Going slow on VAT

The indefinite postponement of the implementation of Value Added Tax provides an opportunity for a reappraisal of its consequences, especially for the States whose finances are a shambles.

THE countrywide implementation of Value Added Tax (VAT), which is portrayed by its proponents as "the tax to end all taxes", has beem postponed yet again - this time indefinitely. The withdrawal of, what is arguably the most ambitious tax "reform" attempted in India, has been termed as "the mother of all rollbacks". In the face of massive resistance from traders, the target date of April 1 was postponed to June 1. Although 16 States subsequently agreed to implement the VAT regime from June 1, Union Finance Minister Jaswant Singh announced in early May that the measure had been postponed "indefinitely". Apparently, there was pressure from the traders' lobby, and the fear of a backlash from the electorate of States going to the polls later this year.

However, there are others who are celebrating the rollback for what they regard to be more important reasons. A more considered reaction to VAT has come from its critics who argue that its implementation poses a grave danger to the existing arrangements governing Centre-State financial relations and that no tears need be shed if VAT is never implemented at all. There is the fear that VAT can lead the already beleaguered State governments on the road to financial ruin. Moreover, there is also the apprehension that the Union government is under pressure from the International Monetary Fund (IMF), which has in recent years been insisting that developing countries move over to a VAT-based tax regime. The IMF has pushed VAT despite the fact that the results of its own recent studies are equivocal about the impact of the tax on government finances.

In principle, VAT seeks to address the problem of taxing inputs at multiple levels along the supply chain. The argument for a VAT rests on the contention 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 so that there is no tax on tax that has already been paid. This implies that taxes, at any stage along the chain, should only be applied on the value addition that occurs at that level, instead of levying them on value addition that has already occurred. This, it is argued, avoids the problem of multiple taxation. Such a tax system will not only reduce prices but also enable a more efficient allocation of resources in the market. Since entities along the 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. This will ensure "self-policing" of the tax system, and economic agents themselves will, it is argued, solve the problem of tax evasion that is the bane of the Indian tax system. In sum, proponents of VAT argue that it is a modern, efficient, fair and easy way to implement the tax system. It is also argued that a unified, countrywide VAT will prevent States from indulging in a race to the bottom by offering competing incentives to economic agents in order to attract investment. This will also, incidentally, serve the objective of developing a pan-Indian common market.

West Bengal Finance Minister Ashim Dasgupta told Frontline that VAT was "enormously friendly" to taxpayers and unfriendly to "tax dodgers". He regards VAT as being a progressive tax, and not a regressive one as alleged by its critics.

It is important to recognise the fact that the VAT regime that is planned only aims to replace the sales tax, which State governments currently impose. The Constitution guarantees this domain exclusively for the States. The origins of the Indian experience with VAT can be traced to 1986 when V.P. Singh, then Finance Minister in the government headed by Rajiv Gandhi, introduced Modvat (modified VAT). Modvat was aimed at applying the VAT method in manufacturing, to replace the central excise. Over the years, Modvat coverage increased, and it was renamed Cenvat in 2000.

The ongoing initiative envisages VAT as a tax to replace the multiple taxes levied on sales by State governments. Although the term VAT suggests taxation of value addition, a more accurate way to understand it in the current context would be to regard it as a tax on consumption. Despite the controversy, it is clear that the burden of VAT will fall on consumers as soon as it is imposed, irrespective of what befalls traders or the State governments. In fact, a study of VAT conducted by the IMF in 2001 pointed out that in several countries there was a spurt in inflation after it was implemented. The study also observed that the VAT system was more suited to smaller economies.

The attempt to implement a State-level VAT regime began in November 1999, when a conference of Chief Ministers, convened by the then Union Finance Minister Yashwant Sinha, authorised the formation of an Empowered Committee of State Finance Ministers to work out its modalities. Ashim Dasgupta assumed charge as the chairman of the committee. After several rounds of discussions, the committee arrived at four basic rates for VAT.

The Indian VAT, covering about 425 commodities, is to have four rates - no tax on necessities (41 commodities); 1 per cent tax on precious commodities such as gold and ornaments; 4 per cent tax on most inputs and other essentials (287 commodities); and 12.5 per cent on goods not specified under the other three categories (91 commodities). In addition, 20 per cent tax has been prescribed for "demerit" goods. It has turned out that the highest VAT rate of 12.5 per cent is also regarded as the "revenue neutral rate", the rate at which the revenue from the levy of the tax after the switchover to VAT does not result in lower revenue mobilisation. Exports are completely exempted from VAT, in keeping with the current perception of boosting exports at any cost. Interestingly, studies of the VAT in Europe (Sweden, Italy, Germany and the United Kingdom) show that VAT has not had any significantly impact on exports.

Traders with an annual turnover of less than Rs.5 lakhs will not be covered by VAT. Moreover, those with an annual turnover between Rs.5 lakhs and Rs.25 lakhs will be covered by a compounding scheme, which requires them to make a payment of 1 per cent of their annual gross turnover. Advocates of VAT have argued that these exemptions will ensure relief for small and petty traders and that only a fraction of the trading segment, particularly the larger traders, will be covered by VAT. Critics, however, argue that a stunted VAT defeats the very rationale for having such a system. Moreover, they also fear large-scale tax evasion by traders who will divide their units in order to dodge the threshold for VAT.

Although the continued imposition of the Central Sales Tax (CST), which is collected by the Union government, is incompatible with the VAT regime, the Empowered Committee has announced that the CST rate is to be reduced from 4 per cent to 2 per cent from the current financial year, and completely phased out by April 1, 2005. This is a contentious issue because the Union government's CST collections are shareable with the States as part of the norms of the Finance Commission, which sets the terms on which the transfer of resources between the Centre and the States takes place. This is a significant issue for funds-starved States; the share of States in CST is expected to be about Rs.15,000 crores in 2003-04. Moreover, the States have argued that they stand to lose revenues because the surcharges and other taxes that they currently levy on sales would be rendered incompatible in a VAT system.

In an attempt to increase the pressure on the straggling States, the Centre announced that its package of 100 per cent compensation in the first year for States implementing VAT will not be on offer for those States which do not implement it during the current fiscal. In his last Budget speech, Jaswant Singh had announced that the compensation to States implementing VAT would be 100 per cent in the first year, 75 per cent in the second, and 50 per cent in the third. Meanwhile, the Union government threw in another carrot to make the States fall in line. The recent passage of the bill in Parliament enabling States to levy taxes on services such as transport, insurance and telecom was obviously a means of enticing them to agree on VAT.

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 consequence for State government finances, which, in most cases, are already a shambles. Whatever the consequences for 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 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, most State governments 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.

There is fear that rampant evasion that characterises the Indian tax system will wreck State finances if VAT is implemented without making institutional changes in the tax structure and reorienting the nature of the fiscal regime that has emerged since the advent of liberalisation. Experts have said that the problem of non-compliance, outright evasion and bogus claims by traders not only threaten to undermine the system, but risk the States finances. The system of credits that dealers will make on the system can also cause havoc to State finances. In fact, there is evidence that indicates that State governments will be swamped by the spurious claims made on them. A study conducted by the National Institute of Public Finance and Policy (NIPFP) of the Modvat scheme, covering the period between January 1994 and July 1995, revealed that evasion, non-compliance and outright fraud were rampant under the system. The study showed that in many cases claims were made without any invoices or on the basis of spurious invoices; in several cases, the same invoices were used to claim multiple credits. Writing in the Economic and Political Weekly (May 10), Sukumar Mukhopadhyay, former member of the Central Board of Excise and Customs, pointed out that even computerisation will 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. Mukhopadhyay points out that once traders understand that the tax authorities are unable to track and examine their credit filings, they will deluge the system with spurious and fraudulent claims.

In fact, the VAT's credit-based system has caused serious problems even in developed economies. For instance, in the U.K., it is estimated that the government loses 2 billion annually owing to the racket in invoices. One effective method, known as the "missing trader" fraud, involves bogus traders, registered under the VAT regime, engaging in a series of transactions across Europe and then disappearing without paying their dues. In effect, even as State governments run the risk of finding their revenues diminished, the added burden of mounting claims on their finances by the trading class threatens to empty their coffers.

CRITICS of VAT argue that the several advantages that supposedly characterise it could be put in place by adopting other measures without undermining existing constitutional guarantees or by causing of State governments to go bankrupt. For instance, the problem of tax competition among States could be resolved within the existing federal system, by agreeing to adopt a common fiscal policy vis-a-vis prospective investors. Several studies on VAT have observed that it is particularly unsuited for a federal polity because it flattens the terrain without taking into consideration the specificities of individual States. Moreover, it undermines the ability of sub-national entities to use fiscal policy in the service of economic development. Ikramul Haq, an authority on VAT in Pakistan, which has been under pressure from the IMF to implement VAT, observes that its real objective is to "utilise the system of tax credits to place the ultimate and real burden of tax on the final consumer and to relieve the intermediaries of any final cost".

It is generally acknowledged that indirect taxes are more regressive because their incidence is the same across all social groups; conversely, direct taxes are reckoned to be a more useful tool if achieving equity is a stated policy objective of governments. Instead, over the decades, the state has increasingly sought to reduce direct taxes, while increasing the proportion of revenue that comes from the levy of indirect taxes. Mukhopadhyay points out that VAT is "basically regressive" in nature. In a situation of declining revenues, the States may be tempted to increase VAT rates, which, theoretically, they would still be able to do. However, there is apprehension that the States, weakened by their poor finances, may be unable to have the leverage they now have in dealing with economic agents in a liberalised environment.

Eminent economist and former West Bengal Finance Minister Ashok Mitra describes VAT as a "major assault on the Constitution". Most of the major taxes such as income and corporation taxes, and excise and customs duties are collected by the Centre. The States are left with the taxes on land, amusement and sales. Mitra said: "For most States, roughly 88 per cent of the total tax revenue comes from sales taxation." He believes that the nature of the national "political landscape" will not allow the government to carry out a constitutional amendment necessary for a national VAT decided by the Centre. In fact, Mitra reckons that any attempt by the Centre to amend the Constitution to set it on a path towards a national VAT will be interpreted as a move to alter the "basic structure of the Constitution", as laid down in the Keshavananda Bharathi case by the Supreme Court in 1973. Mitra argues that this is why the Union government has, instead, asked each of the State governments to pass its own legislation amending the sales tax law.

Critics have also pointed out that the Union government, realising that a legal change is not on the cards, has attempted to woo the States by offering them short-term relief when they are facing a grave financial crisis. There is also apprehension that the Union Finance Ministry is attempting to straitjacket State governments by forcing them to pass legislation amending their individual sales tax Acts, based on the model Bill that it has circulated among them. While the Union government has accepted some Bills (notably, that of Madhya Pradesh), several others have not received the mandatory presidential assent. Critics regard this as a move by the Finance Ministry to force the States along a linear path towards VAT, losing their autonomy in the process.

Ashim Dasgupta dismisses the allegation that the implementation of VAT will imply the abrogation of the States' sovereignty. "The rate structure can be revised, and the special characteristics of the States will remain intact and in no way compromised," he said. Referring to the "lack of agreement" among political parties on VAT, he said a meeting of political parties was scheduled soon to "facilitate" its implementation.

Although the government has made a retreat on VAT, mainly because of pressure from one of its key constituents, and the fear of the "reform's" consequence in the coming elections, the delay provides the much-needed breathing space for a closer examination of the consequences of VAT.