Principle of VAT

VAT (Value Added Tax) has its origin in West European Countries. Generally, any tax is
related to selling price of product. In modern production technology, raw material passes
through various stages and processes till it reaches the ultimate stage e.g., steel ingots are
made in a steel mill. These are rolled into plates by a re-rolling unit, while third
manufacturer makes furniture from these plates. Thus, output of the first manufacturer
becomes input for second manufacturer, who carries out further processing and supply it
to third manufacturer. This process continues till a final product emerges. This product
then goes to distributor/wholesaler, who sells it to retailer and then it reaches the ultimate
consumer. If a tax is based on selling price of a product, the tax burden goes on
increasing as raw material and final product passes from one stage to other.

For example, let us assume that tax on a product is 10% of selling price. Manufacturer
‘A’ supplies his output to ‘B’ at Rs. 100. Thus, ‘B’ gets the material at Rs. 110, inclusive
of tax @ 10%. He carries out further processing and sells his output to ‘C’ at Rs. 150.
While calculating his cost, ‘B’ has considered his purchase cost of materials as Rs. 110
and added Rs. 40 as his conversion charges. While selling product to C, B will charge tax
again @ 10%. Thus C will get the item at Rs. 165 (150+10% tax). In fact, ‘value added’
by B is only Rs. 40 (150–110), tax on which would have been only Rs. 4, while the tax
paid was Rs. 15. As stages of production and/or sales continue, each subsequent
purchaser has to pay tax again and again on the material which has already suffered tax.
Tax is also paid on tax. This is called cascading effect.

Cascading effect of taxes - A tax purely based on selling price of a product has cascading
effect, which has the following disadvantages :

COMPUTATION OF EXACT TAX CONTENT DIFFICULT - It becomes very difficult to know the real tax
content in the price of a product, as a product passes through various stages and tax is
levied at each stage. This is particularly important for granting Export incentives or for
fixing regulatory prices.

VARYING TAX BURDEN - Tax burden on any commodity will vary widely depending on the
number of stages through which it passes in the chain from first producer to the ultimate
consumer.

DISCOURAGES ANCILLARISATION - Ancillarisation means getting most of the parts/components

manufactured from outside and making final assembly. It is common for large
manufacturers (like automobile, machinery etc.) to get the parts manufactured from
outside and make final assembly in his plant. If a component is purchased from outside,
tax is payable. However, if the same component is manufactured inside the factory, no
tax would be payable. Thus, manufacturers are tempted to manufacture parts themselves
instead of developing ancillary units for supply of the same. This is against the national
policy, because it discourages growth of Small Scale Industry and increases concentration
of economic power.
INCREASES COST OF PRODUCTION- If a manufacturer decides to reduce ancillarisation, it
increases cost of production and waste of scarce national resources, as the large
manufacturer may not be in a position to fully utilise the production capacity of the
machinery.

- Same article may be used for various

CONCESSIONS ON BASIS OF END USE IS NOT POSSIBLE
purposes e.g. Copper may be used for utensils, electric cables or air conditioners.
Government would naturally like to vary tax burden depending on use. However, this is
not possible as when Copper is cleared from factory, its final use cannot be known.

EXPORTS CANNOT BE MADE TAX FREE – Though final products which are exported, are exempt
from tax, there is no mechanism to grant rebate of tax paid at the earlier stages on the
inputs. - - It may be noted that as per WTO (World Trade Organisation) stipulations,
exports can be made free of domestic taxes, but export incentives as such cannot be
given.

Disadvantages of single point tax - Most of States have introduced single point sales tax
to avoid cascading effect and also for convenience of collection. Sales Tax is usually
collected at the first stage, i.e. at the manufacturing stage or on first sale after goods are
imported from out of the country or are brought from out of the State. There is no tax at
subsequent sales. The system of collecting tax only at first stage has following
disadvantages -

(a) Since sales tax has to be collected at the first stage itself (which is obviously
wholesale stage), the tax rate has to be more. This encourages evasion and really
sales tax becomes a tax on honesty (i.e. more the honesty, more the tax payable).

(b) If somehow, goods escape the tax at first stage, the goods escape tax net
altogether as there is no way by which it can be caught at any subsequent stage.

(c) There is ample scope for under-valuation at first stage, since there is no tax
payable at subsequent stages, even if goods are subsequently sold at much higher
prices.

Probably Delhi is the only State where sales tax is levied at the last stage and not at first
stage. It is almost universally accepted that tax evasion is maximum in Delhi.

Concept of VAT - A concept of VAT was developed to overcome the difficulties in

conventional system of commodity taxation. VAT means “Value Added Tax”, which
means that the tax is payable only on value added at each stage and not on the gross sale
price. In the example we saw in para 2.1, if ‘B’ purchases goods from ‘A’ at Rs. 110 and
sells the same to ‘C’ at Rs. 150, the value added by B is only Rs. 40 and hence under the
VAT scheme, the tax would be payable by ‘B’ only on Rs. 40.

This concept was developed particularly in West European countries where they have a
common market of all Western Europe. They found that if the goods are taxed on the
basis of sale price, idea of European Common Market will not be successful, as people
will be discouraged to buy goods from other countries if they have to pay full tax on
goods purchased from other countries. The idea of VAT was evolved to overcome this
difficulty. Europe has created single market by abolishing fiscal frontiers since 1993.
Destination principle is operating through an account based computerised information
system in Europe.

Due to advantages of VAT, presently VAT has been introduced in over 120 countries,
including countries in Africa, Asia, Europe, Middle East, South America, North America
and even China. However, USA has not gone into VAT yet.

Advantages of Vat - Advantages of VAT are as follows :

Exports can be freed from domestic trade taxes

It provides an instrument of taxing consumption of goods and services
Interference in market forces is minimum
Aids tax enforcement by providing audit trail through different stages of production
and trade. Thus, it acts as a self-policing mechanism.

The disadvantage is that paper work required increases considerably and it is not as
simple as a single point sales tax.

CONSUMPTION TYPES OF ‘VAT’ - In Consumption Type VAT, ‘Value Added’ is considered by

deducting all purchases, raw materials and capital items. Consumption type VAT is
popular and it is adopted by most of the countries for following reasons : (a)
Administration control is easy due to ‘credit method’ that can be adopted (b) It makes no
distinction between capital intensive and labour intensive activities (c) Tax avoidance by
classifying capital goods purchases as revenue purchases is avoided. (d) It is in harmony
with the 'destination principle' (e) It simplifies tax administration as there is no need to
distinguish between purchase of capital goods and consumption goods.

DESTINATION PRINCIPLE - The advantage of ‘consumption type’ VAT is that tax burden is
only at the last i.e. consumption stage. This is useful for taxation structure based on
'destination principle'. At all the earlier stages of production, there is no tax burden in
view of the credit obtained when the inputs are used for production of final product.
Thus, it becomes easier to give concessions to goods used by common man or goods used
for manufacture of capital goods or exported goods and charge heavy duty on luxury
goods.

How VAT system works

System of VAT works on tax credit method. In Tax Credit Method of VAT, the tax is
levied on full sale price, but credit is given of tax paid on purchases. Thus, effectively,
tax is levied only on ‘Value Added’. The ‘Tax Credit Method’ is better as (a) Audit
control is much better, which helps in controlling tax evasion. It acts as a self-policing
mechanism (b) Flexibility in applying varying tax rates to different commodities (c)
Useful in giving tax benefits on exports (d) Invoice at any stage indicates the total tax
burden on that product upto that stage. - - Most of the countries have adopted 'tax credit'
method for implementation of VAT.

SUBTRACTION METHOD OF IMPLEMENTATION OF VAT -Other method of implementation of VAT is

‘subtraction method’, where purchase price is deducted from sale price and VAT tax is
paid on net amount. This method is highly cumbersome and practically impossible when
various inputs are used to manufacture numerous outputs. Moreover, if tax is paid on net
amount, dealer’s margin is disclosed, which no dealer would like to do.

TAX CREDIT METHOD IS SIMPLE METHOD TO IMPLEMENT VAT - The ‘input tax credit’ is not ‘credit’ in
true sense of the term, but an easy and simple way to ensure that tax is paid only on
‘value added’ at each stage, as explained in illustration below.

Illustration of tax credit system - Let us assume that tax on a product is 10% of selling
price. Under usual system of taxation, Manufacturer ‘A’ supplies his output to ‘B’ at Rs.
100. Thus, ‘B’ gets the material at Rs. 110, inclusive of tax @ 10%. He carries out further
processing and sells his output to ‘C’ at Rs. 150. While calculating his cost, ‘B’ has
considered his purchase cost of materials as Rs. 110 and added Rs. 40 as his conversion
charges. While selling product to C, B will charge tax again @ 10%. Thus C will get the
item at Rs. 165 (150+10% tax).

Under VAT system, ‘B’ will purchase goods from ‘A’ @ Rs. 110, which is inclusive of
duty of Rs. 10. Since ‘B’ is going to get credit of duty of Rs. 10, he will not consider this
amount for his costing. He will charge conversion charges of Rs. 40.00 and sell his goods
at Rs. 140. He will charge 10% tax and raise invoice of Rs. 154.00 to ‘C’. (140 plus tax
@ 10%). In the Invoice prepared by ‘B’, the duty shown will be Rs. 14. However, ‘B’
will get credit of Rs. 10 paid on the raw material purchased by him from ‘A’. Thus,
effective duty paid by ‘B’ will be only Rs. 4. ‘C’ will get the goods at Rs. 154 and not at
Rs. 165 which he would have got in absence of VAT. Thus, in effect, ‘B’ has to pay duty
only on value added by him.

Illustration of tax credit method to avoid cascading effect – Following example will
illustrate the tax credit method of VAT .

Transaction Transaction With

without VAT VAT
Details A B A B
Purchases - 110 - 100
Value Added 100 40 100 40
Sub – Total 100 150 100 140
Add Tax 10% 10 15 10 14
Total 110 165 110 154

Note - 'B' is purchasing goods from 'A'. In second case, his purchase price is Rs 100/- as
he is entitled to VAT credit of Rs 10/- i.e. tax paid on purchases. His invoice shows tax
paid as Rs 14. However, since he has got credit of Rs 10/-, effectively is paying only Rs
4/- as tax, which is 10% of Rs 40/-, i.e. 10% of 'value added' by him.

Meaning of Value added - In the above illustration, the ‘value’ of inputs is Rs 110, while
‘value’ of output is Rs 150. Thus, the manufacturer has made ‘value addition’ of Rs 40 to
the product. Simply put, ‘value added’ is the difference between selling price and the
purchase price.

Adjustment in tax rate to avoid reduction in revenue - In the above illustration, it is

obvious that tax revenue will go down in VAT system, if same rate of tax is maintained.
Hence, VAT rate will have to be suitably increased to ensure that tax revenue does not
reduce. This rate is termed as ‘Revenue Neutral rate’ (RNR). It is the VAT rate at which
tax revenue remains same despite giving credit of duty paid on inputs.

RNR SHOULD BE LOWER THAN PRESENT SALES TAX RATE - As discussed earlier, sales tax is levied at
the first stage i.e. wholesale stage and no tax is levied at subsequent stage. However, in
VAT system, tax will be collected at consumption stage, i.e. last stage. Thus, if today,
sales tax rate is 15% on wholesale price of Rs 100, under VAT system, tax will be
collected at consumption stage i.e. on retail price of (say) Rs 125. Thus, RNR will be
lower than present sales tax rate of State Governments. It has been decided to levy sales
tax at RNR of 12.5% by most of the States.

States already have system of set off - Some of State Governments already have a system
of partially granting set off of sales tax paid on inputs. Some States do impose turnover
tax on dealers with large turnover. Vat is in effect an extension of the set off method and
turnover tax system.

Defects that had cropped up in sales tax system in India

Since intra-state sales tax is a State subject, the provisions of local sales tax are
implemented by States. Even in respect of Central Sales Tax, the CST Act is
implemented by respective State Governments and revenue of CST goes to State from
which movement of goods commenced. CST Act authorizes State government to grant
exemption from central Sales Tax by issuing a notification in official gazette. - - Over the
years, many defects entered into structure of sales tax, due to aforesaid peculiarities.

UNHEALTHY COMPETITION AMONG STATES - There was competition among States to increase the
sales tax revenue. Business tended to be diverted where sales tax rates were low. Some
States reduced rates of Central Sales Tax and even waived the condition of submission of
C form. Thus, buyers found it economical to purchase goods from neighbouring State.
Often, goods from the State were sent to another State on stock transfer basis and brought
back in the Same State as Inter-State Sale. [In many cases, it is said that only papers
were going, goods were not going].

SALES TAX INCENTIVES TO NEW INDUSTRIES - Sales tax Incentives were offered to attract new
industries in the State. This distorted the tax structure. When one State started giving
sales tax incentives, other States had no option but to grant similar incentives. When all
States grant more or less same incentives, it no more remains an ‘incentive’. Such
‘incentives’ totally ruined State finances. Many malpractices started. Often unit was
started merely for purpose of obtaining sales tax incentives. It was closed as soon as
incentive period was over. Bogus invoices were prepared to show sales from developing
area, while actual manufacture and dispatch was from developed area. This defeated the
basic purpose of granting incentives. - - Old industries suffered as they could not compete
with new industries to whom sales tax incentives were available.

Steps taken to stop the menace - Luckily, the problems were realized and all States
agreed to take necessary steps. In the Conference of Chief Ministers of States held on
16-11-1999, it was decided to implement uniform floor rates of sales-tax for the entire
country. States could charge sales tax rates higher than the floor rate but not lower. It was
also decided to phase out sales-tax based incentive scheme for industries, reform the
Central Sales Tax system and implement VAT. Most of the States have taken steps to
implement these decisions.

STEPS TAKEN BY STATES TO INTRODUCE VAT - Discussion papers on VAT has been issued by
many States. Some State governments have published draft VAT Act and rules. Some
States have even sent draft Acts to President for approval. Each State is implementing
VAT in its own way to suit its needs. [Assent of President is required as the State VAT
Acts propose introduction of check posts and transit passes. As per Article 304(b), State
can impose reasonable restrictions on freedom of trade with other States or within the
State, if Bill or amendment is introduced after sanction of President. - - Otherwise, tax on
sale within the State is a State subject and assent of President is not required].

Though basic concepts are same in VAT Acts of all States, provisions in respect of credit
allowable, credit of tax on capital goods, credit when goods are sold inter-state are not
uniform. Even definitions of terms like ‘business’, ‘sale’, ‘sale price’, ‘goods’, ‘dealer’,
‘turnover’, ‘input tax’ etc. are not uniform. Schedules indicating tax rates on various
articles are also not uniform