Three important considerations on the mind of the finance minister that are likely to influence indirect tax measures in Budget 2011 are the need for fiscal consolidation, persistent double-digit inflation, and preparing the ground for the goods and services tax (GST) roll-out. Balancing these will indeed be a challenge.
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The fiscal deficit of the government of India in 2007-08 was 2.56% of gross domestic product (GDP). The onset of the economic slowdown in 2008 and the subsequent fiscal stimulus measures increased the deficit to 6.64% of GDP in 2009-10.
With the economic upturn, and the partial rollback of excise cuts, the 2010 budget projected the fiscal deficit to come down to 5.5% of GDP in fiscal 10-11. However, thanks to better-than-expected GDP growth, and the third-generation (3G) spectrum auction, the deficit is expected to be lower, closer to 5% of GDP. Excise revenue has grown 42% during the first nine months, significantly higher than the annual projected growth of 27%.
Despite the lower deficit, there is a need for further fiscal consolidation. The bounty from the 3G auctions was a one-off windfall in fiscal 2010-11, which needs to be replaced by recurring revenue. The 13th Finance Commission has recommended the Centre’s fiscal deficit be reduced to 3% by fiscal 2013-14. This would require the revenue deficit to be brought down to zero.
These targets cannot be met without further discretionary measures. The government has little scope for income-tax increases, pending the approval of the new direct taxes code. Indirect tax increases would also not be popular as they would fuel inflationary pressures in the economy, which are already a major concern.
Such tax increases could be appropriate if the inflationary pressures were due to excess discretionary demand. This is not the case for food inflation, which is driven by a combination of supply disruptions and international factors.
Meanwhile, a number of state governments have already increased their value-added tax (VAT) rates by as much as 2.5 percentage points (the lower rate from 4% to 6%, and the standard rate from 12.5% to 15%), leaving little room for rate increases by the Centre. The burden of fiscal consolidation would thus have to fall predominantly on the expenditure side of the budget.
On the revenue side, the Centre could, and is expected to, propose important structural changes to excise duties and service tax to facilitate the roll-out of GST and to minimize the pain of transition.
The Centre remains committed to introducing GST. It is a fundamental reform to move the Indian economy to the double-digit growth trajectory.
Discussions are continuing at the highest level to resolve the current political stalemate between the Centre and some of the states. A new draft constitutional amendment is being discussed. The Technology Advisory Group for Unique Projects, headed by Nandan Nilekani, continues to develop an optimal information technology (IT) framework for implementation of GST. The budget should provide further clarity on the road map to GST.
One area of disagreement between the Centre and the states is the small dealer exemption threshold, which is currently Rs5 lakh for state VAT, Rs10 lakh for service tax, and Rs1.5 crore for central VAT (Cenvat). The Centre suggested a threshold of Rs10 lakh common for both Centre and state GSTs. The states have, however, asked that the threshold for the Centre’s GST be kept at Rs1.5 crore to minimize any adverse impact on small manufacturers.
A single common threshold is necessary to simplify compliance. As a first step, the Centre could lower the Cenvat threshold from Rs1.5 crore to, say, Rs50 lakh. The affected manufacturers could be given the option to pay tax, under the composition scheme, of 1% or 2% of their total turnover (without the benefit of the Cenvat credit). This would narrow the divergence between the Centre and state thresholds.
The Centre could also initiate a phase-out of Cenvat exemption for items that will become taxable under GST. The exempt list under GST is expected to be limited to about 100 items that are currently exempt from state VAT. The Centre could phase out the Cenvat exemption for some or all of the items not on the state list by imposing a tax on them at a lower rate, say, 4% (compared with the standard rate of 10%). The manufacturers would then be eligible to claim a credit for the Cenvat paid on their inputs, minimizing the net impact on them.
Another important change the Centre could consider is expanding the service tax base to all services, except those which are explicitly exempted (that is, those on the “negative list”). The current system of taxing only the specified services as per a positive list has spawned extensive litigation on the meaning and interpretation of taxable services. The government should follow the negative list approach, as recommended by the Dr Govinda Rao committee on service tax reforms. This would lead to a dramatic simplification of service tax rules.
Graphic by Sandeep Bhatnagar/Mint
The author is a tax partner at Ernst and Young.
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