Finance Commission may consider compensation for States to advance the implementation of a “Flawless” GST

Dr. KELKAR ADDRESSES 3rd NATIONAL CONFERENCE ON GST FOR ACCELERATED ECONOMIC GROWTH AND COMPETITIVENESS

Following is the text of the Speech delivered by Dr. Vijay Kelkar, Chairman Thirteenth Finance Commission on the occasion of ASSOCHAM 3^rd National Conference on "GST for Accelerated Economic Growth and Competitiveness", organized here today:

"Introduction

It is indeed a privilege to be present at this seminar on "GST for Accelerated Economic Growth and Competitiveness" and share some thoughts on the Goods and Service Tax.  

Over the past fifteen months, in my capacity as Chairman of the Finance Commission, I have had the privilege of visiting twenty five States in our country and discussing with the respective State governments their views on our Terms of Reference and how the Commission should go about its work. One important item in our Terms of Reference relates to consideration of "the impact of the proposed implementation of the goods and service tax with effect from 1^st April 2010 including its impact on the country's foreign trade." A number of State governments have expressed their views on the GST to us while voicing their own concerns.   Independently, a number of economists, practitioners and financial journalists have raised issues and suggested options relating to the implementation of GST.  I  am aware that  the GST debate has so far been dominated by the concerns of two of the three major players in this policy triangle - the Central  government on the one hand and the different State governments on the other. The third group of stakeholders - trade and industry should proactively seek to influence this debate so that their concerns, needs and aspirations can be incorporated into the GST design as well as the implementation protocols. I therefore congratulate ASSOCHAM for organizing this seminar which will be addressed by important policy makers and   implementers. I am confident that this seminar would result in a set of concrete recommendations that can be forwarded both to the Government of India as well as the Empowered Committee of the State Finance Ministers for their consideration. As you will all agree, policy can be best influenced when it is still malleable and I urge not only ASSOCHAM but also all the other trade associations to  closely study all  possible  ways in which  the  GST will impact their membership and put forward their views  on the various issues  as  early as possible in anticipation of,  rather than consequent to a draft  GST law which may be put up for discussion. 

Much can and has been  said on the merits of the GST. It will bring about a  phase change on the tax firmament  by redistributing the burden of taxation equitably between manufacturing and services. It will  lower the tax rate by broadening the tax base and  minimizing exemptions. It will  reduce distortions by completely switching to the destination principle. It will  foster   a common market across the country and   reduce compliance costs. It  can provide a fiscal base for local bodies to enable them to fulfill their obligations.  It will facilitate investment decisions being made on  purely economic concerns,  independent of tax considerations.  It will promote exports. A  recent study on the impact of GST on foreign trade indicates  that the rate of growth of exports  will be significantly higher than that for imports. GST will also promote employment. Perhaps, most importantly, it will  spur growth. As I have mentioned elsewhere, it has been estimated that the GST implementation increased   Canadian  GDP  by 1.4 percent.  In India, we can expect a similar kind of positive impact.    This  means gains of  about 15 billion dollars annually. Discounting these  flows  at a modest  3 percent per annum, the present value of the GST works out to about half a trillion dollars. This is indeed a staggering sum and suggests the need for energetic action to usher the GST regime at an early date.  I will attempt to address important questions relating to effective implementation of the GST regime.

Concerns relating to GST

 Most concerns expressed about the implementation of GST can broadly be  divided into three categories  -

a. Design issues

b. Operational issues.

c. Infrastructure issues.

I shall take these up one by one.

Design issues: 

What should be the design of the GST ? The broad framework of GST is now clear. This is on the lines of the model approved by the Empowered Committee of the State Finance Ministers. The GST will be a dual tax with both central and State GST component levied on the same base. Thus, all goods and services barring a few exceptions will be brought into the GST base. Importantly, there will be no  distinction between goods and services  for the purpose of the  tax  with a common legislation applicable to  both.  

 However a number of  issues remain to be resolved. These are presently under the consideration of  the Empowered Committee under the Chairmanship of Dr Asim Dasgupta, the distinguished Finance Minister of  West Bengal. These issues include : 

The rate structure and value  

The primary concern of all State governments is protection  as well as enhancement of existing revenue streams.  There are  three  parameters which need to be balanced here - one is the  range of  taxes presently being levied which will be subsumed into the GST. This will determine the tax base of the GST. The other two  parameters are the number of rates and the  numerical value of these  rates   which will be applied to this base . 

All indirect taxes on the supply of goods and services would need to be subsumed into the GST. The Empowered Committee in its road map  of Dec 2008 has indicated which taxes which will  qualify.  The Finance Commission has appointed a Task Force to advise the Commission on the implementation of  GST.  For the purpose of  computing the Revenue Neutral Rate the Task Force assumed that apart from VAT, stamp duty, vehicle tax, taxes on goods and passengers, taxes and duties on electricity, entertainment tax, entry tax, luxury tax, taxes on lotteries, betting and gambling, purchase tax as well as all State cesses and surcharges will be subsumed into the State GST.  Central Sales tax will stand abolished. From the government of India  side, Central  excise, additional excise duties, service tax, Additional Customs duty (CVD), and all cesses and surcharges (other than educational cess) will be subsumed  into the Central GST. 

There  appears to be agreement that the best option would be a  bare minimum number of rates, at best two, preferably one. We assume that a single rate structure  will find favour with a very limited set of exemptions available for basic foodgrains as well as basic education and health services. This  single rate will  ensure low compliance costs, obviate classification disputes, and ensure uniformity of approach amongst all players. But to be attractive, a single rate cannot be too high. At the same time, the rate must be high enough to address the concerns of States regarding revenue neutrality. 

Using data from about 18.25 lakh business entities for the year 2007-08, the Task Force has generated very interesting data relating to the     GST rate which will maintain the same  level of income for the centre  and States respectively in a minimal exemption regime. Their preliminary calculations suggest that Revenue Neutral Rate  will be  substantially below   the combined Central and State rates.  It is necessary that these and similar  calculations which may have been made by  other stakeholders be  published for debate and examination.  States also need to satisfy themselves that not only will the GST rate  applied be revenue neutral nationally but also individually and wherever this is not initially so, adequate compensation provisions are made.  This public  scrutiny  will thus  ensure that  a reasoned view is taken on the rate to be applied as well as on the exemption regime which should be adopted. The report of our Task Force will be published on the Finance Commission's website shortly and I hope that  that this will contribute to better awareness and constructive policy dialogue.

Rules of Supply for goods and services

While CST will be abolished  in the GST regime, the  treatment of  inter state sales will need to be carefully thought through.  It would be necessary to guard against tax arbitrage where local sales which will be taxed could be shown as inter state sales which will not. The CST Act   provided for documentation to attest the interstate nature of the sales. A  number of models are being examined by the Empowered Committee which will serve as alternatives. Since the final model adopted would have a direct bearing on the ease of inter state trade transactions as well as the compliance cost, I would urge that all trade and industry associations involve themselves in this choice through voluntary submissions of their views to the Empowered Committee.

Putting in place the  Rules of Supply for the  inter state  provision of services  will be  demanding. Services produced and consumed within the same  State would not pose a problem as far as the appropriation of taxation proceeds is concerned. However,  some  services  may be supplied from  one State, consumed in another and paid for in a third State. A set of rules  to determine the taxation jurisdiction  and appropriation would  need to be worked out.   There is adequate international precedent for this but here again, trade and industry associations could take proactive steps to suggest possible options.

The  framework for exemptions, thresholds and  composition

The existing sales turnover  thresholds for VAT taxation vary widely across States. Some small States have specified a threshold turnover of ₹ 2 lakhs per annum. Larger States have stipulated ₹ 40 lakhs per annum. The turnover range for composition  eligibility is equally diverse.  The list of exempted goods also differs across States. To allow for uniform treatment of inter state transactions nationally, it may be necessary that these variations be  bridged so that tax cascading is  eliminated. However, the concerns of smaller States need to be kept in mind.  For this reason, perhaps such convergence could be targeted over a certain period of time rather than immediately.

Operational Issues

Common Approach

For GST to be successful, all States and the Centre  should implement it in a similar fashion. Only this will bring about the national common market which is one of its goals. This will be possible when there will be a common law, a common assessment procedure and perhaps even a common return. The Empowered Committee can provide the required leadership to engender this  uniformity of approach between all the States amongst themselves and also with the Union government. 

Sharing of information

Recent experience relating to revenue collections from the Central Sales Tax have raised the issues relating to tax arbitrage. It appears that local sales  under  the VAT regime are   being shown as lower taxed CST sales leading to revenue loss. Some States have expressed concerns and  referred  to  tax  evasion in  developed countries which have a VAT in place. They  have sought reassurance that revenue leakage would  be effectively checked in the GST system.  Apart from putting in place a comprehensive  IT network,  sharing of tax related information and coordination amongst all the States  will  be crucial for this. Perhaps the Empowered Committee could   set up a coordination mechanism to address such concerns. Trade and industry bodies also have a strong role to play in curbing such malpractices.

Infrastructural Issues

IT infrastructure  

A simple system for inter-state verification of dealers  and transactions is essential to ensure tax  compliance and check avoidance. It will also be essential for enforcing the rules of supply discussed earlier. Given the volume of such transactions, this system  necessarily has to be IT based. The present system Tax Information Exchange System ( TINXSYS)  does not appear to be fully operational across all States. There are  asymmetric benefits to States in putting in place such infrastructure   and this appears to be  affecting  their incentives to do so. We need to put in place a system which will uniformly incentivize all States to participate in and contribute to the verification system. Or alternatively, one central agency could be charged with maintaining this system. Both the alternatives available are challenging, but  this needs to be done.

Checkposts

Most States have put in place a system of checkposts on its road borders. Apart from other verifications which may take place, these checkposts   verify and document inter-state sales of goods carried by the vehicles which cross these borders. These details are then  cross verified with the VAT returns of the importing dealers. The need for such an arrangement to continue in the GST regime has been emphasized, especially in view of the abolition of CST and the possibility of tax arbitrage. However , the fact remains that such checkposts by the very nature of their operations, generate enormous delays in road traffic, sometimes upto three hours per checkpost. A freight  truck travelling by road   between Delhi and Chennai will need  to cross five   State borders and ten checkposts. Delivery times for goods may be extended  significantly because of delays at  checkposts. The arrangement also encourages rent seeking behavior.

It may be difficult to eliminate checkposts given the valid concerns of State governments  which may extend beyond  collection of taxes and movement of goods to vehicle fitness examination, prevention of trafficking, collection of  local cesses, etc. But what appears  to be egregious is that the same vehicle has to pass through two checkposts while crossing one border - the exporting States checkpost and the importing States checkpost. Both these checkposts are often located within a  couple of kilometers  of each  other and a vehicle driver has to spend considerable time in both. Perhaps, it may be possible for both the States to put up a combined checkpost. Officials of both States could sit together and conduct their verifications in one checkpost. Or one State  could handle traffic on one direction and the other State in the other direction. But essentially there would be only one check per border for a goods vehicle. Such an arrangement will significantly reduce travel time. The Finance Commission is prepared to support creation of such checkposts if the respective State governments are willing  to operate jointly. 

Impact on Small Enterprises

The impact of  GST on small enterprises  is often cited a  concern.  On the State GST  component, the position will be  exactly the same as under the present  VAT regime. There will be  three categories of small enterprises in the GST regime.  Those below the threshold need not register for the GST. Those between the  threshold and composition turnovers will have the option to pay a turnover based tax or opt to join the GST regime. Given the possibilities of input tax credit, not all small enterprise may seek the turnover tax  option. The third category of small enterprises above the  turnover threshold will  need to be within the GST framework. Possible    downward changes in the threshold  in some States consequent to the introduction of GST may result in obligations being created  for some dealers. In such cases suitable provisions could  be made  to provide  direct assistance to the affected  small enterprises  if considered desirable .

In respect of Central GST,  the position is slightly more complex.  Small scale units manufacturing specified goods are allowed exemption of excise upto a turnover of ₹ 1.5 crores. These units, which  may be required to register for payment of GST, may see this as an additional cost. We welcome suggestions from trade bodies on how this issue can be addressed.

A "Flawless" GST   

Ideally the GST would subsume all the major State Level taxes, use a single rate, allow for only essential exemptions and eliminate all barriers to trade.  This flawless GST will feature  the following characteristics.

Harmonisation

For GST to  be effective, there should be identical GST laws across States as well as at the Centre. I  propose  that not only the law but also the  methodology  relating to levy, assessment, collection and appropriation of the GST should be similar across States and the centre.  Such a unified approach will  simplify  procedures, eliminate bottlenecks and drastically reduce transaction costs  for dealers, enabling them to leverage  cost and time gains from  the new taxation system. Necessarily, such an approach requires that tax rates for most goods and services be common across the country as should be the list of exemptions and thresholds. These considerations  would need to be kept in mind while  considering  fiscal autonomy  of States.  Some States have proposed a mechanism which ensures that in future, changes in the essential elements of GST are made only with the concurrence of all States and the center. Such a mechanism will  provide stability of the taxation regime and  suggestions from trade and industry would be welcome on how to move forward on such a proposal.  

Common Procedure- levy,  assessment, collection, appropriation 

For industry to reduce its transaction and compliance costs, it is necessary that apart from a common law, the implementation of the law be also similar across States. All stages of the taxation chain  from the levy of the tax to its assessment  collection and appropriation should be similar. This would involve similar rules across States dealing not only with assessments, audit, refunds but also more basic issues like registration, filing of returns, treatment of transportation of goods etc.  A common dispute resolution mechanism as well as a mechanism for giving advance rulings would further facilitate trade and industry.   Here too, associations  can play a very useful role by providing advice  and suggestions on the modalities  to be followed.

Expanding the envelope

The broader the tax base, the lower will be the GST rate. I therefore  return to an issue raised in the 2003 FRBM Task Force report - the taxation of real estate.  The construction sector  is a significant contributor to the national economy. Housing expenditure dominates  personal consumption expenditure. Further, the present  piece meal taxation of this sector encourages perverse incentives. Raw material is charged CENVAT, the works contract is charged VAT and stamp duty is levied on the sale. With no provision of input tax credit in place, there is little  incentive to  record such  transactions  either at the construction stage or at the sale stage at their correct value. This leads to substantial loss of tax revenue and fuels  the parallel economy.  I  am aware that the present discussions  on the GST configuration do not consider the inclusion of this sector. However, given the potential long term benefits to the economy and to a successful GST, I would  urge that the construction and housing sectors be included in the GST tax base, either immediately or during a  subsequent  phase.

Another  possible  step  to expand the GST  tax base will be the inclusion of the rail sector. This will be necessary if a level playing field is to be provided to the road  and air transportation sectors  which will be subject to this tax. This inclusion will also ensure that all  inter state transportation of goods can be tracked through the proposed IT network. The  railways themselves will benefit from this  by availing input tax  credit on the significant purchases made by them.

Benefits to State Government

A few State governments have recently indicated their opposition to the implementation of GST at the present juncture. While their  objections need to be carefully examined, it must also be recognized that while implementation of the GST is aimed at being revenue neutral to the States, it will be budget positive for the government.  This is because governments are large purchasers in the market for their own consumption and their cost of procurement will come down significantly with the implementation of GST.  Apart from these static benefits, dynamic benefits will be generated in the medium term through more economically efficient production, improved competition and more importantly greater employment.

Role of the Finance Commission  

 It is possible that some States may want assurances that existing revenues will be protected when they implement GST.  The Commission is willing to consider providing for compensation in order to advance the implementation of a "flawless" GST. 

Next Steps 

I have shared with you my views on what should be some of the goals of the Goods and Services Tax. I am acutely aware that there has been as yet no   agreement on which of these goals will be adopted and  how then will we   reach the selected  goals. The two major players - the Empowered Committee and the Government of India are  discussing these issues.  As I mentioned earlier,  the policy on GST  is still malleable and industry and trade associations can play a  valuable role  in forging it. I would urge that ASSOCHAM and all similar promotional bodies study some of  the issues highlighted above and present their suggestions to the Empowered Committee and the State governments. In particular, they could work on  the  appropriate treatment of inter state sales of goods and services; the thresholds, composition and exemption regime which should be  adopted; the treatment of small industry; the assessment and audit regime to be adopted; the inclusion of real estate in the tax base and even a draft GST law.

Conclusion

During his recent interaction with State Finance Ministers, the Finance Minister has encouraged State Governments to implement GST from 1^st April 2010 noting that this was a critical part of the government's economic reforms program. This is a strong signal. The agenda is vast. All stakeholders need to and must contribute to the present debate. Once GST is introduced, outreach efforts by all agencies will be equally important.

I would like to conclude by thanking ASSOCHAM for giving me this opportunity to share some of my thoughts on such an important subject with you."