Explained: What is VAT?

Reading time: 8-10 minutes.

On April 22nd, a litre of fuel went up by almost ₹6 in Assam despite global fuel prices hitting rock bottom, due to increase in VAT. There was a notification issued increasing the rates of tax on diesel and petrol, which stated that tax rates were increased under the relevant section of the Assam Value Added Tax Act, 2003. A State has the liberty to impose taxes only on fuel and liquor. Accordingly, a)  VAT on diesel is fixed at 23.66 paise in the rupee or ₹17.45 per litre whichever is higher and b)  on petrol and other motor spirits, it is fixed at 32.66 paise in the rupee or ₹22.63 per litre, whichever is higher. As a result, the rate of petrol has gone up by Rs 5.85 per litre after the hike taking the new price at Rs.77.46 per litre. Diesel will cost Rs 70.50 with a hike of Rs 5.43, a litre.

The Finance Minister of the state stated, “The finances of the State have suffered due to the COVID-19 lockdown” and feared that Assam might not be able to meet expenditure in June, including paying salaries to the lakhs of State government employees if there was no infusion of funds. Fuel prices have always been higher in Assam compared to the adjoining northeastern states and this step will widen that gap, which encourages many vehicle owners in border areas to buy fuel from the neighbouring states, as a result of which the purpose of the hike goes in vain. The Finance Minister backed the decision by stating that global oil prices dip may have a huge effect on the State’s revenue as they have a fear of losing their royalty which is received from the Central government for Assam’s crude oil production. He even stated that once the crisis is over, the State may rollback the increase.

What is VAT?

Value-added tax (VAT) is a type of indirect tax levied on goods and services for the value-added at every point of production or distribution cycle, starting from raw materials and going all the way to the final retail purchase. The value-added tax (VAT) is the tax on value added by any economic activity (be it at the manufacturing, wholesale, or retail level) to the commodities and services it buys from other economic activities. A comprehensive form of VAT covers value added at all three levels of business activities, viz, manufacturing, wholesaling, and retailing, the period between production and final use of various goods and services. Currently, this form of VAT is predominant in the fiscal systems of many developed and developing countries.

There are three broad types of VAT depending on the extent of coverage of gross value added in the tax base. These are a) consumption VAT, b) net income VAT, and c) gross income VAT. The consumption VAT is the tax on the final sales by an integrated business firm carrying all the three levels of economic activities. As an illustration, take a firm which starts with the production of wheat, goes down the line to produce flour and bread and further down the line to engage in the wholesaling and retailing of bread. In carrying out the above process, the firm adds value to goods and services at each successive stage of business in comparison to the previous stage by using its own men and machines. The final price which is the price paid by the consumers for bread covers all the value additions at successive stages.

Therefore, it appears that the sum of value additions at various stages is equal to retail or final sales to consumers. But this is true only in a closed and static economy. However, in the case of an open economy having imports, the retail sales of a commodity exceed the value added by domestic production to meet the part of domestic demand. It is so because the value-added in producing imports accrued to the home country. To sum up, it is the consumption tax that is levied on a product based on value addition. Value-added taxation is based on taxpayers’ consumption rather than their income. VAT applies equally to every purchase, in contrast to a progressive income tax, which levies greater taxes on higher-level earners.

The vast majority of industrialized countries that make up the Organisation for Economic Cooperation and Development (OECD) have a VAT system. The United States remains the only notable exception. Most industrial countries with a VAT adopted their systems in the 1980s. Results have been mixed, but there is certainly no tendency among VAT countries to have small budget deficits or low government debt. According to one International Monetary Fund study, any nation that switches to VAT initially feels the negative impact of reduced tax revenues despite its greater revenue potential down the road.

Advocates say it raises government revenues without punishing success or wealth, as income taxes do, and it is simpler and more standardized than a traditional sales tax, with fewer compliance issues. VATs and sales taxes can raise the same amount of revenue; the difference lies in at what point the money is paid—and by whom. Critics charge that a VAT is essentially a regressive tax that places an increased economic strain on lower-income taxpayers and also adds bureaucratic burdens for businesses.

When is VAT applied?

VAT is charged based on consumer expenditure, and it is charged at different levels. Under a VAT system, a dealer collects tax on his sales, retains the tax paid on his purchase and pays the balance to the government. It is a consumption tax because the final consumer ultimately bears it. The tax paid by the dealer is passed on to the buyer. It is not a charge on the dealer. VAT is instead a multipoint tax system with provision for collection of tax paid on purchases at each point of sale.

 A commodity can fall under the scope of VAT in various situations. All business transactions involving the sales of goods/commodities carried on within a state by individuals, partnerships, or companies will be covered by VAT. VAT will not cover small businesses with sales below a certain limit according to the jurisdiction of that particular place. The applicability of VAT has some requirements like permanent establishment, bookkeeping facilities or ability to contract or taxpayer who exceed the monetary threshold in a tax jurisdiction. For instance, a taxi driver cannot charge VAT on his services.

Law regarding VAT in India:

One of the most popular instruments of any Governments in developing countries is to increase indirect tax rates (particularly Sales Tax/VAT) to increase revenue. Indirect taxes dominate the tax system of the developing countries in general and the sub-national governments in particular. In India, sales tax is the single largest source of revenue for the state governments. In a federal country, like India, there are governments at different levels with constitutionally assigned fiscal responsibilities. However, the state sales tax systems were inefficient, highly complex and low revenue yielding. The sales tax laws were highly complex, with too many rates of tax (even with multiple rates on same commodities) and too many exemptions and concessions. Economists highlighted three ways of introducing VAT in India namely, at the central level, dual VAT and state VAT and argued that India will benefit from the introduction of VAT. After repeated interactions and discussions, most of the states have finally agreed and implemented VAT in India at the state level with effect from April 1, 2005.

The White Paper on VAT in India indicates that the reason behind the introduction of VAT was to enhance the efficiency and transparency of the commodity tax system and increase the buoyancy of such tax revenue. VAT was introduced as an indirect tax in the Indian taxation system to replace the existing general sales tax. The Value Added Tax Act (2005) and associated VAT rules came into effect beginning April 1, 2005, in many Indian states. A few states (Gujarat, Rajasthan, MP, UP, Jharkhand and Chhattisgarh) excluded themselves from VAT during its initial introduction but later adopted the tax. Every state has its VAT legislation, rates, taxable base, and list of taxable goods. Value Added Tax (VAT) is a major source of revenue for all Indian states and union territories (except Andaman and Nicobar Islands and Lakshadweep).

The fiscal responsibilities are normally shared by three levels of government, -central, state and local governments. Governments at all three levels may levy taxes on commodities and services so that a tax reform leading to an introduction of VAT by the government at one level can have fiscal consequences for the governments at other levels also. Therefore, a tax reform requiring the introduction of a VAT in a federation should have many objectives like (a) the tax reform should be revenue neutral between the governments. In other words, it should not cause gain in revenue to government at one level at the cost of governments at other levels. (b) the tax base should be uniform across the nation. (c) the lower level governments like the provincial and local authorities should have the autonomy to set the tax rates to reflect their own social and economic priorities and fiscal needs.

The Indian Constitution has demarcated the functions of central and state governments. The functions of governments are classified under three groups: centre list, state list and concurrent list. The centre list consists of defence, national industries and mines, foreign affairs, banking and currency, interstate commerce. The state list covers health, education, agriculture, irrigation, roads, and law and justice. Labour relations, education and criminal law fall under concurrent list. Accordingly, the Indian Constitution makes revenue and expenditure assignments to governments at different levels to carry on the constitutionally entrusted functions.

Although the fiscal relations and functions are demarcated, the centre is given higher power in such matters and it is justifiable on various grounds. In a federation like India, it is very tough to maintain the centre-state relations, which is why each state has its VAT laws for proper implementation and levying. Different states apply different VAT rates according to their implied law. Different VAT rates and laws in states made it one of the most complex taxation systems. It is a burden on low-income consumers, encourages tax evasion and creates higher costs for businesses.

Critical analysis:

As the pandemic continues to ravage economies across the world, policymakers are seeking effective measures to mitigate.  The immediate future appears to be dire especially for developing and emerging markets like India. In such situations, radical fiscal measures like this particular step of hiking the tax rates on crude oils are a burden to the people of the State. VAT was introduced to facilitate Indian markets to boost their trade and encourage ease of doing business and allow for transferability for consumers.

Many laws are being misused during these times of crisis, so is VAT. It has been used not only to save the State’s royalty but also as a shock retention tool. Compared to other federations like Germany, Brazil, and Canada, India operates on a different level and it can never implement the VAT system as efficiently as its counterparts due to increasing disparity between the centre and the states. Implementation of a comprehensive VAT with one or two rates for centre and states in India, though desirable from the practical point of view, can have problems from a developing country’s perspective. Many economists suggest that uniform general consumption tax should be assessed on a broad base and at a uniform rate.

Given a choice between a VAT and a tax on retail sales, a developing country has to opt for VAT, because retail sales departments are small, unstable, and informal in those countries. But after India adopted Goods and Services Tax (GST) in July 2017, it replaced VAT on most goods. GST might not have subsumed VAT, but it is a huge change for Indian fiscal policy after adopting VAT.

Conclusion:

With an economic hit, there has understandably been a lot of criticism regarding the gross inadequacy of the government’s response to stabilize it. This crisis had highlighted the importance of adequate fiscal space to manage future distress. The country has to learn re-prioritize expenses and allocate resources so that the states are not forced to take such harsh measures to bear the losses.

At the end of the day, the low-income group is the greatest sufferer of any such policy and the government need to provide them with an alternative plan in a situation like a pandemic. For now, the financial crisis is puffed by the pandemic, but the situation after the lockdown is still a question, as the rolling back of these harsh measures cannot be guaranteed.

Author: Meher Mansi from School of Law, Christ University, Bangalore.

Editor: Harinie.S from Symbiosis Law School Hyderabad.

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