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Wednesday, Jan 16, 2002

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Outbound logistics and local taxes

Janat Shah
Balram Avittathur

THE increase in competition and the swings in the economy in the last few years are forcing Indian firms to cut costs and improve customer service. With the induction of technology and better manufacturing practices in the last few years, many firms feel the scope to improve efficiency within the factory premises has substantially narrowed. However, the situation is quite different when it comes to outbound logistics.

Despite many initiatives, empirical data suggests that efficiency can be improved in outbound logistics. Thus, more firms are concentrating on improving this area. Considering the explosion in product variety and markets, this mindset is crucial for the profitable running of firms. So, it would be worthwhile to understand the impact of the current sales and other state taxes structure on the logistics performance of Indian firms.

The main components of logistics costs are inventory, transportation and warehousing costs. Some important drivers of these costs are tariffs such as Central sales tax, local sales tax, entry tax, octroi, turnover tax, etc. Many of these taxes are State subjects. Traditionally, there has been no mutual consultations or agreement among the States on making taxes uniform. The local sales tax rates vary significantly between States.

The States have also been competing with one another in offering sales tax concessions to attract investment proposals, making decisions such as the location of manufacturing facilities, warehouses, etc, dependent on these taxes. Many firms locate manufacturing facilities either to use backward area concessions or to take advantage of sales tax concessions.

If these facilities are located in areas with poor transport infrastructure, far from the markets, the savings made in setting up the facility are lost because of the increased transportation and inventory-related costs.

The present CST structure has more or less ensured that firms maintain at least a depot in each State, such that the material flow to the retail outlets in a particular state happens only from the depots of that State.

For instance, from the logistics efficiency viewpoint, despatching material from the Bangalore depot to a retail outlet at Hosur (Tamil Nadu), 40 km from Bangalore, would be easier than doing it from the Chennai depot. However, to avoid the CST burden, a firm will despatch material to Hosur only from Chennai depot. Hence, companies will have to work with State boundaries rather than geographical convenience for logistics planning. The inventory level is directly proportional to the square root of the number of inventory points. Apart from high inventory costs and higher warehousing costs, more depots result in higher co-ordination and establishment (facilities) costs. The issue is more significant as companies strive to network their stock-points through IT.

The present ST structure also presents another drawback. The closely-knit value chain comprising multiple firms — each focussing on competencies — is likely to perform better than a vertically integrated entity. In the current structure, value chains comprising multiple firms will have to pay sales tax at each inter-firm material transaction, resulting in a cascading effect. A vertically integrated firm does not suffer from this cascading effect as material transactions within firm do not attract sales tax. The proposed concept of value added tax (VAT) on the lines of MODVAT for excise duty would remove this anomaly. It is clear that an ST regimen as disparate and loosely co-ordinated as in India results in transportation through longer distances on inferior roads. This results in longer and uncertain lead times, higher inventories and higher fuel costs.

It is common knowledge that the State borders are centres of corruption, smuggling and harassment. According to experts, smuggled goods (across States to evade taxes) account for 15 per cent of the total goods flow. A fair share of corporate resources are spent in paper work and clearing various formalities. Many firms have full-fledged departments just to follow up with the various departments on local taxes. It is also common knowledge that truck operators have to spend much time at State borders.

The present ST regimen contributes substantially to high levels of finished goods inventories in the manufacturing, logistics and retailing sectors. The holding of large inventories is detrimental to firms and developing economies that suffer from scarcity of financial resources. At present, the average finished goods inventory for the entire Indian manufacturing sector is about 40 days.

Various studies of the retailing sector indicate that average finished goods inventory in the outbound logistics and retail segments of the supply chain are 90-100 days. As the manufacturing sector accounts for about $140 billion of GDP, the above statistics means that $50 billion is locked in inventories. Reducing this inventory by 10 per cent, in this instance, would release $5 billion of scarce capital.

Given the present system's drawbacks and from the supply-chain management point of view, it would be worthwhile to search for simpler and more efficient alternatives, while ensuring that the government revenues are maintained. In fact, a simpler mechanism would enable higher compliance of tax rules.

The recent efforts by the Centre and States in ensuring uniform ST floor rates are a significant step in the right direction. These are expected to reduce distortions in material movement and reduce incentives for smuggling. The Council of States also decided recently to avoid competitive concessions offered in terms of local tax holidays. VAT is a positive attempt at addressing the anomalies in the logistics sector.

However, minimum sales tax by itself will not ensure a more efficient logistics set-up. A uniform and single sales tax rate is required. A single authority (either the Central Government or a body constituted by the Council of States) to whom firms can pay sales tax directly (such as excise duty) is an option the Government should seriously consider. This agency will be responsible for the distribution of taxes to the respective States on the basis of consumption. This will eliminate the need to maintain the vast number of sales tax offices at State borders with large manpower and paper work. It would substantially cut transport lead-times, traffic jams at the borders, corruption and harassment.

As Indian firms prepare to take on global competition, there is an urgent need for the Union and local governments to wake up to the need of restructuring local taxes along the above lines. This will also ensure level-playing fields for Indian firms while competing with world class firms.

(Janat Shah is Professor, IIM, Bangalore, and Balram Avittathur is Assistant Professor, IIM, Calcutta.)

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