BASIC CONCEPTS OF VALUE ADDED TAX

 What is VAT ?

A value added tax (VAT) is a form of consumption tax. From the perspective of the buyer, it is a tax on the
purchase price. From that of the seller, it is a tax only on the value added to a product, material, or service, from
an accounting point of view, by this stage of its manufacture or distribution. The manufacturer remits to the
government the difference between these two amounts, and retains the rest for themselves to offset the taxes they
had previously paid on the inputs.

The value added to a product by or with a business is the sale price charged to its customer, minus the cost of
materials and other taxable inputs. A VAT is like a sales tax in that ultimately only the end consumer is taxed. It
differs from the sales tax in that, with the latter, the tax is collected and remitted to the government only once, at
the point of purchase by the end consumer. With the VAT, collections, remittances to the government, and credits
for taxes already paid occur each time a business in the supply chain purchases products.VAT is a sales tax
collected by the government (of the state in which the final consumer is located) which is the government of
destination state on consumer expenditure. Over 120 countries worldwide have introduced VAT over the past
three decades and India is amongst the last few to introduce it.

India already has a system of sales tax collection wherein the tax is collected at one point (first/last) from the
transactions involving the sale of goods. VAT would, however, be collected in stages (installments) from one stage
to another.

The mechanism of VAT is such that, for goods that are imported and consumed in a particular state, the first seller
pays the first point tax, and the next seller pays tax only on the value-addition done – leading to a total tax burden
exactly equal to the last point tax.

 Why VAT is necessary

India, particularly the trading community, has believed in accepting and adopting loopholes in any system
administered by the state or the Centre. If a well-administered system comes in, it will close avenues for traders
and businessmen to evade paying taxes. They will also be compelled to keep proper records of their sales and
purchases. Many sections hold the view that the trading community has been amongst the biggest offenders when
it comes to evading taxes. Under the VAT system, no exemptions will be given and a tax will be levied at each
stage of manufacture of a product. At each stage of value-addition, the tax levied on the inputs can be claimed
back from the tax authorities.

At a macro level, there are two issues, which make the introduction of VAT critical for India:Industry watchers
say that the VAT system, if enforced properly, forms part of the fiscal consolidation strategy for the country. It

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could, in fact, help address the fiscal deficit problem and the revenues estimated to be collected could actually
mean lowering of the fiscal deficit burden for the government.

The International Monetary Fund, in its semi-annual World Economic Outlook released on April 9, expressed its
concern over India's large fiscal deficit at 10 per cent of the GDP. Further any globally accepted tax administrative
system will only help India integrate better in the World Trade Organization regime.

How VAT operates

The standard way to implement a value added tax involves assuming a business owes some fraction on the price
of the product minus all taxes previously paid on the good.

By the method of collection, VAT can be accounts-based or invoice-based. Under the invoice method of
collection, each seller charges VAT rate on his output and passes the buyer a special invoice that indicates the
amount of tax charged. Buyers who are subject to VAT on their own sales (output tax), consider the tax on the
purchase invoices as input tax and can deduct the sum from their own VAT liability. The difference between
output tax and input tax is paid to the government (or a refund is claimed, in the case of negative liability). Under
the accounts based method, no such specific invoices are used. Instead, the tax is calculated on the value added,
measured as a difference between revenues and allowable purchases. Most countries today use the invoice
method, the only exception being Japan, which uses the accounts method.

By the timing of collection, VAT (as well as accounting in general) can be either accrual or cash based. Cash basis
accounting is a very simple form of accounting. When a payment is received for the sale of goods or services, a
deposit is made, and the revenue is recorded as of the date of the receipt of funds—no matter when the sale had
been made. Cheques are written when funds are available to pay bills, and the expense is recorded as of the
cheque date—regardless of when the expense had been incurred. The primary focus is on the amount of cash in
the bank, and the secondary focus is on making sure all bills are paid. Little effort is made to match revenues to
the time period in which they are earned, or to match expenses to the time period in which they are incurred.

Accrual basis accounting matches revenues to the time period in which they are earned and matches expenses to
the time period in which they are incurred. While it is more complex than cash basis accounting, it provides much
more information about your business. The accrual basis allows you to track receivables (amounts due from
customers on credit sales) and payables (amounts due to vendors on credit purchases). The accrual basis allows
you to match revenues to the expenses incurred in earning them, giving you more meaningful financial reports.

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Merits of VAT
In the advantages part we will first look after the broad coverage of VAT in the Indian market. Then we will
consider the level of security the Indian VAT is having on our revenues. Obviously the selection of items to be
covered by VAT in India will be given a bullet to think upon and at last we will check out the co-ordination VAT
in India will be having with our existing direct tax system.

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 under declaring 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 emphasizes and simplifies it and is
likely to make firms more careful not to evade because they know of the possibility of cross check.

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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.

Demerits of VAT
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 recognizes 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.

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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 rationalization 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

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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 stabilize thereafter.

4. VAT favors 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

Overview of state level VAT in India:

VAT was introduced into the Indian taxation system from 1 April 2005.
VAT is basically a State subject, derived from Entry 54 of the State List, for which the States are sovereign in
taking decisions. The State Governments, through Taxation Departments, are carrying out the responsibility of
levying and collecting VAT in the respective States. While, the Central Government is playing the role of a
facilitator for the successful implementation of VAT. The Ministry of Finance is the main agency for levying and
implementing VAT, both at the Centre and the State level.

The Department of Revenue, under the Ministry of Finance, exercises control in respect of matters relating to all
the direct and indirect taxes, through two statutory Boards, namely, the Central Board of Direct Taxes
(CBDT) and the Central Board of Customs and Central Excise (CBEC). The Sales Tax Division, of Department of
Revenue, deals with enactment and amendment of the Central Sales Tax Act; levy of tax on sales in the course of
inter-State trade or commerce; levy of VAT; etc. The Central Board of Excise and Customs (CBEC) deals with the
tasks of formulation of policy concerning levy and collection of customs and central excise duties, allowing of
Central Value added Tax (CENVAT) credit, etc. While, the decision to implement State level VAT has been taken
in the meeting of the Empowered Committee (EC) of State Finance Ministers, held on June 18, 2004, where a
broad consensus was arrived at to introduce VAT in all States/ Union Territories (UTs).

The entire design of VAT with input tax credit is crucially based on documentation of tax invoice, cash memo or
bill. Every registered dealer, having turnover of sales above an amount specified, needs to issue to the purchaser
serially numbered tax invoice with the prescribed particulars. This tax invoice is to be signed and dated by the
dealer or his regular employee, showing the required particulars. For identification/ registration of dealers under
VAT, the Tax Payer's Identification Number (TIN) is used. TIN consists of 11 digit numerals throughout the
country. Its first two characters represent the State Code and the set-up of the next nine characters can vary in
different States.

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In India's prevalent sales tax structure, there have been problems of double taxation of commodities and
multiplicity of taxes, resulting in a cascading tax burden. For instance, in this structure, before a commodity is
produced, inputs are first taxed, and then after the commodity is produced with input tax load, output is taxed
again. This causes an unfair double taxation with cascading effects. Hence, the VAT has been introduced to
replace such sales tax structure. Moreover, it seeks to phase out the Central Sales Tax (CST) and several efforts
are being made in this regard.

At the State level, the Empowered Committee of State Finance Ministers has finalized a design of VAT to be
adopted by all the States/ UTs. This basic design of VAT retains the essential features of VAT and keep them
common for all the States/ UTs, like, the rates of VAT on various commodities are kept uniform for all. At the
same time, it provides a measure of flexibility to the States/ UTs so as to enable them to meet their local
requirements.

At present, there are 2 basic rates of VAT, namely, 4 per cent and 12.5 per cent, besides an exempt category and a
special rate of 1 per cent for a few selected items. The items of basic necessities and goods of local importance
(upto 10 items) have been put in the zero rate bracket or the exempted schedule. Gold, silver and precious stones
have been put in the 1 per cent schedule. There is also a category with 20 per cent floor rate of tax, but the
commodities listed in this schedule are not eligible for input tax rebate/set off. This category covers items like
motor spirit (petrol, diesel and aviation turbine fuel), liquor, etc. Some of the other features of VAT in the State (as
finalized by the Empowered Committee) are:-

 As per provision for eliminating the multiplicity of taxes, all the State taxes on purchase or sale of goods
(excluding Entry Tax in lieu of Octroi) are required to be subsumed in VAT or made VATable.

 A provision has been made for allowing 'Input Tax Credit (ITC)' which is the basic feature of VAT.
However, since the VAT being implemented is intra-State VAT only and does not cover inter-State sale
transactions, ITC is not to be available on inter-State purchases.

 Exports to be zero-rated, with credit given for all taxes on inputs/purchases related to such exports.

 There are provisions to make the system more business-friendly. For instance, provision for self
assessment by the dealers; provision of a threshold limit for registration of dealers in terms of annual
turnover of Rs. 5 lakhs; and provision for composition of tax liability up to annual turnover limit of Rs. 50
lakhs.

 Regarding the industrial incentives, the States have been allowed to continue with the existing incentives,
without breaking the VAT chain. Further, no fresh sales tax/ VAT-based incentives are permitted.

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Haryana became the first State in the country to introduce Value Added Tax (VAT). Till 2007, VAT has been
introduced by more than 30 States/UTs, including Tamil Nadu(implemented VAT from January 1, 2007) and the
UT of Pondicherry (implemented VAT from April 1, 2007). From January 01, 2008, the Government of Uttar
Pradesh has made VAT effective in the State. Some of the other States/ UTs which have implemented VAT are:-

 Andhra Pradesh

 Chhattisgarh

 Delhi

 Goa

 Gujarat

 Jammu and Kashmir

 Jharkhand

 Karnataka

 Kerala

 Maharashtra

 Meghalaya

 Orissa

 Rajasthan

 West Bengal

Over the years, the experience of implementing VAT in India has been very encouraging, with the Empowered
Committee constantly reviewing the progress of implementation. The revenue performance of VAT-implementing
States/UTs has also been very significant. During 2006-07, the tax revenue of the 31 VAT States/UTs had
collectively registered a growth rate of about 21 per cent over the tax revenue of 2005-06. During 2007-08, the tax
revenue of 32 VAT States/UTs showed a further growth of 14.6 per cent during the first six months of 2007-08
(April-September) as compared to the corresponding period of last year.

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