Column: States back to pre-VAT chaos

Written by Satya Poddar and Rahul Renavikar | Updated: Nov 28 2013, 21:26pm hrs
While continuing to block the introduction of GST, the states are making changes to the Value Added Tax (VAT) laws which are a blow to the economy. The most recent change is an amendment by Tamil Nadu, which severely restricts the tax credits in respect of inputs used in inter-state sales. It denies credit for the first 3% of the tax on any inputs for use in inter-state saleswhich attract the 2% Central Sales Tax (CST)and the first 5% on tax on inputs for inter-state branch transfers. Effectively, inter-state shipments become subject to a tax of up to 5% in the exporting state. Similar restrictions apply in Gujarat. It blocks 2% of input taxes on inter-state sales and 4% on inter-state branch transfers.

These changes are retrograde and amount to the states shooting themselves in the foot. They increase the cost of production and investment and discourage location of production in the state. The economy suffers, so do the states as, without production, they would have no revenue to collect. It is strange for Tamil Nadu and Gujarat to implement such policies while they have been aggressively wooing manufacturers to locate production facilities in their jurisdictions.

When VAT was introduced in 2005, it was levied in a harmonised manner across the states with a uniform base, tax rates and rules and regulations. Full credits were allowed for input taxes, including those for inputs used in inter-state sales. The only blockage was for inputs going into inter-state branch transfers which were not subject to the CST. This model simplified compliance, provided boost to investment and economic growth, reduced tax-cascading and significantly improved voluntary tax compliance through proper tracking of inputs and outputs. Thanks to the massive deviations over the last few years, the current system bears little resemblance to the original model.

The system has now degenerated into a tax jungle of 30-plus different VATs. The changes negate the very objective of having VAT, viz. harmonisation of tax rates and base, full input tax credits to minimise tax-cascading, and simplification of rules and procedures to facilitate voluntary compliance.

We are now back to the pre-VAT era in terms of multiplicity of tax rates and diversity of the base. Currently, the VAT rates vary from 1% to 15% depending upon the commodity. Take, for example, the tax on mobile phones. They attract 5% tax in Bihar, 12.5% in Maharashtra, 12.5% in Delhi (phones costing more than R10,000), 14.5% in West Bengal (phones with MRP exceeding R20,000).The variation in tax rates results in trade diversions, and breeds malpractices camouflaging sales within a state as inter-state sales. When Maharashtra increased the tax rate on mobile phones to 12.5% from 4% in July 2009, legitimate sales in the state fell precipitously by 65% in the very first month. The grey market spawned, and some of the sales were diverted to the neighbouring states.

There is no harmonisation of compliance procedures, the return forms, annexures to the return forms, tax payment due dates, and input tax credit claim procedures. Complying with these divergent systems has become a nightmare for the taxpayers, especially those with pan-India presence. Automation has failed to provide the requisite relief. For larger businesses, tax computations can require configuration of hundreds of permutations and combinations, which even world class ERP systems are not capable of automating. While most states have introduced e-filing of VAT returns, the computation of tax on the returns is still not automated. Moreover, there is a plethora of schedules and forms which fall outside the embrace of e-filing.

The retrograde steps taken by the states over the past few years, have recreated the vicious circle of narrow base, higher rates, lower compliance and lower revenues, which plagued the sales tax system that was replaced by VAT. It is well established that a simple tax regime with a broader base and lower rates, coupled with better taxpayer services, is an enabler for voluntary compliance and higher revenues. This virtuous circle has now become a mirage.

Instead of focusing on achieving better compliance for more revenues, the states have chosen to increase the tax rates and restrict the input tax credits. These measures are perverse and unprincipled. Full credit for input taxes is the most significant and defining feature of a VAT. Without it, the VAT becomes a turnover tax (TOT) under which tax applies to each transaction in the supply chain in a cascading manner, i.e., with no credit for the tax already paid at earlier stages. Unlike a VAT which is recognised as the best form of sales tax, a TOT is the worst. It prevailed in Europe and was gotten rid of and replaced by VAT several decades ago because of the damages it inflicted on the economies.

The states experimented unsuccessfully with this tax during the last decade prior to the introduction of VAT. It was levied at modest rates of 1% to 2%. The states hoped to raise substantial revenues even at these low rates, but the only thing it succeeded in raising were loud howls of TOT hatao, TOT hatao from the aggrieved businesses.

It is strange that the states have forgotten the lessons of that experiment and are effectively converting VAT into TOT by denying/restricting input tax credits.

While the governments are haggling over the design of GST, the industry hoped that the states would utilise the intervening time constructively in developing the infrastructure for the GST and harmonising their existing VAT systems with the GST. Instead, the states are moving in the opposite direction, with little regard or concern for its impact on the economy.

The least they could do is to support the businesses in the current economic slowdown by not aggravating their tax woes.

Rahul Renavikar, executive director, tax & regulatory services, EY, contributed to the article.

The author is partner, Policy Advisory Group, EY.

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