The Value Added Tax regime, which came into effect in parts of the country on April 1, is criticised for undermining the constitutional principles defining Centre-State financial relations and affecting the States' finances which are already under a strain.
V. SRIDHAR in ChennaiSUHRID SANKAR CHATTOPADHYAY in KolkataTHE countrywide implementation of Value Added Tax (VAT) finally got off the ground on April 1. But it remains as divisive as ever. Several States have chosen not to implement it. Eight major States, five under the control of the Bharatiya Janata Party (BJP), and Tamil Nadu, Uttaranchal and Uttar Pradesh, have postponed its implementation. Opposition to VAT remains strong. Traders across the country welcomed VAT with a three-day nationwide strike.
The divisions on VAT are quite sharp. While the big industry organisations welcomed it and lobbied aggressively for its implementation, small businesses, particularly retail traders, protested against it. The BJP was quick to realise the potential of dissent from this substantial section. The party, which initiated the move towards VAT, changed tack. Two weeks before the regime was to take off it announced that States under its control would not implement VAT until "requisite preparatory steps" were taken by the Union government. It said that BJP-ruled States would not implement VAT until the Centre committed itself to a road map to phase out the Union government-levied Central sales tax.
The attempt to implement a State-level VAT regime began in November 1999, when a conference of Chief Ministers, convened by Union Finance Minister Yashwant Sinha, authorised the formation of an Empowered Committee of State Finance Ministers to prepare the road map for its implementation. West Bengal Finance Minister Ashim Dasgupta was made the chairman of the committee.
VAT is an attempt to address the problem of taxing inputs at multiple levels along the supply chain. Proponents of the tax argue that since inputs that go into the making of a product are already taxed once, they should be set off at the higher levels along the chain. They claim that this would avoid the "tax on tax" effect, which is inflationary. This implies that taxes, at any stage along the supply chain, should only be levied on the value addition that occurs at that level, instead of levying them on value addition that has already occurred. The tax, levied on the value that manufacturers and traders add at each stage in the process of production and distribution, is to replace effectively the State governments' sales tax. A uniform VAT rate across the country, it is claimed, will replace the web of sales tax rates that different States levy. Unified VAT rates would result in a pan-Indian market, which manufacturers and traders can address. It will also halt the practice of States indulging in a race to the bottom by offering competing incentives to attract investment.
Proponents of VAT argue that it will reduce prices and enable a more efficient allocation of resources in the market. Since entities along the supply chain have a stake in claiming set-offs for value addition that they have carried out, each of them has a stake in maintaining accounts in a transparent manner. The "self-policing" this entails will result in better compliance and solve the problem of tax evasion. VAT, from this perspective, is a modern, efficient, fair and simple tax system.
Why should a tax that appears so reasonable at first glance provoke so much acrimony? The apprehensions about VAT can be broadly classified into three sets. First, there are fears that VAT's proponents grossly exaggerate the advantages of the tax when compared to the sales tax, which has been the single most important source of revenue for the States for the past 75 years. Second, critics allege that VAT violates the constitutional provisions that govern Centre-State financial relations. They also apprehend that the move towards a unified VAT will impose a squeeze on State finances at a time when they are already under strain. Critics contend that the States are being hustled into implementing VAT. Third, there are fears that VAT, instead of being a simple tax, will actually turn out to be far more complicated. More important, the complexities of the tax structure would make it difficult for smaller players to remain in business. This, critics allege, will reduce competition and enhance the power of monopolies and the concentration of economic power.
Professor Prabhat Patnaik, economist at the Jawaharlal Nehru University, New Delhi, counters the claim that VAT would not cause a "cascading effect", which sales tax is supposed to cause because it taxes inputs that have already been taxed. He points out that if the total quantum of revenue raised by the government under both regimes is the same, one cannot be more inflationary than the other. He pointed out that VAT is only different from the sales tax insofar as it is a stage-wise levy. "I just do not see the point in the argument that somehow this cascading effect is bad. I do not see how a stage-wise distribution of taxes [VAT] can be more efficient than the other method [sales tax]. I have even come across people who say that the cascading effect is inflationary, which is nonsense," he said.
Regarding the contention that VAT would unify the Indian market, Patnaik said: "I just do not see the point in the notion that VAT is going to unify the market... . Who says that the Indian market is not unified? Many advanced countries do not have VAT. For instance, the U.S. has no VAT regime. Who is going to say that the U.S. is not a unified market?"
Critics of VAT also dismissed the contention that VAT is simple, easy to administer and deters tax evasion. They argue that in fact it is more cumbersome and difficult to administer than sales tax. Sukumar Mukhopadhyay, former member of the Central Board of Excise and Customs, said that computerisation would not solve the problem caused by bogus claims. Only physical verification of individual invoices, of which there will be millions, can weed out the bogus claims made by traders, dealers and manufacturers.
Once traders understand that the tax authorities are unable to track and examine their credit filings, they will deluge the system with spurious claims. This is exactly what happened in several advanced countries. France, where the idea of VAT originated, has had problems with the tax. In 1981, according to Mukhopadhyay, the "net evasion" of VAT, defined as the deviation between actual and hypothetical revenue, amounted to 18 per cent. This amounted to 6.6 per cent of the total revenues, and 0.7 per cent of France's GDP. In India the mounting bogus claims on State finances by the VAT-able entities class can add significantly to the problem of diminished revenues that VAT itself may cause.
VAT rates that have been announced are in two slabs: 4 per cent for essentials and industrial inputs and 12.5 per cent for most other commodities. Amaresh Bagchi, former Director of the National Institute of Public Finance and Policy, argued that a revenue-neutral VAT rate - that is the rate at which States' revenues would not be less than what they were prior to the implementation of VAT - would have to be at least 14 per cent. Since most of the commodities would be taxed at the VAT rate of 4 per cent or 12.5 per cent, it appears likely that State governments will suffer losses post-VAT.
Eminent economist and former West Bengal Finance Minister Ashok Mitra, who has challenged the State's VAT legislation in the Calcutta High Court, said that West Bengal's collection of revenue from the tax on essential commodities would decline from Rs.3,070 crores in 2004-05 to Rs.1,070 crores in 2005-06. He estimates that tax collection under the VAT regime would result in a revenue of about Rs.3,800 crores in 2005-06, compared to Rs.6,000 crores in the current year.
Patnaik explains that the VAT rate needs to be higher than the prevailing sales tax rate because it is applicable only on value addition made by entities. In comparison, sales tax is applicable on the value of output. Since the value of the output would be higher than the value addition at any stage of production or distribution, the VAT rate would necessarily have to be higher than the sales tax rate in order to generate the same volume of revenues for the States' coffers.
THE crux of the arguments against VAT rests on the fear that it will ruin the States' finance, while undermining the constitutional guarantees that govern Centre-State financial relations. The foremost concern is about VAT's consequences for State finances, which, in most cases, are already a shambles. Whatever the consequences for the prices of commodities in a post-VAT situation, it is evident that VAT rates have to be substantially higher in order to maintain State government revenues at the same level as they currently are in a sales tax regime. However, since the State governments are to be bound by a unified system of VAT rates, they would lose the freedom to set tariffs to compensate for a fall in revenues. In fact, many are worried that VAT will send them on the road to ruin. The contention that VAT will lead to lower prices is also viewed with scepticism. Critics argue that traders may well hike their own margins instead of passing on the benefits to consumers.
Nirmal Kumar Chandra, formerly Professor at the Indian Institute of Management (Kolkata), pointed out that small manufacturers were likely to suffer losses in a VAT regime. He said that bigger retail traders might find it more profitable to buy directly from big producers, rather than smaller entities. Moreover, the duality that has been caused by the exemptions granted to smaller entities (those with a turnover of less than Rs.10 lakhs a year) is likely to put them at a disadvantage vis-a-vis bigger producers and traders. A big player will be able to set off taxes paid down the chain by supplying or sourcing from a similarly placed larger retailer or manufacturer rather than a smaller one. In effect, the smaller producers and dealers will become marginalised as a full-blown VAT regime unfolds.
The Centre has held out the carrot of compensation to States joining the bandwagon. In the first year States implementing VAT will be compensated fully the shortfall in revenues that results from VAT; in the second year this will be scaled down to 75 per cent, and it will taper off to 50 per cent in the third year. From the fourth year there will be no compensation. However, recent reports indicate that this is not likely to happen. The Union Budget for 2005-06 has earmarked Rs.5,000 crores for compensation. However, the shortfall in just one State - Karnataka - is estimated to be more than Rs.2,000 crores. The shortfall in States such as Maharashtra and Andhra Pradesh, which have a higher revenue base, is likely to be higher. It is obvious that the compensation is likely to fall far short of the promises made by the Union Finance Ministry.
Offering a political economy perspective on VAT, Patnaik said that the push towards VAT had come at a time when State finances were under severe pressure. It is coming in the wake of the Twelfth Finance Commission's recommendation that States access funds from the market rather than the Centre (Frontline, April 8). "This, in itself, would be bad enough. But things could get far worse when these States will approach lending agencies such as the World Bank, the Asian Development Bank or seek assistance from American, German, French or British capital, agreeing to whatever conditions these agencies may choose to impose." This, he said, "is a recipe for the balkanisation of India. I think the move towards VAT and the fiscal stance that is being adopted is extremely dangerous. Of course, all this is a part of the liberalisation package. In fact, this is what these agencies want. They want to deal directly with the State governments. For instance, they find it much easier to get them to open up their diamond mines or the mineral sector in general. To some extent the buffer of the Central government and the accompanying parliamentary scrutiny would not be available to check the actions of these agencies."
Moreover, regional imbalances would get accentuated because of VAT. Poorer States, where there is less value addition, are likely to suffer more because of VAT. Patnaik said that whatever happened to the overall tax revenue, "its distribution across States is certainly going to get skewed". Haryana is often quoted as a good case for VAT. But Haryana, or States which are closer to metropolitan centres, are the ones where there is greater potential for value addition. These States are likely to get more revenues than other, poorer ones. There is lesser value addition in the poorer States; moreover, they are basically centres producing primary commodities. The value addition norm of the tax is thus likely to be loaded against the poorer and less industrialised States.
Patnaik points out that the imbalance "is not going to get covered by the three-year compensation formula that the Centre has promised the States". "Once the compensation tapers off, the poorer States are going to be left high and dry. To forget all of that in the name of some absurd and abstract notion of efficiency seems to me to be very wrong," he said.
Patnaik said that neither the Finance Ministry nor the States had done any study of the likely impact of VAT on State finances. He regards VAT as "a centralisation of the tax system" whereby the rules across the country could be made uniform in order to conform to the needs of foreign capital. Patnaik points out that "big capital" prefers centralisation. "It would rather not to go to each of the States asking them not to tax this or that commodity. This is easier done with the Finance Ministry in Delhi. VAT is part of the liberalisation process. Many of the industrialists are committed to this agenda. The idea of a federal polity is not approved by big capital."
Patnaik argues that while it is easy to dismiss the traders' opposition to VAT as being governed by their own "self-interest", it is necessary to understand the underlying issues. He thinks that both the BJP and the Congress would come under pressure from the large constituency consisting of traders. He feels that the Left now appears to have an "open mind" on the issue. "The Left has not taken up the VAT issue in the way they have taken up some of the other issues. But I think once the Left makes up its mind, it will have a major impact, he said."
