In the search for ways and means to arrest the declining revenue-GDP ratio at the Central level, extending the consumption tax to the services sector has gained public attention. There is considerable speculation that the coming budget will expand the tax net in this area. Declining revenue-GDP ratio, particularly that of the domestic indirect taxes, has certainly to be arrested to restore fiscal balance and generate the resources needed to fulfil the many promises made in the Common Minimum Programme.
The case for a proper calibration of tax on services does not rest merely on improving the revenue productivity of the tax system. Surely, that is the most important consideration and, therefore, should gain topmost priority. In an economy where over 70 per cent of the incremental GDP during the last decade has originated in the services sector, the objective of enhancing revenues cannot be achieved without extending the tax to most services.
However, an equally important rationale for expanding the scope of the tax emanates from the need to properly calibrate domestic consumption taxes. A properly worked out taxation of services is necessary to ensure neutrality of taxation between goods and services and to evolve a manufacturing stage value added tax (VAT) on goods and services at the Centre and a retail stage VAT at the state level in a co-ordinated manner. This would imply that strategic action in the design and implementation of the tax is necessary.
In the past, taxes on services have been levied in an ad hoc manner. Starting with three services in 1994, the tax has been extended to about 50 services, although only seven services generate more than 90 per cent of the revenue collected from the tax. To chart out a proper and strategic calibration of the tax on services, an Expert Group was appointed in 2001. It submitted its report in April 2002, in which it laid out a road map for the reform, in the context of evolving a co-ordinated system of VAT at the Central and state levels. The Kelkar Task Force Report on indirect taxes reiterated the recommendations of the Group. However, the approach to taxing services has continued to be ad hoc and selective.
The calibration of service taxation in the context of VAT should have the widest possible coverage. A proper VAT is a tax on goods and services and for both broadening the base and administrative convenience extending the coverage to all services is important. Relieving taxes on all inputs and capital goods requires that all services with only a few exceptions should be taxed. Exemptions should be confined to public services, essential public utilities, important merit goods such as basic education, healthcare, and intra-firm services (between employers and employees) and exports.
Besides, there can be exemption of specified business (research and development) services, communication services (postcards and money orders), construction related services (rural housing, slum development), educational (adult education, distance education), financial (basic banking and insurance) and cultural (libraries, sports) services.
The general taxation of services is important from the viewpoint of administrative convenience as well. It avoids the necessity of having to define each service for the purpose of taxation and consequently minimises the potential for dispute and litigation. Another important recommendation of the Group was that the classification system has to be changed to conform to the WTO system.
Administrative considerations, however, call for exemption of small service providers and unorganised services. The calculations by the Expert Group showed that in respect of the tax on seven services, 97 per cent of the tax is collected from service providers having a turnover of more than Rs 10 lakh and prescribing the threshold at this level may not cause significant evasion of the tax. These small dealers constitute about 80 per cent of the total number and, therefore, exempting them would appreciably ease the administrative burden. These calculations were done three years ago and at present exempting service providers with less than even Rs 20 lakh turnover would be appropriate.
General taxation of services is not an end in itself; it should eventually be merged with tax on goods to evolve a proper VAT in the country. There is a broad consensus among the economists and policy makers that a dual VAT is appropriate in India even though this is not the first best solution. This implies that merger of service tax with the CENVAT (central VAT) at the Centre should result in the evolution of MANVAT (Manufacturing stage VAT). At the state level this should result in the destination-based consumption type retail stage VAT.
This brings us to the question of sharing the power to tax services with states. There is consensus that the prevailing cascading type, predominantly origin based, complex sales tax system should be transformed into destination based retail VAT. In order to achieve this, it is necessary to provide tax relief on all inputs and capital goods. Providing complete input tax relief is possible only when the states have the power to tax all goods and services. The selective approach to taxing some localised services by states will not serve the purpose because, mapping of nation-wide and state-wide services is not always possible and more importantly, input taxes will have to be relieved from all goods and services.
The argument that the states will find it difficult to tax services with pan-state scope or that it is difficult to identify the place of origin and destination in respect of services such as telecommunication, railways, and transportation of goods across States does not hold water. In a destination based tax system, tax liability will have to be extended all the way up to the last sale point — irrespective of its origin — be it on goods or services. What is important is the conceptual clarity on the treatment of inter-state transactions. Thus, to achieve dual VAT, concurrent taxation of services is not a pro-state or a pro-Centre issue. This is simply an inevitable measure to achieve a more rational tax system.
The writer is director, National Institute of Public Finance and Policy, New Delhi, and chairman, Expert Group on Taxation of Services