Under VAT, each state provides tax credits to manufacturers for inputs sourced from within its borders but not for those coming from outside. The Centre continued to levy a tax of 4 per cent on such goods and distribute the proceeds among the states. Evidently, the inability of the present system to capture all transactions occurring within the boundaries of a state, regardless of where the goods come from, has necessitated the continuance of the CST. It follows that the case for continuing with the CST will disappear if the states move towards a totally harmonious system under VAT. Although some progress has been achieved here, the goal is still elusive.

The other major shortcoming was the less than universal coverage of the scheme, when it was introduced less than two years ago. With Tamil Nadu having joined in, Uttar Pradesh is the only large state still staying away. The timing of the moves to taper off the CST - initially it will be brought down to 3 per cent from the present 4 per cent - seems propitious.

Currently, central sales tax (CST) is levied on inter-state trade by the Centre and distributed to the states, over the next four years-for which they will be compensated financially. It is yet another move towards an eventual national goods and services tax (GST), which, envisioned to be in place by 2010, would integrate central and state taxes on both goods and services. In so far as GST adheres to the canons of simplicity, coherence and equity in taxation, this is a good goal. And CST deserves to go. As a tax, it is a relic of the past. Its manner of imposition is a nightmare for businesses, and its cascading impact on prices (since rebates cannot be claimed) is an efficiency deadweight.

It is incompatible with the Value-Added Tax (VAT) regime favoured by states that have seen the logic of a system that charges only on value-added, allowing for set-offs against taxes already paid on inputs. VAT is efficiency-enhancing not just because it does not overburden commercial activity, it incentivises a disaggregation of the value chain into specialised components, resulting over time in better resource allocation. It also encourages tax evaders to clean up their act, especially those that have narrow value-addition margins and can set off large sums.

Clearly, VAT is the way ahead. Yet, if VAT worried some people, the CST phase-out has worried some states. They fear the loss of a tax base that has been flush with money. Compensation, thus, was at the core of the wrangle. In May last year, state finance ministers demanded at least half the entire central service tax collections (and also additional powers to tax 124 intra-state services) in lieu of forgoing CST revenues. Since then, however, the states' VAT revenues have been so strong-state VAT grew 26.1 per cent during April-October 2006-that the state finance ministers have scaled down their demand for compensation.

VAT logic is taking hold. But it is time to settle the irreularities in the current state VAT regime in the interests of greater uniformity and transparency. Often, the same products attract varying VAT rates across different states. Though the state VAT regime envisages a uniform tax structure with two main rates of 4 per cent and 12 per cent, there have been gross deviations (a special rate of 1 per cent here, an exemption there). Non-VAT products such as petrol also have varied levies across states. In such boom times, convergence should be easier to push for.