Amaresh Bagchi: State VAT: Some imperatives

To realise the benefits of VAT, some critical weaknesses need to be cured

The value-added tax (VAT) is firmly on the country's reform agenda. Excise duties levied by the Centre, christened Cenvat, are already in the VAT mould.

The deficiency in Cenvat arising from a stand-alone service tax has been remedied in this year's Budget with the extension of credit paid on inputs across goods and services. Sales taxes of the states are also going to be replaced with a harmonised VAT from April 2005, based on a blueprint finalised by the empowered committee of state finance ministers.

Meanwhile, the task force headed by Vijay Kelkar has come up with a proposal for an integrated VAT on goods and services to be levied by the Centre and the states in parallel, removing all the sundry taxes like the octroi levied by the states.

If acted upon, the task force proposals will change the domestic trade tax system radically. However, the pros and cons of the proposals need to be debated in greater depth as questions have been raised about its feasibility under the Constitution as it stands now and even desirability, particularly because of the implications for vertical fiscal imbalance, and thus federal fiscal relations.

The matter for immediate concern is whether and how far the scheme of VAT touted by the empowered committee would serve to advance the domestic trade tax reforms in the right direction.

In a federation, ideally, a subnational sales tax, of which the consumption-type VAT is a modern variant, should bear three economic attributes. First, it should tax all sales of goods as well as services within a state at a single rate.

This facilitates compliance and administration by avoiding the need to distinguish between products taxed at different rates. Besides, many products can be used for final consumption as also as inputs.

Second, it should not tax sales to business so that choices of production and distribution techniques are not distorted. Third, it should follow the destination principle whereby imports are taxed like domestic products while exports, whether to other states or to other countries, are relieved of all domestic trade taxes.

This serves to allow a free flow of goods and services within the federation and thereby foster the common market. There is, however, no requirement that all states must levy the tax at the same rate.

At first sight, the contemplated state VAT scheme has all the appearances of a VAT as commonly understood, viz. multistage sales taxation with credit for taxes paid on business purchases.

However, a close look reveals certain rather critical weaknesses that need to be cured if the benefits of a full-fledged VAT are to be realised. The major weaknesses are three-fold: Absence of services in the base, multiplicity of rates, and insistence on uniform rates across states.

A major weakness of the proposed state VAT scheme is the absence of services in the base. With service taxation now squarely on the Union list, it is difficult to see how the states can be empowered to include services in their VAT base. With the ambit of the service tax levied by the Centre expanding every year, the pitch is queered beyond redemption. Some way must be found to remedy this deficiency.

As for the rates, the states are reported to have agreed to a three-rate structure: 4 per cent for some 250 items (agro-products and manufacturing inputs), 12.5 per cent for 217 other items, and 1 per cent for gold and precious metals.

Differential taxation and that too for so many items violates the first requirement of a good VAT as noted above. The VAT system of the European Union allows a "reduced rate" for less than a dozen commodities that are considered essential for human consumption for distributional reasons and even that is thought undesirable by many.

Then the rates are supposed to be applied uniformly across all states, leaving no discretion for any state in the matter. This undermines the fiscal autonomy of the states and is unnecessary. All federations (and economic unions) have to contend with the tension between the fiscal sovereignty of the constituent units and harmony in their tax systems to achieve a single market.

The destination-based VAT serves to resolve this tension neatly by enjoining that business to business (B to B) sales across states bear no tax while allowing them freedom to tax their citizens at rates of their choice, subject only to a floor, the latter felt to be necessary to check harmful tax competition.

The Sixth Directive of the European Commission (EC), while providing the framework for VAT for all member countries, prescribes only the "floor" for both standard and reduced rates.

A proposal was advanced by the EC in 1996 for a uniform rate of VAT across the European Union to reduce the compliance costs of the "deferred payment" system now in operation for "zero-rating" intra-EU B to B sales but it has found no support among member countries as it was to be an infringement of their fiscal sovereignty.

In the US, the states enjoy complete freedom in sales taxation as long as they do not interfere in inter-state trade and commerce. Faced with problems created by e-commerce and distant sales and to bring about a measure of harmony, a project was launched in the year 2000 to streamline states sales taxes (SSTP).

While enjoining uniformity in many matters like defining products, source rules, and so on, SSTP does not envisage any curb on the powers of the states in rate fixation.

One wonders what prompts the states in India to opt for "uniform floor rates," from which no one can deviate and thereby surrender a vital element of their fiscal autonomy unless they find it expedient to shed their revenue-raising responsibility and turn more and more to the Centre to meet their expenditure.

With the level of taxation varying among the states at present, a standard rate of 12.5 per cent is also not going to be revenue-neutral for all states. There will be large revenue gaps in states that have been raising substantial revenue with above average tax effort while surpluses will emerge in others.

If the ambit of reduced rates is restricted only to essential items, the RNR for most states is unlikely to go beyond 8 to 12 per cent. A floor rate of only 8 or 10 per cent would be appropriate for all.

Instead of agreeing on a uniform rate, states would do well to harmonise their VAT laws and procedures. That is still gravely wanting.

Another deficiency in the scheme under contemplation is the absence of a sound strategy to guard against fraud when the central sales tax is abolished and inter-state sales are zero-rated in the state of origin. Zero-rating can be disastrous for revenue unless adequate safeguards are put in place.

Several models are now available for operating a destination VAT at the state level (vide for instance International Tax and Public Finance, November, 2003). These need to be debated and the model that suits us best put in place before CST goes.

There is also the question: What is the sanction behind the empowered committee's decisions? What happens to a state if it chooses not to join or go its own way? Can it be punished by any authority under the Constitution? It is imperative that these issues are addressed before "agreements" engineered by the empowered committee are implemented.

(The author is Emeritus Professor, National Institute of Public Finance and Policy)