The Hindu Business Line : Countdown to VAT: Impact on Centre-State finances

The introduction of VAT has posed a problem in federal economies, developed or developing. The issue is more complicated in India as commodity taxation is levied at two levels — excise duty by the Centre and sales tax by the States. While such a system has no parallel elsewhere, the Centre and State must resolve quickly the compensation issue so that VAT implementation is on course, says S. Sridharan.

THE Finance Minister, Mr Jaswant Singh, in his Budget speech, described the implementation of Value Added Tax (VAT) as a historic reform of the domestic trade tax system that would take place in the highest tradition of cooperative federalism. But will it happen, considering the opposition to its implementation?

Even a cursory study of the draft VAT Acts of different States would reveal that the VAT to be implemented from April 1, 2003 only orients the present Sales Tax Acts towards VAT and is only the first step towards a harmonised VAT throughout the country. In most countries where VAT has been implemented successfully there is a single authority levying tax on goods and services. The introduction of VAT in its true spirit has always posed a problem in federal economies, irrespective of whether they are developed or developing countries. The issue is a little more complicated in India as commodity taxation is levied at two levels — excise duty by the Centre and sales tax by the States.

While such a system has no parallel elsewhere, the introduction VAT in a federation is by no means an easy task. Indeed, much of the imperfection in the introduction of VAT in India is precisely because of its federal nature.

One of the major roadblocks in the successful implementation of VAT is the revenue loss to the States on implementation of VAT.

VAT transition impact on State finance

Why do States lose on transition to VAT?

Table 1 presents the rate of tax structure (other than on liquor) in different States before harmonisation with the uniform sales tax floor rates.

The major source of revenue for the States comes from petroleum products and liquor. The rates of tax of liquor are not likely to be lowered under VAT and these goods may not be covered under VAT.

Under VAT, the rates of tax will be 0 per cent (necessities), 1 per cent (precious commodities), 4 per cent (essentials and industrial inputs), RNR (revenue-neutral rate) 12.5 per cent (taxable goods not specified at other rates) and higher rates of tax on petroleum products and liquor.

With the realignment of the rates of tax under VAT, the loss to the States with a smaller spread of rates and maximum rate of tax less than 20 per cent is not likely to be substantial. The existing rates of tax may require only little adjustment to fit into the proposed VAT rates. Most States levy a surcharge on sales tax and an Additional Sales Tax of 1-3 per cent. Under VAT there will be no place for surcharge and Additional Sales Tax, and the States will have to contend with revenue loss on scrapping of these levies.

Further raw materials and capital goods, in most of the States, are under the sales tax Acts subject to tax at concessional rate of 3-4 per cent. Under VAT, the concessional rate of tax will not apply. The raw materials and capital goods will be subject to tax at the rates applicable to the respective goods. The loss to the government is that the input tax rebate will apply to raw materials and on capital goods also (though on capital goods input tax rebate is deferred in most of the States) and the Government may not realise the 3-4 per cent taxes that was hitherto collected.

The loss of revenue in a State with predominantly revenue from manufacturing sector is therefore likely to be higher than a State, which imports from other States and where most of the revenue is realised from trading activity. If the revenue neutral rate is not fixed at a higher level, loss on transition to VAT, particularly in highly industrialised States, is unavoidable. The revenue-neutral rate (RNR) projected by some of the States is presented in Table 2. The consensus RNR is 12.5 per cent and, therefore, the inevitable loss on transition to VAT.

VAT transition loss compensation

Since the transition to the VAT regime has been postponed twice during the past two years, mainly due to differences between the Centre and the states on the compensation issue, the Finance Ministry had acceded to the demand of the States for compensation on transition to the VAT regime.

The Centre has agreed to compensate States 100 per cent of their "notional losses" in the first year (2003-04), 75 per cent in the second year and 50 per cent in the third year as per an "agreed formula". The quantification of the loss on transition to VAT will be contentious and will be a major hurdle. The estimated revenue loss in highly industrialised States would be substantial. Initial estimates indicate that the likely loss in the first year of transition to VAT to Andhra Pradesh is Rs 400 crore, Karnataka Rs 750 crore and Tamil Nadu Rs 600 crore.

It has been repeatedly asserted by the Central Government officials that loss on transition to VAT may not be as projected. The initial reluctance to compensate "notional loss" may be because of the apprehension that the States may claim a higher loss.

While the States estimate the revenue loss on transition to VAT at Rs 6,000 crore (as per initial estimates) in the first year, Mr Jaswant Singh seem to believe that the revenue loss to States on transition to VAT may be only Rs 700 crore, which is the provision in the Expenditure Budget in the form of grants. It is to be noted that the compensation of loss to States on transition to VAT is on an "agreed basis", which is yet to be agreed upon between the States and the Centre.

Impact of CST phase-out

Even before the dust had settled on the issue of compensation to the States on transition to VAT came the decision of the Empowered Committee to reduce the Central Sales Tax to 2 per cent from April 1, 2003 and complete phase out in from April 1, 2005.

CST is a major revenue source for many States and the estimated total revenue to the States from CST in 2003-04 is Rs 15,000 crore. Reduction of CST to 2 per cent would translate into a revenue shortfall of about Rs 7,500 crore in 2003-04. The estimated CST revenue to some of the major States are Maharashtra: Rs 1,800 crore, Tamil Nadu and Gujarat: Rs 1,000 crore each, West Bengal: About Rs 800 crore, Andhra Pradesh: Rs 700 crore, and Haryana: Rs 600 crore.

CST has proved be a bane for VAT's implementation in India. It is clearly a massive revenue generator for States. Yet, it results in a cascading effect and is VAT-incompatible. Though CST is incompatible in a VAT regime, the ground realities have to be appreciated. The Centre should not have moved in haste the proposal to reduce CST to 2 per cent.

States should have been allowed at least a year's time to implement VAT and gradually move towards a fully "destination based VAT". The economy is not yet buoyant and revenue to the States are not likely to increase substantially in 2003-04 and it is natural that the States with greater share of revenue from CST object to the proposed reduction of CST rate to 2 per cent. The loss will be recurring and the demand is therefore for compensation on a recurring basis.

The Finance Minister had in his budget speech stated that the Union government would compensate states for the loss of revenue on account of the reduction in the CST. Interestingly, the Budget for 2003-04 has not made any provision on this account!

The issue of revenue loss that would arise out of an eventual phasing-out of the CST have not yet been fully resolved. It, therefore, appears that the reduction of the CST rate to 2 per cent may not happen on the date of implementation of VAT and may be effective only after a compensation package satisfactory to the States is finalised.

Power to States to tax AED goods

As part of the revenue compensation package, textiles, tobacco and sugar, commonly known as AED goods, will now be subject to State VAT in addition to the levy of tax under the Additional Duties of Excise (Goods of Special Importance) Act, 1957.

The rate of tax to be levied by the States shall not exceed 4 per cent. If the rate of tax levied by the State exceeds 4 per cent, the State may lose the share of revenue under the AED Act. This move, to be effective from a date to be notified, ostensibly is to help the States augment revenue and to integrate these goods in the VAT chain.

At present, the States merely receive 1.5 per cent of the Central tax revenues distributed to them according to the Finance Commission's formula for giving up the right to levy sales tax on the three commodities.

Compensation by service tax levy

The lower provision of Rs 700 crore in the Union Budget for compensation of VAT transition loss to the States in the Expenditure Budget may also due to the fact that the Constitution (Ninety-fifth Amendment) Bill, 2003 has been tabled in the Lok Sabha. The Bill provides that the proceeds in any financial year of any service tax shall be (a) Collected by the Government of India and the States, and (b) Appropriated by the Union Government and the States in accordance with such principles of collection and appropriation as may be formulated by Parliament by law.

This Constitutional amendment and the consequent legislation would give the Centre the power to levy the tax and both the Central and the State governments sufficient powers to collect the proceeds.

According to the Revenue Secretary, Mr C. S. Rao, one of the main reasons for enhancing the general service tax rate from 5 per cent to 8 per cent in this Budget is to allow States to appropriate, say, 2-3 per cent of the overall 8 per cent service tax and leave the rest to the Centre.

The proposed service tax legislation would determine the modalities and principles of collection and appropriation by the Centre and the States.

It is reported that for 2003-04, the Centre has budgeted total revenues of Rs 8,000 crore from service tax, of which Rs 2,360 crore, or 29.5 per cent, will devolve to the States as per the Eleventh Finance Commission's formula.

Even after States are empowered to collect and appropriate revenues from, say, three out of the overall 8 per cent service tax rate, they will still be entitled to 29.5 per cent of the Centre's balance 5 per cent collections under this head.

Let us hope that the Centre and State resolve quickly and finally the compensation issue so that VAT implementation is on course.

(The author is a VAT consultant and is the editor of stvat.com, a portal on Sales Tax VAT in India. He can be contacted at sridharan@stvat.com )

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