The Telegraph
Since 1st March, 1999
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- Like many economic policies, VAT has its gainers and losers

The value added tax, or VAT for short, which has been introduced in 21 states in the country last April, is certainly one of the most controversial pieces of economic policy adopted in the recent past. To the unprepared commoner it is also the most confusing. Indeed, like many other economic policies, VAT has its gainers and losers. This implies conflicts of interest, disagreements and strifes. But the sound and the fury have been magnified by the fact that a number of separate issues have cropped up with the introduction of the new tax regime. The warring groups, who seem to be opposing or supporting the new system, are often doing so to express their disapproval of or endorsement for one particular issue, rather than for the system as a whole. To understand the merits or demerits of the new system it is necessary to understand some of the issues.

One can, in fact, identify a number of policy objectives associated with the VAT. Here we shall be concerned with a couple of them. First, the new system aims at removing multiple taxation and the resultant cascading tax burden, which was prevalent under the old sales tax regime. Second, the tax reform intends to abolish the complicated multiple categorization of commodities with each category attracting a different tax rate. It tries to simplify the tax structure by introducing only two basic VAT rates of 4 per cent and 12.5 per cent for most commodities apart from a specific category of tax-exempted goods. The proponents of VAT claim that these policy changes will reduce the tax burden of buyers and sellers, decrease final prices, and increase the tax revenue of the government. To appreciate the merits of these claims one needs to have a deeper understanding of the new system and for that purpose it is helpful to consider an example.

Start with the old sales tax regime. Suppose, for simplicity, there is a uniform 10 per cent tax rate levied on the sales of all commodities. Consider a producer who buys intermediate goods worth Rs 1,000 and pays in addition tax of Rs 100 (at the rate of 10 per cent) on the purchase. He adds value worth Rs 900, which includes wages and profits, to the intermediate goods.

Therefore, when he sells the final output it is worth Rs 2,000, which of course includes the tax of Rs 100 paid on the intermediate goods. On this Rs 2,000 a further tax is levied at the rate of 10 per cent when the commodity is sold by the producer to the final consumer. The final consumer pays a price of Rs 2,200 of which Rs 1,000 goes to the intermediate goods supplier, Rs 900 to the final goods producer and Rs 300 to the government as tax revenue. Two things are to be noted. First, in the example, the total value added, which basically measures the value of goods produced, is Rs 1,900. The tax rate, though announced to be 10 per cent, is effectively more than 15 per cent of the value added.

Second, the tax burden is more than 10 per cent because of double taxation and taxation of taxes paid on earlier stages of production. Since the value of the intermediate goods is added to the value of the final goods, the intermediate goods is being taxed twice. Moreover, the tax of Rs 100 paid at the intermediate stage is added to the final price and so the consumer is paying a tax on this amount as well. By taxing economic transactions at every stage, the sales tax regime is discouraging economic transactions and encouraging giant vertically integrated firms, which can produce their own intermediate inputs. Clearly, such forced vertical integration can not be efficient.

As already indicated, one of the main purposes of the new regime is to get rid of double taxation. In our example if VAT is introduced, assuming the tax rate remains unchanged at 10 per cent, the final producer can claim a tax refund of Rs 100 which he has already paid while purchasing intermediate inputs.

This directly reduces the tax burden of the producer and the tax revenue of the government but has an ambiguous effect on the final price. It is possible that the whole tax benefit is absorbed by the producer as additional profits. In that case the final price will remain unchanged. But if there is some competition in the market, it is rather likely that the producer will try to make use of the tax cut to gain some additional customers by reducing the price. If he does so his competitors will follow suit and there will be a general fall in prices. In any case, if the tax rate remains constant, the introduction of VAT may either reduce the price or, in the worst situation, keep them constant. In other words, a switch from sales tax to VAT, with tax rates remaining the same, can never raise prices.

The tax rates are not remaining constant though. Simplification of the tax structure by bringing down almost all commodities either to the 4 per cent or to the 12.5 per cent category involves reduction in the tax rates of some commodities and increase in some others compared to the previous levels. So if we look at a particular commodity, its tax rate and price may go up after VAT is introduced. It is to be understood that this price increase is not because of the adoption of VAT as such, but on account of recategorization of commodities. The flip side is that, owing to the same reason, the prices of some other goods must fall. Moreover, even if the tax rate on a particular commodity goes up in the new regime, the tax rate on its inputs might go down. Because of this and the removal of double taxation, the final price might actually go down even when the tax rate on the final commodity has gone up. On the whole, therefore, VAT is expected to reduce prices and even if it induces a price increase of certain commodities, it is not likely to be significant.

What are the traders unhappy about then' Why are they on strike' They should be glad that the tax burden and prices are going down on the average. They should be pleased that the business environment is becoming less distortionary.

There is yet another puzzle. If the tax burden is to go down on an average, how can government revenue increase' The answer to both questions is basically the same. The government is expecting to earn more revenue because VAT is expected to bring transparency to the tax system and drag a significant number of taxpayers under the tax net. Tax credit under VAT is possible only if documentary evidence is produced to the government. This is expected to force buyers to ask for a receipt from sellers, making transactions transparent and overt. This, in turn, is expected to raise tax receipts in the long run. In the short run, however, tax revenue might fall due to the direct effect of removing double taxation. That is why the Central government has promised to compensate the states for their loss of revenues in the short run.

The traders are indeed apprehending that they would have to pay more taxes in the long run. This seems to be the real cause of their discontent. Of course, it cannot be projected as a legitimate reason for resorting to long strikes and so other issues are being highlighted. Some point out that it would be too costly to do the paper work required by the new system. Others point to the possibility of increased corruption and harassment in the hands of dishonest tax officials. None of the fears is well-founded though. If a trader finds it costly to do the paper work, he has the option of paying a smaller tax on his gross turnover and forgo the tax credit. Similarly, corruption can not make a trader worse off because he will never be asked to pay a bribe exceeding the amount of his tax credit. The crux of the matter, therefore, is that traders in general hate to pay taxes and the new system is threatening them to do exactly that.

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