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Delhi: Come All Fools Day (1 April 2003), and almost
all the states and union territories of India will switch
over to the value-added taxation (VAT) system. Some of
the states have already framed their legislation while
some will pass their legislation in the coming days.
The
states have agreed, in large measure, to adopt the Model
VAT Law framed by the Empowered Committee of State Finance
Ministers with the help of the National Institute of Public
Finance and Policy, Chennai.
To
understand the principle on which VAT works, let us consider
an example, say, of a textile processor. He buys his raw
material, which is cloth from the market, for a sum of
Rs 10,000. Under the present taxation system, he has to
pay a tax of say, 10 per cent, which brings his cost of
raw materials to Rs 11,000.
The
raw materials are then processed into finished goods,
which now has a market value of, say, Rs 20,000. On sale
of the goods for Rs 20,000, once again a tax of 10 per
cent is levied, bringing the total selling price to Rs
22,000. Here, the total tax collected is Rs 3,000. That
is Rs 1,000 initially and Rs 2,000 in the second stage.
Now it becomes clear that tax on the raw materials is
collected twice and is unfair to the taxpayer.
VAT
attempts to eliminate this anomaly. Continuing with the
above example, under VAT, tax in the second phase will
be levied only on the value-added portion. Thus a tax
of 10 per cent will be levied on Rs 9,000, which is the
value-added portion and the total amount of tax collected
will be Rs 1,900 as against Rs 3,000 under the earlier
system.
What
makes VAT superior?
Under the VAT regime, prices of goods will fall. This
will lead to an increase in the demand for goods resulting
in more sales and eventually more tax collections for
the governments. This has worked successfully in western
countries, which follow the VAT system of taxation.
The
VAT system will also improve tax compliance. The textile
processor under the VAT regime will insist on an invoice
for his raw material purchases as that will be the proof
that he had paid taxes on his raw materials initially
and will entitle him to a credit. Thus, non-cash transactions
will be eliminated, which will widen the tax net.
Speaking
at a recent workshop on VAT organised by the Karnataka
Chambers of Commerce and Industry, Renuka Vishwanathan,
a member secretary of the Tax Reforms Commission, said
VAT is expected to encourage savings, investments and
economic growth.
She
also went on to add that VAT has emerged as the most effective
mechanism worldwide for levying and administering taxes
on consumption. Most countries have adopted the VAT structure
of commodity taxation because of its non-distortionary
impact.
“The
shift to VAT is the most desirable fiscal reform for the
country today, and as commodity taxes account for three-fourths
of the tax revenues of states, this would result in radical
transformation of their tax structures. The magnitude
and nature of the contemplated change made it the most
significant event in fiscal federalism since Independence,”
she said.
VAT
was first introduced in a modified way in India in the
mid-eighties by the central government, which had, for
nearly a decade, been persuading state governments to
switch over to VAT but without success till now.
The
state governments’ reluctance to switch over to VAT
was stemmed by the fear of loss of revenues. Under the
earlier system, which was in force since the days of princely
states, any state government was virtually free to slap
any sorts of tax like entry tax, purchase tax and what
not to increase their revenues.
While
this may have brought them revenues, these taxes were
also dampeners to free and unrestricted interstate sales.
The new regime ensures similar tax levies for all the
states and smoother flow of interstate trade.
Till
about a few months back only a handful of states were
agreeable to switch over to VAT. It is to the credit of
Finance Minister Jaswant Singh that he has now managed
to convince almost all the states and union territories
to switch over.
The
switchover, however, has come with a rider. The central
government has guaranteed that they will reimburse the
state governments for the loss of revenues, if any, in
the initial years. A totally unnecessary step, according
to many economists.
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