The Hindu Business Line : VAT 2005: Will it add value to economic reforms?

INITIAL hesitations about the Value Added Tax (VAT) regime have been finally resolved with the announcement by the Finance Minister, Mr P. Chidambaram, that VAT will be a reality, come April 2005. Only one State so far is dissenting and efforts are on to bring it round.

This writer is one of those who expressed reservations about moving over to VAT with a federal system like India's and its largely unlettered trading classes. I had particularly cited the example of the US, which has, to the best of my knowledge, stayed away from VAT for its own valid reasons.

There are complications in enforcing VAT in a fully federal set-up like ours. But with the announcement by Mr Chidambaram, the Rubicon has been crossed. The Empowered Committee under the leadership of Dr Asim Dasgupta has found it possible to work out a viable consensus among all the States.

As the Finance Minister himself pointed out, the country is now poised on the edge of one of the most radical reforms in tax structure since Independence. What precisely is in store with VAT 2005 is, however, in the womb of the future, given the political compulsions of different parties, notwithstanding the White Paper. This article tries to address some of the relevant issues. Admittedly, VAT is more efficient as a tax in the sense that it avoids cascading of taxes and renders self-policing easy. At the same time, it can breed sophisticated attempts at evasion, since evidence of tax paid on inputs is virtually a gateway to VAT refunds. Such evidence can be manipulated by those who specialise in tax avoidance. Experience in the UK and the EU with VAT has shown that large leakages are common in VAT, with false claims for refund. Our experience with Modvat had highlighted this when a CAG's enquiry showed thousands of crores of Modvat being evaded through false entries of inputs bearing excise duties.

The White Paper addresses most of these questions and concerns. It emphasises the potentiality of cross-checks with computerised information systems. This is, indeed, a desirable and timely change from traditional VAT systems, which had proceeded on paper trail-based verification.

The faith placed by the Empowered Committee in the advantages of computerisation incidentally shows the distance we have travelled since the early 1990s when computerisation was still new to the I-T Department notwithstanding hesitant starts in the 1980s.

Doubts are, however, being raised as to whether the proposed computerisation involving intense interaction with computers for every trader is feasible.

The success of VAT, which depends on its containment of false claims for VAT refund, will depend on the success of our efforts to effectively computerise the whole system and ensure freedom from glitches, some of which have been experienced in the direct tax administration system leading to delays in refunds and tax collections. Here is to hoping that Indian software experts will be able to handle the problem with their customary efficiency. But, the task of adequately educating the trading community as well as the sales tax administration of State is formidable, and requires careful and dedicated attention.

The proposals in the White Paper involve a sea-change in the sales tax administration of the country. Above all, the accumulated stock of legal pronouncements by various Tribunals and Courts relating to sales tax will have to be reinterpreted in the light of the new VAT legislation, unless the latter takes them into account. Hopefully, the VAT legislation will be simple and not a breeding ground for litigious actions.

The Finance Minister has indicated in the White Paper that Central Sales Tax (CST) will be phased out. This is a serious matter. It involves abandonment of upwards of Rs 15,000 crore of revenue. The replacement of CST will by itself create a number of complications in inter-State trade. Whether there will be a smooth transition from a CST-based trading pattern to a VAT-based one remains to be seen. Trade has by now got used to claiming the benefits of the relatively lower tax levied under CST on inter-State transactions.

While the White Paper has promised a transitional period for the current CST, what is to replace it is not clear, unless it be that VAT will be at standard rates for both intra-State and inter-State transactions.

The White Paper has not addressed frontally the issues posed by the Kelkar Task Force in regard to the States' rights to tax services. VAT by definition has to cover both services and goods. Maybe, I have read the White Paper wrong. But it does not come out clearly in favour of including services under the VAT net. This is, of course, a matter that the Finance Minister will have to address by empowering the States to levy service tax. It is logical that States should be so empowered. The question may be raised as to how precisely the Centre will compensate the States for their losses as a result of introduction of VAT. Prima facie, this argument goes against the logic behind the imposition of VAT, which is expected to enhance the revenues earned by the States by virtue of its combination transparency and efficiency. But the fact is that the Finance Minister has promised to compensate States for losses they may incur consequent on imposition of VAT.

How exactly are these losses to be assessed? The determination of losses suffered by particular States as a result of the introduction of VAT can be quite complex as it will involve a decision on what the ST revenues would have been in the absence of VAT. This, of course, depends on the assumptions regarding the general economic situation and the elasticity of the ST revenues. On the whole, it seems prudent to suggest that the issue be determined by a body similar to the Finance Commission. Ultimately, the success of VAT depends on the quality of administration, the state of data infrastructure and the cooperation of the trade and industry. Taking the last factor first, there is an understandable, albeit inexcusable, reluctance on some in the trade circles to cooperate with the new system.

This is due to the fact that the VAT data will disclose in effect what income the declarant makes — the income being the difference between the declared input costs and the value realised by sale of goods. There is a natural reluctance on the part of the trade to be honest. But the fact that being honest pays dividends in respect of VAT is the argument in favour of the new system. The direct tax administration, which will, no doubt, be a beneficiary of the additional information that VAT data will give it, will be able to catch in the income-tax net a large proportion of the traders and small businesses, who have so far been outside the net. This is one of the important side benefits of the introduction of VAT. But stressing too much on this side-dish may dampen the enthusiasm of the tax-payer for the main course.

"Hasten slowly" seems to be the preferred maxim to be followed by the direct tax administration, which hopes to mine the data disclosed by VAT. An initial period of forbearance in aggressively dealing with the VAT-exposed tax evaders with a firm assurance of enforcement in the longer run may encourage the reluctant trader into compliance with VAT.

The White Paper does not disclose clearly how the ultimate integration of Cenvat and State VAT will come out. This is particularly relevant in the case of textiles. The proposal to modify additional excise duty on sugar, textile and tobacco is part of the White Paper. When exactly this will be done is unclear. Additional excise duty on these commodities was introduced by T. T. Krishnamachari, when he was finance minister in the 1960s, to reduce the harassment of a large number of traders by sales tax officials. What will happen to the additional excise duty under the VAT regime is not clearly spelt out. What the White Paper states is that VAT on sugar, textiles and tobacco will not be imposed for one year after the adoption of VAT and thearrangements will continue.

Ultimately, Customs duties are also proposed to be made part of VAT. This is logical, considering that many exporters pay custom duties on the imports they make to produce their export goods. There seems to be some hesitation, however. A complete integration of customs duties with VAT is desirable. All in all, the VAT revolution promised by the White Paper is a desirable and definitive step forward in modernising and rationalising the tax structure of India. Continuing cooperation between States, the Centre, trade and industry has been in evidence during the deliberation of the Empowered Committee. This cooperation has to continue even while the authorities at different levels face the nuts and bolts of implementation.

One hopes that VAT 2005 will herald a new era of transparent, seamless and consumer-friendly tax system that adds value to our economic reform.

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