Essay on Value Added Tax (VAT) in India

In this essay we will discuss about Value Added Tax (VAT) in India. After reading this essay you will learn about: 1. Origin of VAT 2. Meaning of VAT 3. Implementation  4. Empowered Committee on VAT and its Efforts 5. Highlights of VAT implemented from 1st April, 2005 6. VAT Regime.  

Contents:

1. Essay on the Origin of VAT
2. Essay on the Meaning of VAT
3. Essay on the Implementation of VAT
4. Essay on the Empowered Committee on VAT and its Efforts
5. Essay on the Highlights of VAT implemented from 1st April, 2005
6. Essay on the VAT Regime

Essay # 1. Origin of VAT:

The value Added Tax (VAT) is normally levied on the added value of goods in various processes of its production and distribution. As for example, the raw materials after necessary processing has been converted into final goods and these manufactured goods are then channelled through wholesale and retails outlets for reaching the final consumers.

At all these stages, some element of value addition takes place. Thus value added tax is a tax levied on the value added to the product at all these stages. Value Added Tax (VAT) was first introduced more than 50 years ago for bringing fundamental changes in the indirect tax structure.

It also remained confined into a handful of countries until the 1960s. Today it has been implemented in more than 125 countries and became a key source of revenue to the government. The spread of VAT throughout the world is broadly based on the fact that it has been able to raise more revenue than the sales tax it replaced.

But introduction of VAT in a federation like India is not an easy task. Bird and Gendron and Peggy Musgrave also acknowledge that there is no perfectly satisfactory solution to the problems of indirect taxation of inter-state sales in federations.

Fiscal economists normally justify VAT on the following three grounds:

(a) It is a neutral tax

(b) It removes cascading and

(c) It achieves zero rating of experts.

These arguments hold good if VAT could be introduced in perfect manner. Economists make common mistake comparing VAT with imperfect income tax, or sale tax or excise duties. One of the most authoritative and of quoted expert on VAT, Mr. Allan A. Tait has cautioned the readers against such dubious comparison.

While making an assessment of imperfect VAT, we find that much of its virtues eulogized so frequently vanish both in theory as well as in the Indian context. If the VAT is introduced in most perfect and imperfect manner, it may lead to a situation where all the virtues of neutrality, removing cascading improving export-competitiveness become unreal and unattainable.

India may face such problem of VAT is to be introduced in different states with such imperfections.

In the mean time, different states are claiming to follow a variety of revenue—neutral rates ranging between 18.5 and 11 per cent. VAT is not certainly suited for proper administration if the number of rates so adopted is many. Already 125 countries including China and Sri Lanka have adopted VAT, which is considered as a modern system of taxation.

Essay # 2. Meaning of VAT:

The most comprehensive and theoretically appealing way of domestic indirect taxation is a Value Added Tax (VAT). A full fledged VAT is, in essence, an ad-valorem tax on domestic final consumption levied and collected at all stages between production and the point of final sale. At each stage the tax is confined to value addition which is market value of sales minus purchases.

The “invoice method” of value added taxation is usually adopted because it has the property of capturing taxes evaded or missed earlier in the production chain. The VAT simultaneously achieves these two objectives by taxing sales at every stage of production but allowing full deduction of taxes paid on purchases.

The producer, therefore, pays the Government only the net amount or the tax on value added, as verified from the purchase and sale invoices. Even if the due tax has not been charged on any of the purchased inputs there would be no invoice for it and a deduction would be unavailable.

Therefore, the missed tax could be recaptured. In a poor country like India with its large unorganised and small scale sector, the VAT has an additional advantage over the retail sales tax. As the VAT is collected at every stage of production, taxes which are missed at one stage can in principle be recaptured at a later stage.

Considering these advantages, all developing countries, therefore, have already switched over from turnover, excise and wholesale taxes to the value added tax.

In a federal set up, there are three possibilities for a comprehensive national VAT. VAT could be a Central levy. In that case, the rates would be levied and controlled by the Centre. The collection would be shared by the Centre and the States. VAT could be a purely state levy where the Centre completely with-draw from the field of domestic indirect taxes.

Thirdly, there may be a system of dual Centre-State VAT with well defined spheres of responsibilities.

In the mean time, the Central Government was in the process of introducing the Value Added Tax (VAT) system and several steps have already been taken in this direction in the last two Budgets. India would like to go about implementing the VAT gradually to ensure better acceptability.

Another area where progress has been made was reduction in the number of rates in excise duty which had declined to 3 from a peak of 22 rates. The Finance Department would like to seal it down to only two to three rates.

However, there would be certain problems in introducing the system in the country in certain areas. The MODVAT scheme would be difficult to extend to the textiles sector as there were about at least 14 lakh power looms in the country. Some other problems may crop up in relation to the small scale sector exemption and in connection with the definition of the manufacturers.

Another practical problem would be due to the poor computer system in the country which was yet to have a comprehensive network without which it would be nearly impossible to check the false invoices. VAT system was gaining popularity the world over with over 125 countries already adopting it.

Such nations included even developing countries like Bangladesh and Malaysia. But since the VAT was a highly complicated system there was a need for a massive educational campaign before it was actually introduced. USA and South Korea had followed a massive educational campaign before its introduction.

But it must be recognised that the introduction of a comprehensive VAT is not a very easy task in a federation like India. The National Institute of Public Finance and Policy (NIPFP) are also preparing a paper setting out the issues and options for VAT in the Indian context.

This will help in formulating a VAT system which is very much acceptable to the centre and the states. So under the present circumstances it can be said that the Government will be able to introduce a nationwide value added tax soon. If the experience of other countries in introducing the VAT is any indication, both states and consumers have no reason to fear the new tax regime.

According to an International Monetary Fund (IMF) publication, except Norway and the UK all the 36 countries that implemented VAT, mopped up- higher revenues after the transition to the new tax regime. Of these, 17 countries did not witness any immediate price hike attributable to the new tax, while the remaining 19 states experienced minimum changes in prices.

The change in price were calculated after factoring in inflation. Most of the 120 countries that shifted to VAT did not see any major price rise.

The State Finance Ministers’ meeting held on 2nd December, 1995 to discuss the reports of the Committee of Finance Ministers on Sales Tax Reform and also of the NIPFP reached a broad consensus on introduction of the Value Added Tax (VAT) in a phased manner after adequate preparation by individual states.

The Finance Ministers also agreed that a monitoring committee consisting of the State Finance Ministers be set up to monitor the implementation of agreed tax reform measures and review the steps taken for the introduction of VAT. Thus the value added tax (VAT) system is at the final stage of implementation.

While addressing in a workshop on VAT in Calcutta, organised by the Federation of Indian Chambers of Commerce and Industry on 3rd January, 1996 the Director of National Institute of Public Finance and Policy (NIPFP) Mr. Parthasarthi Shome discussed the problem relating to prevalence of multiple rates of taxation and replacing the existing system with a rationalised and simple one without causing any depletion of funds for the State exchequer.

He further observed that “Nearly 100 nations, till now adopted the VAT system although light variations in enforcement had been observed, depending on the system of Government and the local needs.”

Essay # 3. Implementation of VAT:

In the meantime, a considerable degree of progress in the implementation of state value added tax has been achieved. In the Conference of Chief Ministers of states held on 16th November, 1999, it was unanimously decided to implement uniform floor rates of sales tax in the entire country.

It was also decided to phase out sales-tax based incentive schemes for industries, reform the Central Sales Tax System and simplify the tax system as prevailing in the states by introduction of Value Added Tax (VAT). It has now been decided that all States and Union Territories would implement VAT from April, 2003.

An Empowered Committee of State Finance Ministers has also agreed upon the following sequence of steps to ensure introduction of VAT in place of retail sales-tax system in states:

1. Passing of VAT legislation and framing of rules and regulations;

2. Computerization of dealers who will fall within the ambit of VAT;

3. Training of tax officials, traders and consumers associations;

4. Publicity for consumers;

5. Implementation of VAT, assigning VAT identification numbers to tax payers; and

6. Implementing transitional measures for introduction of VAT.

In this direction, the main endeavour of the various state governments is to reform their sales tax regimes in the following manner:

(a) Convert sales taxes into VAT by moving over to a multi-stage system of sales taxation with rebate for tax on all purchases with only minimal exceptions.

(b) Allow input tax credits for all raw materials and parts, consumables, goods for resale and production machinery and equipment’s.

(c) Replace the structure of tax rates with two or three rates within specified bands, applicable in all states and Union Territories.

(d) Remove the exemptions except for a basic threshold limit and items like unprocessed food and also withdraw other concessions like tax holiday.

(e) Zero-rate exports out of the country.

(f) Tax inter-state sales to non-registered persons as local sales.

(g) Modernize tax administration, Computerise operations and the information system; and simplify forms and procedures. Thus, it is expected that with the introduction of VAT regime by the states and Union Territories, in general, a uniform common market will develop in the country.

In India, introduction of State Level VAT is the most significant tax reform measures introduced at the state level. The state level VAT so implemented has replaced the existing States Sales Tax. On 18th June, 2004, the decision to implement state level VAT was taken in the meeting of the Empowered Committee of the State Finance Ministers where a broad consensus was attained for introducing VAT from April 1, 2005.

According, VAT has been introduced by 30 states and UTs so far. Tamil Nadu has implemented VAT from January 1, 2007. Uttar Pradesh has not yet taken any decision in this respect. In implementing VAT, the Central Government has played the role of facilitator.

A compensation formula has also been finalised in consultation with the states for providing compensation, during 2005-06, 2006-07 and 2007-08, for any losses incurred in revenue for introducing VAT. Accordingly, compensation is being released according to this formula.

Technical and financial support has also been provided to the states for VAT computerization, publicity and awareness and also in other related aspects.

The Empowered Committee finalized a design of VAT to be adopted by the states, through long deliberations, which seeks to retain the essential features of VAT, which at the same time, providing a measure of flexibility to the states so as to enable them to meet their local requirements.

Thus, introduction of state VAT to replace the earlier Sales Tax systems of the states has been one of the important tax reform measures taken on indirect tax side. VAT has been introduced by all the states and Union Territories (UTs), except the UTs of Andaman and Nicobar Islands and Lakshadweep.

Sales tax and VAT being a state subject, the Central Government actively played the role of facilitator for successful implementation of VAT.

In the mean time, a package for payment of compensation to states for any revenue loss on account of introduction of VAT has been implemented. An amount of Rs 19002.82 crore has already been released by Central Government to the states till date on account of claims filed by the states for the years 2005-06, 2006- 07 and 2007-08.

Technical and financial support on 100 per cent basis is now being provided to north eastern states to enable them to take up computerization of their VAT administrations. Similar project for computerization of VAT administration for Himachal Pradesh and Jammu and Kashmir with overall cost of Rs 40.49 crore has been sanctioned.

A mission mode project for computerization of VAT administrations of states and UTs has also been launched. Fifty per cent funding is also being provided to empowered committee of State Finance Ministers for implementation of the Tex Information Exchange System (TINXSYS) project for tracking of inter-state transactions.

Up till now the experience with implementation of VAT has been very much encouraging so far. The new system has been received well by all the state-holders and the quantum of state revenues have also grown rapidly since the introduction of VAT.

The experience of implementation of VAT has been very much encouraging. This new system has been received well by all the stakeholders. The transition has also been quite smooth with the Empowered Committee constantly reviewing the progress of the implementation.

Essay # 4. Empowered Committee on VAT and its Efforts:

In November 1999, the Government of India formed an empowered Committee with Sri Ashim Dasgupta, the then Finance Minister, West Bengal as its chairman and all Finance Ministers of the states and UTs as its members so as to facilitate tax policies of the states.

The Empowered Committee of State Finance Ministers reaffirmed its intention to introduce state-level Value Added Tax (VAT) from April 1, 2003. It also requested the Centre the expedite the process of necessary clearances.

On October 18, 2002, the conference of state Chief Ministers, presided over by the Prime Minister, endorsed the introduction of VAT from April 1, 2003. Again in the Empowered Committee’s meeting held on March 4, 2003, all major states approved of this intention.

The Committee is of the view that the introduction of VAT instead of the conventional sales tax system will not only lower the tax burden on manufacturers but also enable the state governments to earn more revenue once the initial phase of uncertainty passes. The revenue will increase with the expansion of sales tax base.

In the conventional sales tax system, manufacturers were subject to ‘input tax’ or tax on’ raw materials and ‘output tax’ or tax on the final product. In the VAT system, the total tax levied would actually be the difference between the amount of input and ‘output taxes’ or tax on the final product. In the VAT system, the total tax levied would actually be the difference between the amount of input and output taxes.

No doubt, there is the possibility of revenue loss in the initial years of VAT system. To cover up the initial revenue loss of the states the empowered committee sought financial protection from the centre. The committee also demand that the states should get back the right to impose services tax and the tariff on surplus production of tobacco, sugar and cotton textile.

Accordingly, the then Union Finance Minister had also announced in the Budget 2003-04 that the centre would compensate states for the loss of revenue for the introduction of VAT in the initial years. The compensation was to be 100 per cent of the loss in the first year, 75 per cent of the loss in the second year and 50 per cent of the loss in the third year (2005-06) of the introduction of VAT.

Empowered Committee of State Finance Ministers also endorsed the suggestion that every state legislation on VAT to have minimum set of common features. Accordingly a model VAT Bill was circulated to all the states. Introduction of VAT was expected to increase revenue buoyancy, as the coverage expanded to value addition at all stages of production and distribution chain.

At a meeting of the Finance Ministers of all states and UTs on January 17, 2003, states and UTs again reiterated their firm commitment to introduce VAT from April 1, 2003. It was decided that VAT legislation of all states & UTs would nave common provisions in respect of all important matters and that a simple VAT legislation with maximum convergence would be implemented.

It was also agreed that along with the introduction of VAT, the origin based Central Sales Tax would be phased out. It was also agreed that the Additional Duties of Excise (Goods of Special Importance) Act would be suitably amended to empower States to levy sales tax/VAT on sugar, textiles and tobacco with a ceiling rate of 4 per cent.

This would be done without affecting the existing levy of Additional Duties of Excise on these items by the Union Government.

However, the Empowered Committee on VAT was decided to distinguish between capital good and other inputs in the state tax models, which was in contrast to the recommendations of the task force on indirect taxes headed by Vijay Kelkar, advisor to Union Finance Minister.

The difference in the stand taken by the two panels made it difficult to reconcile the state value added taxes with the central value added taxes (CENVAT), which has already come into force for work of the categories.

Thus the introduction of VAT created a big controversy in India with both traders and general public protesting against this new system in view of its cascading impact on the price situation. In recent decades no other taxes has attracted so much of criticism from trade, business and consumers in general.

However, the Government of India considers the VAT as a single tax which is expected to remove the scope of reversal rates of sales tax and thus it is capable of offsetting scope of imposition of multi-joint sales tax, which envisages several rates and thereby its incidence results in hike in prices of raw materials, finished products and various other items which are in demand for both consumption and processing.

Thus the VAT is a simple and transparent tax on sale of articles. Instead of multiple rates of sales tax, the VAT is only of four rates of tax on raw material and finished products. As the sales tax on multiple point, raises the price of articles but VAT can remove such scope.

However, there cannot be any guarantee that VAT would fully eliminate the risk of marginal increase in price as the rate of VAT would also be subjected to variations. But the advantage of the VAT can be derived only if the rate of VAT is very scrupulously and strictly enforced. Indulgence of any type landing to variations in the rate of VAT may finally lead to rise in the price of various articles and products.

However, the VAT has two most important advantages. Firstly, it is neutral between different types of goods and services as it is levied at uniform rates in general. Thus it never alters the price ratio between commodities. Secondly, VAT is also neutral between different businesses on one hand and methods of production on the other.

Thus VAT does not treat different companies differently and treats different types of technology- alike. Moreover, the VAT system will also be able to prevent leakages of resources arising out of tax evasion in sales tax and excise duties. In-spite of these advantages, differences among the states regarding implementation of VAT is standing in its way of effective implementation.

However, the problem can be solved by introducing a national level uniform policy relating to the rates and applicability of VAT. Thus an effective policy must be formulated for reducing the unfavourable impact of price rise of essential goods, medicines etc.

It can be stressed in this regard that as the country has become successful in keeping the price of petrol, wine etc. within certain limits by enforcing the rate of VAT in a meaningful manner, so there is no reason to think why the same policy should not be applicable in respect of essential goods, medicines and commodities for mass consumption.

Thus while framing the new acts, it should be drafted in such a manner that it does not create any controversy in respect of its interpretation in different states. Here the simple principle as recommended by Kelkar and other economists has not been followed so far. Even the various terms contained in the Act also differ widely.

Compensation Formula:

The Central Government has promised to compensate all states for any revenue loss and help build a computer network system for the implementation of VAT. States would get 100 per cent compensation for revenue loss, if any, in the first year, 75 per cent of the loss would be compensated in the second year, 50 per cent of the losses would be made up in the third year.

The Empowered Committee of State Finance Ministers which decided to implement VAT by April 1, 2005 finally implemented the VAT as per the promised deadline (April, 2005) in 20 states. After missing the deadline for more than four times in the last 6 years, the Empowered Committee finally implemented the VAT as per its revised deadline.

Essay # 5. Highlights of VAT Implemented from 1st April, 2005:

Following are some of the important highlights of VAT which is implemented in India since April, 2005:

1. VAT to replace Sales Tax, local taxes from April 1, 2005.

2. Government assured the states of three-tier compensation package for revenue loss in the first three years.

3. VAT regime would cover over 550 items.

4. 46 natural and local unprocessed goods are exempted.

5. Petrol, diesel, ATF, sugar, textile and tobacco are kept out of VAT.

6. No decision is yet taken on VAT on CNG.

7. Medicines, agricultural and industrial inputs are kept at 4 per cent VAT slab.

8. Precious metals are kept at 1 per cent VAT.

9. States are having option to exempt or levy 4 per cent VAT on food grains.

10. States are free to choose 12.5 or 4 per cent VAT on tea.

11. Remaining final products are to attract 12.5 per cent VAT.

12. VAT regime is to ensure set-off for input tax paid.

13. Overall tax burden will come down as a result of VAT.

14. Prices in general will fall.

15. States’ revenues are expected to go up.

16. VAT will bring transparency in the system.

17. Threshold limit for traders under VAT is fixed at Rs 5 lakh.

18. Traders with turnover of Rs 5 lakh to 50 lakh can pay 1 per cent VAT.

Thus the value added tax regime finally commenced its operation in 21 states and UTs from 1st April, 2005 as per the deadline fixed by the meeting of Empowered Committee. The Committee is also trying to convince the remaining seven states to implement VAT within their state at its earliest by evolving a consensus.

Essay # 6. VAT Regime:

India initiated vat regime on 1st April, 2005 after a long exercise. Accordingly, the process of implementation of VAT was initiated in 20 states in the first phase. The Empowered Committee has also persuaded the remaining seven states to comply with the VAT regime.

The VAT system is considered as the most ideal form of substitute for the cumbersome indirect taxes and the system is well known to the modern fiscal system throughout the world. The VAT system is likely to reap some benefits to the people and the country as a whole.

One of the most important benefits that would flow from this tax regime is that the tax payers will now pay less tax on their purchase because under the system of sales tax and excise duty at every stage of input production and sale it leads to widespread cascading effect. Thus under the system of VAT, consumer price will not vitiate as taxes will be charged on the value added at each level of production.

As for example, the baker will not have to bear the taxes on wheat, sugar, fuel, butter and all other inputs and will only pay the tax on the amount he sells for bread minus the cost of everything that are required into the making of the finished product.

Secondly, as the VAT system is likely to reduce the complicacy of tax returns and enhanced the transparency into the system, this new system will raise incentive to pay tax and thereby increase tax compliance and also reduce generation of black money.

Thirdly, under the system of VAT, the scope of tax evasion will be almost absent thus the government exchequer will yield much larger revenue collection without putting extra cost of collection and additional monitoring.

Further, it is estimated from the successful VAT—introducing economies, that the new system of VAT would cut down at least one-fourth of the existing tax liability of consumers on relatively high cost items.

In this connection, the experience of Haryana, which is the first state in India to introduce VAT in 2004, has belied all doubts about the implementation and prospect of the system as the collection of tax was much in excess of the quantum expected.

Thus the experience of many countries of the world has amply proved that the system of VAT with moderate rates given the fiscal structure an expedient and forceful indirect tax mechanism.

Although the VAT is implemented in the states with three slabs, viz., 4 per cent, 1 per cent and 12.5 per cent, but ultimately these slabs would be merged into one rate only in order to make the system more simplified.

Moreover, the VAT regime started initially with 550 items but the Empowered Committee is likely to extend the list of items to 2000 units so as to remove anomalies and bring in uniformity across states. Thus the new system of VAT would widen the tax base in the long run and would make the tax system more rational.

However, what is required at this moment is that business community, particularly small units should pick up the habits of maintaining proper accounts and the tax collectors be duly trained about the process and procedure of VAT implementation. The government will have to avoid all other existing levies at the earliest possible time.

It is expected that the country will he settled with the new system of VAT within one year. In the mean time, the Central Government has taken a decision to phase out Central Sale Tax (CST) from April 2007. Thus announcing a clear road map for phasing out CST and other levies will create a congenial atmosphere for the implementation of VAT.

Thus under the present provision what is being introduced is a multi-point tax with provision for input tax credit in intra-state trade which is far away from a full fledged destination based VAT. This imperfection need to be corrected by consensus.

But the empowered committee is not so serious implementing the system as state level tax and simultaneously there would be no other tax such as entry tax, cess, luxury tax, expenditure tax etc.

It has been suggested that all the articles, drugs, medicines and allied products must be kept in schedule of essential commodities attracting the tax rate of 4 per cent. Just as the price of all life saving medicines should be uniform throughout the country, all taxes levied by the states on medicine and other essential commodities should also be uniform.

All other levies such as entry tax, octroi, surcharges, cess etc. on medicines and other commodities must be with-dawn immediately so as to avoid variations in the price of life saving medicines and other commodities.

Thus the type of VAT which we are introducing is a fractured VAT for attaining an illusory benefit of neutrality and anti-cascading but at the same time keeping scope for the possibility of rampant erosion in the form of taking false input credit with bogus invoices. Things would have been much better if we could introduce the uniform rates of retails sales tax (RST) with no .input credit, no CST and no entry tax.

GST:

Thus after successfully implementing the Value Added Tax (VAT) in all states, the government is now working on implementing a comprehensive goods and services tax (GST) at Centre and States by 2010. GST is proposed to be introduced from April 1, 2010 to integrate all indirect taxes on goods and services at the state and Central level.

The VAT panel had already accepted recommendation of a working group to have dual GST structure one at the state level and the other at the central level. The VAT panel has also worked out the rates at which the proposed Goods and Services Tax will be levied by the states and the Centre.

Thus at this juncture there cannot be any choice other than VAT. Rather, VAT should be introduced in a meaningful manner throughout the country. Thus the country should attain a consensus on its modalities.