G. Srinivasan

AS THE preparatory process for Union Budget 2005-06 has already begun with the Finance Minister, Mr P. Chidambaram, holding the customary confabulations with various players of the economy, hope runs high that the the Government second Budget will have a recipe of far-reaching reform, especially when the maiden effort of the United Progressive Alliance (UPA), in July 2004, could not boldy take the reform path for want of time and understanding of managing a disparate coalition.

The picture is better now, with the Centre pitching for consolidating all piecemeal reforms, and States also agreeing to the value-added tax (VAT) system that would hopefully end several distortions and inherent contradictions in the extant system.

A sort of curtain-raiser to the advent of VAT is to happen on January 17 when the Empowered Committee on VAT, headed by the West Bengal Finance Minister, Dr Ashim Dasgupta, would present a white paper on the new regime, setting out the structure and design of putting in place the VAT with least transition cost to trade and industry while simultaneously ensuring consumer welfare.

Tax experts contend, justifiably, that in a country such as India, where much of the population has fairly low income and consumption, there must be reliance on indirect taxes for taxing that section of population.

Hence, there is a medley of an income-tax to be levied on the better-off individuals and a tax on consumption by all citizens to be measured indirectly through the expenditure on goods and services. The challenge for a fiscal expert is to devise a system that would enable the government to neither affect the income and consumption of individuals nor cause any adverse fallouts on the economy.

Alongside, the system should be made equitable in that equals will pay similar tax and non-equals differently, with the better-off paying more and the worse-off paying less progressively. A lot of mist and mistrust surround the VAT with State governments demanding compensation for any revenue loss they may face with the sales tax gone.

There is strident opposition from retail and wholesale trade, especially the section not paying sales tax. As apprehensions and confusions reign supreme in the absence of a proper understanding of what VAT means, to those who will administer it, those who pay it and those affected by it, Business Line spoke to the eminent fiscal expert, Dr Raja Jesudoss Chelliah, at the Madras School of Economics of which he is the Chairman.

The octogenarian fiscal guru, who headed the country's Tax Reforms Committee (TRC) during Dr Manmohan Singh tenure as Finance Minister in the Narashima Rao Government, gets into his elements when asked to demystify VAT. For one who headed the Fiscal Analysis Division of the International Monetary Fund (1969-1973); founder-director of the National Institute of Public Finance and Policy (1976-1985); Member of the Planning Commission (1985-90) and Fiscal Advisor to Dr Manmohan Singh (1993-95), Dr Chelliah feels that in a country with a federal Constitution, the constituent States have to adopt a consumption (or destination) type of indirect tax, if a common market is to be preserved, cost escalations are to be precluded, and inter-State tax exportation is to be minimised.

Here is an uptake from Dr. Chelliah on what VAT is, its ratiocination, its ramifications and the misplaced miasma it has engendered all-round.

"The proposal to shift to VAT by April 1 is a very important step as all major States are going to adopt it at the same time and have agreed on several common features. It is a landmark in the economic history of India. Once this is done, there will be two value-added tax systems — one at the Centre, the Central Value-Added Tax (CENVAT), and the other at the State level. They will exist side by side and efforts will be made to harmonise the two. CENVAT will be applicable only at the manufacturing stage whereas the State VAT is levied on domestic trade transactions.

The adoption of VAT as the major system of domestic trade transaction is extremely important — the VAT system enables the governments to levy tax on the principle of destination and only on the value of consumption.

"Although VAT is levied at each stage, there will be no cascading, that is, tax on tax or increase in cost due to holding higher cost inventories. This is because all inputs are exempt from tax: The producer/seller gets a rebate on the tax he has paid on his purchases against the tax payable on his output. As a result, the benefits are that the final tax burden is transparent. Second, if the rebate is given at all the intermediate stages including the stage of inter-jurisdictional trade, then the tax becomes a destination-based tax. By exempting capital goods from VAT, the VAT is converted into a consumption tax.

This means a tax can be an equitable one levied on each person according to his/her consumption. This is achieved through least distortions to the allocation of resources and avoidance of escalation in costs.

"Since inputs are not taxed, the costs are minimised. This enhances the competitiveness of the whole economy. The acceptance of the principle of destination implies that in a federation it is the States where the consumption takes place that can tax a commodity and not the State where production takes place.

"In the Indian context this means that the inter-State sales tax will have to be phased out as part of the reform. Then inter-State transaction will be "zero-rated," that is to say on inter-State sales nominally a zero rate of tax will be levied and against that, the input taxes paid will be rebated (refunded). This is the same procedure that is adopted in respect of inter-country exports.

"To sum up, the advantages of having a VAT system are (i) minimisation of cost, (ii) avoidance of economic distortions in terms of methods of production and even location of production, (iii) creation of a common market across which goods will flow free of tax — this increases consumer welfare as well as international competitiveness, (iv) enables government to tax according to the principle of equity. "Administratively, it is desirable and convenient to have one Central VAT in a country including federations. The proceeds of the tax can be shared between the Centre and the States. Having one Central VAT avoids the problem of coordination, harmonisation and special problems connected with State taxation of services rendered across the States. However, in India having one Central VAT is not possible because the States would like to have the power to tax goods and services. The second best solution is to allow the States to do so, subject to the condition that they will adopt VAT.

"VAT should cover not only goods but also services because from economic point of view, there is no distinction between goods and services. The Constitutional position in India is that the Central government can tax goods at the manufacturing stage and services, whereas the States can tax goods at all stages but only a few services mentioned in the Constitution (such as entertainment, transport of goods by road). The States now claim that they should be given the power to levy taxes on services

"(On all services as in the case of goods) The Kelkar Task Force recommended that the Centre should be given the right to levy a VAT on goods at all stages and on services and the States will also have the same powers. It appears that this part of the recommendation is not being considered seriously.

"However, the question of giving power to the States to levy tax on all or some of the services is being considered. In this regard, it must be pointed out that several intractable problems will arise if the States are given the power to levy tax on services rendered across the State boundaries. This is borne out by the problems in the case of inter-provincial services tax in Canada as also in the inter-country service tax in the European Union. Therefore, for the time being, the States should be given the power to levy VAT largely on local services.

"Ultimately, it would be necessary to harmonise the States VAT and CENVAT. The sum total of the rates of the two taxes should be taken to judge the bearable burden of indirect taxes in the country. Some opposition to VAT flows from the fear that VAT is a very complicated system as it requires keeping of records and purchases and taxes paid, while retail and wholesale traders not paying sales tax now dread VAT.

"Introducing for trade and small businesses a self-assessment system can mitigate the problem. Also, small businesses could be given the option to pay a one per cent tax on total turnover, without being eligible to claim rebate for input taxes."

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