TCYONLINE

WE COACH THE NATION

VALUE ADDED TAX

The Need of the New Millennium

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 about 160 nations
have adopted VAT primarily due to its taxonomy and administrative expediency.

India has been rather slow in adoption of VAT. 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 ( modified VAT). 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.

But VAT has not been seen as the favorite taxing system by most of the states. The state
sales taxes, which account for approximately 60 percent of the states own tax revenue, no
reforms have so far been attempted and they are still sticking to highly inefficient taxing
procedure.

The basic problem with their system is that 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.

Then there is the problem of multiplicity of rates that vary from state to state varying from
10 to as high as 15. These range from one to 25 per cent. This multiplicity of rates along
with retarding the progressive impetus also create the need of unnecessary calculations on
part of tax payers. In addition, this increases the cost of compliance while not really
benefiting revenue.

The tax structure also suffers from unwanted variation. The reason is; that apart from
general sales tax, most states levy an additional sales tax or a surcharge. Additional
tax/surcharge is based either on their total turnover or on the graduated turnover with
different rates for different slabs of turnover. 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.

TOP CAREERS & YOU

www.tcyonline.com/topedge
topedge@tcyonline.com
+91-161-460-908, 461-364
TCYONLINE
WE COACH THE NATION

One of the most common results of this highly heterogenic tax system is the practice of
the manufacturers to go for vertical integration thereby reducing the chances of external
purchases.

Finally, the existing system of commodity taxes is biased. It interrupts with the producers'
choice of inputs as well as with the consumers' choice of consumption, thereby leading to
severe economic distortions.

Thats why the system like VAT is becoming need of the hour. 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-tier structure of 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.

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 Cenvat) 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

TOP CAREERS & YOU

www.tcyonline.com/topedge
topedge@tcyonline.com
+91-161-460-908, 461-364
TCYONLINE
WE COACH THE NATION

system to be adopted. Indeed, it should not be too large creating under utilization. At the
same time in the selection of the system the principle of simplicity must be emphasized
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 prioritization. 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.

On the part of the tax payers it is important that the requisite preparations are also
attempted well in time. The most important aspect relates to the obligations of taxpayers
in terms of developing accounting requirements under VAT. Owing to the requirements of
VAT the smooth functioning of VAT would critically depend upon taxpayers keeping careful
and complete records.

Preparations 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; a period of 3 to 5 years. Alternatively,
the existing origin based CST should be converted into a destination based central
purchase tax.

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.

TOP CAREERS & YOU

www.tcyonline.com/topedge
topedge@tcyonline.com
+91-161-460-908, 461-364