The North Block will soon be abuzz with Budget talk once again. The preparatory steps for the forthcoming Budget are being taken and the tax proposals for it will be finalised in the next few months.
It is expected that the proposals will signal continuity and change to eventually achieving a stable and rational tax system. Indeed, in a federation, a co-ordinated calibration of the tax system is necessary to enhance revenue productivity and to achieve a harmonised tax system with fiscal autonomy to states.
This, probably, will be the last Budget for initiating concrete reform measures before the political cycle will hijack the reform agenda.
An important item in the reform agenda relates to preparing the groundwork for the levy of the goods and services tax. In this year's Budget speech, the finance minister stated, "It is my sense that there is a large consensus that the country should move towards a national level Goods and Services Tax that should be shared between the Centre and the States", and set April 1, 2010, as the date for introducing the GST.
While this statement was made to raise the rate of service tax from 10 to 12 per cent, it is important to take the reform further. The introduction of the GST requires many initiatives in the Union Budget, besides a convergence of rates of tax between goods and services.
There are a variety of conceptual and implementation issues that need to be resolved in making a transition to the GST. It would be appropriate to put out a position paper for discussion among the states as well as the general public for gaining consensus on the structure and operation of the levy.
The important questions relate to the issue of achieving tax harmonisation while retaining states' fiscal autonomy. Most observers feel that there is need for a paradigm shift in the tax policy - to move away from the principle of separation in the assignment system to one of assigning concurrent tax powers to the Centre and the states.
The best possible solution is to have the GST levied at the Centre and the states setting their own rates on the base determined by the Centre. There has to be a clear demarcation of tax room for the Centre and the states by specifying the ceiling rates.
Indeed, the question as to who will levy the tax, who will collect the tax and how it will be appropriated should be discussed extensively before consensus is reached.
Be that as it may, there are important steps that should be taken to unify excise and service tax rates. In particular, the time is ripe for taking steps to transform the existing CENVAT into a manufacturing stage value-added tax on goods and services.
For this, it is important to move away from selective taxation of services and extend the tax to all services with a small exemption list. This will expand the tax base, simplify administration and reduce litigation.
When the service tax is made general, it is enough to define "service", and each of the taxed services need not be defined. As the tax credit mechanism works between excise duty and service tax, it is easy to make a transition to a manufacturing state GST. In the next stage, CENVAT and service tax could be unified to have a common exemption limit and rate.
Extending service tax to all taxable services, besides being an important transitional measure, would also bring in significant additional revenue. There are a number of untaxed services causing a narrow tax base and unintended distortions.
To take an example, in 2005-06, the turnover from railway fares and freights was over Rs 91,000 crore (Rs 910 billion) and in 2007-08 it could be Rs 140,000 crore (Rs 1400 billion) and at the prevailing rate, could yield Rs 14,000 crore (Rs 140 billion).
In fact, extending the tax would help to achieve uniform taxation of the road, rail and air sectors. Given that the tax credit mechanism operates for both goods and services, this will not add to cascading and will make the central VAT more effective.
An expansion of the base should accompany a further convergence of rates between the service tax levied at 12 per cent and the median excise duty rate of 16 per cent. This actually gives an opportunity to reduce the general CENVAT rate to 15 or even 14 per cent. This will actually sweeten the pill of raising the service tax rate.
It is also necessary to unify the rates within excise duty as well. This would require converting specific into ad valorem rates. There are not many items in this category but there is no case for continuing with specific rates.
Cement is the prime example of this and the forthcoming Budget would do well to rationalise it. This will simplify administration because calculating tax credit will become easier. This year's Budget reduced the tax rate on a number of items to 8 per cent. Indeed, the small cars, DVD drives, flash drives and combo drives, or the packaged software could well be taxed at the general rate. Encouraging small cars, however desirable it may be, should not burden the tax system. We need to realise that assigning multiple objectives to tax policy only adds to complications and introduces distortions.
Another set of measures relates to the reduction and eventual phasing out of the CST. A reduction of central sales tax to 2 per cent may require compensation to the states to the tune of about Rs 9,000 crore (Rs 90 billion).
Returning the additional excise duty items - sugar, textile and tobacco - to the states for the levy of VAT will have to be considered. The states will also have to be given powers to impose service tax to enable the levy of a full-fledged VAT on goods and services.
Indeed, all these may not solve the basic problem of low revenue productivity of excise duties unless immediate measures are taken to build an efficient information system and have a re-look at various tax preferences.
In fact, the credit for the high buoyancy of direct taxes in the last four years goes to the TIN, initiated under Vijay Kelkar's advice. Indeed, the computerisation of the excise system holds the key for enhancing revenue productivity and this would require professionalism beyond the capacity of the NIC and the finance ministry can take its cue from the success of TIN for direct taxes.
The author is director, NIPFP.