The empowered committee of state finance ministers on the value-added tax has come up with a formula for the compensation to be paid by the Centre to the states for implementing the proposed tax.

According to the proposal, the compensation package will be capped at 10 per cent of the shortfall in the projected total general sales tax collections in the state for the relevant year. The proposal has been circulated among the state governments.

The Centre has committed to compensate the entire loss borne by states during the first year of implementation of the VAT. This is to come down to 75 per cent and 50 per cent in the second and third year, respectively.

The Centre and states are pushing for introduction of a VAT regime from April 2005.

The formula will be discussed at the meeting of state finance ministers on November 2, when a final decision is likely to be taken.

"Though the cap will not be binding, its objective is to ensure that the states do not become slack in ensuring better tax compliance and collections," an official said.

For example, if in the second year of the VAT rollout a state earned Rs 80 compared with the Rs 100 it would have normally earned under the existing general sales tax system, the Centre would reimburse 75 per cent of the loss of Rs 20 suffered by the state. Under the proposed formula, the state would thus only get Rs 15 as compensation from the Centre.

The empowered committee is of the view that the compensation mechanism should be designed to minimise inverse incentives that may arise from an open compensation proposal.

"This is critical for the states, since slackness in the initial years of introduction of the new tax can permanently distort the tax system and adversely impact revenue productivity in the long run," the official said.

The compensation for the revenue loss incurred by the states will be released monthly, based on figures provided by the finance secretaries of the states.