The Hindu Business Line : The State of VAT

The Tamil Nadu government's white paper on `State-Level Value-Added Tax' released in January 2005 states: "The VAT will not only provide full set-off for input tax as well as tax on previous purchases, but also abolish the burden of several of the existing taxes, such as turnover tax, surcharge on sales tax, additional surcharge, special additional tax, etc. In addition, Central Sales Tax (CST) is also going to be phased out."

It is expected that State-level VAT will be self-policing, improve tax compliance and reduce price, which together will increase tax buoyancy. Though the sales tax rates are expected to be the same across States under State-level VAT, there is some flexibility — States are allowed to exempt 10 items of their choice from State-level VAT, and to incorporate slight changes in the tax laws and administration.

The Centre, which initially allocated Rs 5,000 crore in Budget 2005-2006 for payment of compensation for revenue loss on account of implementation of State VAT, reduced it to Rs 2,500 crore as only 22 States introduced VAT in 2005. In 2006-07, the allocation towards compensation is Rs 2,500 crore. This seems to be inadequate, as the revenue loss for States is likely to be large on three counts.

One, by design the input tax credit is bound to reduce States' tax revenue. Two, the amount of tax credit to be allowed by States is likely to be larger than warranted if one goes by the excessive VAT credit allowed by the Central Excise Department as mentioned in the various CAG Reports. Three, on an average, tax rates in State VAT are less than the tax rates in the earlier sales tax regime.

VAT rates

The State-level VAT has three rates — 1 per cent on bullion, 4 per cent on essential commodities, and 12.5 per cent on other commodities.

Fifty-six items are exempted from the State VAT; petrol and liquor attract non-VAT sales tax rate of more than 20 per cent. Therefore, sales tax is not entirely VATable; there is no single VAT rate, which is considered essential for efficient tax administration. Since April 2005, States have moved commodities between the 4 per cent and 12.5 per cent categories.

Recently, Kerala increased the VAT rate on some luxury commodities and construction materials to 20 per cent. These are done citing reasons of trade diversion between States, higher revenue and need for progressiveness in the tax structure. Thus, tax rate harmonisation across States has not yet been achieved.

Under State VAT, the trader is given set-off for input sales tax. Conceptually, this set-off should, on the one hand, reduce the tax revenues to State governments and, to a similar extent, reduce prices when the tax credits are passed on to the customers. On this account, as the own tax revenues of States are bound to decline, the Centre had promised to compensate 100 per cent of such loss in 2005-06, 75 per cent in 2006-07 and 50 per cent in 2007-08. No compensation will be given thereafter.

Looking at the revenue efficiency of VAT administered by the Central Excise Department since 1986-87 and the year-long experience of State-level VAT, many changes in the tax system are needed for garnering the intended benefits of State VAT, namely, revenue efficiency and promoting undistorted trade across States.

Lessons from State VAT

The general opinion is that sales tax revenue has increased substantially after the introduction of State VAT. One has to look at two issues here.One, whether the increase in tax revenue is in tandem with the increase in the tax base and whether the input tax credit is passed on to the customers.

The Budget documents of the eight major States that adopted VAT along with that of two non-VAT States reveal the fact that, except Punjab, all the other States, despite increase in State VAT revenues on trade, sales, etc., face a sizable decline in their sales tax buoyancies. Further, the input tax credit is also not passed on to the customers as the annual inflation indices in the VAT-implemented States are, on an average, higher than those of non-VAT States.

The Table gives the sales tax buoyancy (sales tax revenue as percentage of nominal GSDP) of 10 major States along with the annual inflation (calculated using the average Consumer Price Index) of urban non-manual employees.

The sales tax buoyancies, if calculated only for the commodities covered by State VAT, should be lower than the ones given in the Table.

The sales tax revenues of States include non-VAT and cascading sales tax on petrol and liquor which attract more than 20 per cent tax rate. If the tax revenue and the corresponding tax base for petrol and liquor are excluded, then the sales tax buoyancies due to the State VAT would be quite low.

Thus, it is clear that the revenue loss to State governments would be substantial. Further, a cause for concern is that the benefits of input tax credit are not passed on to the consumer.

Despite the existing revenue loss, State governments have agreed to reduce CST by 1 per cent from October 1, 2006, subject to the willingness of the Centre to compensate for the consequent revenue loss. In this regard, the States want the devolution of services taxes to be increased to 50 per cent and powers to impose tax on intra-State trade on 68 new services.

In sum, this analysis raises the following issues:

Either a political consensus should emerge to harmonise tax rates or the strengthen tax administration to stop trade diversions due to differences in tax rates.

Coerce the Centre to adequately compensate for the loss of revenue owing to implementation of the State VAT and phasing out of CST.

Strengthen the tax administration to discourage excessive input tax credit claims by the traders.

(The authors are Full Time Member, State Planning Commission, Tamil Nadu, and Research Fellow, Madras School of Economics, Chennai, respectively. The views are personal.)