The CMP of taxation

Last week’s big news of course is the states have agreed to a deadline by which their sales taxes will be replaced by a value-added tax (VAT). Of course, since this is not the first time such a deadline has been agreed to, it may be prudent to hold the champagne just yet.

Especially since states have a long way to go—despite the state chief ministers’ resolve to reduce the number of taxes a decade ago, for instance, states like West Bengal (the champion of VAT, ironically) still have around 16 rates of sales tax.

Nor, despite this resolution, did the states move to a multi-point tax-collection system all these years. Most collect the tax at the point it is sold to the wholesaler, while others like Punjab, Haryana, Himachal Pradesh, and Delhi collect it at the last point of sale to the final consumer.

Since single-point collections are typically higher in value, this makes tax evasion more attractive, and this is one of the reasons as to why a VAT is more efficient—it’s an open question as to whether states can move to a multi-point collection regime so soon.

The major problem with what’s been agreed to last week, however, is the potential damage to the central exchequer which has agreed to compensate the states for the loss in revenue they’d have in a non-VAT regime in comparison with a VAT one—this will be 100 per cent in the first year, 75 in the next, and 50 in the third. Presumably there’ll be no compensation after this.

In principle, there may be no compensation required as VAT-chains increase tax compliance since the rate being charged at each point of the chain is so small that no one thinks it worth his while to evade it.

Indeed, the National Institute of Pubic Finance and Policy did a detailed study examining each tax collected in Andhra Pradesh and West Bengal, and concluded there’d be no revenue loss by shifting to VAT provided certain things were done.

One was to allow the states to once again begin collecting sales taxes on sugar, textiles, and tobacco (this was ceded to the central government in 1956, which then paid the states an “additional excise duty” in lieu of this from the total pool of taxes it collected). No firm decision has been taken on this as yet.

To be fair, the compensation principle was first brought in by the NDA’s Jaswant Singh. But that was precisely why Chidambaram set up a technical experts committee to ensure the VAT design was revenue-enhancing, and to ensure the compensation wasn’t open-ended. While that’s what the committee delivered him, he’s virtually thrown these recommendations out of the window.

Under the proposed VAT, there will be two rates of tax, 4 per cent and 12.5 per cent. Four is for what are called essential goods and inputs, and the higher one for the rest. Around 250 items have been put under the 4 per cent list and another 200 or so are at the 12.5 per cent rate.

The problem is one man’s input is another’s final consumption—sugar is an input for a sweetmeat shop but final consumption for a household, for instance. While this creates one type of distortion, the real one comes from the huge difference in the two rates. Let’s say an input, sugar, is taxed at 4 per cent.

So, on Rs 10 per kg of sugar, the tax will be 40 paise. Let’s say the tax on the other ingredients, milk and ghee, also inputs, is another 80 paise. Now let’s say this is used to make halwa, which is sold at Rs 80 per kg and attracts the 12.5 per cent duty, which works out to Rs 10. Clearly it is not in the interests of the shopkeeper to tell the taxman about his Rs 80 sale just in order to claim a rebate of the Rs 1.2 tax paid on sugar/milk/ghee—in other words, this huge difference increases the incentive to evade taxes.

The technical experts are reported to have recommended the number of items on the 4 per cent list be pruned, but this has been ignored.

The experts also recommended the first year’s compensation (of 100 per cent) be subject to a cap of 10 per cent of the total taxes the states collected, to incentivise them to collect more taxes (this has not been accepted in this Diwali season of cheer and gifting to friends/relatives).

Worse, since 2004-05 will be taken as the base year for deciding compensation, states like Karnataka introduced an entry tax to be able to boost the base-year revenues, and West Bengal brought in a turnover tax!

Once you get the (artificially boosted) base figure of 2004-05, the projected non-VAT collections are calculated by using the tax-growth in the best three years out of the last five years. So, if the 2004-05 tax is 100 and the tax growth in the last five years was 10 per cent (but 15 in the best three years out of these five), the first year’s non-VAT collections will be taken to be 115, 132.3 in year 2 and 152 in year 3. The experts, however, suggested using the average of the full five years, and so their non-VAT collections would be 110,121, and 133, respectively.

In which case, Chidambaram could now land up giving the states up to an extra 5 per cent of their tax collections in year 1, 8.5 in year 2, and 9.5 in year 3. Considering state sales taxes are around Rs 100,000 crore today, that’s a lot of money. It could also be the difference between Diwali and diwalia (bankruptcy in Hindi) for the Centre!