States need more tax powers

In a decentralised system of government, the responsibility for delivering many public services is cast on lower-level governments.

Decentralisation serves to enhance welfare by increasing people's influence over the decisions of governments that affect them. It is this logic that provides the rationale for devolving more powers to the panchayats and municipalities through constitutional mandate.

However, if decentralisation is to be meaningful, sub-national governments must have substantial sources of revenue of their own. Otherwise they tend to depend excessively on transfers, forcing them to work as no other than spending agencies of the governments above.

That raises the question: "What should be taxed and by whom?" This has been a central issue in federalism literature, but the discussion has often been inconclusive.

Following Musgrave's classic formulation, it is generally accepted that the power to levy income taxes, personal and corporate, as also taxes on foreign trade should be with the national government, and taxes on consumption like retail sales tax with governments at the lower levels, the states in our case.

Local governments may levy taxes on immobile bases such as residential properties within their jurisdictions and also benefit taxes that serve to realise the cost of their services. None should however be allowed to export its taxes by taxing citizens of other jurisdictions.

This has been broadly the basis of tax assignment in federations, though with significant variations across countries.

For instance, in the US, the states have concurrent powers with the federal government over most taxes and levy, apart from sales tax, tax on the incomes of their residents and companies by "piggybacking" on the federal income taxes.

In the US, local governments also piggyback on income tax levied by the federal government and retail sales tax levied by the states. Piggybacking on federal income tax is practised in Canada too.

By and large, the Indian Constitution follows the classical line: customs, income taxes and excises in general are assigned to the Centre, while the powers to levy sales tax, land revenue and a few other sundry taxes are vested in the states. The tax powers of local governments were left to their respective states to decide.

Though apparently neat, based as it was on the principle of "separation", this arrangement however turned out to be messy and inadequate on several counts.

While vesting the power to tax incomes on the Centre, presumably as a legacy of history, the Constitution excluded income from agriculture from the purview of the Union income tax, violating the canon of horizontal equity and opening up scope for evasion and litigation.

This has also required making arbitrary attribution of the contribution of cultivation and manufacturing in the production of items like tea.

The powers to levy excise duties and sales taxes also suffered from severe base segmentation as the relevant entries in the Constitution ran in terms of only "goods", to the exclusion, by implication, of "services".

By virtue of its residuary powers (made explicit by a recent Constitutional amendment), the Centre has started levying tax on services, constraining the field of sales tax and now VAT levied by the states.

With the expansion of the coverage of central excises to all manufactured goods in 1976, the taxes on commodities levied at the two levels of government tended to overlap. With the introduction of tax on inter-state sales--the Central Sales Tax--tax exporting too came to be practised in a big way.

Even otherwise, states and local bodies resorted to tax exporting wherever they could; a classic example is the huge revenue (over Rs 2,000 crore a year) collected by the Mumbai Municipal Corporation from octroi on crude coming in from Bombay High.

In many ways thus, the scheme of tax assignment laid out in the Constitution has proved dysfunctional. Evidently, the scheme needs rethinking if the tax system is to be brought in line with sound principles.

The idea of moving towards a two-level VAT--the GST mooted by the Kelkar Task Force and widely acclaimed as desirable--cannot materialise without some amendment in the Constitution.

Rethinking on tax assignment has become imperative also with the revolution in information technology and advent of e-commerce, rendering the levy of sales tax at lower levels of government untenable. This has led to serious discussion on the feasibility of introducing a federal level retail sales tax in the US.

In India, "efficiency" considerations seem to be prompting imposition of curbs on the tax powers of states. The conditions prescribed for accessing many of the Central funds require the states to bring down the rates of taxes leviable by them, e.g. stamp duties, to a prescribed level.

Though apparently evolved by consensus among the states themselves, the ceiling on the general rate of state VATs that came into being this April also constrains the powers of the states in the matter of determining the rates of taxes supposed to be in their domain.

Despite exhortations from many quarters, the states in their turn seem to be reluctant to devolve significant tax powers to the local bodies or freedom to use the powers given to them.

It needs emphasising that these curbs on the tax powers of the lower level governments run counter to decentralisation. While there are not many taxes with good revenue potential that can be levied at sub-national levels without causing distortions, surcharges on residence-based central taxes like the personal income tax as in the US and Canada provide a good alternative.

What matters most in this context are the powers to fix the rates. Not every tax levied by the Centre lends itself to this mechanism, the destination-based VAT, for example. Even so it is time the scope for such empowerment was seriously explored.

Otherwise, the dependency syndrome, which is already acute in India with many states depending on the Centre for over 50 per cent of their revenue (some over 70 per cent) and all states, including the relatively affluent ones begging for "assistance" from the Centre every now and then, will be further accentuated. Similar exploration should be done to empower local bodies.

In their case the task is all the more urgent as their dependence on transfers is even starker. Along with empowerment, there should be a strict hard budget constraint so that all governments are compelled to exploit adequately the tax powers at their disposal.