VAT - in India

VAT will replace the present sales tax in India. Under the current single-point system of tax levy, the
manufacturer or importer of goods into a State is liable to sales tax. There is no sales tax on the further
distribution channel. VAT, in simple terms, is a multi-point levy
on each of the entities in the supply chain with the facility of
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hands of each of the entities is subject to tax. For instance, if a
dealer purchases goods for Rs 100 from another dealer and a
" "
tax of Rs 10 has been charged in the bill, and he sells the
" "
goods for Rs 120 on which the dealer will charge a tax of Rs

12 at 10 per cent, the tax payable by the dealer will be only Rs www.vatrefund.co.il
2, being the difference between the tax collected of Rs 12 and
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Purchase
price
Rs
100
Tax
paid
on
purchase
Sale
price
Tax
payable
on
sale
price
Input
tax
credit
VAT
payable
-

Rs

10
Rs
12

Rs
-

(input
(output
Rs

Rs

tax)
120
tax)
10
2

VAT levy will be administered by the Value Added Tax Act and the rules made there-under.
VAT can be computed by using either of the three methods detailed below
The Subtraction method:- The tax rate is applied to the difference between the value of output and

the cost of input.

The Addition method: The value added is computed by adding all the payments that is payable to

the factors of production (viz., wages, salaries, interest payments etc).

Tax credit method: This entails set-off of the tax paid on inputs from tax collected on sales.

India
Note

opted

for
:

tax

credit
Also

method,

which
look

is

similar
for

to

CENVAT.
MODVAT

States such as Andhrapradesh, Kerala, Maharashtra, Madhyapradesh, Delhi and Haryana have
experimented with VAT albeit in a limited manner, covering only limited goods. The experiments never had
the full-fledged features of VAT and were only concoctions. These states have even called off their
experiments owing to different reasons. If one analyses why VAT or its variant failed in Maharashtra, which
was the only state to come closer to a true VAT regime, the following reasons emerge:
1. Dual methodologies of computation of VAT credit Error! Hyperlink reference not valid. , one for the
Manufacturing stage and the other for the trading stage, thus breaking the audit trail. It may be noted that
one of the advantages of VAT system, as we would be dealing later on, is the audit trail that is created in the
VAT
chain.

2. Presence of a large number of tax deferral and holiday schemes, which resulted in a narrow base. It may
again be noted that under VAT, which is multi-point, the tax rates have to be reasonably low, and lower tax
rates presupposes that the tax base is wide. These two features were not present in the Maharashtra tax
regime.
3. Low level of awareness among traders, and even administrators, giving rise to fears and apprehensions.
Owing to this, there was considerable consternation among the trade, which gave rise to open revolt against
the
system.
4. Partial implementation of the ideal VAT with the existing system coexisting even under this regime.
5.
6.

Increased
Multiplicity

burden

on

of

rates

retailers
of

of
tax

Bookkeeping
under

the

and
VAT

compliance.
regime.

7. Drop in revenue for the State Government, though there are no studies attributing such reduction to the
system
of
taxation.
Thus States had indeed tried some variations of VAT, but eventually gave up due to a variety of reasons.

Necessity of VAT in India

India, particularly the trading community, has believed in accepting and adopting loopholes in any system
administered by the state or the Centre. If a well-administered system comes in, it will close avenues for
traders and businessmen to evade paying taxes. They will also be compelled to keep proper records of their
sales
and
purchases.
Many sections hold the view that the trading community has
been amongst the biggest offenders when it comes to evading
taxes.
Under the VAT system, no exemptions will be given and a tax
will be levied at each stage of manufacture of a product. At
each stage of value-addition, the tax levied on the inputs can
be
claimed
back
from
the
tax
authorities.
At a macro level, there are two issues, which make the
introduction
of
VAT
critical
for
India.

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Industry watchers say that the VAT system, if enforced

properly, forms part of the fiscal consolidation strategy for the
country. It could, in fact, help address the fiscal deficit problem and the revenues estimated to be collected
could
actually
mean
lowering
of
the
fiscal
deficit
burden
for
the
government.
The International Monetary Fund (IMF), in its semi-annual World Economic Outlook released on April 9,
expressed its concern over India's large fiscal deficit - at 10 per cent of the GDP.
Further any globally accepted tax administrative system, will only help India integrate better in the World
Trade Organisation regime.

Advantages of VAT
Since ages always a reform is made for the benefit in the process of development. It was Chanakya who
first wrote that a government should tax its people like a shepherd shears his flock or a bee gets nectar from
a flower. But apparently that fiscal wisdom died with him. Let us not experience the same with VAT in India. It
has a baggage full of benefits. Few advantages of VAT in India are mentioned below.
It will be a virtual crime not to look to the other side of the coin of the Indian VAT system. Disadvantages will
always give birth to amendments to the existing policy so that traders can ride jerk free on it adding value to
the existing Indian taxation system. We have also discussed upon the friction of VAT below.

Advantages

of

VAT

In the advantages part we will first look after the broad coverage of VAT in the Indian market. Then we will
consider the level of security the Indian VAT is having on our revenues. Obviously the selection of items to
be covered by VAT in India will be given a bullet to think upon and at last we will check out the co-ordination
VAT
in
India
will
be
having
with
our
existing
direct
tax
system.

1)

Coverage

If the tax is carried through the retail level, it offers all the
economic advantages of a tax that includes the entire retail
price within its scope, at the same time the direct payment of
the tax is spread out and over a large number of firms instead
of being concentrated on particular groups, such as
wholesalers
or
retailers.

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base by bringing all transactions into the tax net. Specifically,
VAT gives the new government the opportunity to bring back
into the tax system all those persons and entities who were
given
tax
exemptions
in
one
form
or
another
by
the
previous
regime.

2)

Revenue

security

VAT represents an important instrument against tax evasion and is superior to a business tax or a sales tax
from
the
point
of
view
of
revenue
security
for
three
reasons.
In the first place, under VAT it is only buyers at the final stage who have an interest in undervaluing their
purchases, since the deduction system ensures that buyers at earlier stages will be refunded the taxes on
their purchases. Therefore, tax losses due to undervaluation should be limited to the value added at the last
stage. Under a retail sales tax, on the other hand, retailer and consumer have a mutual interest in
underdeclaring
the
actual
purchase
price.
Secondly, under VAT, if payment of tax is successfully avoided at one stage nothing will be lost if it is picked
up at a later stage; and even if it is not picked up subsequently, the government will at least have collected
the VAT paid at stages previous to that at which the tax was avoided; while if evasion takes place at the final
stage the state will lose only the tax on the value added at that point.

If evasion takes place under a sales tax, on the other hand, all the taxes due on the product are lost to the
government.
A significant advantage of the value added form in any country is the cross-audit feature. Tax charged by
one firm is reported as a deduction by the firms buying from it. Only on the final sale to the consumer is
there
no
possibility
of
cross
audit.
Cross audit is possible with any form of sales tax, but the tax-credit feature emphasises and simplifies it and
is likely to make firms more careful not to evade because they know of the possibility of cross check.

3)

Selectivity

VAT may be selectively applied to specific goods or business entities. We have already addressed essential
goods and small business. In addition the VAT does not burden capital goods because the consumption-type
VAT provides a full credit for the tax included in purchases of capital goods. The credit does not subsidize
the purchase of capital goods; it simply eliminates the tax that has been imposed on them.

4)

Co-ordination

of

VAT

with

direct

taxation

Most taxpayers cheat on their sales not to evade VAT but to evade personal and corporate income taxes.
The operation of a VAT resembles that of the income tax more than that of other taxes, and an effective VAT
greatly aids income tax administration and revenue collection. It is interesting to note that when Trinidad and
Tobago set out to introduce VAT it chose one of its top income tax administrators as the VAT Commissioner.
It must be stressed once again that if properly implemented VAT can ultimately lead to a reduction in overall
rates
of
tax.
Revenues will not be sacrificed but would in fact be enhanced as a consequence of the broadened tax base.
This does not seem to be a bad idea at all.

Disadvantages of VAT
The main disadvantages which have been identified in connection with the Value Added Tax are:

1)

VAT

is

regressive

It is claimed that the tax is regressive, ie its burden falls disproportionately on the poor since the poor are
likely to spend more of their income than the relatively rich person. There is merit in this argument,
particularly if it attempts to replace direct or indirect taxes with steep, progressive rates. However,
observation from around the world and even Guyana has shown that steep tax rates lead to evasion, and in
the
case
of
income
tax
act
as
a
disincentive
to
effort.
Further, there is now a tendency in most countries to reduce this progressivity of taxes as has been done in
Guyana where a flat rate of income tax has been introduced. In any case VAT recognises and makes room
for progressivity by applying no or low rates of tax on essential items such as food, clothes and medicine. In
addition it allows for steep rates of tax on luxury items, although this can create problems for administration
and open opportunities for evasion by way of deliberate misclassification, a problem incidentally not peculiar
to
VAT, and
which
takes
place
extensively in
the
area of
customs
duties.

2) VAT is too difficult to operate from the position of

both
the
administration
and
business.
(a)
The
administration
It is often argued that VAT places a special burden on tax
administration. However, it is worth noting that wherever VAT
was introduced one of its effects was the rationalisation and
simplification of the previous indirect tax system and its
administration. Each of the previous indirect taxes such as
customs duties, purchase tax and excise duties replaced by
VAT had its own rate structure as well as a different tax base
and separate administrative procedure. The consolidation and
incorporation of numerous indirect taxes into the VAT would
simplify the rate structure, tax base, and administration of the
indirect tax system, thereby eliminating the overlapping auditing

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practices that had plagued those systems.

In addition, the abolition of a number of alternative indirect taxes releases experienced personnel to focus on
a single tax. It also means reduction in the number of forms used, legislation to be applied and returns and
accounts
with
which
the
business
person
has
to
contend.
(b)
Business
It is true that the VAT is collected from a larger number of firms than under any form of income tax or single
state sales tax; to the typical smaller firms the complexities of the tax and the need for more extensive
records
(for
example,
to
justify
deductions)
are
likely
to
prove
serious.
However, it is often overlooked that businesses already function with considerable administrative
responsibility for a number of laws including the National Insurance Act and the Income Tax Act.
Under the Income Tax (Accounts and Records) Regulations of 1980 every person, without exception is
required to maintain detailed and extensive records of all its transactions. Compliance with this will certainly

ensure compliance with VAT regulations, and since there is an actual benefit to be derived from accounting
for
VAT
paid
on
input
there
is
an
incentive
for
proper
record-keeping.
As we have noted before, VAT also allows for the exemption of small businesses from the system.
Under any form of sales taxation, small businesses have to be granted special treatment because of their
inability to cope with the requirements of keeping adequate records which larger enterprises can handle at a
reasonable cost. The intent of the special treatment is to reduce the administrative burden on small
enterprises, but not the taxes that normally would be charged on the goods and services they supply. The
revenue loss at the final link in the commercial cycle is limited only to the value added at that stage ,whereas
in the case of income tax or sales tax the entire tax is lost. To recover the loss from exemptions, a flat tax on
turnover
may
be
applied.
In the larger businesses with proper staff and computers, the task is really one of double entry book-keeping
and
any
additional
work
is
hardly
ever
noticed.

3.

VAT

is

inflationary

Some businessmen seize almost any opportunity to raise prices, and the introduction of VAT certainly offers
such an opportunity. However, temporary price controls, a careful setting of the rate of VAT and the
significance of the taxes they replace should generally ensure that there is no increase if any in the cost of
living. To the extent that they lead to a reduction in income tax, any price increases may be offset by
increases
in
take-home
pay.
In any case, any price consequence is one time only and prices should stabilise thereafter.

4.

VAT

favours

the

capital

intensive

firm

It is also argued that VAT places a heavy direct impact of tax on the labour-intensive firm compared to the
capital- intensive competitor, since the ratio of value added to selling price is greater for the former. This is a
real problem for labour-intensive economies and industries.

Items Covered in Indian VAT

550 items covered

270 items of basic needs, like

medicine, drugs, agro &
industrial inputs, capital &
declared goods 4% VAT

Rest 12.5% VAT. Gold & silver

jewellery - 1%

Tea-producing states options

either percentage VAT

Petrol, diesel, liquor, lottery not

included *

Sugar, textile & tobacco

excluded for one year

Traders with turnover of less than 500,000 rupees are exempt from the new tax.

Note : * Some states like Delhi have imposed VAT on diesel at 20%, which is higher than the 12% sales tax
charged earlier. Similarly, Delhi imposed VAT on LPG at 12.5%, which is also higher than the previous sales
tax
rate
of
8
percent.

All business transactions carried on within a State by individuals, partnerships, companies etc. will be
covered
by
VAT.
"More than 550 items would be covered under the new Indian VAT regime of which 46 natural and
unprocessed local products would be exempt from VAT", a PTI report quoted West Bengal Finance Minister
and
VAT
panel
chairman
Asim
Dasgupta
as
saying.
About 270 items including drugs and medicines, all agricultural
and industrial inputs, capital goods and declared goods would
attract
four
per
cent
VAT
in
India.
The remaining items would attract 12.5 per cent VAT. Precious
metals like gold and bullion would be taxed at one per cent.

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Considering the difficulties faced by the tea industry, it was
decided that tea-producing states would be given an option to
levy 12.5 per cent or four per cent subject to review in 2006.

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Petrol and diesel would be kept out of VAT regime in India,
which
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marketable
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Dasgupta was quoted as saying that the panel was yet to take
a
view
on
CNG.
Following opposition from some of the states, it was decided that states would have option to either levy four
per cent or totally exempt food grains but it would be reviewed after one year.
Three items - sugar, textile and tobacco - covered under Additional Excise Duties, will not be under VAT
regime
for
one
year
but
the
existing
arrangement
would
continue.

The Indian VAT panel relaxed the threshold limit for traders coming under VAT regime from Rs 5-50 lakh of
turnover
from
the
previous
stance
of
Rs
5-40
lakh.
Traders within this limit can pay a composite VAT rate of one per cent but would not be entitled to input tax
credit.

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The Impact of VAT in India

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VAT is most certainly a more transparent and accurate

system of taxation. The existing sales tax structure
allows for double taxation thereby cascading the tax
burden. For example, before a commodity is produced,
inputs are first taxed, the produced commodity is then
taxed and finally at the time of sale, the entire
commodity is taxed once again. By taxing the commodity
multiple times, it has in effect increased the cost of the
goods and therefore the price the end consumer will pay
for
it.

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The transaction chain under VAT assuming that a profit

of Rs 10 is retained during each sale.
SALE 'A' OF CHENNAI
'B' OF
SALE
'C' OF
@ Rs. 100/BANGALORE @ Rs. 114/- BANGALORE

SALE
@ Rs. 124/

'D' OF
SALE
CONSUMER
BANGALORE @ Rs. 134/IN

BANGALORE

Tax implication under Value Added Tax Act

Seller

Buyer

Selling Price
(Excluding Tax)

Tax
Rate

Invoice value
(Incl Tax)

Tax
Payable

Tax
Credit

Net
TaxOutflow

100

4% CST

104

4.00

114

12.5%
VAT

128.25

14.25

0*

14.25

124

12.5%
VAT

139.50

15.50

14.25

1.25

Consumer

Total to Govt.

134

12.5%
VAT

150.75

16.75

15.50

1.25

VAT
CST

16.75
4.00

*Note: CST Paid cannot be claimed for credit. CST is assumed to remain the same though it
could to be reduced to 2% when VAT is introduced and eventually phased out.
VAT can be considered as a multi-point sales tax with set-off for tax paid on purchases (inputs)
and capital goods. What this means is that dealers can actually deduct the amount of tax paid by
him for purchase from the tax collected on sales, thereby paying just the balance amount to the
Government.