In his Budget speech, Finance Minister P Chidambaram reiterated the United Progressive Alliance government's commitment to implementing value-added tax by April 01, 2005.
But has thought been given to all the necessary technical and administrative preparations that need to be in place before VAT is introduced?
The first preparation relates to making the taxpayer understand that in the globalised economy, trade and industry can ill-afford to have the existing first-point sales tax, which tends to raise consumer prices by an amount higher than what accrues to the exchequer due to the phenomenon of cascading.
On the one hand, the effort should be to remove the misconception that VAT is being introduced primarily to mobilise larger resources.
On the other hand, traders and manufacturers need to be persuaded that VAT should be considered an opportunity to gain competitive advantage and to improve business operations.
Reconsidering the design of state-VAT is another important task. While there are many issues related to design, the most important is the floor rates that have been recommended for state-VAT.
It is proposed that the states should have three floor rates: zero per cent, 4 per cent and a standard rate of 10 to 12.5 per cent with some exceptions. Gold, silver, precious and semi-precious stones will have a VAT rate of 1 per cent, while liquor will have a higher VAT rate with a floor of 20 per cent.
A zero per cent rate is applied to natural and unprocessed products, which are in the unorganised sector (such as betel leaves, earthen pot and so on); items that are legally barred from taxation on sale (such as newspapers, national flag and so on); and items that have social implications (such as books, periodicals, slate, slate-pencils and so on).
Four per cent is applicable to essential commodities such as branded bread, bulk drugs, paper and so on; declared goods such as iron and steel, hide and skins, and so on; industrial and agricultural basic inputs, such as printing ink, coir, bidi leaves, fibres, seeds and so on; and capital goods.
For all other goods there will be a floor rate of between 10 per cent and 12.5 per cent, with the actual rate fixed by the respective states.
In principle, the above rates should be acceptable to all, but a closer scrutiny of the commodities falling in the different rate categories suggests that much has yet to be done.
For example, a scrutiny of the list of items taxable at the 4 per cent suggests that some items could be placed in the general rate category. These include hosiery goods, umbrellas, readymade garments, hydrogenated vegetable oil (vanaspati ghee), edible oils, areca nut powder, betel nut, tamarind and tobacco, among others.
In addition, a long list of 167 industrial inputs and packing materials need not be put in the 4 per cent category. It should be clearly understood that under the VAT regime all these items should be brought into a general rate category.
In this context, it is important to stress that there are no universal inputs in the economic system. Input-output relationships clearly reveal that any item that is an input for one consumer could be the final product for another.
Hence, the tax rate should be decided such that all these items fall in the general category, with the option of refund or set-off under VAT, when the item is used as an input.
Another significant point is the nomenclature of "uniform floor rates". While floor rates of 4 per cent and 10 or 12 per cent are understandable, the word "uniform" indicates that the rates of tax should be the same in all the states for a particular commodity, which may not be acceptable to the states.
Does this mean that the states will give up their power to raise additional resources in the future through VAT? Or, does it imply that Arunachal Pradesh, which until recently did not have sales tax, will have the same rates as Maharashtra?
If the concept of uniform rates were accepted, it would mean that no state would make any further tax effort as per its capacity to mobilise resources. This would have disastrous consequence for the state's finances in the long run. This aspect needs to be hammered out.
What could be done is to treat these rates as "floor rates". That is, no state should be allowed to have rates lower than these. Otherwise, the states could trigger off a "rate war" or follow a "beggar my neighbour" policy.
Instead, states should be allowed to have rates higher than these for mobilising additional resources as and when possible and required. It is neither feasible nor desirable to suggest that the states surrender their milch cow and be at par with other, less developed states in terms of VAT rates.
States that have a complex structure of sales tax with additional sales tax, turnover tax or surcharge need to have a higher rate of VAT as compared to other states.
As of now, states have regarded these recommended four rates to be the given rates. Accordingly, they have initiated exercises for estimating "revenue neutral rates".
However, there has been no effort by the states to have rates similar to the ones being levied already. In fact, all these exercises must be attempted afresh, assuming rates closer to reality.
A closer look at the VAT structure in other countries shows a similar pattern. In the European Union, for instance, VAT rates among member countries range from 15 per cent to 25 per cent. Even in Canada, rates vary from one province to another.
Another area of concern under VAT relates to the special treatment of small dealers. In fact, this has been the main controversy in the past as well.
After much debate, the empowered committee has taken a step towards having a scheme of compounding for small dealers having a turnover of Rs 5 lakh to Rs 40 lakh (Rs 500,000 to 4 million). Notwithstanding this, the overall design remains faulty because of lack of comprehension.
It must be understood that by increasing the exemption limit, no charity is being shown to the small traders. It is done to allow small dealers to pay tax without incurring a high compliance cost as compared to large dealers.
Also, these dealers do not pay substantial revenue to the government in comparison to increase in cost of administration.
Most countries, therefore, provide for special schemes through which exemption limit is raised or tax liability is compounded.
The Model VAT of 1998 has provided that small dealers falling in the range of Rs 5 lakh to Rs 25 lakh (Rs 2.5 million) would pay a 1 per cent tax on their gross turnover.
This was based on the idea that these dealers while paying 1 per cent of turnover would also pay at least 10 per cent on their value added (assuming 10 per cent value addition in the gross turnover) without going into the nitty-gritty of maintaining tax records.
However, it is important that these dealers are allowed to issue vouchers showing VAT paid by them. Otherwise, these dealers are discriminated against in the market and their business is affected.
On the contrary, the proposed design of VAT will introduce a composition scheme for dealers with turnover up to Rs 40 lakh, but these dealers will not be allowed to issue an invoice showing VAT on it.
This is not in the spirit of VAT. Here it is important to keep in mind that the idea of "composition" is not to take these dealers out of VAT. All the dealers are supposed to be under VAT; small dealers pay a composition tax and maintain only skeleton accounts.
It is important to understand that these dealers must be allowed to issue an invoice that shows the amount of tax, to enable their purchaser to claim input credit.
The author is director of the Foundation for Public Economics and Policy Research.