The 10 per cent VAT rate would apply to states, mostly in the north, where sales tax rates were less, while 12.5 per cent would be applicable for those having higher sales tax rates mostly in the south, Additional Revenue Secretary, Anupam Dasgupta, told reporters in New Delhi on Monday.
The decision, which was taken at a meeting of Finance Minister Jaswant Singh with the Empowered Committee on VAT last week, also envisages that compensation to states for revenue loss would taper off in three years.
The Centre agreed to compensate 100 per cent in the first year of VAT introduction, 75 per cent in the second year and 50 per cent in the third year.
Dasgupta said implementation of VAT is expected to increase revenue of states in the long run and have a "softening effect" on prices, with the effective tax burden coming down. But, in the short run, prices of some items may surge.
The Centre also agreed to bring in Constitutional amendments to insert a new Article 268 A to enable states to collect and appropriate service tax.
The new article would provide two lists of items on which the Centre and states can levy service tax and a third negative list comprising government and social services that will be exempt from the tax.
While only the Centre would be empowered to fix the rates of service tax, states would be allowed to collect and appropriate tax on certain services to improve their revenue.
Apart from the 10 and 12.5 per cent revenue neutral rates for most items, there would be four more rates- nil for defence and strategic items, one per cent for precious metals, four per cent for essential agricultural items and 20 per cent for demerit goods like alcohol and tobacco.
Giving the rationale for two VAT rates, Dasgupta said the states having lower sales tax rates would be able to raise their tax to 10 per cent, while those levying higher 17-18 per cent tax would have to lower it to 12.5 per cent. Ultimately, the VAT rates would be merged into one uniform rate, he said.
The finance minister has insisted that states have to come up with "simple and uniform" VAT laws that would replace the existing plethora of local taxes including sales tax, turnover tax, purchase tax and entry tax, Dasgupta said.
All states and union territories agreed to send their draft VAT bills to the Centre by end of this month for presidential assent.
Eight states and all union territories have sent in their proposals, of which Maharashtra, Madhya Pradesh and Chattisgarh, have been cleared while that of West Bengal, Karnataka, Uttaranchal and Mizoram are being processed.
Of the seven union territories, Andaman and Nicobar and Lakshadweep Islands do not require any legislation as no taxes are levied there.
Central sales tax would be phased out in three years after introduction of VAT, as it resulted in distortion of internal trade and impeded development of a common market.
"CST disturbs the basic design of VAT and has a cascading effect. States unanimously agreed that CST must go," Dasgupta said. CST contributes Rs 13,000 crore (Rs 130 billion) to exchequer.
The phase out and the compensation package for CST is yet to be worked out. The proposal for the phase out as of now is reduction from four to three per cent in first year, then to one per cent in second year and nil in the third year.
Dasgupta said Centre would bring in the constitutional amendments in the Budget session to put the law in place by June 1.
The Centre would also introduce amendments to the legislations on additional excise duties now levied on special goods along with the Finance Bill.
The amendment is being brought about to empower states levy sales tax and VAT on sugar, textiles and tobacco from June.
This would be done without affecting the existing duties on excise by the Centre and the states have agreed to adopt a uniform floor rate of one per cent on these three items.
In the case of service tax also, Dasgupta said the list of services that would come under the ambit of states would be determined by the nature, scope and geographical location.
The VAT committee would monitor the progress after the new tax regime is introduced.
"World over, it has been found that VAT has led to stability in rates and softening of prices barring one or two exception. Hence, any apprehension that it would increase prices or lower revenue was farfetched," Dasgupta said.