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Make VAT rates flexible
June, 17th 2006


17th June, 2006

Make VAT rates flexible

Diversion of trade is generally commodity specific

VAT rate autonomy for States is desirable because it enables them raise revenues according to their varying and changing expenditure requirements.

One of the objectives of Value Added Tax (VAT) is to curb trade diversion and the consequent rate war among States, by ushering in a regime of uniform tax rates.

According to the White Paper on State-Level Value Added Tax, the proposed VAT design would "stop unhealthy tax-rate `war' and trade diversion among the States, which had affected interests of all the States in the past." Accordingly, the States are to operate with only two rates of 4 per cent and 12.5 per cent. Besides, there is a specific category of tax-exempted goods and a special VAT rate of 1 per cent only for gold and silver goods.

Although uniformity in VAT rates has been achieved across the States in respect of a majority of commodities, the move has drawn flak from a section of policymakers and analysts on the ground that it would deny the States autonomy in fixing their tax rates. Rate autonomy is desirable because it enables the States raise revenues according to their varying and changing expenditure requirements.

As one of the country's eminent fiscal experts Amaresh Bagchi has put it, "uniformity is neither desirable nor necessary" because not only does "it virtually take away a vital ingredient of the most productive revenue source of State governments" but it also breaks the link between States' "decisions to spend and tax which makes for efficiency in the public sector." (`VAT and State Autonomy', Economic and Political Weekly, April 30-May 6, 2005.)

Suggested alternative

As an alternative, the opponents of the uniform rate regime have been suggesting a Uniform Floor Rates (UFR) system. Interestingly, this has been the stand of even the World Bank (`State Fiscal Reforms in India: Progress and Prospects', Macmillan, New Delhi, 2005). Under this, States are given the freedom to levy rates, which can be higher than or equal to the floor prescribed on any commodity, but cannot go lower.

It was found that the number of rate slabs was large in many States after the switch to the UFR system. As a result, rate differences persisted among the States leading to trade diversion. This situation emerged mainly because many States levied higher rates than the prescribed floor rates on several commodities. Thus, neither a uniform rate nor a UFR is an optimal and effective solution to check diversion of trade and rate war.

Alternative solution

Any alternative solution should not only help eliminate these possibilities but also provide autonomy for States in choosing their rates. The best way to achieve this is to allow the States choose their VAT rates on commodities, which are not prone to trade diversion and rate war.

In the case of commodities that are susceptible to trade diversion and rate war, the States should apply uniform rates. Now the question is: Which categories of commodities are prone to trade diversion and rate war and which are not? The current tendency is to attribute diversion of trade to rate differentials in respect of all commodities no matter whether the commodity in consideration is susceptible to trade diversion or not. This view is not correct as it was taken without appropriate empirical evidence on the phenomena of trade diversion and rate war.

Diversion of trade is generally commodity specific. For instance, consumers might find it more lucrative to purchase an expensive electronic gadget than a commodity like toilet soap from a neighbouring low tax State. An important requirement for trade diversion is that the tax-induced price differential should be higher than the cost of transporting commodities from other States. This is typically possible in the case of greater monetary value/physical quantity of purchases associated with a single trip across the State border.

It follows that out-of-the-State purchases would be more lucrative for high-priced, high/low volume (weight) and easily transportable (HLE) commodities than low-priced, low/high volume and difficult to transport (LLD) commodities. This is because the inter-State transportation cost of HLE commodities as a proportion of the value of the commodities would be much lower than that of LLD commodities examples are electronic goods (high priced-low volume), motorcar (high priced-high volume), toilet soap (low priced-low volume), and cement (low priced-high volume).

To see whether this point is indeed true, let us examine the movement of average sales tax rates of selected HLE and LLD commodities for the period 1980-81 to 1999-00 in the context of five border-sharing southern States, namely, Andhra Pradesh, Karnataka, Kerala, Tamil Nadu and Pondicherry. The geographical closeness of these States as well as the presence of traditionally low tax regime of Pondicherry had rendered this region highly vulnerable to trade diversion and rate war.

An indicator of the presence of diversion of trade and rate war is the existence of a "race to the bottom" in tax rates, which can be identified with falling average tax rates over a period of time. Absence of a race indicates that the States fix their rates independent of the fear of tax-induced migration of trade. A race to the bottom emerges in the presence of trade diversion and rate war because each State, in its attempt to attract trade or prevent tax-engendered loss of trade to other States, prefers to outdo others in tax rate reduction.


The average tax rates of all HLE commodities declined sharply over the years 1980-81 to 1999-00. Against this, the average rates of all LLD commodities have increased significantly during the same period. The steep fall witnessed in the average tax rates of HLE commodities suggests that trade diversion and rate war existed among the southern States in regard to HLE commodities.

The continuously rising average rates of LLD commodities indicate the absence of diversion of trade and rate war among the States in respect of such commodities. The increasing average rates of LLD commodities also suggest that, in the absence of trade diversion and rate war, the States could fix rates optimally/efficiently.

R. Sthanumoorthy
(The author is with ICFAI Business School (IBS) Research Center, Chennai)

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