Big Idea for Budget 2004

My dear Chidambaram,

I hear you are asking around for Big Ideas for the budget. Obviously you want to try and repeat your performance in 1997, when your budget was hailed as a dream budget.

In 1997, businessmen were ecstatic over your slashing income tax from 40% to 30%, abolishing tax on dividends and cutting indirect taxes. I too hailed the budget but not just because of the tax cuts: after all, taxes had been cut earlier too. What gripped me was your vision of India moving forward from its half-baked reforms towards the systems of ASEAN, aiming to become part of the Asian economic miracle. This put the tax cuts in perspective.

The Asian financial crisis and fall of the United Front government soon led to the collapse of your dream budget, but your vision of moving towards ASEAN became part of the national ethos. The NDA government started off in the opposite direction, but soon reversed itself and ultimately went decisively for the ASEAN goal laid out in your 1997 budget. That is a measure of the strength and durability of your Big Idea.

Another Big Idea for the 2004 budget will not come easily. Your meetings with economists and businessmen yielded many small ideas, but no conceptual breakthrough. Well, let me put forward a Big Idea for your consideration.

Let us create a leak-proof system for taxes on goods and services, which yields so much money that you can, in all fairness, abolish income tax altogether for all but the well-off.

In technical parlance, this will mean creating a unified value added tax (VAT) of say 16% to replace the current melange of excise duty, customs duty, service tax and sales tax. Once that is in place, you can raise the income tax exemption to Rs 5 lakhs a year, so that all but the highest-paid salaried persons escape income tax. In one go, millions of income tax payers will be relieved of their liability, and rightly so since they will be paying a 16% tax on what they consume. It will reduce tax headaches, reduce corruption, and get you a flood of revenue.

It will be equitable too. Farm produce will be exempt from a unified VAT: it is impractical to collect from millions of small farmers. This will keep low the tax burden on farmers, which is what the CMP wants. Zero VAT on agriculture also means that poor people, who spend most of their income on food, will escape taxation.

There has been much misleading talk in India about state government’s imposing a VAT. This is a misnomer: the proposed tax is only on the value added at the trade level, not on manufacture, advertising, transport or importation. A proper VAT needs to cover the full chain of economic activity. Such a unified tax alone can check evasion, which is massive today.

Consider a manufacturer of shirts. The cloth he buys will include 16% VAT. He gets a refund of this when he pays VAT on selling the shirt. The difference between his payment and refund constitutes the net tax on the value he has added. Now, if he tries to evade VAT on shirts, he cannot claim a refund on the VAT on cloth. So he will end up paying some tax willy nilly. This is the beauty of a unified VAT: even if you try to evade it, you cannot escape the tax on purchased inputs. The fruits of evasion fall so drastically that honesty becomes the best policy.

This Big Idea will encounter two major snags. First, it requires amendment of the Constitution to provide for a unified VAT in place of the current mix of central and state taxes. You can get states to agree to this only by guaranteeing them a huge tax bonanza in return for the Constitutional change. You can safely guarantee them an additional Rs 10,000 crore/year, maybe Rs 20,000 crore/year: sealing leakages in the tax chain should yield at least this much additional revenue.

Second, a unified VAT will centralise tax rates, robbing states of tax flexibility. This too can be overcome by allowing states to levy state VAT on items of their choice, which can be collected as a surcharge on unified VAT. Such a system — state taxes piggy-backing on central ones — already works in Canada.

You cannot bring about such a change overnight. But it is a visionary and worthwhile goal to strive for over five years. It will take you to the very forefront of modern tax systems. It will be a blessing for millions of honest tax payers. It will bring millions of tax evaders into the tax net. And it will be progressive, exempting farmers and the poor while taxing the rich. Go for it.

What do you think?