VAT to GST

India’s Shift Switch over from Value Added Tax to Goods and Service Tax:

A Stock Taking

           

Abstract

India has witnessed substantial reforms in indirect taxes over the past two decades with the replacement of State sales taxes by Value Added Tax (VAT) in 2005 marking a watershed in this regard. Prior to VAT implementation, the tax structure was considered problematic primarily due to the “cascading effect of taxes” whereby an item is taxed more than once from the production to the final retail sales stage. Exporters were also becoming less competitive in the international market due to the huge input costs involved (tax burden of a commodity increases manifold as it is taxed repeatedly) through the earlier sales tax mode – reflected in higher prices of products as compared to global competitors. To avoid this kind of a tax structure, VAT was introduced so that taxes are paid on the “value added portion” by each producer and the hurdles of the cascading effect are done away with. But shortcomings were also noticed in the VAT structure and efforts were made to further rationalise the system. For instance, a number of Central taxes like customs duty, surcharge were not included in Central Value Added Tax (CENVAT) while indirect taxes at the State level such as entertainment and luxury taxes were left out of the purview of VAT.The major problem with VAT is that CENVAT on certain commodities remains included in the value of goods to be taxed under State VAT. Thus, the same set of goods is taxed repeatedly – once by the Centre and then by the State. Moreover, since VAT is applied on goods only (tax on services in India is a complicated issue due to various exemptions and definitional problems), there is also the task of calculating tax on services and adding it to the VAT on goods. The government has therefore recognised the need for harmonisation of goods and services tax so that both can be levied in a comprehensive and rational manner in a new taxation regime – Goods and Services Tax (GST).

1.      Introduction

India has witnessed substantial reforms in indirect taxes over the past two decades with the replacement of State sales taxes by Value Added Tax (VAT) in 2005 marking a watershed in this regard. Prior to VAT implementation, the tax structure was considered problematic primarily due to the “cascading effect of taxes” whereby an item is taxed more than once from the production to the final retail sales stage. Exporters were also becoming less competitive in the international market due to the huge input costs involved (tax burden of a commodity increases manifold as it is taxed repeatedly) through the earlier sales tax mode – reflected in higher prices of products as compared to global competitors. (Poddar, S and Ehtisham Ahmad, 2009).

To avoid this kind of a tax structure, VAT was introduced so that taxes are paid on the “value added portion” by each producer and the hurdles of the cascading effect are done away with. But shortcomings were also noticed in the VAT structure and efforts were made to further rationalise the system. For instance, a number of Central taxes like customs duty, surcharge were not included in Central Value Added Tax (CENVAT) while indirect taxes at the State level such as entertainment and luxury taxes were left out of the purview of VAT.

The major problem with VAT is that CENVAT on certain commodities remains included in the value of goods to be taxed under State VAT. Thus, the same set of goods is taxed repeatedly – once by the Centre and then by the State. Moreover, since VAT is applied on goods only (tax on services in India is a complicated issue due to various exemptions and definitional problems), there is also the task of calculating tax on services and adding it to the VAT on goods. (Government of India (nd.)) The government has therefore recognised the need for harmonisation of goods and services tax so that both can be levied in a comprehensive and rational manner in a new taxation regime – Goods and Services Tax (GST).

2.      The Indian Tax Structure before Value Added Tax (VAT)

The tax system that prevailed before VAT was subject to “multiple taxation” that can be better understood through the following illustration:

Generally, any tax is related to the selling price of a product i.e., tax is imposed on the price at which a product is sold. Suppose there are three producers in an economy – A, B and C. Producer A is the initial producer who does not have any input costs. Producer A’s output is supplied to B and that of B is supplied to C. Assuming that the output value of producer A is Rs.1000 and a tax is imposed on it at a 10 % rate, B would get the output at Rs.1100 (inclusive of tax at 10 %). A sells the output to B inclusive of tax, failing which A would have to pay the tax from his/her own pocket. Producer B carries out further processing and his/her output value is Rs. 1500. (Output value might be anything, depending on the profit and conversion considerations of producer B.)

Table 1: Cascading Effect (or Tax-Upon-Tax) of Sales Tax (Amount in Rs.)
Producer/ Manufacturer	Cost of Input	Value of Output	Tax Rate	Selling Price Including Tax Rate	Tax Burden
Producer A	_	1000	10 %	1100 (1000 + 10% of 1000)	100
Producer B	1100	1500	10 %	1650(1500 + 10 % of 1500)	150
Producer C	1650	2000	10 %	2200(2000 + 10 % of 2000)	200

While selling the product to C, B will set the price of output incorporating tax (again at the rate of 10 %). Thus, C will get the item at Rs. 1650 (1500 + 10 % tax on Rs.1500). Supposing producer C decides the output value at Rs.2000, he/she would perhaps sell the product at Rs.2200 and not at Rs.2000 (inclusive of 10 % tax rate, i.e., Selling Price = Rs.2000 + 10 % of Rs.2000)

As the stages of production and/or sales continue, each subsequent purchaser has to pay tax repeatedly on the output that has already been taxed. The important point is that the same product is being taxed more than once at different stages of production and the problem is that the tax burden on the final consumer is enormous (Table 1). This kind of a taxation system has given rise to a number of problems as follows:

There might be a tendency to escape / evade the tax liabilities. As production and sales continue, the tax burden increases. (In the above example, A passes a tax burden of Rs.100 to B and B passes Rs.150 to C.) If tax evasion increases, government tax revenue would decline. 

If tax rates are not uniform at different stages of production, it is very difficult to measure overall tax content of a product. (If more producers - A, B, C, D, E, F and G – are considered and if tax rate deviates from 10 % to 15 % and 20 % at different stages, the calculation at the final stage would be very cumbersome and increase administrative costs.) This also creates lack of transparency in the overall tax system. Households are subject to heavy tax burden as the taxes are passed on at every stage till the final consumer.

Tax burden has made Indian products less competitive in the international market. As manufacturers and exporters need to pay higher tax rates at later stages of production, it would not be possible for them to sell products at lower prices in the international market. If they cannot sell the product at prices less than or similar to their international competitors, they will find that the demand for their product declines.

3.      Implementation of VAT in India

VAT was introduced in the Indian taxation system from April 1, 2005 in an effort to address the problems associated with the earlier Sales Tax. India is one of the 123 countries across the world that is following the VAT mode, which is an improvement in several respects. In the previous example, ‘value added’ by B is only Rs.500 (1500 –1000).

To clarify, the price (value) set on the final product by producer B is Rs.1500 (value of producer B’s output), and he/she has purchased input at Rs.1000 (value of output of A).

Now, tax on producer B would be only Rs.50 (i.e., 10 % of Rs. 500) while the tax paid in reality was Rs. 150 (10 % of Rs. 1500). (Note that in the former case, tax is paid on the ‘value added’ while in the latter, it is paid on ‘selling price’ as well as the difference of the tax burden in the two cases). For practical purposes, VAT can be calculated in the following manner:

™™                        Input tax for B is Rs.100 (i.e. tax on output of A)

™™                        Output tax for B is Rs.150 (i.e. 10 % of Rs.1500)

™™                        VAT = Output tax - Input tax = 150-100 = Rs.50

In VAT, the idea is that B will pay tax on only Rs. 500, i.e. value added by him/her. This is called the “tax credit method”, which means the deduction of tax paid on inputs from tax collected on sales. There are other methods by which VAT can be calculated such as the ‘Subtraction method’ wherein the tax rate is applied to the difference between the value of output and cost of input [i.e., on the value added portion, Tax Liability = T (Value of Output-Cost of Input) where T is tax rate)]. In India, the tax credit method is generally used. Then, it does not matter whether a product passes one or many stages, as every producer will pay tax only on value added by him/her to the product and not on the selling price of the product.

GST would also follow the “Tax Credit Method”. However, the essence of GST is to correct certain shortcomings of VAT like bringing services under a cogent tax net, which is not possible under the VAT system. (Bird, M. R. and Pierre-Pascal Gendron, 2005). Hence, GST has been modeled as an extension of the current VAT that would make the tax system more comprehensive and smoother in its functioning.

4.      Shortcomings with VAT

The VAT system is definitely an improvement over the earlier one in the sense that it is more transparent and curbs tax evasion to some extent, thus generating more revenue for the government. Being less cumbersome, it reduces administrative costs as also eases the tax burden on the final consumer. But despite its advantages, a number of drawbacks of VAT have become apparent, both at the Central as well as the State level.

4.1.Elevated rate of output tax

A major problem with VAT is the way it taxes inputs and outputs. Inputs are taxed at four percent and outputs at 12.5 percent. Taxing inputs and outputs at different rates are problematic because what is input in one case can be output in another. For instance, sugar is an input for a restaurant but for a household it is an output (Govinda Rao, M., 2009).  Therefore, there is a potential tendency to avoid output tax as the tax is relatively higher than input tax (a margin of 8.5 percent).

4.2.Exemption games

Another problem is the number of exemptions for some sensitive products (e.g. exemption on food items) and different rates of taxation (e.g. luxurious items are likely to be taxed at higher rates than necessary items). Be that as it may, the VAT system cannot be blamed (at least the theoretical context), given the political set-up and implementation failures due to various legal loopholes.

The above problem is particularly evident in the case of CENVAT and service tax. Ideally, the tax base should include all types of services with a limited list of exclusions but the government is unwilling to adopt such a tax base due to apprehensions that a number of services that are politically sensitive would be subsumed under it. The prevailing CENVAT system lacks optimal design and has multiple tax rates whereby it treats goods and services separately and differentiates between commodities covered under Maximum Retail Price (MRP) and other commodities.

At the State level, the problem arises due to classification of goods under different tax schedules. In general, the expectation is that lower tax rates be applied to necessary commodities consumed by the poor. But, this is not so in State level VAT. For instance, the lowest rate of one percent is applicable to precious metals, jewellery and related products not consumed by the marginalized sections of society. The medium rate of four percent is applicable to basic necessities (and to a range of industrial inputs and IT products). As a result, it becomes difficult for retailers to determine the tax rate applicable to a particular item without referring to the legislative schedules.

4.3.Gray areas

There are several gray areas, which are creating confusion. One cannot decide whether it is exempted or not.  The State VAT tax design also lacks clarity in case of taxing pharmaceuticals and works contracts. The VAT is applied in a presumptive manner rather than through a specified mechanism.

4.4.Doors for manipulation

Another problem with VAT is that manufacturers can manipulate the system by false invoicing (claiming lesser value added than the actual) through an understanding among themselves in order to evade tax burden, thus generating lower tax revenue.

4.5.Lack of consensus

Further, where the government takes into account the poor people, the tax system would be differentiated. On the other hand, a differentiated tax structure would complicate the administrative process and an evaluation of the impact of the tax design would become difficult due to differential rates. This is applicable in particular for VAT. Now, there can be unending disagreements and debates regarding what should be the optimal tax policy.

5.   Dreams of Ideal Taxation system

However, the most prominent issues that a tax system must be amenable to are:

5.1.   Simple: The tax system must be simple (the more complicated it would be, the more would be the administrative and/or compliance cost¹ and tendency towards tax evasion)

5.2.   Conducive: The tax system should be conducive to a certain amount of revenue for the government.

5.3.    Fair and Redistributive: Fairness is key to a good tax system in which the poor would end up paying less proportionally of their revenue than the rich.

5.4.    Representative: It needs to be ensured that the poor and their interest groups can be represented in tax policy making, so that policies are being continuously improved for the benefit of the widest possible constituency of citizens. This requires transparency and the possibility to have a dialogue over tax policies with stakeholders.

In this context, it is argued that there should be a harmonization in the tax laws and tax rates across the country at the Centre and State level for better compliance and enforcement of tax system.

6.      Rationale for Goods and Services Tax (GST)

Despite the success of VAT in the context of the Indian economy, there are still certain shortcomings in the structure of VAT both at the Central and at the State level as discussed earlier.

•         Limitations in Centre VAT system: There is CENVAT but several taxes are still out of the ambit like surcharges, additional customs duties etc. In some goods we get input tax and not in others, making the tax filing system complex and cumbersome.

•         Limitations in State VAT system: The States also have VAT but again story is the same. Many taxes like luxury taxes, entertainment tax etc, are not included. There is no input tax credit in case of CENVAT paid on certain items.

•         Interstate Sales Tax (CST): Though it is an important source of revenue for states it is seen as very burdensome by businesses. The companies make goods in one state but on distribution inside the country; end up paying taxes in each state. They are supplying goods within the country and should just be taxed at one place.

•         Inclusion of Services in VAT system: Production of goods is because of both physical production and services. But Services are taxed only by Centre and that too is done selectively.  The Services need to be taxed at State level and integrated with the Goods VAT system. In the VAT system, taxing service sector is practically difficult. First, due to the tremendous advancement of the information technology and digitization, the distinction between goods and services has become very complicated. In Indian context, the definition of goods is so framed that it should include intangibles like copyright and software. However, software upgrades (which are goods) can be supplied as part of a contract for software repair as well as maintenance services. Some other examples where an object can be ‘services’ and ‘goods’ simultaneously are as follows-

An on-line subscription to newspapers could be viewed as service, but online purchase and download of a magazine or a book would be treated as a purchase of goods. Telecommunication services (for instance, wallpaper for mobile phones, ring tones, jokes, cricket scores and weather reports) also have similar problems, as some of them are treated as goods. Nowadays, goods and services are being packaged as composite bundles and sold to final consumers under a range of supply-chain arrangements. Hence, there is a lacuna in the existing VAT system where the aspect of taxing services is not very clear-cut.

•      International Standard: GST is becoming an international standard and it is important India also has one. There are many factors before international companies while choosing a country for its business and taxation system is one very important factor. With other countries having GST and India not having one, the companies are likely to opt for former ahead of India for locating their businesses. Likewise Indian companies may also prefer to increasingly set their bases in other countries where tax system is more efficient.

•         Eliminates multiplicity of taxes, rates and exemptions.

•         Eliminates cascading effect (‘tax on tax’) created by existing indirect taxes

•          Eliminates dual taxation of the same transaction

•     Only one returns to improve the efficiency in administration.

•          Increase in collection of revenue due to simplification.

•          Ensures uniformity of taxes across the territory, regardless of place of manufacture or distribution

Integration of various taxes into a GST system would make it possible to give full credit for inputs taxes collected. GST, being a destination-based consumption tax based on VAT principle, would also greatly help in removing economic distortions and will help in development of a common national market.

As pointed out by Mahesh Purohit (2007), one of the pioneers in tax policy, under the present system of VAT, services should also come under its net. In his words, ‘Historically, India’s indirect tax system is unique given that under the Constitution, the Union government has the authority to impose a broad spectrum of excise duties on production or manufacture while States are assigned the power to levy tax on the sale of goods. Due to this dichotomy of authority under the Constitution, India has been rather slow in the adoption of VAT. Today, India has adopted a model of dual VAT, replacing Union excise duty with CENVAT and sales tax with State VAT. From an economic stand point, there is hardly any difference between the taxation of commodities and that of services. Therefore, under this system of dual VAT, it is of paramount importance that in addition to goods, services also come under its net. The exclusion of services causes many administrative problems and paves the way for evasion of tax.

The current attempt of GST is also to rectify that. Under the Goods and Services Tax, each manufacturer needs to pay a GST, which is the difference of her ‘output tax’ and ‘input tax’. Hence, it can be said, GST is a comprehensive value added tax levied on goods and services. In a GST regime, goods and services are not differentiated as they move through the supply chain.

7.      Objectives of GST

i.  The most important objective of this new initiative for GST is to amend certain aspects of the Constitution of India in order to make it very clear which objects to be taxed by the States and Centre. Unless such amendments are made it would be difficult to operate GST in an optimal manner. For GST to be effective, it is essential that the States should be given the power of levy of taxation of all services. This power of levy of service taxes has so long been only with the Centre. A Constitutional Amendment Act (CAA) will be made for giving this power also to the States

ii.Another important objective of GST is to remove the burden of Central Sales Tax (CST). When there is a transaction across the States (for example, suppose a buyer in Kerala purchases a product from a seller from Tamil Nadu, the tax on the product is collected by the Center (which is the Central Sales Tax or CST). With the operation of GST, there is no need of CST, since there would be a continuous chain of set-off from the original producer to the final retailer, and all the taxes would be included under a single umbrella of GST. This would reduce the additional burden (administrative and compliance cost) of CST. Moreover, at present there is a massive tax evasion of CST despite of the reduction in tax rates. Apart from this, the CST becomes problematic due to absence of any ‘set-off’ mechanism² and unnecessary ‘tax burden’ across inter-State transactions.

8.      Justification for GST

In fact, the Centre and States have decided not to reduce the Central Sales Tax (CST) rate further. Instead, the tax will be completely withdrawn once the proposed goods and services tax (GST) is introduced. Therefore, the GST at the State level can be justified for the following reasons-

™™   Additional power of levy of taxation of services for the States

™™   Removal of the cascading burdens of CENVAT and service taxes

™™   Inclusion of a number of taxes in the GST

™™   Removal of burden of Central Sales Tax (CST).

9.      Conclusion

As India is embarking on a Goods and Services Tax regime, the major issues that have come up for discussion are the following: Options to the States to join the GST regime; federal and State rates of taxation; place of supply rules; dual authority and so on. The States are concerned about their fiscal autonomy, the model of taxation, loss of revenue and compliance costs for small traders. As regards the models of taxation it is evident that a GST regime is possible with several states following their own VAT systems with differing rates. This will obviously solve the fear of fiscal autonomy of the states. The states have the discretion to move in and out of the GST regime. The system will then accommodate a central GST together with some states having independent VATs. The rates could also be different across the states solving the fear of revenue loss. It is preferable that exemptions are the minimum, but ignoring political pressure may be costly for implementing the system. Independent VAT systems can have varying thresholds, but once harmonized with the GST system the thresholds will have to be uniform. As regards the place of supply rule of taxation, while the predominant practice is to go by the destination principle, there could be deviations from it.

Notes:

1.      A compliance cost is expenditure in terms of time or money to conform to government requirements such as legislation or regulation. For example, in case of filing a tax people have the extra burden of having to keep detailed records of all input tax and output tax to facilitate the completion of tax returns. This may necessitate them having to employ someone skilled in this field, which would be regarded a compliance cost. In fact, tax filing and administration comprises of a number of factors, like data requirements, system of tax rulings and interpretations, procedures for registration, filing and processing of tax returns, tax payments and refunds, audits etc. A rationalised tax structure is helpful in reducing the compliance cost.

2.      The Net tax liability of any registered dealer or manufacturer is calculated by deducting or setting-off input tax credit (i.e. the tax on the inputs and all previous purchases that she/he has used in order to produce her/his output. She/he is entitled to get that from Central government on claim.

References

1.    Bird, M. R. and Pierre-Pascal Gendron(October 2005): ‘VAT Revisited: A New Look at the Value Added Tax in Developing and Transitional Countries’

2.    Government of India (nd.): First Discussion Paper on GST: Comments of the Department of Revenue (DoR), Ministry of Finance, Government of India, on the URL:http://dor. gov.in/writereaddata%5CGOODS%20AND%20SRVICES%20 TAX%5Cgo.

3.    Mahesh C. P.(13 August,2007):‘State VAT should include more services’,Financial Express, URL:http://www.financialexpress.com/...vat...services/210017/ - United States

4.    Poddar, S and Ehtisham Ahmad (March 2009): ‘GST Reforms and Inter governmental Considerations in India’ Working Paper No.1, Department of Economic Affairs, Ministry of Finance, Government of India.

5.    Rao, M. G. (December 19, 2009):‘Goods and Services Tax: Some Progress towards Clarity’, Economic & Political WEEKLY, Vol. XLIV No 12