When a product is zero-rated, there is no tax on the output and any taxes on inputs are fully rebated or refunded. The refund of input taxes removes the cascading effect and the product is fully relieved of tax on both output and inputs. This is how exports are treated in India as well as in all other jurisdictions levying indirect taxes.
By contrast, when a product is exempted from GST, there is no tax on output, but no refund or rebate is provided for the tax levied on machines, equipment, raw material and other supplies that go into the production and distribution of the output. Exemption is only a partial relief from tax. It replaces the tax on output by the tax on inputs.
The taxation of inputs under the exemption system is perniciousit increases the cost of investment and is damaging to productivity and economic growth. Moreover, exemptions discourage domestic manufacturing in India and favour imports. In the case of imports, the production inputs are acquired outside the country, free of Indian taxes. If, for any political or social reasons, a product has to be excluded from GST, it should be zero-rated, not exempted. This is the practice being followed in advanced jurisdictions. For example, food is zero-rate, in Australia, Canada, Mexico and South Africa.
Accepting the conceptual merit of zero-rating, one needs to consider whether zero-rating of petroleum products is necessary and desirable, and whether it is practicable in India.
The states demand for exclusion of petroleum from GST is based on the fear that their inclusion could cause a loss in their revenue from these products. These fears are baseless. There are no VAT jurisdictions where such products are excluded from the GST. In fact, the main reasons for the popularity of GST across world is that it applies at all points in the supply chain and the system of output taxes and input taxes creates an audit trail which allows more effective monitoring of tax compliance and enforcement of tax laws. GST is a cash cow, which yields more revenues, not less.
The same is true for alcohol, which is also in the States wish-list of exclusions from the GST. Taxation of alcohol under the GST would allow the government a better control over the alcohol sector and bring in better transparency. It will help in freeing up the industry from the menace of harmful cartels that peddle illegal and spurious products to consumers, posing a health hazard to consumers in the lower-income brackets. Seamless coordination between the Centre and state administrations would provide audit trail and plug revenue leakages.
There are certain practical difficulties in applying proper zero-rating to petroleum in the Indian context. Due consideration should be given to these before embracing this concept wholeheartedly. First, zero-rating requires a timely and complete refund of input taxes to the producers and distributors. The governments in most countries, especially developing countries, are slow and reluctant to provide refunds. In India, even in the case of exports, substantial delays are encountered in getting the refunds. In many cases, refunds are denied under the pretext of inadequate documentation or procedural deficiencies in filing the refund claims. Without a prompt and full refund of input taxes, zero-rating degenerates into an exemption system, which is detrimental to production efficiency and economic growth.
Second, petroleum products will continue to be subject to current taxes such as sales tax, purchase tax, entry tax in lieu of Octroi and excise duties. It is important that these taxes apply in a non-cascading manner. Under the current regime, cascading occurs most notably through the application of the state purchase tax and entry tax when the crude is acquired by refineries for processing and refining. These taxes are not rebated against taxes applicable on the final products, resulting in cascading. Where the prices are regulated, the burden falls entirely on producers in the sector. In India, these happen to be the Central public sector undertakings. The benefits of zero-rating is lost if the intermediate products like crude attract sale and purchase taxes as under the current regime.
Third, under the destination principle of GST, the burden of such supplementary taxes (sale tax, purchase tax and excise duty) should be confined to the state where finished products are finally consumed. In the example above, taxes on crude are levied and collected in the state where the crude is refined and not where the finished products are consumed. These taxes violate the destination principle and result in misallocation of revenues between the producing and consuming states.
Fourth, proper zero-rating of a product entails that inputs taxes are refunded to the producers and distributors at all points in the supply chain, including the petrol stations and other retailers. There is a risk that this may encourage fraudulent claims for refunds of input tax, particularly from those suppliers who fall in the unorganised sector. States in India have found it difficult to verify the validity of input tax refund claims under the current VAT system and have been dragging their feet to process them expeditiously. The same may happen under the GST too.
Thus, while conceptually zero-rating is a thoughtful response to the political demands of the states, there are many practical hurdles in its implementation. While these obstacles are not insurmountable, the government will be wise to reconsider its decision to zero-rate (or otherwise exclude) these product under the GST.
Satya Poddar & Shalini Mathur
Poddar is Tax Partner, and Mathur is Associate Director, Policy Advisory Services, EY