| Weighing options
The value added tax, the economists’ darling, has become a political hot potato. The original deadline for its introduction was April 1. Then it was postponed to June 1. By the latest count, only 11 states have agreed to introduce VAT from that date. That, too, in a patchwork fashion.
First, one blatant misconception. According to a well-known newspaper columnist, this has been forced on India by the World Trade Organization. This is simply not true. Introduction of VAT is not an obligation under any WTO agreement. In any case, the issue should be whether VAT is good for the country, irrespective of who suggested it. But why are economists, by and large, in favour of VAT and traders and politicians generally opposed to it'
The most important argument in favour of VAT is that it would replace the state sales tax which double-taxes inputs. Take the case of a jeweller. Under the sales tax regime, he has to pay a sales tax when he buys gold. The tax paid on gold purchase gets added to his cost of production. Later, when he sells the gold ornament he has to pay the sales tax as a percentage of his total cost of production up to that point. This means that the input gold gets taxed twice. Under VAT, the jeweller would have to pay VAT when he sells jewellery but he would get a credit on taxes already paid on gold purchase. So, the tax on tax is avoided. The final consumer ends up paying a lower price if the rate of VAT is the same as the rate of sales tax.
You may wonder what happens to the government’s tax revenue. Effectively, the tax rate is going down and that should reduce total tax collection. Here the second benefit comes in. Under the current sales tax system, large-scale tax-evasion takes place. In our example, no cash memo for sales may be issued by the seller of gold to the jeweller. No sales tax is paid. The jeweller would agree to do so since his cost of production would be less if he can avoid the tax. The seller of gold, by keeping the transaction unrecorded, may also reduce his income tax liability. But under VAT, the jeweller can get a tax credit against his future tax liability (when he is selling jewellery ) only if he produces a proper receipt for the tax already paid on gold. So he is more likely to insist on getting proper cash memos. Similarly, when he sells the ornament he would like to maintain sales and tax records by issuing proper receipts to the buyer of jewellery. If he is not paying taxes at that stage, he cannot get the credit for taxes paid at input stage. So, the incentive to hide transactions would be less at all stages. Thus, even with lower effective tax rate, the total tax collection may go up. This has nothing to do with higher volume of sales. It is not suggested that all tax evasion will be plugged but the multi-point recording, better audit-trail and changed incentives should make it more difficult.
The cascading effect of the current sales tax regime produces other undesirable consequences. For example, it encourages in-house production of inputs as that saves the tax at purchase of input stage. In other words, it discourages outsourcing or development of ancillary industries. The sales tax on tax, by raising the cost and price of a domestically produced product, also adversely affects the competitiveness of Indian products vis-à-vis imports.
Transparency and simplification are the other supposed advantages of a full-fledged VAT when it would replace the central sales tax and myriad other state level levies (such as turnover tax, octroi, entry tax, special additional duty and so on) along with a plethora of tax incentives and exemptions. If VAT is the only state-level tax payable when a consumer is buying a product and the rate of tax is known, it would be easy for him to calculate his exact tax liability. At present, the consumer is often at the mercy of the seller regarding the implication of the “local taxes extra” label on a product.
This advantage, however, would not be available the way VAT is being introduced at the moment. CST on inter-state sales of goods would co-exist with state level VAT. The other state levies and exemptions would also continue. Moreover, the non-VATable status of CST means that a manufacturer buying inputs from another state would have to pay the CST at 4 per cent but will not get the input tax credit. This would discourage firms to buy inputs from other states. By the same token, a firm selling its output in another state would have to pay the CST but a competing firm from within the state would be exempt from the tax. All these would undermine the goal of a unified Indian market.
Why are traders up in arms' As already explained, tax evasion would become more difficult. Traders would have to maintain records properly at both input and output stages, which means more paperwork and accounting cost. Finally, they complain that prices would go up which would affect their business.
Tax evasion becoming more difficult is certainly an argument in favour, not against, VAT. Traders with an annual turnover of Rs 5 lakh would be totally exempt from VAT. Those with turnover between Rs 5 lakh and 40 lakh can also opt out of VAT in favour of a turnover tax which would require less record-keeping and paperwork. Thus, problems of “small” traders are being taken care of.
Will VAT raise prices' At present, sales tax on most products are at 8 per cent rate. VAT would have three rates — 1 per cent, 4 per cent, and 12.5 per cent. So, prices of some products may go up if the applicable VAT rate is higher than earlier sales tax. Similarly, prices of some products would fall. In fact, if the VAT rate is the same as the sales tax for a product, the price should come down as the tax on tax is eliminated. In response to popular demand, the proposed VAT rate on medicines has been brought down from 12.5 per cent to 4 per cent. The same may happen for some other essential products.
Will there be revenue loss for the states' VAT rates for different products have been set in such a way that it remains revenue neutral overall. Of course, the subsequent lowering of VAT on drugs and some other products may imply some net revenue loss. Since only some states would be implementing VAT from June 1, the CST at the unchanged 4 per cent rate would continue. The states get a 75 per cent share in CST revenue which would not be affected for the time being. Later, as most states go for VAT, the CST rate would be gradually brought down to zero. The revenue from widened service tax net would also be shared with the states to make up for any revenue loss. Finally, if states still lose revenue, the Centre would compensate 100 per cent of the loss in the first year and partially in the subsequent years.
Finally, the problems of implementation. Efficient administration of VAT over the entire manufacturing and trading chain would require thorough computerization and training of officials at tax departments. Some teething troubles are inevitable at the initial stages.
It is important to keep all stake holders, including traders and ordinary consumers, informed about the implications and to put in place a speedy redressal mechanism for their grievances. Of course, resistance from tax dodgers and some politicians catering to the traders’ lobby is unavoidable. Such resistance can be liquidated over time only by speedy implementation of a full-fledged VAT, together with vigorous campaigns to educate the public about its advantages.