The finance ministrys comments on the first discussion paper of the empowered committee of state finance ministers on goods and services tax (GST) reveal that it wants an uncluttered tax regime, with a wide tax base and exemptions that are few and common across the states and the Centre. In saying so, it has signalled that it is in favour of a low revenue-neutral rate that would apply uniformly across all taxable goods and services, without making a distinction between goods or services, or various goods and services.

One can expect this intent to be reflected in Budget 2010 if the Centre is serious about moving towards a clean tax regime goods that are taxed at lower rate of 4% should be moved to the standard rate of 8%, or 10% if the fiscal stimulus is partly withdrawn. Also, there could be an alignment of central excise duty (Cenvat) and service tax, which currently is fixed at 8% and 10%, respectively.

The finance ministrys argument for a single rate of tax at the state level as well as the central level is sound. The question is: will the states buy Centres reason? States are bound to resist a single rate and, eventually, the Centre and states would compromise to a dual rate, with a plan to move towards a single rate. Centres reservation with the dual-rate tax structure as proposed by the empowered committee of state finance ministers is that it could lead to worsening of the inverted duty structure raw materials and intermediaries may be taxed at a higher rate and finished goods at a lower rate, on the pretext of taxing essentials at a lower rate.

Besides, a dual structure would essentially mean a revenue-neutral rate higher than would be the case with a single rate. Equally dangerous, and that would go against the grain of simplification of tax regime, is that a dual rate structure for goods can lead to demands from service providers for concessional rate for certain services.

The finance ministry has proposed to allow states to maintain exemptions for 99 items, as is the case under VAT, and it does not want that list to be expanded to include more items that are of local importance. At the central level, the ministry has proposed to substantially reduce the 330 exemptions allowed under Cenvat. The intention to have a common list of exemption under central GST and state GST means that Centre will need to trim its list to 99 before GST is implemented.

Reducing exemptions requires political will to withstand pressures from lobbies at both the central and state levels. And, that is a tough task. More likely, we will see a gradual reduction in the number of exemptions.

Critical issues over which GST implementation would face problems include threshold for exemption and compensation. In the case of threshold, the opposition would come primarily from the traders. Although they are subject to state value-added tax (VAT), the implementation of GST will mean that they would have to pay the central levy in addition to the state GST. Also, they would be required to invest in information technology to maintain records as also with compliance. Although the Centre has proposed lighter regulation for smaller dealers, it may not be enough to bring them around.

The empowered committee had proposed a threshold of gross annual turnover of Rs 10 lakh for goods and services, with compensation for north-eastern and special category states where the current threshold is lower at Rs 5 lakh. It had suggested a higher threshold at the Centre for goods and services. The finance ministry has over-ruled the states on this matter. It favours a common threshold at the Centre and at the states for both goods and services, of Rs 10 lakh or more implying larger tax base and more revenues for the Centre.

On compensation for tax losses upon migrating from state VAT to state GST, the Centre is keeping its cards close to chest. Indirect tax consultants reckon, compensation would be a bargaining chip between the Centre and the states, although the finance ministry appears to be inclined to accept recommendations of a task force of the Thirteenth Finance Commission on this.

The task force had said the Centre may create a corpus of Rs 30,000 crore over a five-year period transferring Rs 6,000 crore annually to compensate the states if they were to adopt a flawless GST. A flawless GST, as envisaged by the commission, is impossible as neither states nor the Centre would agree to scrap all exemptions (as suggested by the task force), subsume all local levies, and include property transactions into GST.

At the end of the day, the level of compensation would depend of the agreed revenue-neutral rate. Indications are that the rate would be much higher than the one recommended by the Thirteenth Finance Commission combined rate of 12%, with Centre rate at 5% and state rate at 7%. Most likely, the combined rate would be 16-18%.