Basics Of Value Added Tax
Basics Of Value Added Tax
The Value Added Tax (VAT) is a tax on the value added by any business intermediary through his own activity on the goods and services (Inputs) it buys from the other business intermediaries. In the modern production distribution chain, a product goes through different stages of manufacture and then through different stages of distribution before it reaches the final consumer. Example: Primary producers of steel like TISCO and SAIL make HR coils, which are sold to Cold rolling units. Cold rolling units make CR coils and sell these to different industries like auto parts manufacturers, steel furniture manufacturers etc. These final products like steel furniture are then sold to Distributors, which in turn sell these to Retailers, Retailers sell these to final customer, who is the user of these steel furniture. In this entire process of manufacture of HR steel to purchase of furniture by a customer, the product moved from one intermediary to another till it finally reaches to the customer. In this total chain, the output of first intermediary becomes the input of second intermediary, output of second intermediary becomes the input of third intermediary and so on. Each intermediary does his part of the activity on the product to make it good for use by the next intermediary, this is called Value Addition. Value addition tax is the tax on this value.
Thus, VAT is a multi stage Consumption or Production tax, which is applied to the sale of goods at the various stages of production and distribution chain. At each stage, tax is calculated on Sales (Output) and Vendors are able to able to claim tax credits to recover the tax paid on their purchases (inputs). This results in charging of tax only on the value added portion of each vendor. In our above example, Tax of Rs. 1,400 (10% of Rs. 14,000) will be calculated on sales of CR maker. He will be allowed credit of Rs. 1,200 i.e. the tax paid by him on his purchases from HR maker. Thus he will pay only Rs. 200 (equals 10% tax on his value addition of Rs. 2,000) as tax. The input tax credit is not allowed to the final seller in the chain i.e. Retailer in our example.
The incidence of tax in both the systems is the same i.e. 10% VAT is equal to 10% retail sales tax. It may be noted in our above example that the total amount of tax collected in the total chain of manufacture to sale of furniture to final consumer is Rs. 2,100 (Rs. 1200 + 200 + 400 + 100 + 200), it is the same amount i.e. 10% of Rs. 21,000 which would have been collected in the system of Retail sales tax. Thus difference between VAT and Retail sales tax is that VAT is collected in pieces at each stage which equals the tax on retail sale collected in one lump at the final stage.
Brief History of VAT : Value Added Tax (VAT) India
Brief History of VAT : Value Added Tax (VAT) India
VAT has its origin in European Countries (EC). It was pioneered in France, which introduced a value added type of consumption tax on goods in 1954 that was levied at the production stage. The tax was merged with the existing tax on services and local tax on retail sales into a single comprehensive levy, which extended through the retail stage in 1968. This was then adopted by other member states of EC. Adoption of VAT was made a condition for membership of EC, thereby, it was adopted by other new entrants to EC. Due to this, Europe could create a single market by abolishing fiscal frontiers in 1993.
In the world, more than 160 countries have successfully implemented VAT system of taxation. Out of 24 member countries of Organization for Economic Cooperation and Development (OECD), 21 countries have accepted VAT as their main consumption tax.
Thus, VAT as it exists today was unknown about 25 years back. Its widespread in the last 25 years is one of the most significant event in the evolution of tax structure.
VAT (Value Added Tax) - The Meaning
VAT (Value Added Tax) - The Meaning
VAT is a multi-stage tax, levied only on value added at each stage in the chain of production of goods and services with the provision of a set-off for the tax paid at earlier stages in the chain. The objective is to avoid ‘cascading’, which can have a snowballing effect on prices. It is assumed that due to cross-checking in a multi-staged tax, tax evasion will be checked, resulting in higher revenues to the government.
VAT (Value Added Tax) - The Global Meaning
VAT (Value Added Tax) - The Global Meaning
Globally, VAT is regarded as a tax that is best levied by the Central government - a condition that is difficult to meet in a federal finance system such as ours. It is true that 123 countries have adopted VAT, but most of them have unitary systems of government. VAT is a centrally-administered tax with a revenue-sharing mechanism. It is hard to visualise VAT as a revenue-neutral measure, or one where the states will not lose out in relation to the present system, in a federal set-up.
If VAT is Centrally administered, the tax base is quite wide, comprising imports, production and different stages of sales. If the base is divided between the Centre and states, the chain is broken, making tax evasion easier and affecting the states’ tax base. In countries where VAT is administered by a federal government, revenue collection on imports accounts for a larger portion of total VAT revenues. In an IMF study of 22 developing countries, it was discovered that in about two-third of them, more than half the VAT revenue was collected from imports. In Pakistan and Bangladesh, VAT collection from imports was 64 per cent of the total proceeds from the tax. As tax evasion on bulk imports is difficult, it also helps in checking tax evasion at subsequent stages of the tax chain.
VAT (Value Added Tax) - In India
VAT (Value Added Tax) - In India
VAT is the short form of value-added tax. It will replace the present sales tax. 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 set-off of input tax - that is, the tax paid at the stage of purchase of goods by a trader and on purchase of raw materials by a manufacturer. Only the value addition in the 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 2, being the difference between the tax collected of Rs 12 and tax already paid on purchases of Rs 10. Thus, the dealer has paid tax at 10 per cent on Rs 20 being the value addition in his hands.
Purchase price - Rs 100
Tax paid on purchase - Rs 10 (input tax)
Sale price - Rs 120
Tax payable on sale price - Rs 12 (output tax)
Input tax credit - Rs 10
VAT payable - Rs 2
VAT levy will be administered by the Value Added Tax Act and the rules made there-under.
Disadvantages of VAT (Value Added Tax) in India
Disadvantages of VAT (Value Added Tax) in India
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 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.
Advantages of VAT (Value Added Tax) in India
Advantages of VAT (Value Added Tax) in India
Against these disadvantages are the considerable and weighty advantages. These include:
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.
If retailers do evade, tax will be lost only on their margins because customers that are registered firms gain nothing if their suppliers fail to collect tax, except delay in payment; they will pay more to the government themselves. Under other forms of sales tax, both seller and customer gain by evading tax. One particular advantage is that of the widening of the tax 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.