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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