax services needs to be placed.

The introduction of a Goods & Services Tax (GST) by April 1, 2010, has forced both the central government and the state governments to explore the most efficient way of integrating the taxation of goods and services. One such step is the complete phasing out of the Central Sales Tax (CST) effective from April 1, 2007, the CST has been reduced to 3 per cent from the prevailing rate of 4 per cent and a roadmap has been announced for its further reduction and complete phase out by the year 2010. As abolition of the CST would entail a significant loss of revenue to the states and indeed the phased reduction in the CST is a cause of concern, the states are seeking a suitable compensation package in return. Given the above background, the Centre has recently offered to compensate these states for the CST phase out by offering them the tax revenues arising from 33 of the existing services that are currently taxed by the Centre, as also the revenues from 44 new services that are proposed to be introduced.

The Empowered Committee of the State Finance Ministers, in its meeting at Srinagar, has identified five new services for the purpose of state taxation "" services provided by schools, doctors, hospitals, amusement parks, and coin operated amusement machines. It is understood that the Empowered Committee has cleared this proposal and that a Bill is likely to be introduced in Parliament to enable the aforesaid taxes to be brought into effect.

There is currently a debate as to the relevance and appropriateness of these proposed taxes in so far as they relate to education and medical care. It is a fact that these two sectors were not taxed till date by either the central or the state governments in any meaningful manner given their centrality to public policy and health. These sectors were clearly understood as providing social goods and services. The point is, therefore, whether the move to bring these sectors into service taxation is at all something that the states would welcome.

However, an appropriate and relevant definition of social goods and services is equally required so that an exemption from a tax is limited to only the identified consumers of such appropriately defined goods and services. For instance, service taxes at the central level have been imposed on commercial education, not understood to require any particular dispensation, under service tax for quite some time now. A similar thought process appears to be behind the idea of extension of the service tax to more areas of education. In other words, it is the Empowered Committee's proposal to only tax the educational services provided by private schools and to college fees of Rs 1000 and more per month. Thus, the question is whether the education services provided by private schools and the threshold level of college fee for service taxation are appropriate means of excluding them from the purview of public services and hence eligible for an exemption from tax. It could be argued that given the paucity of public schools of adequate quality, private schools do indeed play a legitimate role in fostering education at large, and an entirely similar argument can perhaps be made in relation to the threshold level of college fee as well.

A similar discussion is currently on in relation to taxation of medical care. The idea that medical care is increasingly a differentiated product and that the states cannot continue to exclude the entire health care sector from taxation is very much the background to the discussion. No blanket exemption from tax for health care can any longer be made. The Empowered Committee indicates that the taxation of health services at the state level will be introduced in a manner that will not affect the health care needs of the common man. It is as yet unclear as to how the healthcare sector segmentation will take place so that the tax is limited only to those services which are consumed by sections of society which can bear the tax.

An entirely different point, and a more fundamental one, is whether the extension of services taxation at the state level, as a means of compensating the states for revenue losses arising from the CST discontinuation, is at all required at this juncture prior to the introduction of the full fledged GST from 2010. This point is relevant given the complexity of the taxation of services at state-level as also in view of the difficult-to-tax areas of education and health care to which the state service tax is proposed to be first extended. To put it differently, the question is whether taxation of services is an appropriate response to the state's desire for revenue compensation. Perhaps there could be other responses to address this request. It, however, seems that the Empowered Committee has deliberated this point and has come to a determination that the taxation of services by the states is perhaps inevitable.

The above point brings into the connected discussion the manner in which such service taxation by states ought to be introduced. The question, given the seeming inevitability of states being entitled to such revenues, is whether it is appropriate for the Centre to continue to legislate on state service taxes and for the states to limit themselves to collection of such centrally legislated levies or should the states be authorised to both legislate and collect the tax. It is probably a fair comment to suggest that the appropriate model of services taxation by the states is still under discussion by the Empowered Committee and that a final picture will emerge in the near future, hopefully sooner rather than later.

To summarise, the issue of services taxation by the states has been addressed from a variety of standpoints both by the central government and the state governments, through the mechanism of the Empowered Committee, and a clear position is expected to emerge in regard to this very complex matter in the foreseeable future.