The Centre may have to bring down the service tax rate under CGST from 12 per cent to 10 per cent. In order to preserve the autonomy of the States, the core SGST rate should be taken as a floor rate.
Continuing fiscal and tax reforms in India have already prepared the ground for a high growth economy. The revised estimates of growth rate of 9 per cent for 2005-06, 9.2 per cent for 2006-07, and estimates that this momentum will be maintained in 2007-08 are welcome news.
To sustain this heady growth performance over a longer period, we need to complete the process of indirect tax reforms leading to a comprehensive goods and services tax (GST).
Following announcements by the Union Finance Minister that GST may well be in place by April 2010, we can expect the Budget 2007-08 not only to spell out the course but also to take the first few steps.
In a modern economy, separate taxation of goods and services is not viable. Value added in the production and sale of many products require inputs both of goods and services, which may be bundled indistinguishably. Beginning with the early nineties, much has already been achieved on the road to reforming our indirect taxes. Four critical steps remain. First, the central sales tax (CST), currently being levied at 4 per cent, needs to be abolished. Secondly, we need to determine a suitable GST rate, which should be much lower than the sum of core rates of Cenvat at 16 per cent and State VAT of 12.5 per cent, which relate to the taxation of goods. Thirdly, States need to be enabled to tax services and the service tax rate should be same as that for goods. Fourthly, the Centre should be enabled to tax value added in the case of goods up to the retail stage.
These changes would lead to a comprehensive and unified system of taxation of goods and services. As we have a federal structure, the task is not so straightforward.
Reforming the CST
The final reform of the CST lies in its abolition. The tax is levied by the Centre but collected by the State Governments who are allowed to retain the revenue proceeds. It was introduced at the nominal rate of one per cent.
Under pressure from the State Governments, the CST rate was progressively increased to 4 per cent. Over time the CST has become an important source of revenue for some States that are known to be `producing' States. While the tax accrues to the producing States, it is paid by the citizens of the consuming States. As such, the CST has been a vehicle of tax-exportation violating the principle that the tax should accrue to the jurisdiction where the final consumption takes place. The total revenue under the CST is estimated to be Rs 19,345 crore in 2006-07 as per the Budget estimates. Some of the major States such as Maharashtra, Gujarat, Karnataka, Tamil Nadu, Haryana, and Andhra Pradesh have a comparatively high share in this revenue. Considering Rs 20,000 crore as the potential revenue under CST for the current year, a decline of 1 percentage point in the CST rate would involve a loss of about Rs 5,000 crore, and the individual annual losses for the States could range from about for Rs 170 crore for West Bengal to Rs 550 crore for Maharashtra. Part of the loss would be made up by increase in the tax base.
In addition, the State Governments are likely to be allowed to levy State VAT at the rate of 4 per cent on imports. This would be comparable to the countervailing duty that the Centre levies on imports. There is also a proposal to exclusively assign revenues from a select set of services to the States as part of the compensation. All signs are that the first steps towards abolishing the CST will be taken in the 2007-08 budget.
Achieving the Long Run GST rate
Achieving the desired overall GST rate decomposed into its Central and State components is a more difficult task. Both tiers of governments have to jointly bring down the overall tax rate, which at present amounts to 16 per cent and 12.5 per cent on the respective tax bases of the Cenvat and State VAT as far as manufacturing and sales of goods are concerned. While the tax rate on goods can come down, that on services, which is at 12 per cent may have to be incrementally uplifted to bring it closer to the long term desired norm.
The suggestion of the Kelkar Committee to aim at a 20 per cent combined GST rate seems to be a suitable target as it compares well with some of the international GST rates. The highest GST rates are in Sweden and Denmark at 25 per cent. Countries at the higher end of the tax rate are Iceland at 24.5 percent and Finland at 22 per cent.
At the lower end, Switzerland, Japan, Thailand and Singapore have GST/VAT rates at 5 per cent or marginally above. Most countries have GST/VAT rates that are less than 20 per cent. For example, in the UK the VAT rate is 17.5 per cent, Spain 16 per cent, Russia 18 per cent, France 19.6 per cent, and Germany 19 per cent. Canada is a federal country where both the federal and provincial GST rates are charged. The combined incidence of federal and provincial rates varies between 6 per cent and 14 per cent.
Central, State Components of GST
There has been a debate on whether we should go for a completely centralised GST, or agree to a State GST. A centralised GST provides harmonisation of tax rates and exemptions by definition. On the other hand, an exclusive State level GST takes state autonomy to the extreme and calls for external harmonisation efforts apart from reducing Centre's capacity of equalising transfers in a country characterised by extreme disparities.
In the medium term, with a view to preserving our federal structure, a system of concurrent taxation consisting of a State GST (SGST) and a Central GST (CGST) seems to be a viable option. One critical question is determining the component tax rates of CGST and SGST keeping in mind the benchmark for the overall tax rate. If the equation of pre- and post-devolution accrual of resources is not to be disturbed as this, in broad terms, has been stable for long years, we may have to settle for almost equal levels for the two components, that is, 10 per cent each. In 2006-07, as per estimates the States are expected to raise about Rs 1,60,000 crore under the State sales taxes and the total revenue of the Centre under the Union excise duties plus service tax comes to about the same as shown in the graph.
This suggestion differs from the recommendation of the Kelkar Committee, which had suggested a division of the 20 per cent GST rate where 12 per cent is for the Central GST and 8 per cent for the State GST. The Twelfth Finance Commission (TFC) had also observed that the 12:8 ratio in favour of the Centre can increase the vertical imbalance in the system.
Administering the Concurrent GST
While the indirect tax system converges to a GST, there is also the issue of reshaping administration of the Centre and State Governments to cater to its implementation. The Centre's administrative capacity vests with the Central excise department whereas the States have a larger capacity in the form of States sales tax establishments. It would be ideal to use both in the implementation of GST. Some areas may have to be exclusively assigned for the central establishment like the taxation of services of an inter-State nature. Services that are retailed may be taxed by the state administration.
In all cases, taxes will have to be collected under two columns pertaining to CGST and SGST. The levy and sharing of tax revenues where extensive inter-State transactions are involved would also cause some problems. However, with the help of IT systems and effective compilation and processing capabilities, it should be possible to handle these problems without much difficulty.
From 2007-08, the adjustments needed may be: one, downward adjustment in the core Cenvat rate to lower than 16 per cent. Secondly, States should be extended the power to levy service tax, which can go up to 10 per cent. Concurrently, the Centre should have the extended power to capture value added up to retail stage under Cenvat.
Finally, the Centre may have to bring down the service tax rate under CGST from 12 to 10 per cent. In order to preserve the autonomy of the States, the core SGST rate should be taken as a floor rate. States if they so desire can raise their state-specific SGST rate above the floor.
However, in an integrated market, competition will ensure that the SGST rates do not diverge unduly. High growth years are the best years to undertake structural reforms in taxation, because growth absorbs most of the initial revenue shocks. It creates a virtuous cycle as tax reforms enable sustained high growth, which facilitates the absorption of initial revenue shocks.
D.K. Srivastava The author is Director, Madras School of Economics. The views expressed here are his personal views.