The discussion on tax reforms in the coming months will centre round evolving an efficient and a harmonised consumption tax system in the country.

The prime minister himself has suggested that we should move towards a harmonised goods and services tax. Calibrating such a co-ordinated indirect tax reform in an environment where the states value their autonomy dearly is not easy.

Given that we have parallel systems of indirect taxation at the central and state levels, each of the systems needs to be reformed to eventually harmonise them.

Thus, central excise duty should be converted into a full fledged manufacturing stage VAT on goods and services and the states sales tax systems should be transformed into a retail stage destination based VAT, before the two are integrated by striking a "grand bargain" to harmonise the two systems.

At the central level, considerable progress has been made by converging widely varying tax rates and extending input tax credit to convert excise duties into a CENVAT.

Although on paper full tax credit is supposed to be given for the prior taxes paid on both goods and services, in terms of actual operation, much remains to be done. Besides, to transform this into a manufacturing stage VAT on goods and services requires considerable reforms.

Transforming CENVAT into MANVAT requires further simplification and convergence of excise duties, which, inter alia, also requires conversion of specific duties into ad valorem, with the exception of a few items such as cigarettes.

It is also important to broaden the base of the tax. Almost 40 per cent of the revenue from excise duties is collected from petroleum products alone and this concentration, particularly on a predominantly intermediate good creates severe distortions. It is also necessary to get rid of area-based exemptions and exemptions to small-scale industries, and rationalise concessions on exports.

A necessary reform is the extension of the scope of service taxation to all services and its merger with CENVAT. VAT on goods on services should apply to all services with a small exemption list and a narrow negative list.

Once the service tax is made general, it may be merged with CENVAT to have a common exemption limit and tax rate. After broadening the base by removing exemptions to small-scale industries and area-based exemptions, and general taxation of services, the revenue-neutral rate of tax could be worked out.

A rate of 12-13 per cent at the manufacturing stage would be equivalent to about 10 per cent retail VAT.

Admittedly, the replacement of cascading and narrow based sales taxes with VAT is the most important tax reform in independent India. The major gain from the tax has been to simplify the tax system considerably.

There is need to further simplify and rationalise the system and the Empowered Committee would do well to address them. This includes confining the number of items in the 4 per cent category to basic necessities, and shifting the "inputs", currently taxed at 4 per cent, to the general tax rate.

In fact, the general rate itself could be brought down to 10 per cent from the prevailing 12.5 per cent. In any case, taxes on all inputs will be credited under VAT and taxing the so-called "inputs" at a lower rate only reduces tax compliance.

The real gains from the reform will accrue only when the tax is extended to all the states and tax credit is extended to inter-state transactions. Hopefully, the states that developed cold feet last year will gear up to the reform task this year. A more formidable challenge lies in abolishing the central sales tax.

It is important to finalise the methodology of relieving taxes on inter-state transactions to make the tax system destination-based and build the information system to administer the levy.

The method of zero-rating transactions at the point of inter-state sale on the lines followed in the European Union has found favour in much of the discussions. However, it requires considerable preparation, particularly computerisation, to ensure that the items eventually zero-rated by the exporting state pay the tax in the importing state.

There can be other models requiring pre-payment of the tax by the importers before the tax is zero-rated in the exporting state, but that would add to the compliance cost.

Abolishing the CST will entail loss of revenue to the exporting states and they will certainly demand compensation. The only way possible to permanently compensate exporting states is to give the states additional tax powers.

The time is opportune to return the power to levy VAT on sugar, textiles and tobacco products. But, it should be clear that the levy on tobacco products should be only at the general rate and sumptuary powers of the levy will continue with the centre.

In addition to the above three items, it is also necessary to give the power to levy service taxation to states to make it a retail stage destination based GST.

There can be two methods of sharing the service tax powers. One is to give the states concurrent powers. This would, create some difficulties in the case of all-India services such as railways and telecommunications.

The sale of service to a registered dealer in another state will entail a treatment similar to that of goods and there are no problems.

However, when the inter-state sale is to a final consumer, it is necessary to define the rules of apportioning revenues. Although this may not be entirely destination-based, some operational rules will have to be evolved as in Canada.

The alternative is to share only the services of regional spread with the states, but this would neither bring in substantial revenues to the states nor enable proper levy of the GST at the state level.

Once we have separate central and state VAT systems, the next step is to work on the harmonised GST at the Centre and a piggybacking levy by the states.

Given the prevailing rate structures, on average both could levy the tax at 10 per cent. This will allow complete input tax relief and reduce the compliance cost considerably. But to achieve the "grand bargain", the states have to agree and this can be done only when their fiscal autonomy is ensured.

This can be a long-term objective, but certainly within the realm of feasibility if both the Centre and states act responsibly.

The author is Director, National Institute of Public Finance and Policy.