The Hindu Business Line : State VAT: Take measures to counter effects

The implementation of VAT as part of the reforms process is inevitable, though its implication for the public revenue of the States is a cause for concern. Corrective measures need to be put in place to counter the adverse impact of this tax system on the economy and on public finances, says R. Srinivasan.

THOUGH there can be no two opinions on the desirability of implementing State VAT, it is of concern that hardly any steps have been taken to counter the problems that may arise during the transition from the existing set up to VAT, as well as the long run effects of State VAT on the economy and on public revenue.

The removal of central sales tax (CST) is bound to affect the public finances of exporting States; realising this, the Centre has agreed to compensate the entire revenue loss in the first year and thereafter reduce the compensation gradually to zero in the fourth year. This will be a source of friction between the Union and the State governments if the general sales tax revenue is not high enough to cover the loss due to the removal of CST from the fourth year.

Though the 12.5 per cent rate of tax is defined as Revenue Neutral Rate (that is, the rate of sales tax that is expected to ensure the revenue of the State government does not decline after the implementation of VAT), the States feel there may be reduction in revenue post-VAT.

The element of truth in this argument is vindicated by the fact that the Centre has agreed to compensate some portion of this loss of revenue and to empower the States to levy sales tax on sugar, tobacco and a few services to facilitate additional resource mobilisation. The actual compensation package is yet to be worked out.

The agreement by the Central Government to compensate entire loss arising due to the phasing out of CST and partial compensation of general revenue loss itself raises question whether the Government can meet these expenditures, given its very high projected fiscal deficit in the current fiscal. The short-run revenue shortage, even after compensation from the Centre, is bound to arise in all the States.

Are they ready to face the consequences given their precarious fiscal situation, manifest in the form of high fiscal deficit and debt ratios? The doubt that arises now is about the timing of the introduction of VAT as it is introduced at a time when both the Union and the State governments are facing seemingly insurmountable fiscal crises.

VAT being a destination tax, each State can raise tax revenue only from its own base of consumption expenditure. The inequality in per capita consumption expenditure is more than the inequality in per capita income across States in India. This will result in high inequality in States' tax revenue.

With the Government's move to increasingly privatise the infrastructure sector, the States cannot compete with each to attract investment by providing good infrastructure and other investor-friendly environs.

Therefore, when inequality in States' own finances are bound to increase, on the one hand, and the availability of infrastructure is also unequal, on the other, there is immediate need to correct the fiscal imbalances between States.

The whole system of Union-State financial transfers should change, respecting and responding to the forced changes (in the name of harmonisation of sub-national tax system) in the State finances.

Both Plan transfers and Finance Commission transfers should be coordinated, and conditional grants towards building up social and economic infrastructure in backward States provided immediately.

More important, the Twelfth Finance Commission should analyse the issue of inequality in States' own revenue in the light of implementation of VAT and, accordingly, decide the horizontal distribution of Union financial transfers among the States.

There is reason to believe that the removal of cascading effect, particularly the tax on tax, will reduce the revenue of the States, at least in the short run. This reduction could be, to some extent, reduced by the taxation of value additions in those commodities, which are hitherto under first-point tax.

Further, the sales tax revenue may also rise due to higher tax rates on certain commodities, removal of exemptions and widening of tax base by bringing in more commodities into sales tax net. The fact of the matter is what sort of distributional impact it will have on the State economy.

It all depends upon the type of commodities under first-point tax and, under multipoint tax in the existing system. If most of the necessary commodities are under first-point tax, the prices of those commodities will rise under VAT, and the distributional effect will be mostly regressive or at best proportional. Therefore, while allocating commodities for 4 per cent and 12.5 per cent categories care should be taken so as not to create adverse redistribution of income in society.

Moreover, when most of the goods and services are brought under the ambit of VAT (as VAT administration desists any exemption) the proportional character of VAT with two rates of tax on all goods and services will have to be countered with suitable public expenditure programmes with clear pro-poor bias, because a proportional tax system would have a regressive effect on real income of poor people.

One can elaborate on the impact of the general VAT system on interpersonal equity because it is not neutral between factors of production. When capital goods are given input tax credit in subsequent transactions and the labour input is not given such treatment, this will create incentives to shift to capital-intensive technology and create inequality between interest/profit incomes and wage income in the economy.

The vociferous opponents of VAT are groups of small traders. On the contrary, the producers and large wholesalers rather welcome the move to implement VAT. The arguments put forth by the small traders are not easy to dismiss. The small traders have been dealing with a host of commodities and, in spite of having only two rates of tax, it will be difficult to maintain accounts for entire purchases and sales.

Though their problems are addressed in the form of keeping them outside the State VAT system and levying a composite tax of 1 per cent on their total turnover, the solution lies in bringing them gradually into the VAT system through providing financial and technical help to maintain their accounts and regularise their trade.

The introduction of VAT is a natural part of the ongoing economic reform of the Indian economy with the objective of making the country a single market with this transparent and harmonious indirect tax system at the sub-national level. The implication of this tax system for the public revenue of the States, however, is a cause for concern. This harmonious tax system is also bound to increase inter-State fiscal inequality in the short run, and aggravate the regional imbalances in the long run, unless immediate corrective measures are taken.

The proportional character of the VAT should be countered through clear pro-poor public expenditure programmes. The Government should consider sympathetically the concerns of the small traders regarding their inability to adhere to the new system of taxation, and technical help should be provided to keep them within the fold of the new tax system.

The inevitability of implementing VAT is understandable; at the same time, the need for corrective measures to counter the adverse impact of this tax system on the economy and on public finances cannot be brushed under the carpet.

(The author is on the Economics faculty of Presidency College, Chennai.)

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