The Hindu Business Line : Phase out the ambiguities

"WAR," said Clausewitz, "is uncertainty accompanied by friction, chance and disorder". The road to tax reform may not be as forbidding. Recent experience has taught us that friction and disorder cannot be completely avoided during such an exercise.

Consequently, efforts need to be redoubled to eliminate that prime imponderable — uncertainty; in reaching the next milestone on the declared road to the Goods and Service Tax. There is the planned phase out of Central Sales Tax (CST), to 2 per cent from April 1, 2006, and zero from April 1, 2007.

In principle, all parties — trade and industry, the Centre as well as the States — have accepted the need to eliminate CST as part of the VAT reform package. The CST Act was amended in 2003 to allow for a tax rate of 2 per cent and awaits notification.

However, the devil insistently remains in the details. How will States be reimbursed for the losses anticipated? States and the Centre need to reach agreement on this major issue.

States apprehend that the CST revenue of Rs 18,000 crore may fall drastically to half when CST is reduced to 2 per cent from April 1, 2006. They want to be compensated in cash for this loss.

It is argued that the reduction in revenue may not be linear, with the lowered CST rate leading to increased compliance and thus smaller than anticipated losses. Conversely, a lowered CST rate may enhance perverse incentives for the trade to report intra-State sales liable to VAT at 12.5 per cent as inter-State sales liable to CST at 2 per cent.

This pursuit of arbitrage may increase CST revenues only at the cost of VAT revenues. The essential thread in this debate seems to be that the Centre, under FRMB pressure, is seeking to limit its exposure to providing cash compensation to States. Alternate fiscal headroom is sought to be provided through a yet-to-be determined mix of four `non-monetary 'options.

These are (a) imposition of VAT on imports, (b) return of taxation powers on AED (Additional Excise Duty) items — tobacco, sugar and textiles to the State, (c) increase in the VAT rates of 4 per cent and 12.5 per cent by 1 per cent, and (d) transfer of tax on select services for collection and appropriation by States.

The levy of VAT on imports is technically unexceptionable in a destination-based VAT regime. Equally, the VAT on goods paid by an importer must be allowed to be set off against downstream VAT paid to States.

In such a case, the net additional revenue to State governments from this measure may be insignificant. Further, such a VAT may need to be levied and collected by the Centre and distributed amongst States on a consumption basis by putting in place a formidable accounting procedure. This accounting cake may not be worth the candle.

Nearly 50 years ago, States agreed to hand over the power of taxing tobacco, sugar and textiles to the Centre in return for sharing of the proceeds of an Additional Excise Duty levied on these items. Returning the power of the taxation on these items may not lead to additional revenue for the States if this is accompanied by lowered devolution from the Centre.

Whether AED can continue to be levied even after such a transfer to States is debatable. Also, at present, the Centre is disbursing about Rs 4,000 crore to the States under this head, while it is collecting only about Rs 2,600 crore from AED.

Understandably, the Centre wants to return this fiscal power to the States. For the same reason, major States do not want it. These major States also apprehend that bringing dealers in tobacco, textiles and sugar into the VAT net is going to be a long-drawn-out exercise. Revenues may not pick up immediately.

Increasing the basic VAT rates of 4 per cent and 12.5 per cent by 1 per cent to generate additional revenue under VAT may not be the solution it portends to be.

The existing VAT rate of 12.5 per cent is already seen as too high. Coupled with the average excise duty of 16 per cent, the total tax burden on most goods would be around 28.5 per cent.

This figure significantly exceeds the 20 per cent rate recommended for standard goods by the Kelkar panel. Trade and industry representatives feel that efforts should be made to reduce this figure, rather than increase it.

Displaying a buoyancy of nearly 65 per cent this year, service tax collections are likely to overshoot the Centre's Budget projection of Rs 17,000 crore this year.

States want a greater piece of this pie than the present 30.5 per cent allowed to them. They want the power to collect and appropriate tax on an agreed list of services. The Centre could retain the major services.

States have a better claim for the residual services for three reasons. First, most of the residual services arise in an incubating environment nurtured by them.

Second, State Governments have much stronger field formations than the Centre to collect service tax.

Third, allowing States to collect and appropriate such taxes will provide positive incentives to `services friendly' State governments. However, the Centre does not appear inclined to part with this golden goose. Increasing the devolution percentage of the collection proceeds to 50 per cent is an alternative being considered.

The review of the four sources of `non-monetary' compensation reveals that State Governments remain lukewarm to them. They would prefer the CST compensation to be provided in cash as has been the case in VAT.

The Centre is not keen to do so for fiscal reasons. The Centre feels that these are viable sources of additional revenue. These differences in perception need to be bridged quickly.

Prompt removal of this uncertainty regarding CST phase-out is necessary. This will enable trade and industry to arrange their affairs in advance and maximally benefit from this reform measure, which is barely two months away.

(The author is Commissioner, Commercial Taxes, Government of Andhra Pradesh. The views are personal. E-mail: vbhaskar@msn.com.)