The Hindu Business Line : A VAT of worries

THE present tax base for mobilisation of revenue is quite narrow. There is excessive dependence on the manufacturing sectors' performance for revenue mobilisation by the Centre and the States. It has reduced both flexibility and revenue growth. Agriculture is largely outside the tax net and the service sector, which accounts for 53 per cent of GDP, contributes less than 8 per cent of indirect taxes. The Central and State governments, in their anxiety to reduce the fiscal deficit, have been increasing the tax rates each year on several products. Such high incidence of tax discourages compliance and leads to evasion.

The complex tax structure, with multiple rates in the case of each indirect tax, leads to prolonged litigation, wasting the precious time and resources of the country. Tax barriers have fragmented the Indian market, preventing the effective use of technology and the reduction in supply-chain costs. The more the value addition in the country at different stages, the more will be the adverse impact of such irrational tax structure.

The FMCG industry is one of the most adversely affected by the irrational tax structure in this emerging competitive environment. Its long value-chain — from basic raw materials to the final consumer — spreads across States. The fiscal policy of the Government should be a growth enabler under the current business environment. It must recognise and respond to the elasticity of demand and enhance the competitiveness of the domestic industry for long-term sustainable growth. It should also promote India as a global sourcing hub for export growth.

These are possible only if the current high tax incidence is reduced, which would increase the demand for goods consequent to a reduction in prices. State governments, however, have not yet responded to the changing business environment and instead of reducing the tax rates, have been hiking sales tax rates. For example, between 1995 and 2000 the sales tax on a number of FMCGs have almost doubled. Such increases have not doubled the tax revenue, proving, thereby, the Laffer Curve theory. State-specific VATwill need to take into account the following key aspects to make it better than the present structure:

All State taxes — sales tax, turnover tax, works contract tax, entry tax and octroi — need to be merged into a single VAT tax.

Classification of products should be uniform across the States, preferably based on HSN to facilitate inter-State trade and reduce disputes.

The classification of products in the case of more than one rate structure should be based on objective criteria and not discriminate between packaged and non-packaged or branded and unbranded goods.

As VAT covers a large number of assesses, including retailers, the documentary procedures should be simple and the tax assessments hassle-free.

In view of the multiple rates, it is important that the proposed rate structure takes into account the objective criteria for categorisation of products. It should recognise the price elasticity of demand at different rates and not destroy the value by keeping excessive rate differentials between two competing products. The different revenue-neutral rates fixed at the initial stage by different States should converge at an early date to facilitate inter-State trade within the country and avoid diversion of trade because of tax barriers. There are certain transitional issues that need to be addressed in the VAT structure. The key among them is to provide for tax treatment of pipeline stocks at the time of introduction of VAT. An appropriate time limit needs to be fixed for use of such tax-paid stocks. The new legislation should provide for simple documentation and record-keeping, as it applies to a large number of dealers, including retailers. The registration of new dealers needs to begin early. More importantly Effective communication of the benefit of VAT is essential for its successful implementation and acceptance.

State VAT is likely to have a mixed impact. It would simplify classification disputes, enlarge the tax base (as the tax incidence will shift from source of destination), and reduce tax evasion, which is currently quite significant in first-point sales tax. The negative implications would include an increase in the tax incidence on consumers owing to the shift in tax incidence from manufacturing price to retail price. In the absence of set-off, unlikely to be available for inter-State purchase transactions at the first stage, it would encourage the sourcing of goods within the state. This can further fragment the Indian market. The proposed State VAT would also partially retain the cascading tax incidence until inter-State transactions are brought within the VAT-set-off mechanism. State VAT could, therefore, be a stepping-stone for the subsequent introduction of comprehensive VAT in a short span. However, if the national VAT is not introduced within the next 2-3 years, it could have an adverse impact on the competitiveness of Indian industry.

A win-win situation for both industry and the Revenue would be to adopt a tax structure that has a combination of reasonable rates on goods and services, which can be set-off to eliminate the cascading effect on a wide tax base.

(Edited excerpts of a presentation at a seminar on VAT organised by the Tax Executives' Forum in Chennai. The author is Director (Finance), Hindustan Lever Ltd.)

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