Now that talk of value-added tax has been revived with a new government at the Centre, there has been a burst of enthusiasm among some sections of policy-makers.
Enthusiasm does not combine best with logic. People are enthusiastic about the concept of introducing a single-rate comprehensive VAT unifying Central value-added tax or Cenvat (central excise), VAT (sales tax) and service tax.
The crisis over VAT: Complete Coverage
In the interests of clear thinking it is necessary to remove some of the misconceptions about what is possible within the framework of the Constitution and economic constraints. What can be expected of VAT, even if it is implemented in its pure form and not in a fractured manner (although that is more likely to be the form in India)?
To begin with, let me point out that there can be no unification between Cenvat and VAT. Cenvat is nothing but an excise duty, a tax on the act of manufacture with the provision for credit of the excise duty paid on the inputs. It would be more appropriate to call it a Central manufacturing VAT. Its imposition is authorised by Entry 84 of List 1 (Union List) of the Seventh Schedule of the Constitution.
Sales tax is authorised by Entry 54 of the State List -- List II. They cannot be combined without amending the Constitution. And a constitutional amendment of this nature will mean the virtual death of fiscal federalism.
India will become a unitary state for all practical purposes. Such a fundamental change in the Constitution is not permissible legally and also not practical because the requisite number of states will not agree to a change that will obliterate their federal status.
What can be done is that service tax, which is a Central tax and is now authorised by Entry 97 of the Constitution, can be combined with Cenvat. It will then be known as a Goods and Services Tax.
This is a system under which input credit for both goods and services are allowed to a firm that sells goods and/or services.
The tax (both Cenvat and service tax) to be paid at the stage of the sale of goods or services will be lower by the tax (both Cenvat and service tax) already paid on the inputs.
So no distinction is to be made between goods and services for such a system. At the same time, the states will introduce VAT in place of sales tax.
This is the system prevalent in Canada. The GST is 7 per cent. It is collected by the Central government and a part of it is devolved to the states. This goes up to the retail stage.
There is also a sales tax that the different states charge at different rates. Even Quebec, which revels in its individualism, has introduced VAT in place of sales tax.
So, it is not a uniform system in that there is a parallel VAT (that is, GST and state VAT) in Quebec. Other states have a system of parallel GST and sales tax. A parallel system means that the input credits and payments of tax are not interchangeable. They run side by side and do not interfere with each other's functioning.
In India we are going to have a similar system. If we have GST at the Centre it will be a combined tax for goods and services, like in Canada, but it will not be up to the retail stage as in Canada. But we will have VAT at the state level that will go up to the retail stage. So this will be India's answer to the retail-stage VAT in Canada.
Overall, it will be a parallel system of:
- goods and services value-added tax at the Central level up to the manufacturing stage; and
- goods value-added tax at the state level up to the retail stage.
Canada is the only comparable federal country for the purpose of VAT. Other federal countries like China and Russia are basically unitary because no dissension is allowed by the states. Australia or Brazil is not comparable for various reasons.
The US is a class by itself in that it has no VAT. The common joke there is that VAT will be introduced by the next president. The US relies fundamentally on Income-Tax, which is more progressive than VAT being a consumption tax. VAT is a regressive tax.
The regressive element can be reduced if more than one rate is introduced. This should be a lesson to those who talk of a single rate of VAT. Equity demands that goods of conspicuous consumption should pay more VAT.
Even developed countries, such as those in the European Union, not only have several rates but also exemption for mass consumption goods. The rates are six in Belgium, six in France, two in Germany, four in Italy, two in Netherlands, five in Turkey, two in Brazil, three in Mexico, one in the UK, Indonesia, Japan, Republic of Korea, Argentina, Canada and Chile.
And most interestingly, China has 12 rates. All countries started with the retail-stage VAT but now have introduced GST, except in China where only some industrial goods and no services have been brought under VAT. In Columbia, all goods and some selected services have been combined. If we take the exemptions, then all countries have multiple rates.
But once there are multiple rates, the concept of neutrality and the anti-cascading qualities of VAT, which are so eulogised, are compromised. VAT ceases to be neutral in regard to allocation of resources when there are exemptions (Tait p. 221 and Hemming and Kay in VAT -- Lessons from Europe).
And another misconception is that VAT increases revenue. A recent study by the International Monetary Fund on VAT in a book called Modern VAT has observed that the evidence of "the supposed ability of VAT to bolster revenue" is weak (p37).
In conclusion, there is no reason to be over-enthusiastic about VAT. Its fundamental limitations, which are exacerbated by the fetters of federalism, have to be understood.
The purists should not shudder at the prospect of a parallel VAT. It is workable -- it has been working in Canada and will work in India. So long as we have parallel Union List and State List in the Constitution, we will have a parallel VAT.
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