The Telegraph
Since 1st March, 1999
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- If VAT survives, it will do so in a compromised form

The author is professor of economics, Indian Statistical Institute, Calcutta

To state finance ministers, VAT might be a Very Attractive Tax, but in the perception of the trader-producer lobby, which declared a bandh recently, it is Vicious, Autocratic and Tyrannical. The poor finance minister at the Centre is caught between the devil and the deep blue sea. With elections round the corner, political exigency requires that the VAT be shelved for a while.

Let us relax therefore in dubious comfort as the rattling streetcar of our economy struggles past the next electoral jam and ponder over such prosaic matters as the definition and logical implications of VAT, read this time as a Value-Added Tax. “Value-added” represents the difference between the value of produce and its cost of production. Imagine that you own a Chinese restaurant and charge Rs 150 for a bowl of chicken soup, paying Rs 80 for the ingredients that you use to cook it. Then the value you have added is Rs 150-Rs 80 = Rs 70.

The latter is a measure of your production, the transformation you have caused to the materials of production (the raw chicken, the vegetables, the sauce, the fuel), which represent production by others. Note that the cost of labour you incur (to pay for your cook’s and waiters’ salaries) is included in the value added, which means that Rs 70 must cover the wages and salaries you pay out and leave you with a profit to continue in business. Thus, the value added by a business enterprise during a financial year is also the sum of the profit and labour incomes it has generated. Just as the value added by a single producer is his contribution to production, the value added by producers constituting the entire business sector is its aggregate value of production. And it is simultaneously the total of incomes earned there.

After a customer finishes his soup at your restaurant, he pays you not Rs 150, but a bit more, say, Rs 159, the extra representing a sales tax of 6 per cent. But this may not be the only tax he pays. The hidden tax (not revealed by your restaurant bill) could include a tax on the raw material itself. For example, if your recipe includes cooking wine and the latter attracts a sales tax, then you have paid for it while buying the wine. But your price of Rs 150 per plate covers that expense. Hence, you are passing on that tax to the customer. What’s more, the 6 per cent tax on your sale is taxing the cooking wine component of your product a second time. Economists describe this phenomenon as a cascading effect, tax on a tax, like a surcharge we pay on our income tax.

The sales tax introduces a wedge between what a consumer pays for a product and the producer’s cost plus profit. Moreover, the difference magnifies in proportion to the cascading effects, causing thereby price distortions. Distortions are a drag on welfare, because in their absence, the consumer could have paid less for the same product and have an excess left for other pursuits.

But then, is that really true' Who after all earns the tax revenue' It is the government that receives it and uses it to pay for the salary of the personnel it employs as well as other administrative expenses. In the absence of the revenue, there may be no policeman to ensure that you enjoy your soup in peace and the man sitting at the next table doesn’t snatch it away. So the loss that you suffer on account of the wedge represented by the tax has to be weighed against the welfare gain from the safety you are assured by the state.

The question that obviously comes up therefore is whether the tax system could be improved upon to reduce the consumer’s welfare loss without sacrificing the services generated by the government. As far as the first issue goes, one must look for a way of narrowing the gap between the producer’s price (Rs 150 in our example) and the consumer’s price (Rs 159). The second issue calls for protecting the government’s revenues. Some believe that the VAT is the answer to the prayer.

Suppose then that sales taxes at all stages of production (the tax on the chicken-feed to produce the chicken, the tax on the chicken, the tax on the soup) are done away with. Instead, a tax is levied on the value added alone. In our restaurant case, Rs 80 would represent wages and profits in the raw material firms. The producers will pay a tax on it, but it cannot be charged to you, because any extra receipt over Rs 80 gets counted as extra value added and hence taxed. Similarly, you pay a tax on the Rs 70 of value you have added, but cannot transfer it to the consumer, or else your value added increases commensurately and so does the tax. Consequently, the aggregate value added, hence income created, at successive stages of production, equals exactly what the consumers spend.

Replacing the sales tax by a value added tax is then equivalent to imposing a distortionless tax on aggregate wage costs and profits of business. Does this improve the government’s revenue' To answer the question, let us try out yet another example.

Assume that the aggregate of values added is Rs 100 and that the VAT rate is 6 per cent. Then, in reality, only Rs 94 accrues as wages and profits net of a VAT of Rs 6. Thus, 94/100 is the share of the value of business output that the private income earners may expect to command, while the government’s command is 6/100. As opposed to this, consider a sales tax of 6 per cent at the final stages of production only (that is, a tax on the soup alone, but not the chicken, to avoid the cascading effect). Then incomes equal Rs 100, but consumers spend Rs 106. The respective shares in the final value of output are 100/106 and 6/106. The government’s share is clearly higher for the former case. (Of course, it might increase in the second case in the presence of the cascading effects.) Besides, the sales tax scenario would escalate the welfare loss discussed earlier, which is absent with the VAT, where the producer’s and consumer’s prices are identical.

The VAT, therefore, is non-distortionary and improves the government’s command over business output. Yet, it does not avoid double taxation altogether. After all, the business sector would not be paying a VAT alone. It must pay a direct tax on its incomes also, in the form of a profits tax. Even if the sales tax is discontinued, the profits tax will stay. Consequently, business firms would be paying taxes on their profits twice, first as a tax on value added and then as a tax on profit. (Wages too are taxed twice. The first time as part of value added and paid for by the employer and the second time as wages and salaries in the hands of the households.) There is ample reason indeed for business to call a bandh!

Traditionally, the Centre collects the income tax and allots hyenas’ shares to the states. With mounting expenditures, sometimes irresponsibly conceived, both the states and the Centre are in the doldrums. The VAT leads to a change in that scenario. It creates a backdoor route for the states to stake a claim in the income tax and a glorious excuse for the Centre not to share its revenues with the states. But neither party can wish away the political importance of business interests either.

If VAT survives, it will do so in a compromised form. An economist, alas, cannot predict the details. As always, it is the politician who will call the tune.

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