Amaresh Bagchi: Time for a two-level VAT

The idea of a parallel Central and state GST (VAT) mooted by the Kelkar task force merits earnest consideration

Among the many commendable suggestions for tax reform made by the Kelkar task force (KTF) on the implementation of the Fiscal Responsibility and Budget Management (FRBM) Act 2003, the one that stands out as the boldest is the idea of a value-added tax (VAT) in the form of a comprehensive goods and services tax (GST) to be levied at two levels of government, Centre and the states.

Despite its loose ends, the idea conjures up the vision of a "world class tax system" in place of the messy regime of myriad taxes on goods and services that operates in the country, particularly at the state level.

Predictably, the idea caught the imagination of many people, and writings poured in urging its early adoption. Endorsement came also from the Twelfth Finance Commission. However, with the replacement of sales taxes with VAT in the majority of the states this year the suggestion seems to have gone to the backburner.

This is unfortunate. For the state VATs that have now come into operation provide only partial alleviation of the inefficiencies inflicted on the economy by our domestic trade tax system. In a rapidly globalising world, no country can afford to run a tax system that is not fully attuned to efficiency in the use of resources.

Hence the need for a comprehensive consumption tax like a destination-based VAT covering all goods and services. Clearly, there is a case for bringing the suggestion for a countrywide GST back on the table.

It is, however, necessary to be clear about what the KTF's suggestion for a GST actually envisages. Contrary to what many influential commentators supposed, while putting forward the idea of GST, the KTF did not propose the tax to be levied only at the national level, taking away the states' power to tax sales.

What the KTF had contemplated is a coordinated Central VAT and state VATs to be levied on a common base at reasonable rates with uniform procedures. The total incidence contemplated by the KTF was 20 per cent, made up of 12 per cent for the Central VAT and 8 per cent for the VATs to be levied by the states, with, however, some flexibility to the states in the matter of rates.

There should be no constitutional hurdle to this reform, the KTF reasoned, since with the 88th Amendment to the Constitution, the Centre can now tax services squarely. The reach of Central value-added tax (Cenvat) can go beyond the manufacturing stage since, according to the KTF, all post-manufacturing value addition results from "service" in some form.

Recognising that the Centre's foray into retail sales taxation may not be welcome to the states as it will mean an encroachment on their traditional tax domain, the KTF proposed a "grand bargain" whereby the states could be persuaded to accept such intrusion into their tax powers in return for the Centre agreeing to allow them to tax services in general.

The KTF's presumption that the Centre now has the power to tax sales, and that, too, down to the retail stage by virtue of its power to tax services is open to question, being prima facie farfetched. It would be advisable to empower the Centre upfront to tax sales at all stages through a change in the assignment scheme in the Constitution.

Given some give and take going beyond devolving the power to tax services, the states may be persuaded to accept the change in the larger interests of their economy. The crucial question is, can a two-level destination based sales tax like the GST be operated in a federal country?

The question came up for discussion at a symposium on "Federal Tax Reform and the States" held in Washington DC this May in the context of the proposal for a national retail sales tax (NRST) for the US to run in parallel with the retail sales tax (RST) of the states and replace the federal income tax.

Concomitantly, the states' RSTs would also undergo some major reform to enable them to meet the challenges posed for sales taxation in a globalising, service-oriented, digital economy. Such reform has become necessary to remedy its glaring infirmities arising from, inter alia, limitations on the states' power to tax inter-state sales emanating from the "commerce clause" of the US constitution and court rulings.

The remedy for that lies in the states moving towards a destination-based VAT or an ideal RST that spares all business purchases (unlike now) and allows a state to tax all sales/purchases for final consumption within its territory no matter the source.

It would also call for some coordination among the states in the matter of tax base and procedures, though not rates (except that there should be as far as possible only one rate per state) as in the EU.

Reflecting this recognition several states joined together in a Streamlined Sales Tax Project (SSTP) which has yielded a Streamlined Sales and Use Tax Agreement laying down a blueprint for reform of state RSTs.

Transformation of state RSTs into VAT or a truly destination-based sales tax would be greatly facilitated had there been a federal-level VAT as well. Hence the idea of an NRST. In a paper presented at the symposium Charles McLure, the renowned fiscal economist has welcomed the proposal as important and timely. But can a two-level VAT or RST work?

Until a few years ago, there was a belief among experts that VAT can be levied in a federation only at the national level. That impression has now given place to the acceptance of the feasibility of a two-level VAT, given some uniformity in the tax base and the procedures.

This realisation has come from the operation of two-level VATs in several federations, notably Canada. The introduction of a federal-level VAT or, alternatively, NRST, however, may not be simple in the US, especially since the federal government there does not have any experience in sales taxation.

Luckily, India has an advantage. Our Union government has long been operating an extensive system of excises, now named Cenvat, which is analogous to a manufacturers' sales tax.

Besides, a beginning has been made in coordination among states with the setting up of an empowered committee. Hence the suggestion for a two-level GST can and should be pursued earnestly.