Eco-Taxes in a GST Regime

Discussion Paper (for internal discussion)

Integrating Pollution-abating Economic Instruments in Goods and Service Tax (GST) regime Project Funded by British High Commission, New Delhi Project Executed by Madras School of Economics, Chennai

March 2010 Madras School of Economics Chennai

Eco-Taxes in a GST Regime

D K Srivastava* K S Kavi Kumar C Bhujanga Rao Brijesh C Purohit Bodhisattva Sengupta

Discussion Paper Integrating Pollution-abating Economic Instruments in Goods and Service Tax (GST) regime Project Funded by British High Commission, New Delhi Project Executed by Madras School of Economics, Chennai March 2010

Madras School of Economics Chennai

* Corresponding author, srivastava@mse.ac.in.

Acknowledgements
In preparing this discussion paper, we have greatly benefited from interactions with a number of economists and officials with whom we had occasion to discuss the subject of environmental tax reform in the context of the introduction of goods and services tax in India. Foremost among the economists and fiscal experts is late Dr. R. J. Chelliah with whom we had several rounds of discussions on this matter at the early stages of this study. We have benefited from interactions with Prof. U. Sankar, Professor Emeritus at MSE. We had occasion to discuss some of the international experience on the matter with Prof. Paul Ekins, Professor, University College, London and Chairman, Green Fiscal Commission, UK and Professor Stephen Smith also of the University College, London. We also discussed these issues with Prof. Anil Markandya of the University of Bath, and Dr. Partho Shome, Chief Economist, Her Majestys Revenue and Customs and some his colleagues. We had fruitful interactions with Dr. Philip Summerton, Dr. Hector Politt of Cambridge Econometrics and Drs. Karsten Neuhoff, Mairead Curran, and Annela Anger of 4CMR, University of Cambridge. We also interacted with Dr. Dr. Judith Rees, Dr. Alex Bowen and Dr. Ruth Kattumari of London School of Economics and Ms. Helen Devenney, Chair of Environmental Taxes Working Group of the Chartered Institute of Taxation (CIOT), London, Mr. Nick Goulding, Past President of CIOT, and Mr. Maric Glaser, Technical Officer, CIOT. We had greatly benefited from interactions on the subject matter with Dr. Kirit Parikh, former member of Planning Commission, Dr. Vijay Kelkar, Chairman, Thirteenth Finance Commission, Dr. Atul Sarma and Dr. Indira Rajaraman, Members, Thirteenth Finance Commission, Dr. Pradipto Ghosh, former Secretary, Ministry of Environment and Forests, Shri Devendar Singh, Member-Secretary, Centre-State Relations Committee, Prof. Abhijit Sen, Member of Planning Commission, Shri R.C. Khwaja, Additional Secretary, Ministry of Environment and Forests, and Shri R.S. Ahlawat, Adviser, Ministry of Environment and Forests. We would also acknowledge the contribution of participants in the First Round Table which was organised in Chennai on February 6, 2010. The participants included Professor Ramprasad Sengupta of Jawaharlal Nehru University, Professor. K. Kavita Rao of National Institute of Public Finance and Policy, Mr. V. Raghuraman, Principal Advisor, Jaguar Oversees Ltd, Mr. Sanjay Mitra, Head of Indirect taxes in ITC, Mr. A.V. Rao, Vice President Projects, Paper Boards and Specialty Papers Division, ITC, Mr. Sivagurunathan, Senior Manager (Manufacturing) of India Cements, Dr. Balaji Srinivasagopalan, IFS, State Forest Commission, Tamil Nadu, Professor Janakarajan, of Madras Institute of Development Studies, and Mr. Chandrakant, Consultant with the Office of Principal Secretary, Commercial Taxes, Tamil Nadu.

The views expressed in the Discussion Paper are those of the authors. Members of the Board of Governors of MSE are not in any way responsible for these views. We had excellent research support from Lavanya P. Arun, Asha Abraham and G. Gajalakshmi. Ms. Sudha and Ms. Jothi provided able secretarial assistance.

Contents
1. Introduction 2. Environmental Concerns in India 2.1. Air, Water and Solid Waste Pollution in India 2.2. Implications of Pollution in India 2.3. Climate Change Impacts in India 3. International Experience in Eco taxes 3.1. Features of Green Tax Reform 3.2. Environmental Taxes in Europe 3.3. Inferences from International Experience in ETR 4. Identification and Taxation of Polluting Inputs and Outputs 4.1. Major Polluting Industries 4.2. Major Polluting States 4.3. Taxation of Fuels and Energy 5. Integrating Eco-Taxes with GST 5.1. Features of Emerging GST Regime 5.2. Framework for Integrating Eco-taxes in GST Regime 5.3. Determining Rates of Environmental Taxes 5.4. Constitutional Reforms 5.5. Complementary Role of Eco-subsidies and State/Local Level Ecotaxes 5.6. Greenhouse Gas Mitigation 6. Conclusions

Appendix 1: The Model GST: Thirteenth Finance Commission

1. Introduction
Pollution has serious implications for economic growth and welfare because of its impact on health, resource depletion, and natural calamities linked to climate change. There are two major groups of policy instruments for achieving pollution reduction: regulatory and market based economic instruments1. Regulatory instruments prescribe emission standards or effluent limits. These require considerable information and involve significant administrative costs for implementation and monitoring. Market based instruments include taxes, subsidies, and trading instruments. In comparison with the regulatory policies, market based instruments may be able to reduce the costs of achieving a given level of environmental protection through incentives. This project examines policy options for coping with pollution in the Indian context using eco-taxes and eco subsidies. It provides a framework in which the central and the state governments can develop a coordinated intergovernmental approach to tackle issues of pollution in the light of Indias growth requirements while keeping pollution within acceptable limits. It is well recognised that environmental taxes provide an effective instrument for incentive based pollution control while generating revenues that can facilitate reduction in the tax rates of other distorting taxes. Eco taxes are not meant to be a revenue-augmenting device. Instead, the idea is to change the structure of taxation without putting additional burden on the tax payers. It reduces the use of resources and pollution by making them more expensive. At the same time it reduces distortionary taxes on labour and capital, making them cheaper, leading to increased output, employment and resource productivity. Many European countries have now started extensively using a number of eco-taxes for controlling pollution and meeting environmental targets including those relating to climate change. India is presently undertaking major tax reforms for the taxation of goods and services, which will integrate taxes like State VAT, CENVAT, service tax, and a host of other small taxes on goods and services, and replace these by a comprehensive goods and services tax (GST). The Thirteenth Finance Commission in its report which has been made public in February 2010 has come out with a model GST scheme in which the Commission has expressed the need to take into account environmental concerns in the design of GST. The main features of the model GST scheme of Thirteenth Finance Commission and its environmental implications alongwith the GST design suggested by the Empowered Committee of State Finance Ministers and the Task Force of the Thirteenth Finance Commission are summarised later in the Discussion Paper. The design of the new tax system requires bringing on board the environmental considerations so that many future changes in GST regime are not called for as in the European countries where VAT has been in existence for some time and environment taxes are new additions.

1 A third alternative is also emerging based on information disclosures. By publicly disclosing the environmental performance of a firm, it is anticipated that the firm would adjust its environmental performance through the market feedback.

It may be noted that the Thirteenth Finance Commission has supported green considerations in the design of GST as well as in its grants. The Commission has observed: For achieving a greener and more inclusive growth path we need a fiscally strong Centre, fiscally strong states and fiscally strong local bodies, or the third tier of government. Therefore, we are proposing the strategy of expansionary fiscal consolidation with no compression of development expenditures. Such a fiscal strategy will provide a more propitious environment for increasing both public and private investments, as well as for better handling of adverse economic shocks that we may face due to external developments. (Para 3.13) Securing the environment is critical for Indias future generations and not just a matter of international commitment. A degraded environment reduces the quality of life for all citizens, but the impact is particularly pronounced on the poor and vulnerable groups, as it is they who suffer the most from degraded access to clean water, air and sanitation, as well as from climate shocks. It is for this reason that, despite the fact that Indias per capita greenhouse gas emissions are much below the world average and far lower than the average of developed countries, we have pursued policies which complement efforts towards mitigation of climate change. It is, therefore, important to incentivise fiscal policies that promote measures for energy conservation, renewable energy, soil conservation, afforestation and more effective and affordable access to clean water at different levels of government. This would impact all levels of government, including local bodies, which face mounting challenges in delivering better access to clean water, better solid waste management and enhanced, but green local infrastructure. Our grant proposals are supportive of such an approach. (Para 3.16) This study also examines the international experience in this context. It is recognised that environmental taxes may have to be levied as non-rebatable cesses or surcharges or at rates that are higher than the core rate of GST. Since it implies an exception to the normal GST norm, the number of polluting inputs and outputs that can be subjected to such differential treatment has to be limited. This discussion paper aims to summarize the main arguments in favor of considering eco-taxes (and eco-subsidies) integral to the ongoing indirect tax reforms in India. The paper also outlines the main differences between three GST designs; viz., that are given by the Task Force of the Thirteenth Finance Commission, the 13th Finance Commission itself, and the Empowered Committee of State Finance Ministers. We particularly highlight the place of environmental taxes in their three designs.

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2. Environmental Concerns in India

2.1 Air, Water and Solid Waste Pollution in India The main forms of pollution are atmospheric pollution, land degradation and soil pollution, water pollution, and noise pollution. The main sources of atmospheric pollution are: (a) combustion of fuels to produce energy for heating and power generation in the household and industrial sectors; (b) exhaust emissions from the transport vehicles that use petrol, diesel oil, etc., and (c) waste gases, dust and heat from many industrial sites including chemical manufacturers and electrical power generating stations. Three main pollutants of ambient air quality are Sulphur Dioxide (SO2), Nitrogen Dioxide (NO2) and Particulate Matter. Carbon dioxide (CO2) and methane (CH4) contribute towards the greenhouse gas emission inventory in India. The main water pollutants are effluents and discharges from industries. The main land and soil pollutants are fertilizers and pesticides. In most of the Indian cities, the annual average concentrations of respirable suspended particulate matter (RSPM) and suspended particulate matter (SPM) reflecting presence of particulate matter exceed the National Ambient Air Quality Standards (see Figure 1). The reasons for high particulate matter levels are vehicles, engine gensets, small scale industries, biomass incineration, boilers and emission from power plants, suspension of traffic dust, and commercial and domestic use of fuels.

Figure 1: Status of Air Quality in India Mid 2000s

Vehicles are a major source of atmospheric pollution. In terms of the relative share of the major states in the all India total number of vehicles, Maharashtra had the highest share of 12.1 percent, followed by Tamil Nadu, which had a share of 11.9 percent. Gujarat was the next with a share of 9.7 percent, followed by Uttar Pradesh with a share of 8.8 percent. In terms of two wheelers, Tami Nadu had the highest share of 13.2 percent followed by Maharashtra at 11.8 percent. In terms of cars, Maharashtra had the largest share but in terms of goods vehicles, Tamil Nadu has a higher share.

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There is considerable inter-state variation in CO2 emissions. State level CO2 emissions figures for 2000 indicate that Uttar Pradesh has the highest level of pollution followed by Madhya Pradesh, Maharashtra, Andhra Pradesh, West Bengal, Gujarat, and Tamil Nadu. Table 1 provides the details. Per capita CO2 emissions as per these figures show that Madhya Pradesh has the highest emission at 660 metric tonnes followed by 440 metric tonnes for Delhi, Orissa and Goa. Punjab has a per capita CO2 emission of 450 metric tonnes. High per capita emissions may be due either to the state undertaking production of polluting material as in the case of Madhya Pradesh, Chhattisgarh, and Bihar or it may be due to high per capita consumption as in Delhi, Goa, Gujarat and Maharashtra. States like Bihar, Orissa, Madhya Pradesh, and Andhra Pradesh have Indias major steel plants that consume a lot of coal. This makes their emission levels disproportionately high compared to their incomes. Looking at the all India figures, nearly 77 percent of the CO2 emissions are from coal. About 70 percent of the coal in India is consumed in the power sector. Table 1: State Level CO2 Emissions: 2000 ('000 metric tons of carbon) Aggregate J&K HP Punjab Haryana UP Rajasthan 696.5 659.1 10845.7 5460.5 44268.3 8929.3 Bihar Orissa WB Assam Gujarat Maharashtra 9012 16172.3 23363.7 1097 18461.5 35595.4 MP AP Karnataka Kerala TN Others 39279.4 30126 9059.6 3034.2 17584.9 43712.6 Per Capita J&K HP Punjab Haryana UP Rajasthan 0.07 0.11 0.45 0.26 0.27 0.16 Bihar Orissa WB Assam Gujarat Maharashtra 0.11 0.44 0.29 0.04 0.37 0.37 MP AP Karnataka Kerala TN Others 0.66 0.4 0.17 0.1 0.28 0.62
Source: Ghoshal and Bhattacharya (2007).

Delhi 6033.8 Goa 652.2

Delhi 0.44 Goa 0.44

In India, about 130 million hectares of land (45 percent of total geographical area) is affected by serious soil erosion through ravine and gully, shifting cultivation, cultivated wastelands, sandy areas, deserts, and water logging. The average degradation percentage is estimated at 18.8 considering all the districts. Some districts of Mizoram, Maharashtra, Uttar Pradesh, West Bengal, Madhya Pradesh, Himachal Pradesh and Bihar have relatively higher percentage of soil erosion compared to the national average.

The activity of mining and quarrying covers underground and surface mines, quarries and wells, and includes extraction of minerals as also activities such as dressing and benefaction of ores, crushing, screening, washing, cleaning, grading, milling floatation, melting floatation and other preparations at the

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mine site. In India, coal is the most important energy source but Indian coal contains 30-40 percent ash and moisture content. Water is polluted by the effluents of industries. Some of the important industries in this context are ferrous and non-ferrous metallurgical industries, mining and ore processing, and industries relating to petroleum, petrochemicals, chemicals, ceramics, cement, textiles, paper, fertilisers, coal (including coke), power (thermal and diesel) generation, and processing of animal or vegetable products industry. Small scale industries (SSIs) are also a major source of industrial water pollution. Both land and water are polluted because of excessive use of pesticides. An inter-state comparison of consumption of pesticides shows that, according to available data for 2004-05, the highest amount of pesticides was used in Punjab followed by Uttar Pradesh, Haryana, West Bengal, Maharashtra and Gujarat. These inter-state differences are the result of both the intensive use of pesticides and the area over which the pesticides are used. The presence of iron in water has affected the largest number of habitations in India. These habitations are located largely in Orissa, Assam, Bihar, and West Bengal. Next in terms of the pollutants affecting water for habitations was fluoride and the states most affected were Rajasthan, Karnataka, Madhya Pradesh, Gujarat and Uttar Pradesh. The arsenic contamination of water was limited to two states only viz., Bihar and Assam. The presence of nitrate was mostly in Rajasthan, Maharashtra, Karnataka, and Bihar. Salinity was a problem in Rajasthan, Gujarat, Maharashtra and Punjab. Figure 2 shows the status of water quality across Indian rivers in 2000s.

Figure 2: Status of Water Quality Across Indian Rivers Mid 2000s

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Apart from the national and state-wise picture, a number of environmental hotspots in the country have also been identified calling for urgent policy intervention. The Blacksmith Institute of New York has been identifying the worst polluted places of the world on the basis of size of affected population, severity of the toxin involved, impact on childrens health and development, evidence of a clear pathway of contamination, and existing and reliable evidence of health impact. In the 2006 report, Ranipet in Tamil Nadu featured among the top ten worst polluted places2. Within five kilometer distance around 68 tanneries operate in Dindigul leading to severe ground water pollution. Tannery effluents are reported to have left only 16 out of 56 wells in Kamatchipuram village uncontaminated forcing people to walk long distances for water. The water and soil pollution from the tannery effluents has the potential to affect about 450,000 people. In the 2007 report, Sukinda valley in Orissa featured among the top ten worst polluted places. Sukinda valley contains about 97 percent of Indias chromite ore deposits and is one of the worlds largest open cast chromite ore mines. With over twelve mines still in operation, a large quantity of waste rock is spread over the surrounding areas and the Brahmani riverbank3. Besides these, the 2006 and 2007 reports also highlight other pollution hotspots of India including Kanpur (chemical pollutants from the tanneries), Ankleshwar (heavy metals and chemicals from the chemical units), Vapi (chemicals and heavy metals from the chemical units), Kolkata (lead pollution from lead factories producing lead ingots and lead alloys), and Mahad Industrial Estate in Karnataka (heavy metals and organic pollutants from the chemical units). 2.2 Implications of Pollution in India World Bank (1995) for the first time provided an aggregate economy-wide estimate of cost due to various environmental pollution in India. The study estimated the health impact of water pollution to be $5,710 million and the agricultural output loss due to soil degradation as $1,942 million. The health impacts of air pollution were assessed as $1,310 million and the loss of live stock carrying capacity due to rangeland degradation was found to be $328 million. The cost of deforestation came to $214million and the loss of international tourism was found to be $213 million. Overall, the results show that the total environmental damage was $9.7 billion per year, or 4.5% of GDP in 1992 values. In a subsequent estimate World Bank (2005) assessed that the annual economic cost of damage to public health from increased air pollution alone

2 While the state government had ordered closure of Tamil Nadu Chromates and Chemicals Limited a decade ago, the legacy of the same still continues with no solution still in sight for the safe disposal of 1,500,000 tons of solid waste generated by the factory over two decades before its closure. Blacksmith Institute and Asian Development Bank estimate that about 3.5 million people are potentially affected due to ground and surface water contamination. 3 As untreated water is discharged by the mines into the river and onto the soil, more than sixty percent of the drinking water is reported to contain hexavalent chromium at levels that are far above the national and international standards. Of the 26,00,000 potentially affected population in the area, a local NGO has estimated that about 25 percent are affected by various pollution induced diseases.

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based on RSPM measurements for 50 cities with the total population of 110 million was close to US$ 3 billion in 2004. Smith and Mehta (2002) have analysed the years of life lost (YLL) and disability adjusted life years (DALY) among the rural and urban children below the age 5 years and estimated the YLL and DALY attributable to the use of solid fuels in the household. It is estimated that annually about 20 million YLL and DALY in India can be attributed to not using the clean fuels. Recently Green Indian States Trust (GIST) has made an attempt to estimate the aggregate impact of natural resource degradation on Indian economy. The resources covered included depletion of forest resources, biodiversity loss, agricultural and pasture land degradation, and loss in ecological services. The gain/loss due to change of these resources are estimated across major states of India and expressed with reference to the NSDP in 2002-2003. In terms of loss due to depletion of timber, fuelwood, and non-timber forest products, Bihar is estimated to have incurred significant burden about 5 percent of its NSDP, followed by Himachal Pradesh (2 percent of its NDSP) and Orissa (1 percent of its NDSP). At all India level, the losses are estimated at about 0.5 percent of NDP. With regard to loss due to depletion and degradation of agricultural and pasture land Rajasthan, Madhya Pradesh and Orissa registered high losses (4 percent, 3.5 percent and 3 percent respectively of NSDP). Himachal Pradesh, Uttar Pradesh and Kerala registered significant loss due to biodiversity loss from the forest degradation.

2.3 Climate Change Impacts in India A wide range of economic activities could potentially be affected by climate change and Indian context the initial national communications (NATCOM, 2004) to UNFCCC summarized the impacts and vulnerabilities. While much is said about the impacts in physical terms, there is little evidence on the economic implications of the climate change induced impacts. Here the discussion attempts to focus on agriculture and provides an overview of impacts in economic terms. Focus on agriculture needs little justification, especially in the Indian context, as it provides livelihood for more than 60 percent of Indian population. Mall et al. (2006) provide a review of climate change impact studies on Indian agriculture mainly from physical impacts perspective. The available evidence shows significant drop in yields of important cereal crops like rice and wheat under climate change conditions. However, biophysical impacts on some of the important crops like sugarcane, cotton and sunflower have not yet been studied adequately. Kumar and Parikh (2001a) have estimated the macro level impacts of climate change using agronomic-economic approach. They showed that under doubled carbon dioxide concentration levels in the later half of twenty first century the gross domestic product would decline by 1.4 to 3 percentage points due to climate change. More significantly they also estimated increase in the proportion of population in the bottom income groups of the society in both rural and urban India under climate change conditions. Adaptation is addressed to only a limited extent in this approach. 15

To address adaptation issues adequately Kumar and Parikh (2001b) and Kumar (2009) have used a novel approach and showed that a 2oC temperature rise and seven percent increase in rainfall would lead to almost 9 percent loss in farm level net revenue (1990 net-revenue expressed in 19992000 prices). The regional differences are significantly large with northern and central Indian districts along with coastal districts bearing relatively large impact. Nearly 130 million people currently live in the area of about 160 thousand square kilometers known as low elevation coastal zone (LECZ) in the three South Asian countries sharing a coast line, namely, Bangladesh, Pakistan and India. Large coastal cities such as Chennai, Mumbai and Kolkota are at average elevation of 2-10 meters, and some 47 million people live in the urban areas in the LECZ. Thus, sea level rise of about 3-5 meters by the end of the century under the climate change scenarios would effectively deurbanize the major population centers along the coast. This in turn could trigger significant inland migration leading to infrastructural problems of serious dimensions in cities such as Delhi, Bangalore, Pune and Hyderabad. Sea-level rise would also lead to loss of trillions of dollars due to infrastructural losses. All environmental legislations in India come under criminal laws. In implementation of the laws as well as in judicial decisions, the issue is on compliance or no compliance, and not on the extent of compliance. The penalties for non-compliance are unrelated to the compliance costs. On the other hand the economic compliance cost increases with the level of pollution prevention or abatement. This type of pollution control regime creates an opportunity for corruption and rent-seeking. The present standards and control regime particularly the ones based on technology standards and input usage norms provides no incentive for polluters to search for and adopt environmentally sound cost minimizing technologies/practices. Discussions with legal experts and the Central Pollution Control Board officials revealed that the present laws do not allow introduction of pollution charges or other market based instruments. For this reason, Chelliah et al. (2007) and Srivastava and Rao (2008), have advocated taxes on polluting inputs and outputs. The information system for levy of such taxes is readily available and there are no legal obstacles for introducing the taxes. These recommendations are in line with the so-called environmental tax reforms. Environmental tax reforms (ETR) constitute an indirect, self-monitoring, incentive-based changes in the tax structure to achieve environmental objectives. These have the potential to induce appropriate environmental decisions through instituting an incentive structure by raising the relative costs of polluting inputs and outputs. ETR is not meant to be a revenue-augmenting device. Instead, the idea is to change the structure of taxation without putting additional burden on the tax payers. ETR reduces the use of resources and pollution by making them more expensive. At the same time it reduces distortionary taxes on labour and capital, making them cheaper, leading to increased output, employment and resource productivity. Similarly, these can 16

be used to reduce the overall tax rate thereby reducing the deadweight losses associated with indirect taxes. Environmental taxes can be advocated from the viewpoint of static and dynamic efficiency gains. Static gains arise through reallocation of abatement among various polluters. As the costs of pollution abatement vary across firms or individuals, environmental taxes have the potential to minimise costs, for two important reasons. First, taxes provide each polluter with incentive to abate in the least-expensive ways and thus achieve a given level of abatement at lower total abatement cost. Second, taxes can avoid the need for the regulatory authority to acquire detailed information on individual sources abatement costs. This would lower the public sectors costs of regulation.

3. International Experience in Eco-taxes

3.1. Features of Environmental Tax Reform Environmental tax reform in different countries across the world mainly aim at shifting the tax burden from factors of production, such as labour and capital, to pollution and the use of natural resources (EC, 1997). Elements of Strategic tax reform generally involve three complementary activities (EEA, 1996; OECD, 1997): Removal of existing taxes and subsidies that have negative environmental impacts Restructuring of existing taxes in an environmentally friendly manner Introducing new environmental taxes

Largely the emphasis in environmental taxes is on energy and transport. Yet over the years new tax bases have been used. For instance, waste end taxes (in Austria, Finland, France, Greece, Italy, Sweden, Norway and UK), packaging (in Italy), solvents (Denmark and Norway), PVC/ phthalates (Denmark), and annual car taxes differentiated according to environmental characteristics (Germany) (EEA, 2000). Fuel tax is levied in all countries in Europe. Environmental taxes provide a continuing incentive for polluters to seek ways to reduce emissions, even below the current cost-effective level. This incentive arises because the tax payment is made on each unit of residual emissions. New technologies may further reduce marginal cost below the tax rate and lead to further abatement. As the demand for green technologies is increasing globally, this can also lead to new comparative advantages, further stimulating employment and output.

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3.2. Environmental Taxes in Europe The implementation of environmental tax reforms goes back to the early nineties. Sweden, Denmark, Norway, Finland and the Netherlands were the early reformers. Sweden was the first EU country to introduce environmental tax reform where specific charges for carbon dioxide, sulphur dioxide and nitrous oxide were introduced and later the ETR became more complex. The revenue from the new tax regime was recycled into a reduced level of income tax and employers' contributions in order to benefit both households and industry. Reforms in Finland introduced a carbon dioxide tax in addition to other energy taxes, although electricity generation was exempted and gas subjected to a 50 percent reduction. Benefits were skewed towards households despite industry being equally affected by the new taxes. Finland's tax shift, estimated at 1.25 percent of GDP, was quite large. Germany increased existing energy taxes and introduced a new electricity tax and recycled the revenue by reducing social security contributions. This amounted to a tax shift of almost 1 percent of GDP. The environmental taxes were complemented by special reductions and subsidies for renewable energy, bio-fuels, and combined heat and power (CHP) facilities. Overall the environmental taxes raised revenues in the order of 2-2.5 percent of gross domestic product. Table 2 provides a summary of the environmental effectiveness of the green shift in taxation across various countries.

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Table 2: Impact of the Green Shift in Taxation: Selected International Evidence

Country and Tax Finlandenergy &carbon tax Period Evaluated 19902005 Impact CO2 emissions 7 per cent lower than would have otherwise been A shift from carbon tax to output tax on electricity in 1997 may have lessened impact 21 per cent reduction in CO2 from power plants by 1995 14 per cent national reduction in CO2 in 1990's, 2 per cent attributed to carbon tax 12 per cent reduction in CO2 emissions per unit of GDP CO2 emissions in affected sectors down by 6 per cent and economic growth up by 20 per cent between 1988 and 1997 and a 5 per cent reduction in emission in one year in response to tax increase In 1990s a 23 per cent reduction in CO2 from as usual trend and energy efficiency increased by 26 per cent Subsidy to renewables may have accounted for greater proportion of emissions reductions than tax Emissions reductions of 0.5 million tons per annum Emissions would have been 20 per cent higher than 1990 levels without tax Emissions 3.5 per cent lower than would have otherwise been Low tax rates may have limited impact CO2 reduced by 15 per cent between 1990 and 1999 and 1 per cent between 1999 and 2005 CO2 emissions 2-3 per cent lower by 2005 than they would have been without tax German re-unification an important factor in reductions UK CO2 emissions reduced by 2 per cent in 2002 and 2.25 per cent in 2003 and cumulative savings of 16.5 million tonnes of carbon up to 2005 Reduction in UK energy demand of 2.9 per cent estimated by 2010 Source Nordic council 2006 Nordic 1999 OECD 2001 OECD 2006 Nordic council 2006 Council

NorwayCarbon &sulphur dioxide taxes

19912007

OECD 2006

Denmarkenergy &carbon tax

1992

Nordic 2006

Council

Swedenenergy & carbon taxes The Netherlandsenergy tax Germanyenvironmental tax reform, taxes on transport , fuels &electricity

19902007 19992007

Nordic council 2006 Swedish Ministry of Finance 2004 Finance ministry, the Netherlands 2007

19992005

EEA 2007 OECD 2006

UK-Industrial energy tax

20012010

Cambridge Econometrics 2005

HMT 2006

Source: Green Fiscal Commission (2009).

3.3. Inferences from International Experience in ETR International experience has shown that environmental taxes can be quite effective in their environmental impact. It has been shown that the fuel taxes have had a significant environmental impact. In a recent study, Sterner (2007) reviews several studies for a number of countries and concludes; Had Europe not followed a policy of high fuel taxation but had low U.S. taxes, then 19

fuel demand would have been twice as large. Sterner observes that fuel taxes are the single most powerful climate policy instrument implemented to date. Environmental tax reform can have a powerful effect on energy use. Ekins (2009) estimates the price elasticity of energy demand in the UK at about (-) 0.64, which implies that a 10 percent increase in the energy price will reduce energy consumption by 6.4 percent. He also finds that energy use tends to increase with value added with an elasticity of (+) 0.5 (meaning that a 10 percent increase in value added will tend to increase energy consumption by 5 percent). Other things being equal, this means that if a sector (or by implication the economy as a whole) is growing, its energy use will be growing too, unless it is restrained by a rising energy price. With a reasonable change in the relative prices of labour and environmental resources, environmental tax reform may significantly change the incentives for innovation and technological development, inducing companies to devote more effort to increasing resource productivity, and less to increasing labour productivity. Industries that reduce pollution, increase resource productivity and encourage a switch to renewable resources. These industries are collectively being called the environment industries (EI) which have two distinct components: the supply of traditional pollution control technologies and services (end-of-pipe treatment) and industries relating to resource management (management of materials and energy). Both components of the EI have contributed to environmental improvement in the EU. There are important lessons for India from the international experience. As India implements its indirect tax reforms, it should ensure that for environmental purposes, the tax on energy continues to cascade and polluting goods and services are differentially taxed at higher rate. Further, India should develop capacity in environment industries where there is the potential of considerable growth of demand rather than concentrating on polluting industries where already there is considerable excess capacity globally.

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4. Identification and Taxation of Polluting Inputs and Outputs

Since the design of ETR should be such that only a limited number of polluting inputs and outputs should be selected for differential rates of taxation or levy of non-rebatable taxes on inputs, the selection of commodities has to be such as to maximize the environmental impact with a limited number of environmental taxes. It should also be dovetailed to regional environmental pollution characteristics. For this purpose, the pollution load of inputs and outputs needs to be worked out. In India, state wise or nation wise measurements of annual pollution loads are not available. However, industrial pollution intensities, defined by the ratio of pollutant output to total manufacturing activity4, are available in the World Bank IPPS (Industrial Pollution Projection System) database. There is a difference between emission and pollution, and the effects of different pollutants on environment and human health are different (some pollutes the soil more than water, for example). The IPSS measurement uses different toxicity ratings for each industry5. Gupta (2002) has identified the Central Pollution Control Board (CPCB) notified 17 categories of polluting industries and measured pollution load for them. However, only 16 categories are considered since Thermal Power Plants are not treated under IPSS as a separate category. Using the same methodology, Pandey (2005) has extended and updated Guptas (2002) initial findings of state level pollutants. 4.1. Major Polluting Industries The Central Pollution Control Board (CPCB) notified 16 industries are mostly concentrated in seven states namely, Maharashtra, Gujarat, Uttar Pradesh, Tamil Nadu, Bihar, Andhra Pradesh and Madhya Pradesh. Together these states contribute more than 70 percent of total value of production of these industries. Iron and steel industry dominates in most cases. The five largest polluting industries along with the states in which they are located are given below: Table 3: Five Largest Polluting Industries
Industry Iron and Steel Oil Refinery Fertilizer Sugar Cement industry States Bihar, Madhya Pradesh Maharashtra and Tamil Nadu Gujarat, Maharashtra, Uttar Pradesh Uttar Pradesh , Maharashtra Madhya Pradesh, Andhra Pradesh

4 Analogous to, say, the input-output coefficients. 5 Hettige et al. (1995).

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The estimates of industrial pollution load have been obtained using the industrial value of production and employment as a measure of industrial activity. Pandey (2005) posits that Indian industries are overstuffed vis--vis the US ones. Hence it is better to work with output based measurements of pollution load rather than employment based measures. Pollution loads are estimated according to the nature of pollutants (water, air, toxic and metal) and also by medium (air, water and land) for the toxic and metal pollutants. The relative contribution of each industry to total pollution load at the all India level shows that the iron and steel industry is the highest polluting industry in terms of all four pollutants except air where it ranks second to cement. Iron and steel is the largest water polluting industry in India with 87.4 percent of the total pollution load. The pulp and paper and aluminum industries rank second and third respectively with their contribution to total water pollution load at 4.6 and 2.5 percent. Sugar and distillery industries rank fourth and fifth, respectively. The main implication of the result is that substantial reduction in total pollution loads can be achieved by focusing pollution control efforts in a limited number of industries. 4.2. Major Polluting States In toxic pollution, there are seven states that account for about 70 percent of the total toxic industrial pollution. 68 percent of the total industrial metal pollution load in the country is contributed by six states. The ranking of states in water pollution is somewhat similar to that of metal pollution. The cumulative share of water pollution load is about 73 percent contributed by seven states. Table 4: Contribution of Selected States to Industrial Pollution Load
State Andhra Pradesh Bihar Gujarat Karnataka Madhya Pradesh Maharashtra Orissa Punjab Rajasthan Tamil Nadu Uttar Pradesh West Bengal Water 7.0 17.1 4.2 3.1 12.9 12.5 10.9 5.1 1.3 4.5 5.5 6.9 Air 8.9 8.6 9.3 4.3 11.2 15.0 6.6 2.7 3.8 7.9 7.5 7.3 Toxic 5.8 8.4 15.2 2.0 7.0 15.9 6.2 2.8 1.9 8.5 7.3 5.4 (percent) Metal 5.8 15.1 4.2 2.9 12.1 14.2 12.1 4.0 1.7 4.1 6.6 7.4

Source: Pandey (2005).

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From Table 4, top 5 states in each category are: Water: Air: Toxic: Metal: Bihar, Maharashtra, Madhya Pradesh, Orissa, West Bengal. Maharashtra, Madhya Pradesh, Gujarat, Andhra Pradesh, Bihar Maharashtra, Gujarat, Tamil Nadu, Bihar, Uttar Pradesh Bihar, Maharashtra, Orissa, West Bengal, Uttar Pradesh

Since one is concerned about the effects of pollution, population density of the states must also be taken into consideration. A high density state (like West Bengal or Kerala) will face higher per capita burden of pollution and we should strictly propose some policy action. 4.3 Taxation of Fuels and Energy In designing eco-taxes, considerable importance needs to be attached to taxation of fuel and energy. In designing taxation of petroleum products, we need to consider (i) the base price of petroleum products (ex-factory or c.i.f. on imported products) and the combined tax-component of taxes levied by the Central and State Governments. When prices are administered, depending on where the price is fixed, a subsidy element also gets involved. In India, after a long period of administered prices for the petroleum sector, a dismantling of the Administered Pricing Mechanism (APM) was announced and made effective from 1.4.2002. Subsidies for the PDS kerosene and domestic LPG were continued on the ground that these were fuels of mass consumption. With a sharp and spiraling increase in international oil prices, particularly since late 2003, combined with sharp week-to-week and sometimes day-today volatility of petroleum prices, this arrangement has virtually collapsed. The explosive increase in the global crude prices increased the volume of subsidy on PDS kerosene and domestic LPG to unprecedented levels. The centre has not been able to follow suitable principles of pricing reflecting the trade parity prices, as recommended by the Rangarajan Committee. Government took back control of price setting for petrol and diesel, and restrained the pass-through of the international prices to domestic consumers. The Central excise levy on petrol and diesel has been a combination of advalorem and specific rates. The contribution of the petroleum sector to the total net excise revenues of the Government was of the order of 40 percent. Moreover, taxes (including sales tax/VAT) and duties constitute a significant proportion of the retail prices. State level taxes are also high for petroleum products. Almost all state governments in India are also levying non-vatable sales tax on crude oil and petroleum products at special rates. Since states suffer different levels of pollution, related to vehicular and other uses of petroleum products, they are entitled to use different rates, reflecting their own environmental considerations. In particular, the higher income states, where per capita consumption of petroleum products may be higher, may levy a higher special rate of tax.

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GTZ (2009) provided a comparison of fuel-prices across the world nations. Figure 3 provides a comparative overview of the gasoline prices across select countries including India. As may be seen, India has demonstrated in the past its seriousness about energy conservation and environmental safety through relatively high fuel-price. As India moves to GST regime every effort must be made through effective environmental tax reforms to ensure that its environmental consciousness continues to inspire the rest of the world.

Gasoline Prices as of mid-Nov. 2008, US Cents/Litre

South Africa China India Brazil USA Canada Russian Japan UK France Germany Italy

20

40

60

80

100

120

140

160

180

--- Thin benchmark line (Brent crude oil);

Thick benchmark line (USA);

Double benchmark line (Spain)

Figure 3. Gasoline Prices International Comparison, 2008 Fuel taxes have sometimes been criticized on distributional grounds. This has generated the popular perception that fuel taxes are regressive. The balance of academic evidence does not favour this view. It was in the early 90s that the question of regressivity in fuel taxation was raised for the first time. It was argued that fuel taxation imposes a larger burden on poor people. A recent study (Datta, 2008) in the Indian context shows that taxes on transport fuels (petrol and diesel) are highly progressive for both urban and rural sectors. A tax on coal is neutral for rural sector while being slightly regressive for urban sector, due to its use as an intermediate input. However, cooking fuels like kerosene and gas show signs of some regressivity. While a tax on kerosene is regressive for both urban and rural sector, the results for gas differ within sectors. While a tax on gas is strongly progressive for the rural sector, it imposes maximum burden on the middle expenditure groups of the urban sector. This issue is being examined further. The objective of an environmental tax is to reduce emissions by reducing consumption of fuel. Thus, unlike a tax imposed for revenue purposes, an environmental tax should be imposed on fuels with elastic demand and on fuels with emission potential. Transport fuels satisfy these criteria and are thus an appropriate case for a fuel tax for environmental purposes. They have

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high emission potential with each litre of transport fuel emitting around 2.3 kilograms of carbon dioxide per litre of fuel. According to Sterner (2007), while the elasticity of transport fuels are inelastic in the short run, they respond to price changes in the long run and have a long run elasticity of (-) 0.84. However studies by Ramanathan and Geetha (1998) report a lower elasticity value of (-) 0.42, which is still sensitive to price changes. In addition, the results of this study show that a tax on transport fuel is progressive. The results hold good even when indirect consumption is considered. Thus a tax imposed on transport fuels achieves the desired objective of emission reduction without having any adverse distributional effects, making a strong case for higher transport fuel taxation. The issue that needs to be examined is whether, there is scope for any further increase in petroleum taxes since it has implications for both growth and inflation. In Indias context taxation of coal is also of considerable environmental significance. In the Union Budget of 2010-11, both customs duty and excise duty on petroleum products has been raised. Coal containing high ash content causes serious environmental pollution and health hazards in transportation and handling, industrial applications, and generation of power. As discussed earlier, coal is the major source of CO2 emission in India. Strong incentives are needed to promote coal cleaning and carbon capture technologies. Some initiatives have been taken in this regard. For promotion of clean coal technologies, action has been initiated with the cooperation of Indo-US Working Group, Indo-EU Working Group, and Asia Pacific Partnership. The environmental management plans are now scrutinized by an Expert Committee setup by the Ministry of Environment and Forests. Under a jointly funded project by the Global Environment Facility, United Nations Development Programme and the Government of India a coal bed methane recovery and commercial utilization project has been approved with the objective of harnessing methane to minimize safety risks in mines and to utilize potential energy source and to mitigate damage to the atmosphere. It is also meant to bring to the country, a state of art methodology for source assessment and recovery techniques of coal bed methane recovery taking account of the Indian conditions.

5. Integrating Eco-Taxes with GST

The system of taxation of goods and services in India has been subjected to extensive reforms since the nineties. As a result, the country moved away from the earlier structure of cascading type of taxes like the central excise duty and the state sales taxes. Even after the levy of Cenvat and Statevat, the Indian tax system is replete with many distortions and inefficiencies. There is continuing cascading between Cenvat, State Vat and Service tax. India is about to embark upon a major tax reform of its system of indirect taxes that will integrate central and state taxes on goods and services resulting into a comprehensive goods and services tax. The issue is as to how to handle environmental tax reform in the framework of GST. As already discussed, many countries that have VAT have also initiated environmental tax reform. We can opt for a suitable design learning from their experience so that we can have environmental taxes well integrated with GST from the very beginning. 25

In regard to the interface between GST and eco-taxes, several features may be noted: In a value added tax regime, input taxes are fully rebated. As such, taxation of polluting inputs will be ineffective as the tax paid on the inputs will be fully rebated, unless a non-rebatable cess is levied on the inputs. Eco-taxes call for differential rates of tax on polluting inputs and outputs but the accepted GST norm is to go for a uniform rate regime although some countries do have more than one rate. In inter-state trade, the destination principle applies and the producing state where pollution may be localized does not get any part of tax revenue. It is only the consuming state that gets the tax revenue whereas the pollution is suffered by the citizens of the producing state. A non-rebatable cess on the GST will provide some tax revenue for the producing state. In GST, exports will be zero-rated. The importing country may tax the good but the country where production and pollution may take place does not get any tax revenue. The same argument at a more local level applies to special economic zones (SEZs). Eco-taxes provide additional tax revenue to enable reducing overall GST rate (RNR) than would otherwise be the case thereby reducing the deadweight costs. Moving to GST with uniform rates may imply a lowering of the current tax load on polluting inputs and outputs where currently cascading may imply higher tax rates. As such without the incorporation of environmental cesses, the move to GST may be environmentally perverse. Introducing ETR into the GST framework requires coordination between the centre and the states and among the states so that another kind of race-to-bottom does not get initiated where industries start to relocate themselves in those states where environmental taxes or regulations are weak. Many countries in the developed countries are imposing restrictions on their imports to ensure that goods imported by them meet environmental norms. The introduction of ETR in GST will incentivise Indian exporters to meet environmental norms and this will support the drive to increase Indias exports. In moving to a destination based GST, many of the producing states will lose revenue because of the abolition of the central sales tax. Although some compensation is being estimated, this will only be for few years. With the ETR in place, the producing states will have a longer term mechanism in their hand to generate revenues that can support their activities for dealing with pollution in their jurisdictions.

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5.1. Features of Emerging GST Regime The Empowered Committee of State Finance Ministers has been deliberating on reforming indirect taxes in India by working out a comprehensive goods and services (GST). On November 10, 2009, the First Discussion Paper has been released by the Empowered Committee spelling out some of the details of the proposed GST. Some of the basic features are as follows: The GST shall have two components: one levied by the Centre (CGST), and the other levied by the States (SGST) Rates for Central GST and State GST have not been determined yet This dual GST model would be implemented through multiple statutes. The basic features of law such as chargeability, definition of taxable event and taxable person, measure of levy including valuation provisions, basis of classification etc. would be uniform across these statutes as far as practicable. The Central GST and the State GST would be applicable to all transactions of goods and services made for a consideration. Taxes paid against the Central GST shall be allowed to be taken as input tax credit (ITC) for the Central GST and likewise for the SGST. Cross utilization of ITC between the Central GST and the State GST would not be allowed. The following Central Taxes should be, to begin with, subsumed under the Goods and Services Tax: Central Excise Duty Additional Excise Duties The Excise Duty levied under the Medicinal and Toiletries Preparation Act Service Tax Additional Customs Duty, commonly known as Countervailing Duty Special Additional Duty of Customs - 4% Surcharges and Cesses. The Following State taxes and levies would be, to begin with, subsumed under GST: VAT / Sales tax Entertainment tax (unless it is levied by the local bodies). Luxury tax Taxes on lottery, betting and gambling State Cesses and Surcharges in so far as they relate to supply of goods and services. 27

Entry tax not in lieu of Octroi Alcoholic beverages would be kept out of the purview of GST Sales Tax/VAT can be continued to be levied on alcoholic beverages as per the existing practice. In case it has been made Vatable by some States, there is no objection to that. Excise Duty, which is presently being levied by the States, may not be also affected. Tobacco products would be subjected to GST with ITC. Centre may be allowed to levy excise duty on tobacco products over and above GST without ITC. For the petroleum products, i.e. crude, motor spirit (including ATF) and HSD would be kept outside GST as is the prevailing practice in India. Sales Tax could continue to be levied by the States on these products with prevailing floor rate. Similarly, Centre could also continue its levies.

For taxation of inter-State transaction of Goods and Services, an IGST model has been proposed. The Centre would levy IGST which would be CGST plus SGST on all inter-State transactions of taxable goods and services with appropriate provision for consignment or stock transfer of goods and services. The inter-State seller will pay IGST on value addition after adjusting available credit of IGST, CGST, and SGST on his purchases. The Exporting State will transfer to the Centre the credit of SGST used in payment of IGST. The Importing dealer will claim credit of IGST while discharging his output tax liability in his own State. The Centre will transfer to the importing State the credit of IGST used in payment of SGST. The relevant information will also be submitted to the Central Agency which will act as a clearing house mechanism, verify the claims and inform the respective governments to transfer the funds. 5.2 Framework for Integrating Eco-taxes in GST Regime In the proposed structure for GST no provision has been made for imposing any taxes for environmental considerations. It provides for a uniform treatment irrespective of whether the good or service is polluting or non-polluting. It also does not provide space for any rate differentiation at the state level to accommodate region specific ecological and environmental considerations. It proposes to merge cesses and surcharges within the GST framework, thereby taking away the autonomy of both the Centre and the State to earmark revenues for any specific purpose including environmental needs. The taxation of petroleum and electricity in this matter will be crucial. At present, the taxation of petroleum products is being kept outside the purview of the GST. This is one option where the centre and the states will have the freedom to determine their own rates. It is being kept out of the GST presently for revenue purposes but could serve environmental objectives also. Alternatively, the petroleum products can be brought into GST with the centre and states retaining the power to levy a non-rebatable cess on top of the core GST rate.

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In a concurrent GST regime, at present as far as goods are concerned two rates are being talked about: a core rate (RNR) and a lower rate, apart from an exempted category of goods. ETR will call for placing environmental friendly outputs into the lower rate category or exempted category. The issue of higher rate for polluting goods and as a result the overall reduction in the core GST rate can be decided together. The revenue from polluting goods has ranged in the EU countries between 8 to 10 percent of total tax revenues. Given the revenue importance of indirect taxes in India, revenue recycling from the higher rate of polluting goods could contribute about 20 percent of the overall GST revenue. This means that the core GST rate (RNR) can be reduced by 20 percent compared to a situation where there is no provision for the taxation at higher rate for the polluting goods. However, it is not necessary to reduce the GST rate in a manner that the environmental taxes become entirely revenue neutral. At least to the extent that revenues are raised through cesses, these shall be taken as an additionality and earmarked for specific purposes. In the international experience, the green shift has implied that at least a good part of revenue from environmental taxes has been used to reduce other distortionary taxes. Whether potential revenue on environmental taxes should be utilised to reduce tax rates in the case of direct taxes, the core GST rate or allow these to augment government revenues are options that need to be examined. From a theoretical view point if promotion of environment is taken as a public good, this public good should be financed by all tax sources and not just environmental taxes. To the extent that the environment has already been damaged and the polluters or polluting activities have already taken place, it may not be possible to tax them on a polluter based principle as the polluting activity has taken place in the past. The improvement of environment, given the stock of pollution from past pollution activities may be taken as an environment public good. For the current polluting activities, the polluter must pay so that the extent of current negative externalities is curbed and suitable redressal is undertaken. From a practical point of view, international experience suggests that part of tax revenue may be used for reducing distortionary taxes to increase the acceptability of environmental tax reforms. Non-rebatable excises are ideal instruments for curbing negative externalities as well as revenue augmentation to take care of the stock of pollution. This revenue may also be used for reduction in the core GST rate. Cesses and user charges are ideal instruments for establishing one-to-one links between eco-taxes and eco-subsidies that are sector - or industry specific. The draft discussion paper of the Empowered Committee made reference to that it called demerit goods and similarly the Task Force setup by the Thirteenth Finance Commission referred to so-called sin goods. Through these goods, one can argue for creation of space for integrating environmental considerations into the GST regime. Empowered Committee Framework In its draft discussion paper the Empowered Committee has discussed about the demerit goods including petroleum products (which as already discussed

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above are one of the main polluting goods in India). The Empowered Committee has argued in favour of keeping the demerit goods including petroleum products, tobacco, and alcohol out of the GST purview. These goods in turn will be subjected to separate excise duties, whereas the Committee suggested a core GST rate of 14-15 percent. The additional excise duty on the petroleum products would contribute towards controlling environmental pollution. By far this is the narrowest specification of the framework for integrating environmental considerations within GST, as it deals with environmental issues indirectly. In the first Discussion Paper, the Empowered Committee has suggested that taxation of petroleum products be kept out of the GST. The centre would be allowed to continue to levy the central excise duty and this will not be rebated. Similarly states will continue to levy sales tax on the petroleum products and this will not be rebated. For alcohol i.e. beverages, the states will be allowed to continue with state excise duty and this will not be rebated. However, if any state has made it Vatable then it can be part of SGST and tax at input levels can be rebated at later stages in the value added chain. In the case of tobacco products, the centre would be allowed to levy a non-rebatable excise. In addition, centre will levy a CGST and states an SGST. For other polluting inputs and outputs, there is no provision for departures from core rate or levy of cesses. Framework of Task Force for 13th Finance Commission The Task Force set-up for the 13th Finance Commission clubbed the petroleum products, tobacco and alcohol under the category sin goods and argued in favour of including them as part of GST and imposing non-rebatable cesses. Arguing that the expanded tax base due to inclusion of services (such as railways) in the tax-net will fetch higher tax revenue, the task force has suggested a core GST rate of 11-12 percent only. The Task Force has worked out a revenue neutral rate for non-Sin goods and services (i.e. goods and services without significant negative externalities) at 5 percent for the centre and six percent for the states. However, they recommend an over all rate of 12 percent even though they argue that even 11 percent may be revenue-positive because of positive impact on corporate tax revenues due to increased profitability. The integration of environmental considerations in this framework is better than the Empowered Committee framework due to inclusion of the sin goods within the GST regime. The Task Force of the Thirteenth Finance Commission identifies emission fuels, tobacco products and alcohol as sin goods. These are to be subjected to non-rebatable excises. Any petroleum products that are used as industrial fuels will not be subjected to the non-rebatable excise. Instead these will be subjected to GST. The Task Force widens the scope of environmental taxation by recommending that apart from stamp duty, vehicle tax, goods and passenger tax, electricity duty, and any amount collected as tax, fee, charge, cess, user charge including environmental goods and services should not be subsumed under GST. Instead these may be consolidated and all such taxes may be called central excises and state excises. However, this framework still has limited scope as it does not address environmental degradation caused by other polluting goods, which may have significant localized impact and is a

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valid concern of the more industrialized states who would have to bear the cost of mitigating the adverse impact of pollution suffered in land, water, and soil although the tax revenue will accrue to the consuming states in a destination based tax system. Thirteenth Finance Commission: Model GST Scheme The Thirteenth Finance Commission has in its model GST made special provisions for certain goods. They have recommended that taxation of petroleum products and natural gas should be included in the tax base of GST. However, high speed diesel (HSD), motor spirit (MS), aviation turbine fuel (ATF) could be charged GST and an additional levy both by the centre and state governments. No input credit would be available against CGST or SGST on the additional levy. A similar treatment would be provided to alcohol and tobacco. The Commission observes that such arrangement would ensure protection of existing revenues while taking care of environmental concerns. The Commission has also observed that the state governments can impose an additional levy on transmission fuels as well as sumptuary goods and they will continue to have autonomy to levy temporary cesses and surcharges. They will also have the authority to continue to levy user charges for services provided to the citizens. The model scheme of the Thirteenth Finance Commission is given in detail in Appendix 1. The Thirteenth Finance Commission has observed: Green growth involves rethinking growth strategies with regard to their impact on environmental sustainability and the environmental resources available to poor and vulnerable groups. It is significant to note that many stimulus packages announced globally to combat recession incorporated a green component. International experience is that green growth promotes inclusivity. Further, the renewable energy sector is relatively labour intensive, with the potential for generating more jobs than the oil and gas industries. (Para 3.15) Environmental issues are increasingly becoming important in the construction of optimal inter-governmental fiscal arrangements. In this report, we have sought to highlight how actions taken by states to maintain and enhance the supply of environmental public goods and to foster positive environmental externalities have resulted in benefits for the nation as a whole. The multidimensional approach to environmental policy within public finance is thus the need of the hour, looking across different dimensions of environmental sustainability and, especially, those that directly affect the poor and vulnerable in their daily lives like soil quality, water, sanitation, pollution and bio-diversity. The environment is a shared legacy with future generations and it is of the first importance that inter-governmental fiscal arrangements protect and foster this legacy for their benefit. (Para 13.8)

In designing an environmentally oriented GST regime few other issues need to be addressed: (a) extent of tax load for polluting goods, (b) required

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constitutional changes and (c) other complementary taxes at state and local level. These are discussed in the following sub-sections. 5.3 Determining Rates of Environmental Taxes Determining the rates of the environmental cesses involves assessing the extra tax load on the polluting goods. There are two approaches to this issue: theoretically the ideal rate is determined by the externality involved. In the second approach, this determination is linked to targets of reduction in pollution. In this case the rate is determined taking into account the priceelasticity of demand and the relevant target. This is the approach being recommended in most of the EU policies where targets of CO2 reduction have been defined by the concerned legislations. The difficulty with the first approach is that it is difficult to measure with adequate precision the extent of externality that needs to be corrected. In the second case also, in most cases the commitment to reduce the extent of pollution has not been defined in quantitative terms. The central government and the state governments will need to determine the pace of reduction in pollution that can be attempted and these could be inter-state variation in the choice of polluting goods and the increment in tax rate on account of pollution may be in the form of cess which is related to the extent of pollution. 5.4. Constitutional Reforms The centre is empowered to levy a surcharge under article 271 of the constitution. If the Empowered Committee option of dual GST is adopted, centre will have to be given powers to tax the value added up to the retail stage in the case of goods instead of only up to manufacturing and the states will need to have power to tax all services. The service tax will need to be taken from article 268 and the GST should be covered by article 270. It would be best to place taxation of goods and services in the concurrent list and delete all the individual taxes of the Union List and State List subsumed in it. This implies giving up a basic feature of the constitution about separation of tax powers of the centre and the states. There are no taxes at present in the Concurrent List. Article 268 A will not be required and article 270 should specifically make mention of the central GST. Both the central and state governments should continue to retain powers to levy non-rebatable surcharges and cesses, and retain power to levy user charges. For polluting inputs and outputs, both the central and state governments should retain the power to levy a non-rebatable excise and where it is to be linked to a subsidy or earmarked industry-specific use, a cess or surcharge. Both the centre and the state should have autonomy to determine the relevant polluting goods where the cess should be levied.

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5.5 Complementary Role of Eco-subsidies and State/Local Level Ecotaxes Eco-subsidies Eco-taxes should be complemented by eco-subsidies. Eco-subsidies can be given to provide incentives to producers and consumers for favouring goods and services that have environmentally favourable properties. Subsidies decrease the relative price of products and encourage their use. There could be direct subsidies financed by the general budget, as also subsidies linked to eco-taxes where tax revenues are partially or fully earmarked for financing eco-subsidies. Eco-subsidies can also be administered through tax expenditures in the form of tax credits or allowances to encourage expenditure for usage of environmentally friendly inputs and outputs. Internationally there are several examples of eco-subsidies. In Netherlands a rebate is provided for replacement of old appliances; in Spain, Hungary and Denmark, a direct payment of subsidy is made for replacement of old appliances. In Italy, the consumers receive a tax rebate for the purchase of energy efficient refrigerators and freezers. In France, purchases of condensing boiler are promoted though a tax credit and in Australia there are region specific subsidy schemes. In many EU and non-EU countries purchases of compact fluorescent lamps (CFL) is encouraged through subsidies. In USA corporate tax credits are given to manufacturers of energy efficient appliances or to the owners of commercial buildings for the installation of energy efficient equipment. Many states in the USA provide subsidies and personal income tax credits for energy conservation. In India also, there are some subsidies to incentivise use of production of energy saving devices or alternative sources of energy. There are several advantages in targeting environmental goals through subsidies. Subsidy schemes can be better targeted to specific consumer groups. In particular, some of the distributional concerns of energy taxation can be addressed through subsidies targeted to lower income groups. Also, direct subsidies can be more calibrated to the product characteristics. Some products need higher subsidies than others. In India, kerosene is an important cooking and lighting fuel. While urban household use kerosene as a cooking fuel, rural households use it for lighting purposes. The demand for kerosene is responsive to prices especially in the rural sector. It ranges from (-) 0.7 for the rural rich to (-) 0.5 for the middle expenditure group. As a lighting source, kerosene is of poorer quality and is more expensive than electricity (Barnes, Plas and Floor, 1997). The results from this paper show that a tax on kerosene is regressive for both the sectors and a major reason for the observed regressivity in the rural sector is that 35 percent of rural households use kerosene primarily to light their homes. Besides regressivity, a tax on kerosene has other aspects of concern. Any tax on kerosene causes the poor to substitute fuelwood, which has strong adverse health implications and can also lead to deforestation. According to Gundimeda and Kohlin (2006), a percent increase in kerosene price increases fuel wood use by 0.7 percent for the rural poor and by 0.4 percent for the urban poor. Thus, any tax proposal should be preceded by compensatory

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proposals for the poor. This can take the form of targeted electricity and LPG subsidy for the poor and should be coupled by a program of rural electrification. The targeted gas subsidy might also help in forest conservation as has been pointed out by Baland et al (2007). State/Local Level Eco-taxes In most states a compounded system of motor vehicle tax exists where a one time levy is paid for the life of the vehicle. Such a system cannot distinguish between the pollution impacts of old vehicles vis--vis new vehicles who may also meet more upto date emissions norms. In many states motor vehicles are taxed at 12.5 percent of the purchase value. This covers two and three wheelers as well as cars, trucks and buses. Only in the case of tractors and trailers a concessional rate is applied, which may be of 4 percent. The motor vehicle tax should be levied every five years and the older cars should be subjected to an increasing level of eco-cess every five years. After 15 years the vehicles should be compulsorily taken out of the road. Many cities in the world impose a congestion tax on certain specified segments of the city area, where there is a heavy density of vehicular traffic. This is implemented through suitable softwares and monitoring mechanisms so that taxes may be collected without any disruption to the traffic. The construction of Green buildings may be encouraged by property tax concession. A rating mechanism called Griha (Green Rating and Integrated Habitat Assessment) has been developed by the Tata Energy and Resources Institute (TERI) and the Ministry of New and Renewable Energy Sources based on inputs from the Power Ministrys Energy Conservation Building Code. The present emphasis on green government buildings should be extended to include private buildings also. The construction of Green buildings may be encouraged by property tax concession. 5.6 Greenhouse Gas Mitigation Much of the global response to climate change problem has so far been on, (a) assessing the extent of mitigation of GHG emissions world over that could avoid dangerous climate change; (b) distribution of mitigation burden across the world nations that fulfills common but differentiated principle of the Earth Summit in 1992; and (c) identifying cost-effective route for meeting mitigation targets and developing mechanisms and institutions that enable cost-effective mitigation. It is in the context of cost-effective mitigation the role of economic instruments plays crucial role. Minimizing the cost of abatement of a given amount of GHG emissions requires all sources to reduce emissions such that their marginal costs of abatement are equal. Standard economic policy prescription would be a market based instrument such as a tax on emissions or tradable permit system for emission rights (please refer box below for an overview on these two instruments). In the absence of uncertainty, both these instruments provide similar solutions although the distributional effects of the two policy instruments would be very different. Environmental economics literature showed that under uncertainty emission permits are better than taxes when

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the marginal benefit schedules are steeper than the marginal cost curves. In the climate change context, available evidence suggests that the marginal cost curve for reducing GHG emissions is very steep and the marginal benefit curve is relatively flat. Thus following Weitzmans theory it could be inferred that tax policy is likely to be more efficient than a permit system for addressing climate change problem. However, if one considers the climate surprises then the marginal benefit curve could be steeper than marginal cost curve and in such scenario permit system may turn out to be more efficient.
Carbon Tax Typology: Baranzini et al. (2000) provide an excellent survey of carbon taxes. The impact of carbon tax depends on the tax base and tax rate. Some definitions found in the literature on carbon tax include: Carbon Tax is a charge paid on each fossil fuel, proportional to the quantity of carbon emitted when it is burned CO2 Tax is similar to carbon tax and it is levied on CO2 instead of carbon Energy Tax is a charge levied on quantity of energy consumed Implicit Carbon Tax is sum of all taxes on energy, including taxes on energy sales (excise duties). It may be noted that petrol and diesel are heavily taxed fuels due to their low demand elasticities; taxing them is an easy way to collect fiscal revenues. Around six countries Sweden, Norway, the Netherlands, Denmark, Finland, Italy have introduced some form of carbon tax so far (Austria and Germany have implemented energy taxes recently). Most countries that have implemented carbon taxes have introduced them in place of other existing taxes on energy. Two of the major issues surrounding carbon taxes are the environmental and fiscal implications associated with its introduction. An environmental double dividend refers to reduction of local pollution alongside carbon emission reduction. Whereas, an economic double dividend refers to reduction of distortionary tax burden through recycling of carbon tax revenues. Permit Trading: Carbon permit trading refers to a wide range of trading possibilities. In classic scenario it refers to the cap-n-trade wherein a cap is specified to an entity and if it abates lower than the cap it becomes a net seller, and if its emissions exceed the cap then it becomes a net buyer. Under the Kyoto Protocol the Annex-I countries can participate in such emissions trading during the Kyoto commitment period. The European Union Carbon Trading Exchange is one of the main centers for carbon trading. Besides this there are other forms of carbon trading with the carbon permits originating from project based emission mitigation activities such as clean development mechanism. Similarly, carbon permits are also traded among entities based on voluntary commitments. The Chicago Climate Exchange involves trading in these commodities.

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In the context of Kyoto Protocol much of the discussion has been on the use of carbon permits for GHG emission reduction, but considerable evidence exists in the literature on use of carbon taxes. In fact as mentioned in the box carbon taxes are being implemented by few countries. In an early study Shah and Larsen (1992) have examined the efficiency costs of carbon taxes for five countries including India. They defined the efficiency costs as the net marginal welfare cost of replacing other taxes by a carbon tax. They found mixed evidence with regard of carbon tax replacing personal income tax and corporate income tax. When carbon tax is introduced with no change in existing taxes, Shah and Larsen (1992) found that carbon taxes would impose net welfare costs for India however, such welfare costs are found to be a small fraction of the revenue generated by the carbon tax. Further, this study found that the efficiency cost of a revenue neutral carbon tax (replacing existing other tax) would be negligible provided one accounts for the welfare gains from the removal of existing price distortions (such as subsidies on fossil fuels). Fisher-Vanden et al. (1997) argue that if the carbon tax were large enough to stabilize carbon emissions then the welfare costs would be significant for India. In a recent study Ojha (2005) found that a carbon tax policy can impose heavy costs in terms of lower economic growth and higher poverty in India. In particular the study showed that a carbon tax aimed at reducing the annual emissions by 10 percent (and with no targeted transfers of carbon tax revenue) could increase the number poor in 2020 by about five percent compared to the no carbon tax scenario. Given the significant economic and welfare costs associated with carbon taxes, Gupta (2003) argues that it may be desirable to couple a stabilization target (aimed through carbon tax) with global emissions trading with permits allocated either through grandfathering, or on per-capita basis. In case of grandfathered permits, India would be a net buyer; but this approach could be still less expensive than domestic abatement targeted through a national carbon tax. On the other hand, in case of per capita allocation, India would be a net seller of permits leading to net gains for India. Despite being symbolically important, Kyoto Protocol is now widely considered as a failure. Neither it has initiated emission reductions globally nor it promises required further cuts in GHG emissions. Scientists have long warned that even 100 percent adherence to Kyoto will do little to limit the change in climate. Prins and Rayner (2007) argue that if the required fundamental changes are needed in climate regime, the world should look beyond Kyoto and suggest the following reorientation in global climate policy: Focus only on big emitters taking all together is not only undesirable but also impractical Allow emission markets to evolve from the bottom-up Increase public investment on war-footing to decarbonize global energy systems Provide equal space for adaptation in climate policy currently a mere $1.5 billion exist as adaptation fund

36

Without these necessary changes in climate policy, they argue that there is great danger of loosing public support. The much discussed Copenhagen summit in December 2009 could not deliver much in terms of taking forward the climate negotiations. In the current stalemate situation the voluntary commitments being made by the big emitters are providing the silver line. The United States, China and India among others have made commitments to reduce either greenhouse gas emissions or greenhouse gas emission intensities. India is aiming to reduce greenhouse gas emission intensities by around 20 percent over the next 15-20 years. Much of the reduction is linked to increasing relative share of service sector in the total output. However, as the country adopts GST, the relative tax advantage enjoyed hitherto by the service sector (compared to the industrial sector) may be lost. As a result the anticipated emission intensity reduction may not be realized unless the ETR are not made integral to the GST regime as argued above.

6. Conclusions
Pollution in India is high relative to prescribed standards. It has serious implications for sustainability of growth due to depletion of natural resources, implications of climate change, and health hazards. Of the two approaches to pollution control, namely regulatory approach and use of market based instruments, the latter has certain advantages. The two approaches are not mutually exclusive and can be used to complement each other. The main economic instruments are eco-taxes and eco-subsidies. Internationally, there has been a noticeable move towards environmental tax reforms of the existing tax structures thereby giving rise to green shift in taxation. India is likely to introduce a major change in its system of indirect taxation by bringing in a comprehensive goods and services tax. This paper has argued the case for Economic Instruments for environmental management. In this context, the proposed GST should also take into account potential interventions through non-rebatable cesses and surcharges, or provision for higher tax rates for polluting goods and services. This could be supplemented by selective subsidies to encourage use of environmentally benign goods and practices.

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References
Baland, Jean-Marie, Pranab Bardhan, Sanghamitra Das, Dilip Mookherjee and Rinki Sarkar (2006): "Managing the Environmental Consequences of Growth Forest Degradation in the Indian Mid-Himalayas," The Institute for Economic Development Working Papers Series dp-161, Boston University - Department of Economics. Baland, Jean-Marie, Pranab Bardhan, Sanghamitra Das and Dilip Mookherjee (2008): Forests to the People: Decentralization and Forest Degradation in the Indian Himalayas," The Institute for Economic Development Working Papers Series dp-169, Boston University Department of Economics. Baranzini, A., J. Goldemberg, and S. Speck (2000): A Future for Carbon Taxes, Ecological Economics, 32, 395-412. Barnes, Douglas F., Robert Van der Plas and Willem Floor (1997): Tackling the Rural Energy Problem in Developing Countries, Finance and Development, June. Blacksmith Institute (2006): The Worlds Worst Polluted Places 2006, Blacksmith Institute, New York. Blacksmith Institute (2007): The Worlds Worst Polluted Places 2007, Blacksmith Institute, New York. Central Statistics Organisation (2007): Compendium of Environment Statistic, New Delhi. Chelliah, R.J., U. Sankar, P.P. Appasamy, and R. Pandey (2007): Eco-taxes for Polluting Inputs and Outputs, Academic Foundation. Datta, A. (2008): The Incidence of Fuel Taxation in India, Economics Discussion Paper 08-05, Delhi, Indian Statistical Institute. EC (1997): Tax Provisions with a Potential Impact on Environmental Protection, Office for Official Publications of the European Communities, European Commission (EC), Luxembourg. European Environment Agency (1996): Environmental Taxes: Implementation and Environmental Effectiveness, EEA, Copenhagen. http://binary.eea.eu.int/g/gt.pdf European Environment Agency (2000): Environmental Taxes: Recent developments, EEA, Copenhagen. http://org.eea.eu.int/documents/presentation_en.pdf Ekins, Paul (2009): Resource Productivity, Environmental Tax Reform and Sustainable Growth in Europe. Fisher-Vanden, Karen A., P.R. Shukla, J.A. Edmonds, S.H. Kim and H.M. Pitcher (1997): Carbon Taxes and India, Energy Economics, 19, 289325.

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Ghoshal,Tapas and Ranajoy Bhattacharyya (2007): State Level Carbon Dioxide Emissions of India: 1980-2000, http://ssrn.com/abstract=999353. GIST (2008): Green Accounting for Indian States Project, Various Monographs, http://www.gistindia.org/publications.asp GoI (2009): Report of the Thirteenth Finance Commission 20102015, Government of India, December. GoI (2009): First Discussion Paper on Goods and Services Tax in India, The Empowered Committee of State Finance Ministers, New Delhi, November. Green Fiscal Commission (2009): How Effective Are Green Taxes, Briefing Paper Two, April. GTZ (2009): GTZ International http://www.gtz.de/fuelprices Fuel Prices, 6th Edition,

Gundimeda, H., and G. Kohlin (2008): "Fuel Demand Elasticities for Energy and Environmental Policies: Indian Sample Survey Evidence," Energy Economics, 30, 517-546. Also MSE Working Paper No. 9, June 2006. Gupta, Sreekant (2003): Incentive-based Approaches for Mitigating Greenhouse Gas Emissions: Issues and Prospects, in M. Toman, U. Chakravorty, and S. Gupta (eds.), India and Global Climate Change: Perspectives on Economics and Policy from a Developing Country, Oxford University Press, New Delhi. Gupta, Sreekant (2002): Environmental Benefits and Cost Savings through Market Based Instruments: An Application using State level Data from India, paper presented at the National Law School of India, Bangalore, India. Hettige, M. et. al., (1995): The Industrial Pollution Projection System, Policy Research Working Paper, World Bank. Kumar, K.S. Kavi (2009): Climate Sensitivity of Indian Agriculture: Do Spatial Effects Matter?, Working Paper, South Asian Network for Environment and Development Economics (SANDEE) (forthcoming). Kumar, K.S. Kavi, and J. Parikh (2001a): Socio-economic Impacts of Climate Change on Indian Agriculture, International Review of Environmental Strategies, 2(2): pp. 277-293. Kumar, K.S. Kavi, and J. Parikh (2001b): Indian Agriculture and Climate Sensitivity, Global Environmental Change, 11(2): 147-154. Mall, R.K., R. Singh, A. Gupta, G. Srinivasan, and L.S. Rathore (2006): Impact of Climate Change on Indian Agriculture: A Review, Climatic Change, 78, pp. 445-478. Ministry of Environment and Forests (2009): Himalayan Glaciers, based on V.K.Raina, G.B. Pant Institute of Himalayan Environment and Development, Almora.

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NATCOM (2004): Indias Initial National Communication to the United Nations Framework Convention on Climate Change, National Communication Project, Ministry of Environment and Forests, GOI. OECD (1996): Environmental Taxes and Green Tax Reform, Paris. Ojha, V.P. (2005): The Trade-off Among Carbon Emissions, Economic Growth and Poverty Reduction in India, SANDEE Working Paper No. 12-05, South Asian Network for Development and Environmental Economics, Kathmandu. Pandey, Rita (2005): Estimating Sectoral and Geographical Industrial Pollution Inventories in India: Implications for Using Effluent Charge Versus Regulation, Journal of Development Studies, Vol. 41, pp 3361. Prins, G. and S. Rayner (2007): Time to Ditch Kyoto, Nature, 449, 973-975. Ramanathan, R.; Geetha, S., (1998): "Gasoline Consumption in India: An Econometric Analysis", at First Asia Pacific Conference on Transportation and the Environment, Singapore, May. Sathaye, J., P.R. Shukla, and N.H. Ravindranath (2006): Climate Change, Sustainable Development and India: Global and National Concerns, Current Science, 90(3), 314-325. Shah, A. and B. Larsen (1992): Carbon Taxes, the Greenhouse Effect, and Developing Countries, Policy Research Working Paper No. 957, The World Bank, Washington, DC. Smith, K.R. and S. Mehta (2002): The Burden of Disease from Indoor Air Pollution in Developing Countries: Comparison of Estimates, International Journal of Hygiene and Environmental Health, 206, 279289. Srivastava, D.K. and C. Bhujanga Rao (2008): Feasibility of Incentive Based Environmental Instruments and State and Central Taxation Regimes, Madras School of Economics. Stern, N., (2006): Sterns Review on Economics of Climate Change, Cambridge University Press. Sterner, Thomas (2007): "Gasoline Taxes: A Useful Instrument for Climate Policy," Energy Policy, 35, 3194-3202. World Bank (1995): Cost of Inaction: Valuing the Economy-wide Cost of Environmental Degradation in India, Washington D.C. World Bank (2005): For a Breath of Fresh Air: Ten Years of Progress with Urban Air Quality Management in India, Environment and Social Development Unit, South Asia Region, New Delhi: World Bank.

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Appendix 1 The Model GST: Thirteenth Finance Commission

Outline of the Model GST Keeping in mind the recommendations of the task force, we outline the design and modalities of a model GST law. Such a model GST would not distinguish between goods and services. It should be levied at a single positive rate on all goods and services. Exports should be zero-rated. Tax compliance costs should be low and tax credits should be available seamlessly across tax jurisdictions. The other design and operational modalities of a model GST are outlined below. Taxes to be Subsumed For the GST to be purely consumption based, all related indirect taxes and cesses should be subsumed into it. Thus, the Central GST portion would subsume the following taxes: i) Central excise duty and additional excise duties ii) Service Tax iii) Additional Customs Duty (Countervailing Duty ) iv) All surcharges and cesses The SGST portion would subsume the following taxes: i) ii) iii) iv) v) vi) vii) viii) ix) x) xi) xii) xiii) Value Added Tax Central Sales Tax Entry Tax, whether in lieu of octroi or otherwise Luxury Tax Taxes on lottery, betting and gambling Entertainment Tax Purchase Tax viii)State Excise Duties Stamp Duty Taxes on vehicles Tax on goods and passengers Taxes and duties on electricity All state cesses and surcharges

Special Provisions for Certain Goods The taxation of petroleum products and natural gas would be rationalised by including them in the tax base. HSD, MS, and ATF could be charged GST and an additional levy by both the Central and State Governments. No input credit would be available against either CGST or SGST on the additional levy. A similar treatment would be provided to alcohol and tobacco. Such an arrangement would ensure protection of existing revenues while taking care of environmental concerns.

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Exemptions No exemptions should be allowed other than a common list applicable to all states as well as the Centre, which should only comprise: (i) unprocessed food items; (ii) public services provided by all governments excluding railways, communications and public sector enterprises and (iii) service transactions between an employer and employee (iv) health and education services. A threshold of Rs. 10 lakh and a composition limit of Rs. 40 lakh have been agreed upon by the EC for SGST in the first discussion draft. It is desirable that these limits be applied to CGST as well. Sales of goods of local importance will fall within these threshold limits, thus keeping them out of the ambit of GST. Dealers with turnover below Rs 1.5 crore were previously exempt from CENVAT. As thresholds need to be consistent across SGST and CGST, such exemptions should not continue. Under the GST regime, dealers with turnovers between Rs. 10 lakh and Rs. 40 lakh will have to pay both CGST and SGST. Their compliance burden will increase. This issue can be addressed if both CGST and SGST are levied and collected from such dealers by a single agency, viz. the State Government, which would then remit the CGST portion to the Central Government. State Government will be responsible for assessment, levy, collection and audit, with Central Government retaining it right to exercise these functions in respect of CGST in specific cases. State Governments could be reimbursed the collection charges for this effort. Wherever the additional levy is likely to cause hardship, a scheme for reimbursement to economically vulnerable dealers could be considered by the government. The present area-based exemption schemes are not consistent across the states where they are applicable. They differ in the admissibility of CENVAT credit as well as the sunset clause. Since it would be difficult to subsume these schemes into the GST structure, it is recommended that they be terminated. The existing schemes should not be grandfathered. Alternative options like refunding taxes paid by industries in these locations could be considered. Treatment of Inter-state Sales All transactions across tax jurisdictions should be free from tax. While exports will be zero rated, inter-state transactions should be effectively zerorated so as to ensure that the tax is collected by the consuming state consistent with the destination principle. Therefore, any model adopted must allow accurate determination and efficient transfer of input tax credit across tax jurisdictions. Further, the model should not impose any undue restrictions on tax credit set-off or increase in compliance costs.

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The place of supply rules for services need to be carefully framed to ensure consistency and credibility. It should be based on international best practice.

GST on Imports Imports from outside the country would be subject to GST on the destination principle. This will require that proof of consumption at a predetermined destination state should be provided. The procedure for collection and appropriation of this tax needs to be put in place. Rules for transferring this tax burden in the case of importers who sell to a consumer in a third state after the import is made, need to be clarified. Operational Modalities To reduce compliance costs and increase collection efficiency, all state GST laws should be harmonised. All stages of the taxation chain, from levy of the tax to its assessment, collection and appropriation, should be similar across states. This would involve similar rules across states, dealing not only with assessments, audit and refunds, but also with more basic issues like registration, filing of returns, treatment of transportation of goods, etc. While CST will be reduced to zero, the necessity of stipulating documentation for interstate trade needs to be carefully examined. The model for taxing inter-state sales finally adopted should provide clarity on the jurisdiction of states while facilitating inter-state trade and stock transfers. Given the volume of such transactions, this system necessarily has to be ITbased. Such an IT network should enable the sharing of information between states and assist in the plugging of revenue leakages. A system to facilitate inter-state verification of dealers and transactions is also necessary. The present system, viz. Tax Information Exchange System (TINXSYS), does not appear to be fully operational across all states. There are asymmetric benefits to states in putting in place such infrastructure and this appears to be affecting their incentives to do so. A system which will uniformly incentivise all states to participate in and contribute to the verification system needs to be put in place. Alternately, one central agency could be charged with maintaining this system. The existing TINXSYS infrastructure should be updated and strengthened. Dispute Resolution and Advance Ruling Mechanism An effective, efficient and uniform system for redressal of anomalies in the legislation should be put in place. This could be an independent and quasi judicial authority with full powers to look into all disputes related to GST implementation, both at the Centre and state level. Such an authority could issue guidelines, administer and enforce agreement between states and the Centre, and between the states themselves. A common Advance Ruling Authority for both the Centre and the states should also be put in place. Refunds Prompt refunds form the core of an effective GST framework, especially as cross-utilisation of input tax credit across CGST and SGST, are

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not envisaged. Delayed payment of refunds enhances the cost of dealer operations and reduces the efficiency of the tax system. The experience with refunds under the VAT regime is not reassuring, even though VAT laws in a number of states mandate payment of interest for delay. State Governments must adopt a more effective refund system. They could consider an electronic system where refunds are directly credited to the eligible dealers bank account. Selective Rollout VAT was introduced in a phased manner by State Governments over a period of nearly three years, between April 2003 and January 2008. VAT dealt purely with the treatment of intra-state sales and states were not explicitly disadvantaged if they did not implement VAT. Transactions between VAT and non-VAT states did not warrant special treatment. However, GST changes the rules of the game. It requires inter-state trade to be zero rated. It empowers states by including services as well as the manufacturing stage in their tax base. It thus creates an uneven balance between states which implement GST and those which do not. Goods and services sold between complying and non-complying states would thus require to be treated differently in the wake of selective implementation of GST. If CST were to continue to apply in non-complying states, inter-state sales would become further complex. Goods passing through a non-complying state, to be finally sold in a complying state, would be burdened by a cascading tax which would adversely affect the price to the final consumer. The seamless flow of Input Tax Credit (ITC) on inter-state transactions would be interrupted. Further, rate mismatches may encourage trade diversion and cost of compliance would become extremely high for inter-state dealers. This would discourage economies of scale. We, therefore, feel that the model GST should be implemented by all states and the Centre at one time, and not be partially implemented in some states. It is for this reason that we recommend that proper preparation for the GST and generating of a consensus amongst all states is a greater priority than complying with the 2010 deadline. However, as has been suggested in some quarters, it is possible for the Centre alone to transform the CENVAT into a GST at the manufacturing stage at any time. It could unify the CENVAT rates and impose a general tax on all services, while adopting a common threshold. As mentioned earlier, a dual tax on petroleum products, tobacco and alcohol could be levieda GST component and an additional levy component with no input credit being provided on the latter. Transition Provisions A number of transitional issues will arise. Provisions to address such issues must be consistent with the model GST. Benefits from Supporting the Model GST This Commission supports the implementation of a model GST for the following reasons:

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i.

The NCAER study computed the present value of GST-reform induced gains in GDP as the present value of additional income stream based on the discount rate of 3 percent representing the long-term real rate of interest. The present value of total gain in GDP is estimated as between Rs. 14.69 lakh crore and Rs. 28.81 lakh crore. The corresponding dollar values are US $325 billion and $637 billion. This represents between 25 and 50 percent of the 2009-10 GDP gained through this major tax reform. The all-government tax revenue will also increase by about 0.20 per cent of GDP, a significant increment to revenues through implementation of the model GST.

ii.

The Task Force report estimated that such a GST would have a tax base of around Rs. 31,00,000 crore. It further estimated that this would require a revenue-neutral rate of only 12 per cent (5 per cent for the Central GST and 7 per cent for the State GST). This is a substantial decrease from the present 20.5 per cent (8 per cent for CENVAT and 12.5 per cent for VAT). This should be the target. Adoption of such a model GST would make India a dynamic common market and also result in generation of positive externalities. Despite lower levels of taxes, the revenue of the Union and the states will be buoyant. Subsumation of all major indirect taxes will result in removal of inefficient taxes. Our manufactures will become more competitive and consequently exports will grow. Provision of seamless input tax credit across all transactions will avoid tax cascading, eliminate double taxation and improve resource allocation. It will foster a common market across the country, reorient supply chains and remove the present bias towards backward integration. Further, it will also inhibit tax induced migration of investment. It will, thus, support the growth of lagging but resource-rich regions. A single rate across all goods and services will eliminate classification disputes and make tax assessment more predictable. The harmonisation of tax assessment, levy and collection procedures across states proposed under the GST will reduce compliance costs, limit evasion, enhance transparency and improve collection efficiency.

iii.

iv.

v.

Successful implementation of GST also offers the possibility of strengthening the revenue base of local bodies that form the third tier of government. The inclusion of real estate in the GST tax base will constrain the parallel economy with consequent positive spillovers into governance and the development of land markets. The NCAER model suggests that GST could lead to better environmental outcomes.

vi.

vii.

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Concerns of State Governments We address below the principal concerns of states relating to revenue from certain products, loss of autonomy in a GST framework, possibilities of states entering GST in a phased manner and treatment of small enterprises. Revenue from Certain Products The model GST will accommodate the concerns of governments with regard to maintenance of their revenues from transmission fuels and sumptuary goods by allowing the imposition of an additional levy over and above the GST. Dilution of Fiscal Autonomy of States Concerns have been expressed by some state governments that the GST regime will constrict their fiscal autonomy and further tilt the vertical imbalance. However, this argument should be viewed in the following perspective: i) While the states will normally not be able to deviate from the nationally agreed model for the GST, such constraints will apply to the Centre as well. Further, the states still have fiscal headroom available. They can impose an additional levy on transmission fuels as well as sumptuary goods and the authority to levy temporary cesses and surcharges in case of emergencies, remains. They can also continue to levy user charges for services provided to citizens. Expenditure policy will continue to remain as a powerful fiscal instrument. Further, the strengthening of their fiscal base will improve their access to capital markets, enhancing their borrowing capacity. The tax base of State Governments will significantly increase with the inclusion of the tax on services as well as the tax on manufacture. The tax base of the Centre, on the other hand, will increase only to the extent of tax on sales. Thus, it cannot be said that the vertical imbalance will increase in favour of the Centre. States will benefit from the abolition of the cesses and surcharges presently being levied by the Centre, as the size of the divisible pool will rise. Presently this amounts to about 15 per cent of the divisible pool. Tax policy is tax administration, and significant scope exists for improving tax collection efficiency through implementation of GST. The GST grant recommended by this Commission compensates for the seeming limitation in fiscal autonomy by enhancing expenditure autonomy through compensation payments and additional formulaic transfers. The GST will be a landmark effort by the states and the Union to further co-operative federalism with all stakeholders contributing to national welfare by accepting its framework.

ii)

iii)

iv) v)

vi)

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Compensation Mechanism An objective compensation mechanism incorporated in the Grand Bargain will provide reassurance to both the Central and State Governments. This has been proposed in Para 5.60 of the Report. Checkposts Most states have put in place a system of checkposts on their border roads. There are a number of reasons for putting in place such physical barriers to trade. These include (i) enforcement of state excise, market cess, forest and vehicle fitness regulations; (ii) applicability of lower taxes on interstate trade than on intra-state trade; (iii) there being no tax on stock transfers; (iv) levy of entry tax on specified goods; (v) levy of octroi by some municipalities; and (vi) internal security. The onset of GST will not obviate all these reasons, and therefore, check posts on state borders may remain. However, it must be recognised that such checkposts, by the very nature of their operations, generate enormous delays in road traffic. The arrangement also encourages rent-seeking behaviour. It may be difficult to eliminate checkposts, given the valid concerns of State Governments. But what appears to be egregious is that the same vehicle has to pass through two checkpoststhe exporting states checkpost and the importing states checkpost - while crossing one border. Both these checkposts are often located within a couple of kilometres of each other and a transport vehicle has to spend considerable time at both. Perhaps, it may be possible for both states to put up a combined checkpost. Officials of both states could sit together and conduct their verifications in a single check post. Alternately, one state could handle traffic in one direction and the other state in the other direction, essentially ensuring that there would be only one check per border for a goods vehicle. Such an arrangement would significantly reduce travel time and we recommend it for consideration. There is an overwhelming rationale for minimising delays and thus reducing transaction costs. States could be encouraged to consider user-friendly options like electronically issued passes for transit traffic in order to reduce truck transit time through their states. The Grand Bargain We propose that both the Centre and the states conclude a Grand Bargain to implement the model GST. Keeping the experience of the implementation of VAT in mind, we suggest that the six elements of the Grand Bargain comprise: (i) the design of the GST; (ii) its operational modalities;(iii) binding agreement between Centre and states with contingencies for change in rates and procedures; (iv) disincentives for non compliance; (v) the implementation schedule and (vi) the procedure for states to claim compensation. The design of the model GST is suggested in paras 5.25 to 5.35. The operational modalities are outlined in paras 5.36 to 5.41. The proposed agreement between the Centre and states, with contingencies for changes in the agreement, is described in paras 5.49 to 5.51. The disincentives for non-compliance are described in paras 5.52. The

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implementation schedule is described in paras 5.57 to 5.59. The procedure for claiming compensation is at Para 5.60. Binding Agreement between Centre and States Compliance of states with the previously agreed upon guidelines for VAT has not been very uniform. A number of states have deviated from the three-tier VAT rates, thus indicating the need to put in place an enforcement mechanism. States are equally apprehensive that the Centre may unilaterally raise tax rates without consulting them. The Constitution does not envisage sharing of tax bases. Taxation powers are listed either in the State List or in the Central List, but not in the Concurrent List. For the first time since the Constitution was enacted, a tax base is proposed to be shared between the Centre and the states. It is, thus, necessary that a firm arrangement be put in place for implementing the GST to prevent deviations from the agreed upon model by either the Centre or the states. One option is the possibility of a Constitutional provision to facilitate a tax agreement between the Centre and the states on the lines of the erstwhile Article 278. One suggestion is that the new Article 278 could read: Notwithstanding anything in this Constitution, the Government of a state may enter into an agreement with the government of any other state or the union government with respect to the levy and collection of any tax or duty leviable by them, and during the period such agreement is in force, the power of such states and union as the case may be, to make laws to impose any tax shall be subject to the terms of such agreement. It has been argued that such a provision will eliminate the need to amend the taxing powers entrusted to the Union and the states through Schedule VII of the Constitution. Such an agreement (between the 28 states and the Centre as parties) could specify the tax rates adopted as well as the conditions under which the agreed tax rates can be changed. The agreement can be made part of Goods and Service Tax laws which the Center and all the states will separately enact. The agreement will, amongst other things, specify the rates to be adopted in these enactments and the implementation schedule. For amending the rates subsequently, it is proposed that all states would need to agree to a proposal to decrease rates. Only three quarters of the number of states would need to agree if the rates have to be increased. The Centre would have a veto power. All amendments to the agreement should be consistent with (i) maintaining the integrity of the GST base; (ii) providing for administrative simplicity and (c) minimizing compliance costs for taxpayers. The agreement will need to be monitored by the Empowered Committee which could be transformed after the implementation of GST into a Council of Finance Ministers with statutory backing.

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Disincentives for Non Compliance Keeping in mind the experience under VAT it may become necessary to deter violations of agreement by visiting a penalty on non-complying states. We recommend that Finance Commissions state specific grants and the states share of the GST incentive grant be withheld for the period during which a state is in violation of the agreement. If a state is in violation for only part of a year, its grant should be reduced to a proportionate extent.

Compensation/Incentive Grants This Commission is aware that the tenor of the ongoing discussions on the GST model and implementation modalities does not include some of the major elements of the model GST outlined above. In our view, any major deviation from the concept of the model GST would dilute its positive externalities, significantly reduce its benefits and reduce the incentive to switch over. For the reasons outlined in Para 5.42, this Commission strongly urges that any GST model adopted be consistent with the Grand Bargain described in Para 5.48. To incentivise implementation of such a Grand Bargain between the states and the Centre, this Commission recommends the sanction of a grant of Rs. 50,000 crore to be provided to all states in the aggregate, subject to the GST framework adopted being consistent with the Grand Bargain. We recognize that while GST on the whole will be revenue neutral, there may be some winners and losers during the initial years of implementation. This grant will accommodate claims for compensation from the adversely affected states and balance will be distributed amongst states as per the devolution formula. The grant of Rs. 50,000 crore would be used for meeting the compensation claims of State Governments between 2010-11 and 2014-15. Unspent balances in this pool would be distributed amongst all the states as per the devolution formula, on 1 January 2015. To allow for the possibility of implementation of GST during 2010- 11, we propose that the grant be initially allocated as given in Table 5.2: Table 5.2: Scheduling of GST Grant Years 2010 -11 2011 - 12 2012 - 13 2013 -14 2014 -15 Amount (Rs. crore) 5000 11250 11250 11250 11250

We see this allocation as substantial for two reasons. First, the Task Force estimation of RNR provides assurance that such a level of compensation may not be required. Second, the amount of compensation required will depend upon the year in which GST is implemented. The total amount of Rs. 50,000 crore may be earmarked for GST compensation and incentive provided the model GST is implemented before 31.3.2013.

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Unspent grants at the end of a year will be carried forward to the next year if GST is implemented before 31.3.2013. If GST is implemented during 2013-14, the grant will be restricted to Rs 40, 000 crore. If GST is implemented during 2014-15, the grant will be restricted to Rs 30,000 crore. To be eligible to draw down this grant, all the elements of the Grand Bargain outlined in Para 5.48 will need to be adopted. If the GST framework adopted is not consistent with this, then this Commission recommends that this grant of Rs. 50,000 crore not be disbursed. Thus, if the Grand Bargain is not concluded, this grant will not mean any net fiscal outgo. If a model GST is implemented and the grant is disbursed, then the resultant increase in GDP and tax revenue will fully finance it. If the Grand Bargain is not put in place, then the grant lapses. There are, thus, no fiscal risks with this grant - only advantages. Implementation schedule of the Model GST We recognise that building consensus on implementing the model GST may be an involved process but equally appreciate that the requirement of a good design is paramount and should not be subordinated to a deadline. International experience tells us that flaws in design are extremely difficult to correct subsequently. We therefore recommend that marginal rescheduling of the timetable for implementation should be acceptable if the design adopted is consistent with the model GST. The objective of the model GST is to optimize tax collection with minimal economic distortions. The Model GST should, inter alia, comprise of (i) a uniform rate for goods and services, (ii) a uniform rate across states, (iii) a zero rate for exports, and (iv) for all other goods and services a single rate, excluding the rate for precious metals. There could be two possible approaches to the implementation of the Model GST: the big-bang approach and the incremental approach. The introduction of the GST is the last mile in the reform of the indirect tax system of this country initiated in 1986 with the introduction of the MODVAT. All stakeholders stand to gain from a swift comprehensive changeover to the GST. To the extent the switchover is staggered, the potential gains from the comprehensive GST outlined in Para 5.42 would remain unrealised. Therefore, we recommend that all the elements of the model GST should be implemented comprehensively at one instance. However, we are aware that two essential elements of the model have not yet been formally discussed by the states and consensus needs to be built before they are adopted. These are the inclusion of stamp duty in the GST tax base to enable the taxation of real estate and the use of a single rate in the GST framework. More time may be required for these elements to be included in the GST framework. Given that the terminal year of the period covered by our recommendations is 2014- 15, we propose as follows. If found necessary, the GST may be initially implemented without these two elements provided that i) At the time of its implementation, the road map for their inclusion in the framework before 31 December 2014 is announced.

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ii) iii)

The GST is introduced with not more than two rates. Properties other than individually owned residential properties are brought into the ambit of GST within two years of its implementation.

This contingency does not preclude the possibility of the Centre implementing GST at an accelerated pace. Modalities for Disbursing Compensation As mentioned in Para 5.10, states had requested that an objective compensation mechanism to support possible revenue losses after implementing GST be put in place. We recommend the following: i. The present Empowered Committee be transformed into a statutory Council of Finance Ministers with representation from the Centre and states. A GST Compensation Fund should be created under the administrative control of this Council. The Central Government shall transfer to the GST Compensation Fund amounts as indicated in Table 5.2 and subject to the conditionalities indicated in paras 5.55 and 5.56. The amounts in the Fund should be used for compensating states for any revenue loss on account of adoption of the model GST and the Grand Bargain as indicated above. The balance, if any, remaining on 1 January 2015, will be distributed amongst the states on the basis of the devolution formula indicated in Chapter 8 of our report, used for distributing resources in the divisible pool amongst states. The amount will be disbursed in quarterly instalments on the basis of the recommendations made by a three-member Compensation Committee comprising of the Secretary, Department of Revenue, Government of India; Secretary to the EC and chaired by an eminent person with experience in public finance. This person would be appointed by the Union Government.

ii.

iii.

iv.

The Way Forward A number of legal and administrative steps need to be taken prior to the implementation of GST. These include stakeholder consultations, amendments to the Constitution and state laws, administrative reorganisation, preparation of GST registration, assessment and audit manuals, staff training and conduct of awareness campaigns amongst stakeholders. We have not touched upon these milestones in our discussion, but are aware that these processes may take substantial time. This is also a reason why we have earlier recommended that the putting in place an excellent design and operational framework for the GST should be given priority, even if this implies rescheduling the previously announced implementation timetable. We recognise that the process of generating a consensus to implement the Grand Bargain as outlined by us may be difficult and involved. However, we believe that such a consensus can, and should be, generated to fully exploit the potential of GST and reap the benefits of its positive externalities. While we would like to support this model GST, which is fully consumption

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based, has provision for seamless credit and imposes low compliance cost, we must allow for the possibility that political economy considerations may will otherwise. In the unlikely event that such a consensus cannot be achieved and the GST framework finally adopted is different from the Grand Bargain suggested by us, this Commission recommends that the grant amount of Rs. 50,000 crore shall not be disbursed. Impact of GST on Projections made by the Finance Commission Though GST requires that all cesses and surcharges be abolished, and this Commission recommends that GST be implemented as early as possible, we have, in our projections, assumed continuing revenue for the Central Government from cesses for the period 2010-15. This has been done for the following reasons. i. Ignoring the positive externalities of GST, the Commission has conservatively assumed that GST will be revenue-neutral. Thus, income from cesses and surcharges will be included in the computation of RNR. In the scenario when GST is implemented, the aggregate revenue figures in our projections will remain unchanged, though the accounting heads under which they are reported may change. Since the catalysing effect of GST on the economy has not been factored in our projections, they can be seen as conservative. A number of critical sectors, including roads, education, and calamity relief, are being funded from the proceeds of cesses levied by the Government of India. The transition plan to the GST must ensure that budget provisions are made to support such initiatives.

ii. iii.

The model, the modalities as well as the timing of implementation of the GST have not yet been finalised. Making projections over a five-year period, assuming the implementation of the GST during this period, would, be a hazardous exercise. This Commission has, thus, for the purpose of our financial projections, assumed that the impact of GST will be revenue-neutral and that the gross revenues of the Centre and states will not be lower than those projected even after GST is implemented. Summary of Recommendations Both the Centre and the states should conclude a Grand Bargain to implement the model GST. The Grand Bargain comprises five elements: (i) the design of the model GST is suggested in paras 5.25 to 5.35; (ii) the operational modalities are outlined in paras 5.36 to 5.41; (iii) the proposed agreement between the Centre and states, with contingencies for changes is at paras 5.49 to 5.51; (iv) the disincentives for non-compliance are described in paras 5.52 (v) the implementation schedule is described in paras 5.57 to 5.59. (vi) the procedure for claiming compensation is at Para 5.60 (Para 5.48). Any GST model adopted must be consistent with all the elements of the Grand Bargain. To incentivise implementation of the Grand Bargain this Commission recommends the sanction of a grant of Rs. 50,000 crore which will taper down to Rs. 40,000 crore and Rs. 30,000 crore if GST is

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implemented after 1.4.2013 and 1.4.2014 respectively. The grant would be used for meeting the compensation claims of State Governments for revenue losses on account of GST implemented, consistent with the Grand Bargain, between 2010-11 and 2014-15. Unspent balances in this pool would be distributed on 1 January 2015 amongst all the states as per the devolution formula (Paras 5.54 and 5.55). The EC should be given formal authority. The compensation should be disbursed in quarterly instalments on the basis of the recommendations by a three-member Compensation Committee comprising of the Secretary, Department of Revenue, Government of India; Secretary to the EC and chaired by an eminent person with experience in public finance to be appointed by the Central Government (Para 5.60). In the unlikely event that a consensus to implement all the elements of the Grand Bargain cannot be achieved and the GST mechanism finally adopted is different from the model GST suggested by us, this grant of Rs. 50, 000 crore shall not be disbursed (Para 5.62). States should take steps to reduce the transit time of cargo vehicles crossing its borders by combining checkposts with adjoining states and adopting user friendly options like electronically issued passes for transit traffic (Para 5.47).

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