Fiscal restructuring in the context of trade reform

Fiscal restructuring for India today must explicitly factor in the impact of trade tariff reform, which has resulted in an uncompensated drop in tax/GDP, of two percentage points (by actuals available upto 2001-02) relative to the pre-reform peak of 16 percent of GDP. The Twelfth Finance Commission is explicitly charged in its terms of reference with raising tax/GDP from present levels. The theoretical literature suggests that revenue compensation for lost trade revenues be sourced from domestic indirect taxes, and recommends a price-neutral destination-based VAT as the optimal instrument. In a federal setting, this will reduce relative tax collections at national level, where trade tariffs are levied, in favour of the subnational level, with which rights to levy domestic indirect taxes are typically shared. Possible resistance to such a restructuring, and the level from which it could originate will be a function of the history of collection shares in the federation; of the relative shares of discretionary and formulaic transfers from national to subnational level; and of the relative importance of redistributive criteria in formulaic transfers. The paper explores these issues for the Indian fiscal federation, and concludes that resistance to reduction in the revenue collection share of the centre is most likely to originate at subnational level. Coupled with the absence of any international empirical evidence on revenue enhancement from introducing a VAT, especially in low-income countries, fiscal restructuring in India has to seek ways by which to enhance revenue collections at the level of the centre rather than at the level of states.