There are ways to do this but they are complicated and the tax base gets correspondingly smaller

The introduction of the goods and services tax (GST) in India seems to be back on the list of priority reforms. The empowered committee of state finance ministers has constituted three committees to examine and resolve remaining contentious issues within the design of GST. Since some of the states are willing to adopt the proposed regime while others are somewhat reluctant, there is a proposal to explore the possibility of implementing GST optionally in the states. This approach worked in the case of VAT and potentially affords some flexibility to the states in adopting and/or even remaining within the GST regime. In exploring this option, it is desirable to ensure that the design of GST is not unduly complicated.

What happens if some states choose to implement GST and others do not? The additional revenue from the VAT regime is mainly attributable to central sales tax (CST) and the tax credits associated with CST. Retaining the CST in these states and moving to a destination-based tax regime in other states can be considerably complicated. The accompanying table provides one likely scenario of taxation. In this scenario, states which get a considerable proportion of their taxes from CST would prefer the VAT regime and those which derive a relatively smaller share of their sales tax revenue from CST, or which expect considerable expansion in the tax base from GST, would seek to move to GST. Since there will be a reduction in the cascading in transactions between GST states, this regime would generate incentive for movement of business to states with GST, if such a regime remains in place for a long time.

Apart from incentives for change in place of business, the above argument does not support the generation of an integrated common market in the country. The most important step in the implementation of GST, therefore, is to ensure that the treatment of inter-state supply of goods and services remains uniform across the states. There are two basic concepts associated with the treatment of inter-state supply of goods and services—determination of place of supply rules, and system of taxation of inter-state transactions. The first component—the place of supply rules—would determine the place where a given transaction would be subject to tax. In the event where the supplier and the user of a particular supply are located in two different states, the transaction would be subject to tax under the taxation of inter-state supply. At present, these transactions are taxed under the CST Act, which allows for a tax to be collected and retained by the exporting state. Since the proposed GST regime is a tax based on destination principle, the exporting state expects to get no taxes on such transactions. Depending on the model chosen for implementation of the tax, the tax can either be collected in the exporting state and transferred to the importing state, or the transaction can be zero-rated in the exporting state and the chain of taxation begins afresh in the importing state. For the GST regime to be something useful and a step forward, it is important that this key feature of the proposed regime remains undisturbed—an export-based tax like CST cannot be retained in the new regime. Else, we would be looking at revenue raising measures not reforms in the system of taxation.

In addition to the above, setting up differential treatment mechanisms for transactions between GST and non-GST states as compared to between GST states and/or between non-GST states would place considerable compliance costs on the dealers since they would have to account for not three types of transactions—local, inter-state and international—but four, if treatment of transactions with GST states varies from that of transactions with non-GST states. And the scenario can be further complicated if any dealer operates in more than one state.

Often in the context of inter-state transactions, within the assumption that the tax would be collected in the exporting state and transferred to the importing state, there has been some discussion on the appropriate rate of tax for these transactions. In the case of CST like levies, there is merit in keeping the tax rates low, but in the case of a destination-based tax, it is useful to keep the taxes as close to the actual rate of taxation. Since the states are potentially asking for some flexibility in choosing rates of tax, in order to prevent a race to the bottom, it is important to define a floor rate of taxation—if there are multiple rate categories, then there is need to separately define a floor for each of these categories. Once such a floor is defined, this rate can be adopted for the taxation of inter-state transactions as well. Since most states would not have an incentive to diverge widely from the floor, the difference between the tax on inter-state trade and that on local trade would not encourage significant trade divergence.

Here it is important also to recognise that CST in its entirety should go, not only on goods within the GST regime but on all goods. Retaining CST on petroleum products/alcoholic beverages and removing the same for goods with the GST regime vitiates the tax system. The states are retaining the right to tax these products in the form of an excise duty either with a GST or independent of GST. This excise duty should remain the only form of cascading tax in the system—since states can choose to implement these excises at self-selected levels, there is no reason to allow the continuation of CST on these products. States with refining capacities should not be allowed the right to tax the rest of the country for this “captive power”!

Interestingly, if the above are ensured, states would be left with very few incentives to continue with the existing VAT regime. For states which choose to implement GST, the tax would be applicable on both goods and services supplied in the state. However, for states that opt to remain in the present VAT regime, the tax would be applicable only on goods and not on services. The tax base, therefore, would be correspondingly smaller.