In the speculation that has inevitably preceded tomorrow’s Union Budget, there has been considerable commentary on the Goods & Services Tax (GST). Though it can safely be said the actual introduction of GST is some time away, many state finance ministers will be listening to Finance Minister P Chidambaram’s speech carefully for pre-GST announcements.

This marks a great leap forward from the position just three months ago when this far-reaching tax reform had been in limbo. That’s because Centre-state relations had soured after the finance ministry refused to compensate the states for losses caused by a two percentage point cut in the Central Sales Tax (CST) three years ago, as a move towards introducing GST.

Then, in November 2012, Chidambaram extended an olive branch in his first meeting with the states after assuming office, and he did so again at a pre-Budget meeting in January. Two weeks later, over 1,668 km away from New Delhi in Bhubaneswar, the Empowered Committee of State Finance Ministers declared a “broad consensus”.

This “broad consensus”, which did not include the Bharatiya Janata Party-ruled Madhya Pradesh and Gujarat, came with a hefty price. Despite its looming fiscal troubles, the Centre had to agree to pay states a collective Rs 34,000 crore as CST compensation for the past three years. It also agreed to either give partial CST compensation for the current year, too, or consider increasing the CST rate from two per cent to four per cent if there is a further delay in introducing GST. The government also relented on the states’ demand to have a floor rate with a narrow band, instead of a uniform rate. The other major decision was to give the states an option to stay out of GST.

This softening of the Central government’s stance has certainly gone a long way towards reviving hopes of an early GST rollout. But the fact is that there are many issues to be sorted out still. Most of them stem from the fact that the proposed GST design comes nowhere close to the initially conceptualised model recommended by the 13th Finance Commission.

Labelled the “flawless GST” model, the commission had recommended uniform tax rates, harmonisation of taxes across the states and minimum exemptions. The compromise proposed in Bhubaneswar is designed to make a beginning, since the states are not yet used to the idea of losing their flexibility to tinker with tax rates. But, say finance ministry officials, the Centre will work towards the “flawless” model in the long run.

Take, first, the issue of multiple rates. This adds a layer of complexity to an already complex issue, but a government official says multiple rates are not impossible. Other countries have multiple-rate GST regimes, notably Canada, which the new Indian model closely resembles. Europe, too, has a band of 10 percentage points with a floor rate of 15 per cent. Thus, some countries like Luxembourg and Brussels have a tax rate of 23 to 25 per cent, while their other European peers levy the tax at 15 to 16 per cent. It is fair to say the European model has not been very successful.

Ultimately, the success or failure of a multiple-rate GST model comes down to a software design issue and the Integrated GST (IGST) rate imposed on the inter-state movement of goods. The main problem that may arise with multiple rates is that if the GST rate is higher in a particular state, traders may transport the goods to a neighbouring state with a lower rate.

Some argue if the states get the flexibility to increase rates, the Centre may also want to avail of that option, too. But if the Union government wants to move towards a “flawless” GST as soon as possible, it will have to lead by example.

The biggest flaw in the proposed model is that it leaves it up to the states to decide whether they want to go for GST and exit later. Experts say though some countries do offer states this option, it is unlikely to work in India. The Bhubaneswar meet agreed to this on the tacit assumption that once states sign up for GST, they will find it hard to exit. That’s because goods may become more expensive in non-GST states, compliance may be poor without cooperation from the Centre, and the state’s tax base may be low because of the exclusion of services in non-GST states.

Indeed, at a meeting with the Empowered Committee on February 14, Chidambaram made it clear a phase out would not be possible. He also stated an amendment to the Constitution would be required to give states powers to collect tax on services, and allow the Centre to tax goods that are currently taxed by the states. Madhya Pradesh is the only state that has opposed a Constitutional Amendment for the fear of losing its autonomy to fix tax rates. It has argued that the basic purpose of GST is to remove the cascading effect of taxes, and that can be achieved without amending the Constitution.

The reason Chidambaram expressed reservations on making GST optional could be that it will break the chain when goods are moved from a non-GST state to a GST state, and vice versa. If there is a uniform GST rate in all states, IGST will be levied on inter-state movement of goods. But it will be difficult for authorities to figure out whether IGST or CST should be levied on the movement of goods between a GST and non-GST state. One option is to treat sales to a non-GST state as exports.

Another point of concern is that the plan to set up a dispute resolution panel for settling disputes between the Centre and the states as well as among the states has been shelved. Some may argue that this defeats the principle of natural justice because people violating the law would also be settling the disputes, a counter argument is that scrapping the proposal was necessary to protect the sovereignty and autonomy of the states. Proponents of the latter view say the mechanism within the GST council should be robust enough to handle the disputes.

Though “the broad consensus” at Bhubaneswar remains the beacon of hope for GST, it is possible that a “narrow consensus” of non-compliant states will determine whether this tax reform, which the 13th Finance Commission calculates can add up to 1.5 per cent to the gross domestic product, will be the success Chidambaram hopes to make it.