The Hindu : Business : Misgivings over States meeting VAT deadline

Online edition of India's National Newspaper
Monday, Nov 29, 2004

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Business

Misgivings over States meeting VAT deadline

A proper VAT on manufacturing and services will enable the economy to get away from the disproportionate burden of taxation on manufacturing, says S. Narayan.

THE ASSURANCE of the Finance Minister that the Value Added Tax (VAT) would be introduced by April 2005 has given rise to expectations, apprehensions and fears. The value added system of taxation, prevalent in several countries, integrates the taxation structure of goods (and services) in a manner that mitigates the cascading effects of taxation on the final product.

The system provides for input tax credit for each preceding activity in the manufacturing or service delivery chain, such that the taxation at each point is only for the value addition at that point. For the end consumer, there is therefore a single rate of tax for the final product which subsumes tax paid at all earlier stages.

This system has been effective in Central Excise for some years now, where the CENVAT permits input tax credit at every step in the manufacturing chain. At a uniform excise rate of 16 per cent, this ensures that at every stage tax paid is only for the value added at that stage.

A composite system of tax credits for earlier stages is working effectively, with clear appeal and adjudication channels to iron out glitches. In the last few years, introduction of countervailing duty (CVD) on imported products at the same rate as for the same products manufactured in India, have provided effective protection for local manufacturers against imports of similar products. In the current year's budget, the concept of VAT has been extended to service tax levied by the Centre, thus integrating Central excise and service tax to some extent.

For the last four years, there has been an attempt to rationalise the State taxes, most importantly sales tax, in a similar manner. The earlier Government set up an empowered group of finance ministers, headed by the Finance Minister of West Bengal, to arrive at a consensus on this issue. The scheme could not be introduced in 2003, due to objections from some States, most notably the traders of Delhi, who were important constituents of the earlier Government. The Finance Minister, after a series of meetings with the empowered group, has promised that the system would be introduced from the first of April 2005.

Revenue neutral rate

Simply put, the rates of sales tax (other than for petroleum and some selected products) are to be fixed at a single rate throughout the country, a rate at which the States feel comfortable that there would be no loss of revenue (the `revenue neutral rate'). The States have also asked for a share in service taxes, either through direct levies on earmarked services, or through devolutions of collections.

The Central Sales Tax, collected by the originating State at 4 per cent on all goods transhipped across State borders, will remain. The States have also asked for compensation if the introduction of State VAT results in any revenue loss, though the Finance Ministry believes that this is not likely to occur. The States are expected to put in place legislation and systems to enable this to happen seamlessly from April 1. The Finance Minister has declared that he is ready to accept and implement any consensus arrived at by the States.

Multiplicity of taxes

It is here that the worries start, and there are several. First, the States levy a multiplicity of taxes including entry tax, octroi, and in some cases a surrogate import duty on goods originating elsewhere. There is no clear commitment from the States that all these additional levies would be removed. And if they are not removed, then the Common Minimum Programme (CMP) commitment to make India a single national market will not be achieved, rather, there would be unequal burden on products.

Second, the issue of Central sales tax is being brushed under the carpet. This tax has enabled manufacturing States to export taxes across State borders. It is interesting that an important cornerstone of the WTO agreements is precisely that taxes will not be exported across national borders! States such as in the Northeast have suffered for several decades, as they are paying taxes to the manufacturing States. A continuation of this will skew regional capabilities in manufacturing even further.

Third, with the manufacturing process spread across several States, how will the process of credit and reimbursement of taxes actually work? There is no evidence of a common IT architecture that will enable tax credits and debits to be handled automatically, through a clearing house system akin to the National Stock Depository for securities.

If there is going to be an attempt to handle this through paperwork and forms, then it is likely to lead to serious procedural delays and delays in reimbursement. There is no evidence of thinking along these lines. There will be horrendous paper work required when these goods move across State borders at different stages of manufacturing.

Quite apart from lack of evidence of putting systems in place, there is little evidence that all the States are ready to introduce the necessary legislations in the winter sessions of their respective legislatures. There is also little evidence of ground level preparation or training of the administrative machinery for this purpose.

More importantly, there is no clarity on whether manufacturing and services are to be treated identically. If a large revenue neutral rate of taxation were slapped on manufactured goods alone, quite apart from making products uncompetitive, it would drive the economy further towards the services sector, with serious consequences for blue-collar employment opportunities.

There is also no evidence that VAT is going to be integrated with imports and exports. In fact, there is no evidence of even thinking along these lines. If this does not happen then, with dropping customs duties and a high revenue neutral rate of taxation, every manufactured product will find itself disadvantaged against imports. This is likely to deal a serious blow to the growth of the manufacturing sector.

Imports should be charged the Central plus State VAT at entry, and all exports should be zero rated, so that the exporter gets a full refund. If this does not happen, there will be no level playing field for the Indian manufacturer.

Conversely, further customs reforms hinge on VAT implementation. If customs duties are reduced without integrating with VAT, there will be further disadvantage to local producers.

VAT is essential for Indian manufacturing to bloom. A proper VAT on manufacturing and services will enable the economy to get away from the disproportionate burden of taxation on manufacturing which is one of the reasons that the economy has got skewed towards the services sector. A half-hearted implementation is likely to affect local industry and trade seriously.

The hands off approach of the Finance Ministry is likely to cost the economy and industry dearly, if the VAT is introduced without addressing these issues. One would only see the overall burden of taxation rising, making the country's products even more uncompetitive.

(The author is former Finance Secretary and Economic Adviser to the Prime Minister)

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