Compensate, Incentivise States To Introduce VAT

Updated: Jul 28 2004, 06:07am hrs
The Union Budget 2004 has reiterated the decision taken by the Empowered Committee (EC) to introduce state valued-added tax (VAT) on April 1, 2005. Earlier, the government had set deadlines twice that could not be met due to various reasons. If the EC does not meet the new deadline, its credibility is bound to get eroded.

An analysis of the causes for the earlier postponements shows that apart from the fact that the states and taxpayers were not fully prepared for VAT introduction, one of the key issues confronting states was the loss of revenue expected after the VAT regime. With their finances already in a precarious position, the states could ill afford to lose revenue from the tax that yields approximately 67 per cent of their own tax revenue.

The experience of VAT introduction in most countries (see Value Added Tax: Experiences of VAT in India and Other Countries, Gayatri Publications) and in Haryana, however, shows no loss of revenue. In addition, the Union finance minister has reassured the states that in the event of any revenue loss, the ministry would announce a compensation package. It is, therefore, important that the compensation package is fair and balanced. It should, on the one hand, meet the actual loss of revenue to the states in the transition period; while, on the other, it should not penalise the states that implement the system properly and manage no revenue loss. In other words, it has to be a compensation-cum-incentive package.

While working out the package, it is important that the following issues are taken into consideration:

nciples Of Loss Measurement
This issue relates to the mechanism of measurement. Generally, it is useful to adopt a normative approach wherein the change in revenue due to VAT for a state is compared with changes in its past revenues vis-a-vis similar changes in VAT revenues and the overall trend of past revenues of all the states. In this context, it is important to note that there will be some loss of revenue when the first-point sales tax is converted into a VAT, depending upon input-credit given to the manufacturers. In the Indian context, a states loss will be of the extent of the input component, and would have to be measured by the input-output relationship in each state. In states where a majority of commodities are taxed at the last point, the loss of revenue will be lower. Punjab and Delhi fall in this category. Punjab already has 81 commodities under the system of input-credit. This would further reduce its revenue loss.

teria For Compensation
Another key consideration relates to determining the basic tenets of compensation. Here, it is important that the quantum of compensation is not open-ended. For example, in Canada, the compensation for harmonised sales tax was given for a fixed period. In Indias case, the eligibility for compensation should be limited to a maximum of five years. Full compensation could be given for the first three years and a gradually reduced one for the next two years. It must be made clear that compensation is to be given only to those states that move to VAT by April 1, 2005. This would serve as an incentive for states to switchover to VAT by the scheduled date.

The autonomy of the states should also be given due consideration. A review of the existing structure of sales tax in all the states indicates that most of them have much higher rates on many of commodities than the floor rates recommended by the EC. VAT should not be used as an opportunity to reduce the tax rate on most commodities and then ask the Centre to compensate the loss. The states must mobilise resources through the existing higher rates. It must be recognised that uniform floor rates refer to the prescribed minimum rate for certain groups of commodities, and if the states want to have higher rates, they have the freedom to do so. Interpretation of this as a single common rate could have disastrous consequences for state finances in the long run.

Some states have a complex structure of sales tax, with additional sales tax, turnover tax or surcharge etc. They, therefore, need to have a higher rate of VAT to compensate the revenue loss from these taxes compared with other states. Member states in the European Union, for example, have rates ranging from 15 per cent to 25 per cent. The rates in the Canadian provinces also vary from one province to another. Empirical studies undertaken at the Foundation for Public Economics and Policy Research indicate that given the floor rates for all commodities, the states do not stand to lose any revenue by retaining the present higher rate structure.

titutional Mechanism
The institutional mechanism for assessing and granting compensation is of significance. As the Twelfth Finance Commission (TFC) is already aware of this, it should deal with it rather than the Centre or the state governments, as each of these may have vested interests. In addition, the TFC recommendation will be in operation from April 1, 2005 for a period of five years. Since the compensation package will also be for a period of five years, it would match the TFC award.

To conclude, the states have to be compensated for loss of revenue due to abolition of CST and VAT. In doing so, the states should be given some tax powers to enable them to raise resources, possibly through taxation of some lucrative services. In addition, they should be compensated if there is any loss of revenue due to VAT introduction. For this, there is need to have a fund for compensation and incentives.

writer is director of the Foundation for Public Economics and Policy Research, New Delhi