Centre-State Financial Relations: How Wise will a Nation-wide VAT be? Ashok Mitra

The outcome of the 2004 Lok Sabha elections is a categorical rejection on the part of the Indian electorate of both religious bigotry and blatant anti-poor economic measures passing as ‘reforms’. There is however a third dimension to the verdict: it marks the emergence of regional parties and others with a strong regional base as entities as powerful as the two major national parties. The proportion of total votes cast for these other parties is about the same as that polled by the Congress and the BJP together. The electorate has given a clear signal that regional aspirations must be speedily fulfilled; otherwise the integrity of the polity itself could be in danger.

To honour this mandate, the Common Minimum Programme, drawn up by the new government should have included a straightforward recommendation for a realigning of Centre-State relations in favour of the States, including suggestions for a drastic revision of the existing financial relations. Unfortunately, the CMP does not mention any such agenda, except the promise to set up another time-consuming commission to go into the matter. Even more intriguing, one of the first tasks the CMP has assigned for the new government is the introduction of a nation-wide Value Added Tax, a number of steps have already been initiated towards this effect.

This is certainly cause for concern, for the Value Added Tax actually aims to replace sales taxation, the main revenue-raising instrument at the disposal of State governments. As it is, the States are currently under heavy financial crunch. The Constitution does not entitle them to levy either income tax or corporation tax or wealth tax. They have no right to determine either the rates structure or procedures relating to excise duty imposed at the point of production of goods and services. They cannot levy import and export duties. All these prerogatives belong to the Centre. The States, besides, cannot raise money from the market without permission of the Centre. They cannot have recourse to the printing press in the manner the Centre can. All that the States enjoy is the right to levy sales and purchase taxes, and such other minor levies as amusement tax, road tax or excise duty on liquor. They are allowed to tax agriculture. But, given the level of rural poverty, such taxation is of extremely limited potential. For most States, roughly between one-half to two-thirds of total revenues accruing to them come from sales taxation. The proposal to scarp sales tax and substitute it by the Value Added Tax is therefore prima facie a further encroachment on their financial rights. Because of their very narrow resource-raising base, the States have been compelled to borrow heavily from the Union government, the burden of which is staggering. It could be an impossible situation if they are now asked to give up the right to levy sales tax and substitute it by a Centrally-directed levy whose revenue prospects are indeterminate at this point of time.

Sales tax and Value Added Tax are distinct from each other. The former is an impost on the sale of a commodity or service at the point of sale. In contrast, VAT is a levy on goods and services which is related to the value of the product or service even as it increases at each stage of production. These technicalities apart, sales tax is specifically listed in the Constitution as a prerogative of the States, while VAT is not mentioned at all. An impression has been sought to be created that whatever is now being done is at the initiative of the State governments and in accordance with the unanimous decision of State finance ministers reportedly reached at a meeting presided over by the Union Finance Minister in 1999. This is a travesty of facts; the initiative has come from New Delhi. The so-called empowerment committee of State finance ministers, which is supposed to be looking after the entire matter, is nominated by the Union finance minister, its secretariat has been set up by the Ministry of Finance, the proposed framework of Value Added Tax with uniform rates of taxation for different categories of goods and services all over the country and uniform procedures for administering the tax has been crafted by the Centre.

Why is this anxiety to rob the States of their right to impose sales tax and substitute it by VAT? The VAT is a dream child of the World Bank and the International Monetary Fund, and is regarded by them as an important adjunct of ‘economic reforms’. There is here an identity in the points of view of the Washington institutions and those held by representatives of industry, that is, by the capitalist class: they both want India to be an integrated market so that capitalist enterprise can flourish without any let or hindrance. Just as there is a single, Centre-imposed and Centre-administered excise duty at the point of production, industrialists are keen to have a similar single, Centre-administered tax at the point of distribution too. VAT fits the bill: once it is uniformly applied all over the country, a national market, it is fondly hoped, will emerge for all goods and services; there will be no bother of separate rates of taxes for the same commodity in different States, nor the irritant of observing different procedures and of differences in definitions and terms. An additional factor swaying the attitude of industrialists is perhaps the belief that, in the case of VAT, they have to deal with only one authority, while sales taxation involves negotiating at various levels.

The prosperity that has visited West Europe subsequent to the cross-over to VAT is cited in this connection. On the other hand, the world’s leading capitalist country, the United States, has proved that there can be life even without VAT: there, the concern for preservation of States’ rights has smothered all other considerations. In Canada too, French-speaking Quebec has stayed away from the Value Added Tax embraced by the other provinces. Moreover, traders as a class are wary of VAT, mostly because of the kind of detailed accounts compliance that the tax calls for. Small traders in particular – and not necessarily only the dishonest ones – fear difficulties in the maintenance of proper books.

Whatever the conceivable gains or losses to industrialists and/or traders, in the Indian context the States are likely to lose from the introduction of VAT. Apart from the fact that the States will in the process be deprived of their major tax instrument — sales taxation — they will also face other problems. The States constituting the Union of India are at disparate stages of development. They have varying structures of production and different patterns of consumption. Some States may need to encourage industries in the State by dangling a lower level of sales taxes to entrepreneurs compared to what prevails in other States, or they may want to discourage the consumption of certain commodities by raising the rates of sales tax. This weapon will no longer be available to them.

Those who advocate VAT because it will, they believe, lead to market perfection, are at best an optimistic lot. Varying rates of sales tax are not the only impediment keeping India from the paradise of an integrated market. Even if sales taxation is abolished, curtails and monopolies will remain, inequalities in income and assets distribution will persist, and so too other obstacles to the free flow of goods, services, labour and capital from one part of the country to another.

Nor should we forget the Constitutional issues that are involved. The States on their own cannot abolition sales taxation; nor can the Centre. That is possible only if a Constitutional amendment is passed. The enthusiasts for VAT obviously want to avoid that route. The Centre has instead advised the States to have recourse to a subterfuge. They have been urged to each pass enabling legislation in their respective legislature with the objective of replacing the existing system of sales tax with the Value Added Tax. The procedure proposed in the body of the legislation is however to amend the existing sales tax legislation. It is doubtful whether such a procedure will be considered as legally valid in a court of law.

The preferred and wiser alternative would have been a Constitutional amendment abolishing sales taxation and removing it from the State list, at the same time introducing the Value Added Tax in the Union list. Whether there will be enough support for such an amendment amongst the States is doubtful; for then, the issue of abridgement of States’ rights would be glaringly brought into the open. Even if such a Constitutional amendment were enacted, given the precedent of Kesavanand Bharati, its validity too could be questioned, since, some will say, it damages basic structure of the Constitution.

All told, the proposal to go ahead with the Value Added Tax is a retrograde measure and deserves to be resisted. The priority in the fiscal sphere should rather be on liberating the State governments from the huge loan burden they at present carry.