Oh VAT a lovely tax

Indian Express, 24 June 2004

The State Value Added Tax will certainly spur efficiency and revenue collection but everything depends on its proper implementation

The government has announced that State Value Added Tax (VAT) will be introduced from April 2005. The NDA had planned to introduce State VAT two years ago but did not succeed as the implementation capacity was and still is absent. This fresh resolve is welcome, as the VAT increases efficiency and reduces distortions. The economy benefits greatly from the increase in productivity that follows from the rationalisation of the tax system. The government benefits from higher revenue collections.

What is good about VAT?

VAT removes the cascading effect of production taxes. Think of the price that is paid by a consumer who buys a refrigerator. When the steel manufacturer sells steel to the producer of refrigerators, the manufacturer pays excise to the government. When the refrigerator is sold, it is charged excise. The consumer pays tax twice. This gives strong incentives to manufacturers to go in for ‘vertical integration’, where many steps of production are put into a single big factory. This is inefficient, because it makes more sense to source components and services from a web of most-efficient producers, spread all over the country.

How does VAT avoid cascading effects?

The VAT does not tax inputs. In this system, the VAT is imposed only on the value that is added by a producer. The seller of the refrigerator is not required to pay tax on the full price of the refrigerator, but only on the value he adds. His ‘‘value added’’ is the value of output minus the value of inputs.

How is VAT implemented?

VAT is implemented through a system of tax credits. The invoice that goes from the steel producer to the refrigerator producer shows two separate items: the price of the steel, and the VAT paid. The refrigerator manufacturer is given a discount on his VAT obligations to the extent that he has invoices in his pocket, of goods purchased by him, where there was a VAT already embedded.

What about fake invoices?

The refrigerator manufacturer can go to the tax authority and claim large credits using fake invoices. This is exactly like the problem of TDS certificates in income tax. In order to address this, each invoice needs an identifying number given by the IT system used by the government. This number would be used to verify that the tax credits being claimed are real.

Why does VAT reduce tax evasion?

Under the old excise system, the refrigerator producers have an incentive to buy inputs from tax evaders, who sell steel at a lower price (since they are not paying excise). Under a VAT, an invoice for steel which has paid VAT is precious for the refrigerator manufacturer, since it directly reduces his tax liability. This is called ‘‘the system of VAT credits’’ which generates an economy-wide improvement in tax compliance and a reduction of black money.

The international experience is strongly supportive of this: Even though VAT gives credits for tax on input purchases, tax revenues go up when the VAT is introduced. The VAT gets political support when it is seen as being more fair, that everyone pays taxes without powerful people managing to evade taxes.

Why do we still have Central Excise and not VAT?

From 1986 onwards, there has been a slow movement from Central Excise towards a VAT. Much progress was made when Yashwant Sinha was Finance Minister in the NDA government. Today, the bulk of what is called ‘‘Central Excise’’ is actually a VAT (called CENVAT), except for excise on petroleum products which is still an excise.

The big weak link is the service tax, which stands separate from excise, and is not a VAT. Producers of services do not get credits for the tax embedded in their manufacturing input purchases. Similarly, manufacturers do not get credits for the tax embedded in their services purchases.

So in short, we have an odd situation: Most goods are in a central VAT, but petroleum products are governed by central excise. Some services are charged an excise and most services are tax exempt. This mess needs to be replaced by a single VAT on all goods and services, as is the case in advanced countries.

Why is VAT refunded when goods leave the country?

Countries keep their exports competitive by not charging their producers domestic taxes. Similarly, when goods come into the country, they are charged the Indian VAT at the point of entry. At the point of export, the VAT gets refunded to the exporter (who could be a passenger on a flight). A country thus taxes only goods that are consumed within the country. Countries that do not have a proper VAT system are putting their exporters at a disadvantage.

So what is State VAT?

States in India currently charge octroi at the entry point, sales tax, and excise duty on a few items like alcohol. It is these taxes that the State VAT proposes to replace. This would eliminate cascading taxes. And, the most important outcome of the introduction of State VAT would be the removal of hindrances in the movement of goods across the country. This is expected to lead to a sharp increase in productivity across all states, a reduction in working capital, and swift movement of many perishables that currently suffer long delays at state borders.

What is the goal?

Trucks will move across India without interruption. A truck will zip at 100 kmph on the new NHAI roads, going from Delhi to Mumbai in 13 hours, without stopping on the way. At present, this takes days owing to the interruptions on the way caused by State Governments.

What can go wrong?

The State VAT can go horribly wrong if we end up with ‘‘customs checkpoints’’ at the boundary of every State, to refund State VAT on ‘‘exported’’ goods and to charge State VAT on ‘‘imported’’ goods. This would fragment India as if we were 28 separate countries. This would possibly be worse than the existing situation. Trucks would definitely not make it from Delhi to Mumbai in 13 hours, so the entire goal would be defeated.

Hence, the key challenge lies in implementation. A good information technology system needs to be built whereby VAT payments from firms across the country are captured in a single database, credits for each State are calculated and payments are made to the State where the value-add took place. This will only work with a sophisticated IT system and sound implementation capacity in all States.

The other area of confusion is about how petroleum products will be treated, how other goods will be treated, and how services will be treated. The central tax system is confused on this, and this confusion will spread to the States. There is a need for clarity about moving to a single VAT on all production. Multiple different rates and rules for different kinds of production will produce a complex and corruption-ridden system.

The system should reduce the cost of compliance to the tax-payer. If the State VAT results in each producer dealing with dual tax administration, more forms, multiple identity numbers and innumerable tax officials, the cost of paying taxes will remain high. The system should provide the tax-payer one single interface with the government who can then sort out how much tax goes to the Central Government, how much to one State and how much to another. Much of the euphoria about VAT needs to be tempered in the light of these implementation challenge. So far, neither the Ministry of Finance, nor the State Governments, have shown any gameplan about how they plan to overcome these problems.

Ila Patnaik