Condemned unheard

The existing sales tax regime in India is characterised by rampant temptation to tax at first point, multiplicity of rates, cascading and numerous exemptions. Most of the states were levying sales tax on the manufacturers for administrative simplicity. It erodes the base by leaving value addition at subsequent stages untaxed besides inducing under-valuation and vertical integration to avoid tax.

Multiplicity of rates and exemption induce inefficiency due to differential tax treatment of various sectors, products and assets besides leading to classification disputes and opening up avenues for evasion. The low tax sectors attract more and high tax sectors less resources than they would in a more neutral system. It leads to serious misallocation of resources. While some degree of rate differentiation may be justified on grounds of equity and progression, however, we forget that exempted items are not only bought by poor but also by rich; in fact, rich get the most out of exemption as poor mostly meet their consumption needs from informal sectors.

The biggest drawback of the existing system is cascading. The effective rate of a cascading tax, by the time it reaches the retail stage, is approximately two-and-a-half times the nominal rate. The levy of tax on inputs without appropriate procedures for relief through tax drawback or refunds/setoff causes escalation of cost/profit at each stage. Consumer prices tend to be higher than is warranted by the amount of revenue accruing to the government.

The liberal incentives to attract investment cost revenue and induces serious resource misallocation by altering relative profitability of industries based on location and promotes uneconomic scale of operation. They merely redistribute investment across different states in an uneconomic fashion. The strongest argument in favour of VAT is its treatment of inputs. By providing for full credit for taxes paid on inputs including capital goods it cures cascading. It successfully tackles inequities arising due to tax exporting and excessive burden on consumers due to higher prices .

VAT provides a stable base. It is less prone to erosion; exemption means loss of input credit, which in a way acts like an automatic stabiliser. A major advantage is its self-policing nature. The invoice-based credit from input taxes aids voluntary compliance and reduces audit cost. It frees the enterprise to select factors and method of production on grounds of efficiency rather than to minimise the impact of tax on their cost. Finally, set-off for taxes on input relieves export from internal indirect taxation and helps a country to maintain its competitiveness. The general thrust of VAT on few and low rates, wide base and few exemptions impart neutrality. An interesting dimension of VAT relates to efficiency cost of raising additional revenue. An efficient tax should raise additional revenue with lowest marginal excess burden or efficiency loss. Being a comprehensive tax with wide base its marginal efficiency loss is less compared to a narrow based high rate sales tax.

However, introduction of VAT is not without apprehensions. It is alleged that VAT is inflationary and regressive, results in loss of revenue due to input tax credit and difficult to administer as number of traders who would register under VAT would increase many-fold. The concern about inflation is based on the assumption that VAT has a broad base. However, inflation is related more with money supply and the way a government handles its budget and the central bank.

Conventional conclusion suggests that VAT introduced in a revenue-neutral manner would have no impact on the aggregate price level since the aggregate demand remains unchanged. On the contrary, if VAT eliminates distortions caused by sales tax it would result in downward pressure on prices. The belief about regression is based on the assumption that poor consume a higher percentage of their income than rich do and they would bear the burden of VAT. However, we must not ignore the fact that poor source their consumption requirements from informal sectors which are not taxed whereas rich procure from organised and formal channels of supply which would bear the burden of VAT and in that sense VAT may prove to be progressive. As regards revenue neutrality, the international experience suggests that on revenue ground VAT has a creditable record. Since VAT broadens the tax base by capturing value added till retail stage, levy of VAT could very well be revenue neutral.

VAT is said to be a complex system to administer as a large number of new registrants would enter the tax net. The problem of large number of dealers can easily be tackled by setting an appropriate threshold for registration. No doubt introduction of VAT would require designing of a new system but the knowledge and skills acquired by the tax officials can very well be used while applying the new system and the inefficiencies of the old system could be eliminated. The complexity that is attributed to VAT originates from multiplicity of rates and exemption and if they are kept under check administrative complexities can be avoided.

What is now required is to make careful preparation and ensure proper dissemination of information about VAT to all stakeholders. It would be most unfortunate if some unfounded apprehensions come in its way. As long as interest of all the stake- holders are secure and concerns of all are addressed and respected introduction of VAT may prove to be much simpler than it is perceived to be.

(The author is an IAS officer, and is currently posted as Managing Director of Delhi State Industrial Development Corporation)