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VALUE ADDED TAX - The Need of the New Millennium

By

Mahesh C Purohit1

Evolution of value added tax (VAT) is the most important fiscal innovation of the present century. Beginning with the adoption of Taxe sur la Valeur Adjoutee by France in 1954, it wash gradually been adopted by other countries. But in recent years it has spread like a prairie fire through out the world bringing the total number of VAT countries to more than 160 with acceptability of a large number of Latin American, Asian, African and Pacific countries. Such increasing popularity of VAT has primarily been due to its taxonomy and administrative expediency.

 

 

 










 

India has been slow in adoption of VAT. In domestic trade taxes, it adopted excise duty at the central level and sales tax at the state level. The central government has attempted reforms in the union excise duties by introducing the principles of VAT since 1986. This was attempted through the introduction of Modvat. Since then the rates have been rationalised, exemptions have been reduced and the coverage has been extended to almost all the commodities commencing with 1991. It has, over the years, been converted into a central VAT.

On the front of the state sales taxes, which account for approximately 60 percent of the states own tax revenue, no reforms have so far been attempted. The existing sales tax system of the states is confronted with many weaknesses.

The first and foremost problem relates to its cascading effect. At present the sales tax is levied on the gross value without allowing any credit or set-off for the taxes paid on inputs (i.e., tax is levied on gross value). Consequently, it tends to create the phenomenon of cascading resulting in increased consumer prices by an amount higher than what accrues to the exchequer by way of revenues from it.

Second, the existing system results in an uncontrolled incidence of the tax. The total effective incidence on any given final product at the end of the chain of production-distribution process would be fortuitous. This is, however, not very clearly seen by the consumers because the tax system lacks transparency. This phenomenon of cumulative incidence resulting from a chain of taxes makes the exact calculations of tax incidence impossible.

Also, there is the problem of multiplicity of rates. All the states, in their attempt to have fine gradations of necessities, and luxuries, provide for plethora of rates. Quite a few states have as many as 12 rates; some of them have even 15 rate categories. These range from one to 25 per cent. This multiplicity of rates not only blunts the progressive effects that are intended but also creates the need for additional calculations by the dealers. In addition, this increases the cost of compliance while not really benefiting revenue.

Heterogeneity prevails in the structure of tax as well. This arises from the fact that apart from general sales tax, most states levy an additional sales tax or a surcharge. Additional tax is based either on their total turnover or on the graduated turnover with different rates for different slabs of turnover. Similar practices prevail in regard to surcharge. Some of the states levy both the additional sales tax and .the surcharge. In addition, the states levy luxury tax as also an entry tax on the sale of imported goods. All these practices of heterogeneity in structure as well as rates cause diversion of trade as well as shifting of manufacturing activity from one state to another.

An economic consequence of widespread taxation of inputs relates to vertical integration of firms, i.e., the existing system of taxes militates against ancillary industries and encourages them to produce more and more of the inputs needed rather than purchase them from ancillary industries.

Finally, the existing system of commodity taxes is non-neutral. It interferes with the producers' choice of inputs as well as with the consumers' choice of consumption, thereby leading to severe economic distortions2.

In view of the above deficiencies in the existing structure, it is important to have a system of value added tax at the state level. Such a system would take away all the above problems and would avoid the distorting economic effects. It. would not cause cascading, nor would it cause vertical integration of firms. Also, it provides total transparency of the incidence of tax. This is because, VAT is a multi-stage sales tax levied as a proportion of the value added (i.e. sales minus purchases which is equivalent to wages plus interest plus rent plus profits). It is collected at each stage of the production and distribution process, and in principle, its burden falls on the final consumer.

Efforts towards introduction of VAT have been under way during last many years. The Committees of States’ Finance Ministers (in 1995 and 1998, respectively) and of the Chief Ministers (in 1999) have put forth recommendations to replace sales tax by VAT. This has now been ratified by the Conference of the Chief Ministers and Finance Ministers held on November 16, 1999.

Prior to adoption of VAT, two major reforms have been adopted. The first reform relates to adoption of a four-rate structure i.e. zero, 4, 8 and 12 percent. In addition, there are two special rates of 1 percent and 20 percent for a few specified items. The rates recommended relate to floor rates- the states have the freedom to adopt higher rate on any of the commodities from the list, but they cannot go below these rates. This would put a brake on the rate war and prevent diversion of trade. The second reform relates to discontinuation of the sales tax based incentives to new industrial units. Until now, all the states were granting such incentives to new industries. These are given in the form of exemption from tax on the purchase of inputs as well as on the sale of finished goods. Incentives were also available in the form of sales tax loans and/or tax deferral. All the studies and the committee reports3 have given arguments against such incentives. It is rightly argued that incentives, when given by all the states, do not serve any useful purpose. All the states put together sacrifice about 25 percent of the sales tax base through such incentives. In addition, these incentives take the form of tax competition (war) and could be termed as harmful tax practices in a federation4.

After implementing the above reforms, the states would move to VAT without much difficulty. However, for the introduction of VAT it is important that some spadework attempted by the administration as well as the tax payers.

On the part of the administration it is most important requirement to have the operation of VAT through a single master file, based on unique tax identification number (TIN). The TIN should bear an economic activity code based on International Standard Industrial Classification. In addition, the TIN must have feasibility for comparison among different taxes such as state-VAT (the existing sales tax), central-VAT (known as Modvat) and income tax (including tax on corporate income). The TIN would also aid in drawing a comparison of tax statistics with the national accounts. In addition, it would facilitate proper use of the database of various systems.

To have effective and efficient governance of VAT, a prerequisite is to adopt suitable computational technology. It is absolutely necessary that a requisite system, suitable to the structure and administrative requirements of each state be selected. However, in adopting computer technology one must keep in mind the capacity of the computer system to be adopted. Indeed, it should not be too large creating under utilisation. At the same time in the selection of the system the principle of simplicity must be emphasised upon. More importantly, it is essential to have proper co-ordination among the states to adapt according to their requirement of software. Pooling their resources for developing requisite software programmes could be cost effective.

In most states training of the personnel needs prioritisation. Even with the existing sales tax system, the staff is not adequately trained. The training is all the more crucial when it comes to administering VAT. Hence, it is extremely important that the staff likely to handle VAT must be trained adequately at all levels.

Important aspect of reform relates to assessment of taxpayers. At present all the dealers are called in the office of the sales tax with books of accounts for assessment. This procedure is not cost-effective. It is important that we switch over to a system of selective assessment. Selection of cases for assessment has to be made in accordance with the various criteria, such as, size, turnover, risk evaluation. It might indeed be useful to cull out a fixed proportion of large and medium sized dealers for assessment on a regular basis. Further, the audit of VAT should be supplemented by cross-checking of invoices. The most important aspect relates to use of Discriminate Function System for audit selection. This function could use other relevant sources such as list of suppliers, number of taxpayers deviating from the normal trend, import data supplied by the customs department, and the information on the fast growing sectors of the economy.

In addition, a Model VAT Law for the implementation of VAT has already been prepared5. This Model Law prescribes all the rules and regulation for the implementation of VAT in the states.

On the part of the tax payers it is important that the requisite preparations are also attempted well in time. While such preparations would be different for small dealers depending upon the provisions for such dealers in the respective tax laws, for the large dealers, the experience of most countries indicate that there is a need for establishment of a Project Management Team, development of legislation and procedures and also the need for reengineering of the tax department. The most important aspect relates to the obligations of taxpayers in terms of developing accounting requirements under VAT. In this context it the interaction of invoices, books of accounts and suitable changes in the system to filing returns would go a long way in its proper implementation. Owing to the requirements of VAT the smooth functioning of VAT would critically depend upon taxpayers keeping careful and complete records. However, asking dealers to maintain more detailed accounts increases their compliance costs. The dealers must, therefore, maintain sufficient details to have information on the following aspects6:

  • Particulars of invoices giving details of tax on sales and credit on purchases,

  • Details of accounts giving information of all purchases and sales, and

  • Interaction between invoices, purchase and sales accounts with the tax return form.

Preparation on the above lines would gear both the tax machinery and tax payers in such a way that the administrative cost of VAT would be low and the compliance cost as well as the harassment to the taxpayers minimum.

A more important aspect for initiating reform process and to set the ball rolling relates to the central sales tax (CST). It is absolutely important that the central government provides leadership and takes a lead in reducing the rate of CST. It must immediately be brought down from 4 percent to 1 percent say by January 2002. The Union government must compensate the states for the loss of revenue; say a period of 3 to 5 years. Alternatively, the existing ‘origin based’ CST should be converted into a ‘destination based’ central purchase tax7.

With the adoption of VAT by the two tiers of government, India would have a system of dual VAT. There would a central VAT levied by the union government to replace the union excise duties and a state-VAT to replace the existing sales taxes with the states. Thus the domestic trade taxes would have two multi-point sales taxes with set-off for tax paid on purchases. These would be collected in installments at each transaction in the production distribution system. These would not have cascading effect due to the system of deduction or credit mechanism. These would be levied on consumption. The final and total burden of the tax is fully and exclusively borne by the domestic consumer and no VAT would be charged on goods exported.

The cascading effect of central VAT on state VAT and vice versa would still be there. The ultimate solution lies in adoption of a full state-VAT. Ultimately, the center has to withdraw from the field of commodity taxes (leaving aside a few items for its own purpose), and the states could have the full commodity tax regime to implement a comprehensive state VAT.


1 The author is a Professor at the National Institute of Public Finance and Policy, 18/2, Satsang Vihar Marg, Special Insititutional Area, New Delhi-110067 .

2 See for details Purohit, Mahesh C (2001), Sales tax and Value Added Tax in India,, Gayatri Publications, Delhi-110052.

3 See, especially the Report of the Finance Ministers Committee to Chart a Time Path for the Introduction of VAT (August 1998) and the Report of the Committee of Finance Secretaries for Identification of Backward Areas (November 1999).

4 The empirical studies attempted for the national capital region indicate that the concessions of sales tax do not affect the location of industry. The concession could be relevant, if at all, when given by one state alone. Similar results are seen from the other studies as well. When all the states give such concessions, such concessions result in zero sum game. No state benefits from these concessions. See for details, Purohit, Mahesh C et. el.(1992),Fiscal Policy for the NCR Region, Vikas Publishing House, New Delhi. In most countries of European Union or OECD some regional development incentives are offered. only through income tax. These are akin to the backward area incentives already prevalent in the Indian Income Tax Law. There are no schemes of incentives in place, which are related to sales tax (VAT-type) instruments.

5 See, NIPFP (1999), Model Sales Tax Value Added Law, the National Institute of Public Finance and Policy, New Delhi.

6 See for details Purohit, Mahesh C (2002), Value Added Tax: How to Comply with It? Gayatri Publications, Delhi-110052 (Forthcoming).

7 See for details Purohit, Mahesh C (2001), Sales Tax and VAT in Inida op.cit. chapter 5.

 

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