'Employment is central to tax policy'

Q&A/ M Govinda Rao

Equity in tax policy is no longer equated with reducing incomes of the rich, but is associated with increasing the incomes of the poor.

The rich who possess capital provide employment to the poor, and employment generation has more to do with expenditure than with tax policy, says M Govinda Rao, Director, National Institute of Public Finance and Policy, and member of the Prime Minister's Economic Advisory Council.

He spoke to Business Standard on what implementation of the value-added tax (VAT) would mean for India. Excerpts:

Will the VAT that will be in place from April 1 result in a loss in tax revenue?

There are at present eight to 16 tax rates ranging from 2 to 16 per cent (even after leaving aside special rates such as 1 per cent on precious metals and 20 per cent on petroleum products).

Most states have now put 275 such goods under the 4 per cent VAT category "" many of these are currently being taxed at 7 to 9 per cent rate. Forty-six commodities have been exempted from tax and the rest have been put under the 12.5 per cent VAT rate.

In effect, the new VAT lowers the tax rate substantially. The question is whether the expansion through better compliance under VAT is enough to make up for the reduced rates. Imagine a situation where the input is taxed at 4 per cent and the output at 12.5 per cent.

The 4 per cent VAT credit on the input will be very small while the 12.5 per cent VAT on the output will be much higher.

So, there is an incentive for the final producer not to report his production "" he will save the 12.5 per cent tax on the output and not get credit on only the 4 per cent VAT on the input.

Which is why a well-designed VAT has lower tax differentials and does not make distinctions between input and output as has been done now.

Other reforms needed include giving back additional excise duty on sugar, textiles and tobacco in lieu of sales tax to the states. The "declared goods" category where the ceiling rate is 4 per cent should also be done away with. These are small things which can turn out to be big irritants later.

What will be the impact of introduction of VAT?

The relative price configuration will change, but since most commodities will be put under 4 per cent rate, the general price level may actually decline.

VAT will however be a better system than what we have currently. West Bengal alone has over 16 tax rates now, and no simplification in tax structure was introduced before VAT. The new system will bring in uniformity in the rate structure and legal framework.

In terms of harmonisation, VAT is huge step forward. The problems would be much less than what you have today.

What about the compensation the Centre has offered to pay to the states?

A study conducted by Pinaki Chakraborty at the National Institute of Public Finance and Policy as late as September 2004 showed that in two major states, Andhra Pradesh and West Bengal, there would be no major revenue impact due to the introduction of intra-state VAT. Central sales tax, or CST, is a different matter.

CST is richer states levying a tax on consumers in poorer states. When compensating larger states like Maharashtra and Gujarat, it is better to give them taxation powers for, say, sugar, textiles and tobacco, rather than giving cash compensation which involves moral hazard.

Promising a 100 per cent compensation is not very desirable because it involves moral hazard but had to be given as it had been promised by the previous regime.

The Technical Experts Committee had suggested a limit should be imposed on the level of compensation "" this was not accepted. We had suggested that 2004-05 be taken as base year and the previous five years' growth be used to make projections. The finance ministry has said that the best of three of the last five years will be used.

This will create additional problems. For instance, the North Eastern states which had to impose sales taxes and raise rates in the last five years to adhere to the floor rates have seen phenomenal growth rates in tax collections "" so they will be over-compensated on this count.

Your reactions on the new Finance Commission recommendations.

In general, the gap filling approach itself is incorrect. It has been the bane of the system because with this approach, each state wants to show a bigger gap so they can get more.

A broad indicator of expenditure needs could be a better basis for giving funds to states. For instance, the number of children in a particular age group should be used to calculate a state's need for education expenditure.

A comparison of the expenditure needs and of resource capacity of a state could provide a measure of the transfers required. The Ninth Finance Commission had made a beginning on this issue.

Other institutional changes required include doing away with the distinction between "plan" and "non plan" expenditure.

The Planning Commission should not give grants, all grants should go from the Finance Commission which should have a permanent professional secretariat.

The Planning Commission should be in charge of physical infrastructure, loans required for them and cost-benefit analysis.

What are the five most important things that need to be done on the taxation front?

The most important thing to do is to strengthen the Tax Information Network with information from the customs, excise and sales tax side. Take a 10 per cent sample, conduct a detailed audit, impose huge penalties and quicken disposal of disputed cases.

The increase in tax revenue last year and the year before that was because the introduction of the permanent account number created a fear of information networking.

Phasing out small-scale industry exemptions and rationalising the excise duty structure are another area.

Cement and sugar duties should be converted to ad valorem rates, all import duty exemptions should go and be replaced with at least a 5 per cent tax, peak duties should be cut 5 per cent, the service tax should be extended to all services (maybe with a threshold of Rs 20 lakh) and then merged with the tax on goods and provide tax credit for both goods and services.

What is the likelihood of exemptions going?

All exemptions will not go. Politically, it is not possible. The world over, there was a time when we thought that equity in tax policy meant reducing the incomes of the rich.

But today's tax philosophy is that equity in tax policy is increasing the incomes of the poor. The incomes of the poor cannot be increased by reducing those of the rich, because the latter possess capital for investment and provide employment for the poor.

To increase employment for the poor, you don't need tax policy so much as expenditure policy.

A 90 per cent marginal tax rate will not bring in equity because you are dealing with less than 3 per cent of the population which actually pays the taxes and it does not make much sense to talk about equity within this class.