The Hindu Business Line : VAT's behind the controversy

Despite the long years spent in defining the value added tax system introduced on April 1, and the consensus sought to be evolved through the work of the Empowered Committee of State Finance Ministers, the scheme remains mired in controversy. C. P. Chandrasekhar and Jayati Ghosh discuss the reasons why uncertainties over the results of the new system still prevail leading to controversy.

WHEN the value added tax (VAT) system was introduced on April 1 this year, after years of preparation, eight States, including three with non-BJP governments, chose to stay out, at least for the time being. In the States where VAT has been introduced, uncertainty and dissent over introduction of the system have resulted in waves of protest, especially among traders.

There are fears of different kinds: that the tax would result in inflation; that the system would increase harassment; that the burden would fall on the poor; and that it would erode the already inadequate revenues of the States, which would be crippled as the compensation for loss of revenues falls sharply over three years and then completely dries up.

To strengthen those fears, in the 10-plus days since the introduction of the system there are reports of confusion regarding the rates applicable to different commodities resulting in some shortages, and indications of increases in prices of a number of commodities.

The reasons for all this lie in the ambiguities that surround this kind of tax. A value-added tax is a tax on the value added at each stage of the production of goods and services. The "value added" at each stage is the amount by which the sales price of the product at that stage exceeds the cost of all the products purchased to make that item. Since the tax is paid at different stages it does not appear in the final bill paid by consumers, giving VAT the features of a tax on business.

But in reality the value-added tax is a sales tax on consumer purchases that is collected in stages. That is, in its pure form the VAT system is more a method of collecting a tax rather than a specific form of taxation.

As a tax, VAT is regressive like sales tax, and results in low-income taxpayers paying more of their income in tax than the wealthy do. The difference really is that VAT is collected a little bit at a time from different stages of the production process, rather than being a lump-sum levied on the final retail sale.

The equivalence of a tax on gross value added to a sales tax upon final output is easy to demonstrate. Thus for any firm, the tax base (on which a rate of tax applies) under VAT would be:

tax base = sales - cost of materials

= wages + rent + interest + profits + depreciation

The latter expression when summed over all firms in the economy equals GNP, which, in turn, equals total final sales in the economy.

However, VAT is not necessarily implemented as a tax on value added or sales net of materials cost. For example, the value-added tax as recommended by the Empowered Committee of State Finance Ministers uses the credit method.

To quote the committee: "The essence of VAT is in providing set-off for the tax paid earlier, and this is given effect through the concept of input tax credit/rebate. This input tax credit in relation to any period means setting off the amount of input tax by a registered dealer against the amount of his output tax. The Value Added Tax (VAT) is based on the value addition to the goods and the related VAT liability of the dealer is calculated by deducting input tax credit from tax collected on sales during the payment period (say a month)."

The near equivalence of this to a tax applied to a base derived by subtracting purchases by enterprises from sales should be obvious, though in practice the firm is taxed fully on the receipts and is allowed a credit for any value-added taxes shown on invoices from suppliers.

Given these features of a VAT system, certain claims made by many, including the Empowered Committee, that there are benefits to be derived from VAT are difficult to sustain. In particular, there are two claims which, when simultaneously advanced, are misleading: the first is that "prices will in general fall"; and second, that "there will be higher revenue growth."

The idea that prices will fall is arrived at using the argument that a tax on sales by different entities producing inputs and final outputs implies taxing some commodities (inputs) at multiple points resulting in a cascading of costs and prices. This argument compares the effect of an in increase in input prices under two different schemes — under sales tax and under VAT. Assuming constant mark-up, a rise in input prices will result in a larger increase in final product prices under a sales tax regime than under a VAT regime.

However, what is of immediate interest is the effect of the transition from a sales tax to a value added tax regime. As the illustrative figures provided in numerical Example 1 indicate, the implicit tax on value added at the final product stage has to be substantially higher than on the sales tax on the value of output if the transition is to be revenue neutral. As a result there would be no difference in final product prices under the sales tax and VAT schemes.

It should be clear that if the transition from a pre-existing sales tax structure to a VAT is to be revenue neutral the modal equivalent implicit tax rate on value added must be higher than the modal sales tax rate. In a tax credit system this would imply that if the rate imposed on the pre-tax value of the inputs is the same as in the sales tax regime, then that imposed on output must be higher.

This would imply that gains in input costs resulting from deduction of value added taxes that were previously paid on such inputs, would be neutralised by an increase in the VAT rate to ensure that revenues do not decline. Hence, assuming that the benefit of the tax credit is passed on to consumers, final product prices inclusive of VAT would in all likelihood remain the same if the transition is to be revenue neutral.

Even if the modal tax rate on value added is not raised by as much as required to ensure revenue neutrality, prices may not fall because producers and/or traders may absorb the proportion by which prices should fall into their profit margins, because of the prevalence of monopolistic pricing practices. This would mean that, on the one hand, revenues would be lower as a result of the transition from sales tax to VAT, and on the other hand, prices would not be lower than they were earlier.

Thus even if the transition to VAT is to be revenue neutral, prices would not fall. If, in addition, as the Empowered Committee claims, the transition would lead to higher revenue growth, then prices would have to rise.

The only grounds on which the committee can claim that revenues would increase without the modal value added tax rate (and therefore final product prices) being substantially higher, is on the grounds that a VAT system results in better compliance.

If enterprises are taxed fully on receipts and then provided a credit for value-added taxes paid in earlier stages, they are being provided with a monetary incentive to demand documents from suppliers which indicate the taxes paid in earlier stages. This would make it difficult for suppliers to evade input tax payments.

While this may sound simple in theory, the experience in practice is quite different. Thus according to Sukumar Mukhopadhyay, a former member of the Central Board of Excise and Customs, the VAT is more difficult to administer because enterprises would tend to make bogus claims for credits against early stage VAT payments. Preventing that would require physical verification of huge numbers of individual invoices and suppliers.

As a result the governments may lose rather than gain in terms of reduction in tax evasion and in terms of the cost of implementation. In France, for example, the shortfall in VAT collections from estimates of likely revenues in 1981 was computed at 18 per cent, which amounted to 6.6 per cent of total revenues and 0.7 per cent of GDP (Refer V. Sridhar and Suhrid Sankar Chattopadhyay, `VAT and Protest', Frontline, April 22, 2005).

If an experience of this kind is repeated in our context, States would be confronted with a sharp shortfall in revenues at a time when they are already experiencing a fiscal squeeze. Many economists, including former West Bengal Finance Minister Ashok Mitra, believe that this is the most likely outcome.

The complexities associated with the new system do not end here. It is well know that while in theory VAT, depending on its exact nature, is equivalent to a tax on consumption, income or final output, in practice the tax as introduced tends to depart, for administrative, political and other reasons, from its pure form, giving it a character of its own. One such instance of departure in the Indian case is the kind of "border adjustments" that are being made at the State level.

Thus the Empowered Committee has deemed it fit to make the following adjustments: While "input tax credit will be given for both manufacturers and traders for purchases of inputs/supplies meant for both sale within the State as well as to other States (emphasis added), tax paid on inputs procured from other States through inter-State sale and stock transfer will not be eligible for credit."

The principle is that each State government would not provide credit for input taxes paid in other States and would garner revenues from taxes on output exported from within the State to other States.

This amounts to stating that if a State is unable to garner the tax on value added in earlier stages of production, then it would not provide any credit for such taxes actually paid to other State governments.

As the numerical examples provided in Examples 2 and 3 illustrate, this implies that larger is the share of inputs imported from other States, the lower would be the tax credit available and higher the price at which a commodity can be delivered within the State or outside.

It should be clear that under this system, producers and traders would prefer input supplies from within rather than outside the State, as it would help keep down prices, raise margins or realise a combination of the two. Ensuring availability of such supplies originating in and sold within a particular State would be easier in those States which are larger and/or more advanced, because the intra-State market would be large enough to support competitive State-level production.

On the other hand, smaller and more backward States would not be able to support adequate volumes of intra-State production, so that producers in those States would have to rely on imports from other States for which they do not get VAT credit. As a result their final product prices would be higher, and local producers would be out-competed by producers from other States. The result could be widening regional disparities in both production and revenue generation that would result in a break down of the consensus which the Empowered Committee and the Government claim to have forged.

Critics also point to the fact that a VAT system with harmonised rates across States and provinces within a country may result in a loss of fiscal autonomy, since State governments have very few instruments left with them for mobilising resources and sales taxes are important ones. By giving up the ability to impose sales taxes and accepting a common set of VAT rates, individual States may find themselves short of resources to finance crucial expenditures and meet their development commitments.

In such circumstance, these governments could become heavily dependent on grants from the Centre or on borrowing from international agencies such as the Asian Development Bank and the World Bank, which could erode their policy autonomy.

Despite these features and the uncertainties associated with VAT, why have successful central governments and some State Finance Ministers been keen on pushing through the VAT system? And why is it that neo-liberal fiscal reform in developing countries has been associated with indirect tax reform aimed at instituting a value-added tax? There are possibly different factors motivating the different actors. In the Indian case, Finance Ministers from States capable of sustaining viable input producing industries may be going along with the VAT because it privileges intra-State producers of inputs and supplies as opposed to producers from elsewhere, by excluding inter-State commodity flows from the system of tax credits. This narrow, parochial perspective can hardly constitute a rational defence of the value added tax system.

A second reason why VAT may be favoured is that it permits reliance on an indirect tax whose regressive effects may not be as visible, and therefore helps the Government provide direct tax concessions to individuals and corporates with the ostensible intent of providing incentives to save and invest.

Since the point of collection of the tax is mostly the enterprise, the impact of the tax is less visible to the consumer who finally bears the burden. In this sense VAT differs from direct taxes such as personal income taxes, sales taxes and property taxes.

However, the tax is directly visible to the business community sections, which fear its adverse effects and have opposed it to differing degrees. But since the incidence of VAT is finally felt by consumers, enterprises cannot be expected to be as strident in their opposition to increases in VAT once the system is in place.

This bring us to the third reason why VAT may be preferred, and this is the possibility of using invisibility to levy relatively high rates across a very broad base of commodities, without the need to provide exemptions, deductions and exclusions associated with income and corporate taxes.

This would help garner large government revenues through a squeeze on the broad mass of the population while conveying the impression of being a government that is non-intrusive, by reducing direct taxes on the specious grounds that it would trigger higher private savings and investment. That possibly is the reason that advocates of neo-liberal reform so strongly support this form of taxation.

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