Tax reform in a federal polity

An important issue in calibrating tax reforms in a federal system is the need to coordinate the reforms at the national and sub-national levels. Tax harmonisation, both vertically among different levels of government and horizontally among governmental units within each of the sub-national levels, is important from the viewpoint of minimising the collection cost, compliance cost and distortion cost. However, the very principle of fiscal federalism entails the choice to the States to vary their public service levels and tax rates.

CENTRE-STATE OVERLAP

In India, the Constitution divides the tax powers based on the principle of separation. The tax powers are listed either in the Union or State lists, but not in the concurrent list. Although this was intended to prevent overlapping in tax powers, in effect, interdependence of tax bases of the centre and states could not be avoided.

Thus, while agricultural income and wealth is subject to tax by the States, power to tax non-agricultural income and wealth has been assigned to the Central government. As a result, it has not been possible to levy income tax on a comprehensive concept of income and this has opened up an important avenue for evasion and avoidance of the tax.

In the case of indirect taxes, while the Centre is assigned the powers to levy “excise duty on manufactured products” and taxes on services, the taxes on “sale and purchase of goods” are assigned to the States. Excise duty on manufactured products, in effect, is the manufacturers' sales tax. Thus, separation of tax powers has not prevented significant overlapping in the tax system.

The prevailing assignment of tax powers has not enabled the levy of an efficient consumption tax system both by the central and state governments. At the Central level, the tax on goods cannot be levied beyond the manufacturing stage and the States cannot levy integrated taxes on goods with services as they do not have powers to levy the tax on the latter. Furthermore, the central sales tax levied to monitor inter-state transactions has made the sales taxes levied by the States predominantly origin-based.

STATE-LEVEL PROBLEMS

The State tax system is beset with a number of shortcomings. As mentioned earlier, the States have found it politically difficult to levy taxation of agricultural incomes, except in the case of a few plantation crops, and this has opened up avenues for evasion and avoidance of taxes on incomes.

The long-term reform in this area should essentially do away with the distinction between the sources of income. The States could be provided with concurrent tax powers to levy a surcharge on the base determined by the Centre. On the indirect taxes side, the bases of State sales taxes, even after the reforms to convert them into value-added taxes (VAT), are narrow, as consumption of services is excluded, and the continuation of the Central sales tax makes them predominantly origin-based.

Furthermore, the entire indirect tax regime at the State level is segmented with a number of taxes coinciding, such as purchase taxes, motor vehicles tax, passengers and goods tax, electricity duty, entertainment tax and stamp duties and registration fees, which need to be unified into a goods and services tax. Finally, the State and local taxes impede the free flow of goods and services across the country. Levies such as entry tax and octroi are in the nature of taxes on import of goods into a local area. Administration of these requires check-posts and this violates the principle of common market within the country.

THE CASE OF GST

An important success story in India is the reform of the cascading type sales taxes into value-added taxes (VAT) by the States in 2005-06. However, even after the introduction of VAT, the tax base continues to be narrow and a large number of other consumption taxes co-exist with the VAT. The narrow base is attributable to the fact that the States can levy taxes only on goods and not on services. Besides, there are a large number of exemptions in every State. Considering these and based on the recommendations of the Task Force on Indirect taxes and later, the Report of the Task Force on the implementation of FRBM Act, both chaired by Dr Vijay Kelkar, the Union Finance Minister, in his Budget speech of 2006 stated, “…It is my sense that there is a large consensus that the country should move towards a national level Goods and Services Tax (GST) that should be shared between the Centre and the States.”

Notably, the consumption tax reform involving the Central and State governments will have to make a compromise between tax uniformity and fiscal autonomy. While the aim should be to get the fundamentals of the reform right, compromise is unavoidable and the solution may have to settle at less than the best from the point of view of tax uniformity, but allowing for some measure of fiscal autonomy.

It is, however, possible that in many States the socio-political considerations may not allow them to adopt uniform minimum exemptions and a single, uniform rate. In fact, even as economists recommended moving over to a single rate of VAT in Sweden recently, the government found it impossible to change over to a single rate. In the European Union, the standard rate of VAT varied from 15 to 25 per cent, with a mean of 19.4 per cent, and except for Denmark, every other European country has one or more rates in addition to the standard rates.

Every effort should be made to minimise rate differentiation from the viewpoint of reducing distortions in the economy. But these are political decisions and compromises are unavoidable.

(The author is Chairman, Economic advisory Council to the Prime Minister.)

(Excerpts from a paper presented at the ‘Conference on Sub-National Tax Powers in Non-OECD Federations’, on December 12.)

COMMENT NOW