The white paper on value-added tax released by the Empowered Committee has unveiled a VAT design, which is unexceptionable. It could not have been better considering that India is a federation of states, some of them unwilling, some overzealous and all generally disparate.

To have come to a consensus on uniform rates, on abolishing some of the existing state taxes and bringing an end to the tax war is, by any yardstick, a major achievement.

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The crisis over VAT

VAT may have many defects but it has many virtues as well. Once introduced, there will be no scope to argue if it is good or bad to have VAT.

Right now, the only question confronting us is how to make VAT more successful within the constraints of a federation.

In no federation does a pure VAT of the pristine variety exist. All of them have various combinations of Central and state control on collection, mixtures of origin and destination principles and generally a concoction of different parameters of base setting, rate setting and collection mechanism.

A comparison of the different systems in federations such as Brazil, Mexico, Germany, Canada and the European Union, is a favourite pastime of fiscal experts.

There is no perfectly satisfactory solution to the problem of taxation of inter-state sale in federations (Bird and Gendron, 2001).

While VAT is widely regarded as a good tax for countries trading with one another, it is generally seen as a bad tax to give to lower level jurisdiction in a federation ("Recent Developments in Tax Coordination" by Michael Keen, Page 409, Canadian Tax Journal, 2000, Vol 48 No.2).

In that context the solution that has been found in the origin-based principle of input tax credit adopted in the white paper cannot be faulted.

Those who hold that destination-based VAT is the only good form should take note that once the VAT rate is uniform in all the states, there is no difference between origin-based and designation-based principle (Robin Burgess and Nicholas Stern, September 1992).

Those hardcore federalists who are shedding tears for the demise of fiscal sovereignty because of an uniform rate may do well to remember that there are other aspects in this design where the so-called autonomy or sovereignty can be exercised.

It is also a good design that the rates are not too many but basically two -- 4 and 12.5 per cent. This is no different from the international pattern.

The rates in other countries are like this: Argentina four, Austria four, Belgium four, Brazil three, Colombia four, Egypt five, Finland four, France three, Italy four, Luxembourg four, Morocco four, Sweden four, Tunisia four, Turkey five, Vietnam three, Germany two, Japan two and so on.

Most of the countries have two rates. A single rate is prevalent only in a few countries such as Canada and New Zealand.

Even the exemption in the case of 46 items is also not out of the way. Almost all countries have exemptions that are termed standard exemptions and other-than-standard exemptions.

What has been quite an achievement in this VAT design is that existing taxes such as turnover tax, surcharge, additional surcharge and special additional tax are being abolished.

Entry tax will be abolished or made VATable. However, this will not apply to entry tax that may be levied in lieu of octroi. The system to self-assess tax or to have independent audits is worthwhile. On 22 points, there will be convergence amongst all the states.

There are, however, various aspects of the proposed regime that could be problematic. The first one is that the incentives may be "continued in a manner deemed appropriate by the states after ensuring that the VAT chain is not affected".

This is an open-ended proposition. How exactly this will be done, whether in the form of deferral or exemptions or some other form has not been made clear in the white paper. It is quite possible that the states have not come to an agreement on this point.

This can be a contentious issue later on. If exemptions are given they do break the VAT chain. The Empowered Committee was given a suggestion that the exemptions may be made optional so that those who want to pay VAT and take input credit can do so.

Thereby, the VAT chain would remain unbroken at least in those cases. No such decision has been taken, as it appears from the white paper. Second, it is not indicated what will be the rate of tax payable on turnover above Rs 500,000 and below Rs 50 lakh (Rs 5 million).

It has been said that the rate will be "a small percentage of gross turnover". It should have been decided already but now at least it should be ensured that it would be uniform through out the country.

Third, the option to impose "entry tax in lieu of octroi" will bring back entry tax through the backdoor. It will undo all the good work done by abolishing entry tax and making entry tax VATable.

Fourth, the differences in the definitions in different VAT Acts still continue. The convergence points do not include this aspect. Even the totally superfluous definition of manufacture has not been removed either.

Since VAT is to be levied on  the value added , there is no need to define "manufacture" which is in any case a highly litigated subject.  Finally, the categorical statement by the Convenor of the Empowered Committee that the "prices will in general fall" is more in the nature of soothsaying than in the nature of an economic analysis based on experiences of different countries.

Extensive research made by economists on the basis of data on fitting price trend lines to consumer price indexes in different countries have led to the conclusion about the impact of VAT on price as "little or no effect".

("VAT Revenue, Inflation and the Foreign Trade Balance" by Alan A Tait in Value Added Taxation in Developing Countries, edited by Malcolm Gillis, et al, World Bank, 1990).

The conclusion is that the VAT design is good but it still needs some hard chiselling and not just fine-tuning.