The Hindu Business Line : Why panic about what VAT will do to prices

A changeover to VAT does not result in any sustained increase in the price level. In most of the cases, it had caused a one-time initial rise in prices, which is reported to be happening in the States which switched to VAT on April 1.

IN THE run-up to the introduction of the Value Added Tax, a common concern, particularly among traders, was the possible inflationary effect of the regime. In fact, such apprehension was not uncommon among countries that introduced VAT. More significantly, the governments were concerned about how consumers would react to any effect on prices. VAT critics try to attribute any price rise to the tax. For instance, they argue that unlike sales tax, the VAT system allows for only limited exemptions, as these break the input tax credit chain.

Consequently, many untaxed commodities in the sales tax system would be taxed under VAT. Also, if under the sales tax system a commodity is taxed only at the first-stage of sale, then VAT on that commodity might raise the total tax burden. This is because, under VAT, tax is levied at each stage of production and distribution of a commodity. However, one cannot ignore the offsetting beneficial effect on prices of the input tax credits provided in a VAT system.

There are news reports of price increases in some of the States that have migrated to the VAT system. In Kerala, for instance, there are reports of poultry prices going up since April 1, as the tax on chicken is now 12.5 per cent against the 9.2 per cent levied under the sales tax regime. Again, the retail prices of leather footwear, it is said, would go up by 10 per cent, with the VAT on it being 12.5 per cent against 8 per cent earlier. In Andhra Pradesh, oil companies hiked petrol and diesel prices soon after VAT came into effect. The reasons given are: One, the tax on petrol and diesel are 2 percentage points more now than earlier. And, two, oil companies are able to pass on the 2 per cent turnover tax levied on them to consumers, as the tax is recoverable under the VAT system.

In Delhi, the prices of used-cars are expected to go up, as 4 per cent VAT has been introduced in the place of a flat sales tax of Rs 750.

Considering these developments, what would be the likely price effect of the switchover to VAT? This is not easy to quantify. The problem in most countries is to find sufficient data to allow ex ante estimates. Still, some generalisations are possible. But before that, it is important to clarify the possible ways of interpreting the price effect of VAT and to what extent the interpretations are valid. If the price effect is interpreted as a continuous increase in the inflation rate, then the inference should be viewed with scepticism. VAT, by itself, cannot lead to any sustained increase in the price level. This is possible only under an expansive monetary policy. None of the VAT-complaint countries faced any sustained price increases. On the other hand, if the price effect is interpreted as a one-time increase in prices, then whether VAT has an inflationary effect depends on a number of factors, which are as follows:

VAT design

The underlying intention behind introducing VAT can influence prices. Conventionally, it is argued that if VAT is introduced with the objective of replacing an existing tax in a revenue-neutral manner — that is, to mobilise the same amount of revenues as under the existing tax — then VAT would have no impact on the aggregate price level, as the aggregate demand in this case is unchanged. This conclusion is based on the presumption that the VAT induces no aggregate supply response from the private sector and, therefore, the budget constraint for the private sector remains unchanged.

If, however, the VAT regime causes an increase in aggregate output owing to higher production efficiency, then there is every possibility of a downward pressure on prices.

Tax shifting and factor earnings

Another important factor influencing prices is the extent of tax shifting. In general, manufacturers and traders attempt to shift the full VAT liability forward at each stage of the production and distribution chain because, under VAT, they act as tax collectors and would wish to recoup their tax and compliance costs. Thus, if the VAT liability is shifted fully forward, it would result in inflationary pressure.

However, the degree of tax shifting is constrained by other factors and it may not always be possible for manufacturers and traders to pass on the tax liability fully to consumers. For instance, if consumers decide to maintain their real level of consumption, it will enable manufacturers/traders pass the tax forward fully leading, thereby, to inflationary pressure. On the other hand, if consumer demand is price elastic and the money supply rigid, shifting of VAT liability forward would result in a fall in aggregate demand. VAT can influence prices by triggering demand for higher factor earnings.

For instance, price increases owing to VAT might trigger wage-induced hikes in business costs. Of course, the ability of the workforce to secure higher wages depends on numerous other factors outside the scope of VAT.

Input VAT liabilities

One of the biggest advantages of the VAT system is that, by eliminating the cascading effects of commodity taxation on prices, it helps reduce the price level. This is because the VAT system allows businesses to deduct the tax paid on their inputs/purchases from the tax payable on their output. The moot question here is whether manufacturers/traders will pass on to the consumer the benefit of the cost reduction arising out of the input tax credit available to them.

If the VAT-able business entities treat their VAT liabilities on inputs as costs even after the changeover to VAT and pass these on to the consumers, then prices will increase. One possible way to do so, in a mark-up pricing regime, is to magnify the mark-up rates.

In a VAT system, higher margins mean higher tax burden on the commodities. It is true that if consumers respond to price increases by cutting down consumption, then it will affect the trade volumes of manufacturers/traders.

However, the latter can confront this by reducing their output rather than their mark-up rates in a bid to lower prices. Such a step may ultimately have serious economic effects. Such strategies have been adopted in Nigeria, for instance. And several countries, in anticipation of such moves by businesses, took effective steps to prevent them.

For instance, in Ireland, before the introduction of VAT, the Government formed a National Prices Commission (NPC) entrusted to run a system of price restraint in the VAT regime.

Since a VAT system requires only a few tax rates, the changeover from a system with numerous rate categories, such as in the sales tax regime in India, will result in significant corrections in the tax rates on various commodities — that is, the rates on some commodities may go up and others down.

In this case, the net impact of VAT on prices is determined by the relative strength of price increases/decreases of the commodities subject to higher and lower revised rates. Much of the price increases reported in the press after April 1 in some States appear to be because of this phenomenon.

A key defect of the previous sales tax regime was the widespread tax evasion. A common practice was to incorporate the tax element which was avoided in the mark-up value and, thereby, earn abnormal profits.

However, under VAT, since the profit margins also come under taxation, to realise the same amount of margin earned by way of avoiding the tax payment, traders will have to up their mark-up rates leading, thereby, to price increases.

To illustrate, suppose a trader originally fixes a mark-up of Rs 50 on his purchase price of a commodity worth Rs 100, which includes a 10 per cent sales tax (Rs 10) on the purchase price, then his selling price and profit after tax (if sales tax is paid) amounts to Rs 150 (100 + 50) and Rs 40, respectively. However, if the trader manages to avoid the 10 per cent sales tax, then his profit after tax would be Rs 50.

Under a VAT system, in the same situation, his VAT liability amounts only to Rs 5 (Rs 15 on the selling price minus Rs 10 on the purchase price) assuming a 10 per cent VAT rate. In this case, the profits of the trader after paying VAT rise to Rs 45 (50 minus 5).

However, if the trader still wants to earn a margin of Rs 50 under VAT, he would have to raise the margin approximately to Rs 55, in which case the selling price of the commodity would go up to Rs 155.

It is difficult to unequivocally relate VAT changes to price changes. International experience shows that a changeover to VAT does not result in any sustained increase in the price level.

In majority of the cases, all that it had caused was a one-time initial rise in prices, which is reported to be happening in the States which switched to VAT on April 1.

(The authors are with the Research and Publications Division of The ICFAI Business School, Chennai.)

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