The path to domestic trade tax reform
M Govinda Rao
November 07, 2006

The finance ministry can take its cue from the success of the tax
information network for direct taxes.
 
The North Block will soon be abuzz with Budget talk once again. The
preparatory steps for the forthcoming Budget are being taken and the
tax proposals for it will be finalised in the next few months. It is
expected that the proposals will signal continuity and change to
eventually achieving a stable and rational tax system. Indeed, in a
federation, a co-ordinated calibration of the tax system is necessary
to enhance revenue productivity and to achieve a harmonised tax system
with fiscal autonomy to states. This, probably, will be the last
Budget for initiating concrete reform measures before the political
cycle will hijack the reform agenda.
 
An important item in the reform agenda relates to preparing the
groundwork for the levy of the goods and services tax (GST). In this
year?s Budget speech, the finance minister 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?, and set April 1, 2010, as the date
for introducing the GST. While this statement was made to raise the
rate of service tax from 10 to 12 per cent, it is important to take
the reform further. The introduction of the GST requires many
initiatives in the Union Budget, besides a convergence of rates of tax
between goods and services.
 
There are a variety of conceptual and implementation issues that need
to be resolved in making a transition to the GST. It would be
appropriate to put out a position paper for discussion among the
states as well as the general public for gaining consensus on the
structure and operation of the levy. The important questions relate to
the issue of achieving tax harmonisation while retaining states?
fiscal autonomy. Most observers feel that there is need for a paradigm
shift in the tax policy?to move away from the principle of separation
in the assignment system to one of assigning concurrent tax powers to
the Centre and the states. The best possible solution is to have the
GST levied at the Centre and the states setting their own rates on the
base determined by the Centre. There has to be a clear demarcation of
tax room for the Centre and the states by specifying the ceiling
rates. Indeed, the question as to who will levy the tax, who will
collect the tax and how it will be appropriated should be discussed
extensively before consensus is reached.
 
Be that as it may, there are important steps that should be taken to
unify excise and service tax rates. In particular, the time is ripe
for taking steps to transform the existing CENVAT into a manufacturing
stage value-added tax on goods and services. For this, it is important
to move away from selective taxation of services and extend the tax to
all services with a small exemption list. This will expand the tax
base, simplify administration and reduce litigation. When the service
tax is made general, it is enough to define ?service?, and each of the
taxed services need not be defined. As the tax credit mechanism works
between excise duty and service tax, it is easy to make a transition
to a manufacturing state GST. In the next stage, CENVAT and service
tax could be unified to have a common exemption limit and rate.
 
Extending service tax to all taxable services, besides being an
important transitional measure, would also bring in significant
additional revenue. There are a number of untaxed services causing a
narrow tax base and unintended distortions. To take an example, in
2005-06, the turnover from railway fares and freights was over Rs
91,000 crore and in 2007-08 it could be Rs 140,000 crore and at the
prevailing rate, could yield Rs 14,000 crore. In fact, extending the
tax would help to achieve uniform taxation of the road, rail and air
sectors. Given that the tax credit mechanism operates for both goods
and services, this will not add to cascading and will make the central
VAT more effective.
 
An expansion of the base should accompany a further convergence of
rates between the service tax levied at 12 per cent and the median
excise duty rate of 16 per cent. This actually gives an opportunity to
reduce the general CENVAT rate to 15 or even 14 per cent. This will
actually sweeten the pill of raising the service tax rate.
 
It is also necessary to unify the rates within excise duty as
well. This would require converting specific into ad valorem
rates. There are not many items in this category but there is no case
for continuing with specific rates. Cement is the prime example of
this and the forthcoming Budget would do well to rationalise it. This
will simplify administration because calculating tax credit will
become easier. This year?s Budget reduced the tax rate on a number of
items to 8 per cent.  Indeed, the small cars, DVD drives, flash drives
and combo drives, or the packaged software could well be taxed at the
general rate.  Encouraging small cars, however desirable it may be,
should not burden the tax system. We need to realise that assigning
multiple objectives to tax policy only adds to complications and
introduces distortions.
 
Another set of measures relates to the reduction and eventual phasing
out of the CST. A reduction of central sales tax to 2 per cent may
require compensation to the states to the tune of about Rs 9,000
crore.  Returning the additional excise duty items?sugar, textile and
tobacco?to the states for the levy of VAT will have to be
considered. The states will also have to be given powers to impose
service tax to enable the levy of a full-fledged VAT on goods and
services. Indeed, all these may not solve the basic problem of low
revenue productivity of excise duties unless immediate measures are
taken to build an efficient information system and have a re-look at
various tax preferences. In fact, the credit for the high buoyancy of
direct taxes in the last four years goes to the TIN, initiated under
Vijay Kelkar?s advice. Indeed, the computerisation of the excise
system holds the key for enhancing revenue productivity and this would
require professionalism beyond the capacity of the NIC and the finance
ministry can take its cue from the success of TIN for direct taxes.
 
The author is Director, NIPFP, mgr@nipfp.org.in