As the deadline for the introduction of the value-added tax on April 1, 2005, approaches, there is considerable apprehension among tax payers, tax collectors and the general public about the levy.

There are questions about the state of preparedness for levying VAT, the questions and the proposed structure and operation of the levy, and, finally, the impact of the tax on economic activity. All these are important issues and need to be resolved before VAT is levied.

The Crisis Over VAT

Fortunately, there is a consensus among the experts on the desirability of levying VAT at the state level, although dissenting voices still exist.

The main dissent is on the possibility of revenue loss and the possible welfare loss if it creates distortions between the formal and informal sectors and prevents the formalisation of the economy (Emran and Stiglitz, "On Selective Indirect Tax Reform in Developing Countries," Journal of Public Economics, Vol. XX, 2004).

It is argued that in an economy with a large informal sector, the entire chain of transactions may escape the tax net, resulting in revenue loss. It is also argued that in a developing economy, the levy of VAT would shift resources away from the formal to the informal sector, lowering GDP.

As many developing countries are characterised by high levels of urban unemployment, a VAT, which applies predominantly to the urban sector may turn out to be a tax on urban wages (Stiglitz, "Development Oriented Tax Policy," Mimeo, Initiative for Policy Dialogue).

There is also a possibility of significant misuse of the tax credit mechanism and this may negate the professed advantages from the self-policing nature of the tax. Of course, we have ample evidence of this in MODVAT (CENVAT) in India.

While it is true that the levy of VAT can pose serious difficulties, the conclusions on the desirability of introducing the tax depend upon the tax it replaces and the welfare implications of the spending the additional revenue finances.

In the Indian context, the proposed VAT is supposed to replace the cascading-type, complex, and predominantly first-point sales tax.

The narrow base of the tax, multiple rates often determined by political reasons or inter-state competition rather than economic rationale, taxation of inputs and capital goods, widespread regime of tax incentives and the large scope for tax evasion due to the single-point tax system -- all these make the tax not only virtually voluntary and negotiated but also highly distorting.

Surely, there cannot be any question on the desirability of replacing this with VAT.

This, however, does not mean that a mere replacement of the prevailing sales tax system with VAT will solve all the problems. A number of measures will have to be taken to ensure that the tax system introduced is simple, has a measure of inter-state harmony, minimises distortions, reduces compliance costs, and, most importantly, enhances revenue productivity.

The last feature is extremely important because, the welfare implications of the tax, inter alia, depend on the marginal expenditures financed by additional revenues.

In the past, reduction in the revenue-GDP ratio for the states led to compression in productive expenditures on social and physical infrastructure, and increase in revenue productivity should be used to augment resources for these sectors.

There is considerable fear that the introduction of VAT could involve a revenue cost and the Centre has assured the states full compensation in the first year. One possible source of loss is the possibility of increase in informal transactions.

It is for this reason that there should be emphasis on putting the computerised information system in place. The decline in the revenue-GDP ratio in the case of central excise duties is, to a considerable extent, attributed to the poor information system and consequent excessive input tax credit taken by unscrupulous manufacturers.

Despite the postponement in VAT and the time available, very few states have taken steps to institute the information system.

The revenue productivity of VAT also depends on its design. The uniformity in the rate structure proposed in VAT has necessitated the introduction of a general VAT rate at 12.5 per cent, which, in some cases, may not be revenue-neutral.

The problem is compounded by including over 270 commodities in the 4 per cent category. This requires lowering the rate on many items currently taxed at 6, 8, and 10 per cent. Besides, the treatment of intermediate goods at 4 per cent could reduce tax compliance.

Differential treatments of inputs and final consumer goods violate the very principle of VAT. The argument for a lower input tax rate that delay in refunds can pose hardships loses its force when input tax relief is given through credit rather than through refunds.

As regards refunds for a zero-rated tax to exporters are concerned, it is necessary to streamline the information system and speed up the processes, rather than distorting the tax structure. Hopefully, the Empowered Committee will rethink on this.

The critical element of a successful VAT is the computerised information system. This is necessary to minimise harassment at inspectors' hands. The traders are naturally wary of the fact that a switchover to the multipoint tax system could increase such harassment.

Improved tax compliance and reduced physical inspection can be achieved only by instituting the computerised information system. This is necessary to assure the traders that the introduction VAT will not result in bother to them.

It is also important to have interactions with traders, and a publicity campaign should start quickly. Much needs to be done in this regard, as opposition to the levy will mount from this quarter, often due to lack of understanding.

It is necessary to assure the traders that only those with a turnover above Rs 45 lakh (Rs 4.5 million) will have to keep detailed accounts and those with less need to keep only information on total and taxable turnover and pay a simplified tax on turnover, unless they want to become part of the "ring". According to information, such traders constitute over 75 per cent of the total.

The problem is not so much about the apprehensions, but the fear of the tax itself. Indeed, Delhi has been a tax shelter throughout, and, given the predominance of the last-point levy, the tax is virtually voluntary except when official and organised purchases are made.

Given the culture of non-payment of tax, the traders are likely to derail the reform process and it is, therefore, important to have a system in which there is no possibility of harassment.

This implies that the central government must take a leadership role rather than remain a bystander. The most important initiative is to see that laws, rules, forms, and procedures are simple and unambiguous, and the system of computerised information is initiated sooner than later.

The central leadership should go beyond financing the information system on inter-state transactions. It should assist the states in organising the information system for intra-state transactions as well, and this should be coordinated with the information system on inter-state transactions.

At present, the two initiatives are undertaken independently of each other. A proper information system could prove to be a boon to the Centre in improving compliance in income tax payment also.