What is VAT?
VAT (Value Added Tax) is a multi-point tax which is levied at every stage of sale with a provision for setting-off of tax paid at the previous stage/tax paid on inputs. Thus, effectively, it is levied on the vale that is added to the price of a product at each stage, either due to the passing of the product through various hands in a channel of distribution or due to some process undertaken on it. And hence the name.
In simple words, VAT works on the principle that raw material passes through various manufacturing stages and manufactured product passes through various distribution stages, tax should be levied on the 'Vale Added' at each stage and not on the gross sales price. This ensures that same commodity does not get taxed again and again and there is no cascading effect. In simple terms, 'value added' means difference between selling price and purchase price. VAT avoids Cascading effect of a tax.
How is VAT different from Sales Tax?
The main difference between Sales Tax and VAT lies in the way the tax is levied. In case of Sales Tax, the tax is generally levied at either the first point or the last point in the distribution chain. It is therefore, a single-point tax system. In case of VAT, the tax is levied at each point in the distribution chain with a provision for setting-off of input tax paid on purchase. Thus, VAT is a multi-point tax system.
Benefits of VAT
Simple, transparent and dealer-friendly tax administration. This will improve tax compliance and also augment revenue growth.
No cascading effect of double taxation of commodities as it grants set-off of tax paid at the previous stage/tax paid on inputs.
A multiplicity of other taxes, such as turnover tax, surcharge on sales tax, additional surcharge, etc. will be abolished.
In addition, Central Sales Tax is also going to be phased out. As a result, overall tax burden will be rationalised, and prices in general will also fall.
The existing system of inspection will be replaced by a system of built-in self-assessment by the dealers and auditing.
Thus, in general, VAT will help common people, traders, industrialists and also the Govt. It is indeed a move towards more efficiency, equal competition and fairness in the taxation system.
Background of VAT
VAT was introduced first in Brazil in mid 1960s, then in European countries in 1970's and subsequently introduced in about 130 countries, including several federal countries. In Asia, it has been introduced by a large number of countries from China to Sri Lanka. Even in India, there has been a VAT system introduced by the Government of India for about last ten years in respect of Central Excise Duties. At the State-level, the VAT system as decided by the State Governments would now be introduced in terms of Entry 54 in List II of VII schedule of the constitution of India.
What is the meaning of 'cascading effect of tax'?
Generally, any tax is related to selling price of product. In modern production technology, raw material passes through various stages and processes till it reaches the ultimate stage e.g., material passes through various stages and processes till it reaches the ultimate stage e.g., steel ingots are made in a steel mill. These are rolled into plates by a re-rolling unit, while third manufacturer makes furniture from these plates. Thus, output of the first manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third manufacturer. This process continues till a final product emerges. The product then goes to distributor/wholesaler, who sells it to retailer and then it reaches the ultimate consumer. If a tax is based on selling price of a product, the tax burden goes on increasing as raw material and final product passes from one stage to another.
For example, let us assume that tax on a product is 10% of selling price. Manufacturer 'A' supplies his output to 'B' at Rs. 100. Thus 'B' gets the material at Rs. 110, inclusive of tax @10%. He carries out further processing and sells his output to 'C' at Rs. 150. While calculating his cost 'B' has considered his purchase cost of materials as Rs. 110 and added Rs. 40 as his conversion charges. While selling product to C, B will charge tax again @ 10%. Thus C will get the item at Rs. 165 (150+10% tax). In fact, 'value added' by B is only Rs. 40 (150-110), tax on which would have been only Rs. 4, while the tax paid was Rs. 15. As stages of production and/or sales continue, each subsequent purchaser has to pay tax again and again on the material, which has already suffered tax. Tax is also paid on tax. This is called cascading effect.
How VAT avoids cascading effect of tax?
System of VAT works on tax credit method. In Tax Credit Method of VAT, the tax is levied on full sale price, but credit is given of tax paid on purchases. Thus, effectively, tax is levied only on 'Value Added'. Most of the countries have adopted 'tax credit' method for implementation of VAT.
No cascading effect of double taxation of commodities as it grants set-off of tax paid at the previous stage/tax paid on inputs.
A multiplicity of other taxes, such as turnover tax, surcharge on sales tax, additional surcharge, etc. will be abolished.
In addition, Central Sales Tax is also going to be phased out. As a result, overall tax burden will be rationalised, and prices in general will also fall.
The existing system of inspection will be replaced by a system of built-in self-assessment by the dealers and auditing.
Thus, in general, VAT will help common people, traders, industrialists and also the Govt. It is indeed a move towards more efficiency, equal competition and fairness in the taxation system.
Background of VAT
VAT was introduced first in Brazil in mid 1960s, then in European countries in 1970's and subsequently introduced in about 130 countries, including several federal countries. In Asia, it has been introduced by a large number of countries from China to Sri Lanka. Even in India, there has been a VAT system introduced by the Government of India for about last ten years in respect of Central Excise Duties. At the State-level, the VAT system as decided by the State Governments would now be introduced in terms of Entry 54 in List II of VII schedule of the constitution of India.
What is the meaning of 'cascading effect of tax'?
Generally, any tax is related to selling price of product. In modern production technology, raw material passes through various stages and processes till it reaches the ultimate stage e.g., material passes through various stages and processes till it reaches the ultimate stage e.g., steel ingots are made in a steel mill. These are rolled into plates by a re-rolling unit, while third manufacturer makes furniture from these plates. Thus, output of the first manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third manufacturer. This process continues till a final product emerges. The product then goes to distributor/wholesaler, who sells it to retailer and then it reaches the ultimate consumer. If a tax is based on selling price of a product, the tax burden goes on increasing as raw material and final product passes from one stage to another.
For example, let us assume that tax on a product is 10% of selling price. Manufacturer 'A' supplies his output to 'B' at Rs. 100. Thus 'B' gets the material at Rs. 110, inclusive of tax @10%. He carries out further processing and sells his output to 'C' at Rs. 150. While calculating his cost 'B' has considered his purchase cost of materials as Rs. 110 and added Rs. 40 as his conversion charges. While selling product to C, B will charge tax again @ 10%. Thus C will get the item at Rs. 165 (150+10% tax). In fact, 'value added' by B is only Rs. 40 (150-110), tax on which would have been only Rs. 4, while the tax paid was Rs. 15. As stages of production and/or sales continue, each subsequent purchaser has to pay tax again and again on the material, which has already suffered tax. Tax is also paid on tax. This is called cascading effect.
How VAT avoids cascading effect of tax?
System of VAT works on tax credit method. In Tax Credit Method of VAT, the tax is levied on full sale price, but credit is given of tax paid on purchases. Thus, effectively, tax is levied only on 'Value Added'. Most of the countries have adopted 'tax credit' method for implementation of VAT.
The aforesaid illustration will work out as follows under VAT system.
'B' will purchase goods from 'A' @ Rs. 110, which is inclusive of duty of Rs. 10. Since 'B' is going to get credit of duty of Rs. 10, he will not consider this amount for his costing. He will charge conversion charges of Rs. 40.00 and sell his goods at Rs. 140. He will charge 10% tax and raise invoice of Rs. 154.00 to 'C'. (140 plus tax @ 10%). In the Invoice prepared by 'B', the duty shown will be Rs. 14. However, 'B' will get credit of Rs. 10 paid on the raw material purchased by him from 'A'. Thus, effective duty paid by 'B' will be only Rs. 4. 'C' will get the goods at Rs. 154 and not at Rs. 165, which he would have got in absence of VAT. Thus, in effect, 'B' has to pay duty only on value added by him.
Disadvantage of Cascading Effect of Taxes
A tax purely based on selling price of a product has cascading effect, which has the following disadvantages :
Computation of exact tax content difficult - It becomes very difficult to know the real tax content in the price of a product, as a product passes through various stages and tax is levied at each stage. This is particularly important for granting Export incentives or for fixing regulatory prices.
Varying Tax Burden - Tax burden on any commodity will vary widely depending on the number of stages through which it passes in the chain from first producer to the ultimate consumer.
'B' will purchase goods from 'A' @ Rs. 110, which is inclusive of duty of Rs. 10. Since 'B' is going to get credit of duty of Rs. 10, he will not consider this amount for his costing. He will charge conversion charges of Rs. 40.00 and sell his goods at Rs. 140. He will charge 10% tax and raise invoice of Rs. 154.00 to 'C'. (140 plus tax @ 10%). In the Invoice prepared by 'B', the duty shown will be Rs. 14. However, 'B' will get credit of Rs. 10 paid on the raw material purchased by him from 'A'. Thus, effective duty paid by 'B' will be only Rs. 4. 'C' will get the goods at Rs. 154 and not at Rs. 165, which he would have got in absence of VAT. Thus, in effect, 'B' has to pay duty only on value added by him.
Disadvantage of Cascading Effect of Taxes
A tax purely based on selling price of a product has cascading effect, which has the following disadvantages :
Computation of exact tax content difficult - It becomes very difficult to know the real tax content in the price of a product, as a product passes through various stages and tax is levied at each stage. This is particularly important for granting Export incentives or for fixing regulatory prices.
Varying Tax Burden - Tax burden on any commodity will vary widely depending on the number of stages through which it passes in the chain from first producer to the ultimate consumer.
Discourages Ancillarisation - Ancillarisation means getting most of the parts/components manufactured from outside and making final assembly. It is common for large manufacturers (like automobile, machinery etc.) to get the parts manufactured from outside and make final assembly in his plant. If a component is purchased from outside tax is payable. However, if the same component is manufactured inside the factory, no tax would be payable. Thus, manufacturers are tempted to manufacture parts themselves instead of developing ancillary units for supply of the same. This is against the national policy, because it discourages growth of Small Scale Industries and increases concentration of economic power.
Increase cost of production - If a manufacturer decides to reduce ancillarisation, it increases cost of production and waste of scarce national resources, as the large manufacturer may not be in a position to fully utilise the production capacity of the machinery.
Concessions on basis of END use is not possible - Same article may be used for various purposes e.g. Copper may be used for utensils, electric cables or air conditioners. Government would naturally like to vary tax burden depending on use. However, this is not possible as when Copper is cleared from factory, its final use cannot be known.
Exports cannot be made tax free - Though final products which are exempt from tax, there is not mechanism to grant rebate of tax paid at the earlier stages on inputs - it may be noted that as per WTO (World Trade Organisation) stipulations, exports can be made free of domestic taxes, but export incentives as such cannot be given.
Advantage of VAT
Exports can be freed from domestic trade taxes
- It provides an instrument of taxing consumption of goods and services
- Interference in market forces is minimum
- Aids tax enforcement by providing audit trail through different stages of production and trade. Thus, it acts as a self-policing mechanism.
The disadvantage is that paper work increases considerably and it is not as simple as a single point sales tax.
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