M Govinda Rao: VAT 2005: Gains outstrip losses

Despite transitional issues that need to be resolved the new system will be less distorting

A senior technocrat in the government, in a state of frustration, seems to have said that in India there is a "strong" consensus for "weak" reforms.

The decision of seven important states not to switch to the new tax regime on April 1, 2005, is a real dampener for the efforts of the Empowered Committee of State Finance Ministers to forge consensus on the reform.

This is also a great disappointment to those who advocated reforming domestic trade taxes to bring about an unhampered common market in the country.

The experience with reforming the domestic trade taxes is a clear example of how little economic considerations matter in political decisions.

After all, it was the NDA government that pushed the VAT agenda when it was in power, though it developed cold feet towards the end to satisfy the traders' lobbies.

But it is difficult to fathom why even for a state like Tamil Nadu, economics does not matter. The concern is about these states shooting at their own feet.

Indeed, the proposed reforms have important shortcomings. There is no gainsaying the argument that it is necessary to have a clear roadmap for abolishing the central sales tax (CST) before introducing VAT.

A clear decision in this regard is necessary and it is important to work out the modalities either through zero-rating, or a clearing house mechanism, or a compensatory VAT.

It is also necessary to institute the information system needed to ensure that the intra-state sale is indeed to the register dealer in the importing state and intra-state trade is not camouflaged as inter-state sale to evade the tax.

Although ICICI Infotech has been retained for the purpose, the conceptual issues relating to the mechanism to relieve the CST to make the tax system destination-based and to preserve the common market are yet to be resolved.

The issue is particularly of concern to the poor, consuming states because its citizens have been paying a significant amount of taxes to the more advanced producing, states in the prevailing system.

Another legitimate fear of dealers is that of harassment by the officials. The recent expose by a television channel about the goings-on in the sales tax department in Delhi has not helped matters.

It is important for all tax departments to clarify and, more so, demonstrate that VAT does not involve a greater interface of taxpayers with tax officials and a critical element of reform is in moving over to an information-based system of administration in which self-assessment plays a critical role.

At the same time, the system should have a certain percentage of the taxpayers subject to detailed audit and the selection of the cases will have to be computer generated based on risk assessment. Even in the cases of detailed audit, it is necessary to lay down the ground rules.

The most important worry for many traders is that they will now have to pay taxes. Delhi, in particular, has been notorious for tax evasion and has been a virtual tax haven, and naturally, the traders in Delhi are the most worried lot.

Even the argument that traders with a turnover of up to Rs 10 lakh are exempted and those with a turnover of up to Rs 50 lakh will pay a simplified tax on turnover has not cut much ice because when you establish the information trail, as VAT does, most dealers would have a turnover above that. Obviously, they will try to every trick and flex political muscles to defeat the purpose.

Now that only 21 states have agreed to proceed with the levy, the situation is certainly not ideal. What happens when most states switch over and others do not? Surely, the states that levy VAT are likely to be the gainers.

In general, the states levying VAT have over 275 commodities subject to the tax at 4 per cent; the non-VAT states will either have to reduce the rates on these commodities or suffer trade diversion in favour of the VAT states, where the tax rates are lower.

Indeed, in respect of some commodities, the VAT states may have higher rates, but they need not fear, because if they lose revenue, the compensation package of the central government provides the insurance.

Thus, on the whole, the states adopting VAT are likely to gain, but the country will suffer more distortions due to trade diversion. As regards the investment climate, the situation may not change much because most investors would expect that even the non-VAT states will eventually fall in line.

In any case, even the non-VAT states have a system of concessional treatment of inputs for tax purposes, but there will be increased demand by investors for further concessions.

The other important outcome of the development is that the compliance cost of the tax would be much higher than what it would have been had all states adopted VAT.

In most discussions, considerations have been made only for tax administrators and immediate taxpayers. From the viewpoint of the ultimate taxpayers, who are the consumers of goods, the critical question is what would happen to prices in the short term.

While there is no reason for the absolute price level to change, relative prices can alter. However, whether the introduction of VAT will result in an increase in aggregate prices cannot be definitely answered. Surely, in respect of a number of commodities, in the tax rate is lower in the new regime and therefore could lower prices. However, the improved compliance of VAT will increase the effective tax rates because people who evaded the tax in the past will have to pay now.

If the benefit of past tax evasion was to the consumers by way of lower prices, better tax compliance could increase the prices on these goods by the quantum of the tax. This can happen in a buyer's market, where the traders adopt every strategy to reduce prices and expand their businesses.

Alternatively, if the traders gained from the tax evasion in the past, the VAT would be a tax on his rent. The actual position is likely to be somewhere in between, depending on the nature of the market.

There are a number of shortcomings in the design of VAT as well as its implementation strategy. To begin with, this is only a halfway house and quite an additional distance has to be traversed. On many issues, the states are not ready.

There has been a lot of publicity campaign in the last couple of weeks, but the emphasis is on cautioning the taxpayers rather than educating them.

There are many transitional issues that need to be resolved and there will be a number of additional issues that will come to the fore as the tax is implemented. It would be too optimistic to expect a smooth transition.

Nevertheless, it is hoped that the new system will be less distorting, will improve revenue productivity, and reduce tax compliance. Surely, we could have done without additional problems of disharmony and confusion due to the reluctance of some states in embracing the reform.

The author is the Director, National Institute of Public Finance and Policy. The views are personal.