Financial Daily from THE HINDU group of publications
Tuesday, Jun 22, 2004
VAT regime: Myths and realities
M. Veerappa Moily
The commitment to review the draft Service Tax Bill piloted by the Union Finance Ministry is also welcome. The Finance Ministry's positive approach to service tax and `declared goods' will recreate the institutional credibility for stabilisation of VAT.
The offer of compensation of loss in the transition period is only a mirage that will not really empower the States to build the revenue base.
There is no doubt that the Centre is already providing some guidance in the introduction of VAT. Given the complexity of the process, however, it needs to take a clear position on what role it will play in further facilitating a State-level VAT. The Centre has to:
The Centre should also pass legislation permitting States to collect VAT on service under the Union tax authority in a manner that would be completely integrated into the State VAT.
Buoyancy of sales tax can improve if a full-fledged VAT is put in place. Enhancing the efficacy of tax administration significantly, however, will call for reforms of the civil services and also the legal system to see that officials are made accountable for jobs entrusted to them and tax offenders are speedily brought to book.
The introduction of VAT would require constitutional amendments to permit its levy on an integrated base comprising goods and services. These reforms cannot come about without strong conviction among policy-makers, given that the tendency among the bureaucracy and conservative trade lobbies is always against reforms.
A positive fallout of the reforms, despite the shortcomings, has been to create public awareness of the need for fiscal prudence. Singapore has led the world in its rapid and widespread adoption of new technology in revenue administration.
Over the past 12 years the government has sought to modernise and computerise Singapore. In a recent survey, 95 per cent of individual taxpayers, 83 per cent per cent of corporate taxpayers and 93 per cent of goods and service tax payers said they were satisfied with the IRAS services, which they found to be convenient as well as competently and courteously provided.
One of the first steps the IRAS took was to convert from a hard-copy filing system to a paperless imaging system that allows documents to be retrieved instantly from networked terminals. This move made the administrative process more efficient and freed staff from unproductive paper-shuffling, permitting better tax-payers service and more `back end' auditing.
First, it was decided at the highest levels that changes would be made. Second, the tax administration was repositioned, reorganised, and given adequate resources to carry out the major tasks with which it was charged. Third, the system was extremely well-planned and implemented in a carefully phased and monitored manner, taking into account client feedback at each stage before moving to the next.
As many as 70 countries have successfully implemented VAT and consequently, the evasion came down to less than 10 per cent. But in India, which is still fumbling with the idea of VAT implementation, the tax evasion is 40 per cent or higher.
Both goods and services create utilities and satisfy wants and are used for production and consumption. In the modern world, it is essential to recognise their interdependence in all economic activity. Taxation of goods cannot be divorced from that on services since it is becoming increasingly difficult to draw a distinction between the two.
Manufacturers provide services related to goods, such as training, advertisement, installation and maintenance. But goods, by definition, are tangible and movable products. Commodity taxation cannot, therefore, cover activities such as fabrication and erection, which are integrally linked to physical goods.
For taxpayers and administrators, laboured legal interpretations are all that separate goods from services, which is a highly unsatisfactory state of affairs. Such differentiation has become obsolete in the globalised economic environment. Failure to tax services leads to cascading and distorts consumer choice by encouraging expenditure on goods at the expense of services and spending.
The piecemeal taxation of services prevalent in the country today violates the canons of equity and neutrality on which a sound fiscal structure should be built.
Exclusion of services creates a bias not only in favour of services but also in favour of goods with a high service component or large trade margins, encourages producers to push trading functions forward to keep down the assessable value of their products and discriminates in favour of sole distributors, especially those who deal in imported goods, who usually provide a higher level of marketing services with costs embedded in the manufacturer's price.
It also discourages standardisation by favouring on-site setting up of a plant or building. The resulting unequal distribution of the tax burden affects consumer choices and militates against industrial activity.
The arguments in favour of VAT on goods apply with equal force to services. If the most desirable method of taxing goods is through VAT, it is also the ideal method for taxing services. Since value-added taxation requires setting-off tax paid on inputs at subsequent stages, taxes have to be levied on services too, and set-offs given to avoid distortions in economic activity.
Service taxation in the country is now based on outdated Constitutional provisions that cry out for reform. Both the Centre and the States enjoy limited powers to tax services in accordance with scattered Constitutional references. There is no reference to service tax per se in the Constitution.
Unless services are brought within the tax base, revenue growth from indirect taxes would remain constrained and the objective of reorienting the tax system towards greater reliance on taxes on domestic consumption would be difficult to achieve.
Exclusion of services from the tax base is undesirable from the angles of equity, economic efficiency and administrative ease. From the efficiency angle, exclusion of services from the tax base distorts resource allocation as it creates a bias in favour of goods as against services.
It is reliably learnt that the Committee on Service Taxes constituted by Government concluded that as much as Rs 89,000 crore can be tapped from service taxes. The report needs serious consideration on the quantum and power of levy to be transferred to States.
Why should State taxes suffer from handicaps that are the direct outcomes of Central manipulations? For instance, in terms of Entry 54 of the State List of the Seventh Schedule under Article 246 of the Constitution, sales taxation is the exclusive prerogative of the States. But way back in 1957, the Centre took away from the States the power to levy sales tax on textiles, sugar and tobacco.
These three commodities were the most lucrative sources of sales tax revenue flowing to the exchequer of State governments; but the Centre chose to take them away. It decided to impose, in lieu of sales tax, what was dubbed as additional duties of excise on the three categories of commodities, with the promise that collections under this head would be transferred to the States after netting for expenses.
`Declared goods' are a classic example of States' sales tax powers getting ceded to the Centre overtime. The freedom for States to opt out of the agreement was severely curtailed by bringing these goods within the list of `declared goods' so that States which withdraw from the tax rental could not levy tax on these goods at more than one point or at a rate above the CST rate ceiling of 4 per cent. Over time, other commodities were also added to the `declared goods' list.
Despite the Constitutional provision to have a common market, the fiscal and regulatory system in India imposes a number of impediments to internal trade. The impediments in India arise from the nature of assignments, competition to `free-ride' by exporting the tax burden to non-residents, asymmetric arrangements in the federal system, autarchic nature of developmental strategy and the legacy of micro-management of a scarcity-hit economy on the eve of Independence.
(The author is former Chief Minister of Karnataka and former Chairman, Tax Reforms Commission, Government of Karnataka.)
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