The government may increase service tax to 15 per cent from April 2006 from 10 per cent at present.

An internal panel of the empowered committee of state finance ministers on the VAT has made this proposal to find ways to compensate states for revenue they will lose due to the proposed phase-out of central sales tax.

The panel, comprising state commercial tax commissioners, is of the opinion that the Centre should tax telecom and financial services. It has also proposed that tax on other services can be administered by states.

The panel, however, has said that for the time being, taxation of services can remain in the Union List of the Constitution and that the rate of tax be decided by the Centre.

The government had raised service tax from 8 per cent to 10 per cent in July 2004 as part of a move towards a common Cenvat and service tax rate. The Centre proposes to reduce Cenvat and raise service tax to achieve this over the next few years.

So, if the service tax is hiked, you will have to end up paying more on your credit cards, etc.

The Centre has been working towards bringing more services under the tax net. At present, tax is levied on 84 services, with telecom, insurance, brokerage, banking and other financial services accounting for nearly half the budgeted collections of Rs 17,500 crore (Rs 175 billion) in 2005-06.

The mop-up from service tax and the CST was estimated at Rs 30,500 crore (Rs 305 billion) during 2004-05. The panel has now estimated revenue from the two levies at Rs 35,000 crore (Rs 350 billion) for 2005-06 and Rs 40,500 crore (Rs 405 billion) for 2006-07. The panel has recommended that a negative list of services be kept out of the ambit of the tax.

Officials said though the empowered committee was keen to phase out the CST, a consensus had not been reached by states on alternative sources of revenue or on the compensation formula for the CST phase-out.

The panel's recommendations will be deliberated upon by the empowered committee before they are taken up with the finance ministry. In February, the ministry had sought comments from states on taxation of services.

In order to protect the present CST revenue of states, the panel has recommended that service tax collections be divided between the Centre and states in a ratio of 47.5:52.5. This 52.5 per cent will be distributed among states in the same proportion as their share of the all-India CST revenue for 2004-05.

The Centre's overall share (47.5 per cent) is proposed to be further divided. Of this,  69.5 per cent will remain with the Centre and 30.5 will go to  states, a formula worked out by  the Twelfth Finance Commission. This formula allows for 30.5 per cent all central taxes to be passed on to states.

In case states' service tax share of 52.5 per cent fall short of the projected CST revenue (by applying the average of the three best growth years out of the last five years with the base year revenue), the central government can compensate states, the panel has recommended.

The compensation formula is similar to the one implemented for value-added tax that entitles states to 100 per cent compensation for losses in the first year of implementation of the VAT.

In the second year, the compensation is pegged at 75 per cent, and for the third year, it is 50 per cent.

Road Ahead

• Telecom and financial services may be taxed by the Centre, others by states.
• A negative list to be prepared; minor unorganised services may be kept out.
• Inter-state services can be taxed at the point of consumption.
• Service tax collections to be centrally pooled and then shared between the Centre and the states.