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how is vat imposed in india

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VAT in India along with rateWe have always seen this word VAT mentioned in our bills when we purchase a consumer durable or service. So what does this exactly mean? VAT simply means Value Added Tax. Why the word “Value Added”? For this answer, let us go back in time and see how taxation was earlier.

For our reference, we can classify taxes as

direct taxes and indirect taxes

. Direct taxes would largely be on individual/corporate earnings like salary, investments, business, property etc. The onus here being that the tax incidence is on you as an individual and you pay it directly to the necessary authorities. Indirect taxes are your sales tax, excise duties etc. which an individual bears or is part of because of his consumption, though he is not directly involved in submitting that tax to the authorities.

Earlier, by its very nature, indirect taxes were complicated. Different items were taxed by different authorities at different stations and hence this led to double taxation and a lot of complexities like inter-state smuggling, inefficiencies, higher prices etc. Moreover, the cascading effect of tax had an impact on selling price of the product and even led to large scale tax avoidance. Hence, VAT was introduced to progressively tax only the value added on the product and not the product as a whole. Under this system, the product is taxed in totality for a certain rate and spread across various stages of value addition. This also simplifies tax incidence.

We shall take an example to elucidate VAT. Let us take a non VAT example first. Suppose the state government in State A has a sales tax of 20% and in State B it is 10%. A toy manufacturer in State A sources timber from State B. Let us say the timber costs Rs100/kg. So, for each kilo the manufacturer pays Rs110 (100*1.1). Now, he makes toys and sells it to a distributor in same state. He wants a margin of 10%. So he shall charge Rs145, since his input cost is Rs110 + margin of 10% i.e. Rs11 + tax on total product of Rs24.2 (Rs121* 20%). Hence the total cost to retailer balloons to Rs145.2. Now if the retailer wants a 10% margin and has to pay tax of 20%, he will finally retail the toy at Rs191.6! The total tax collected by State A would be Rs56.1 and State B would be Rs10, total tax being Rs66.14! Note that the entire burden of tax is ultimately borne by the consumer.

Example for Non-Vat transaction

Now, there are plenty of complications with this scenario. For one, it would be the incidence of tax. If states have differential taxes, then it becomes difficult for a pan India player to keep track and may even influence his decision to do manufacturing and selling in more tax friendly states, which promotes inefficiencies in the system and denies goods and services to many parts of the country. Also, the incidence of tax does not get distributed between the service or value added providers. This also gives rise to double taxation. There are other impracticalities like long physical waits for trucks near state borders, accounting for goods coming in and out of states, leading to delays, increased costs and inefficiencies.

Hence, the Finance Ministry came out with a solution to implement VAT from April 2005. The idea was to introduce this at a transaction level for goods and services, now it has been implemented by all states in India. Taxation under VAT promotes uniformity, increased compliance and a more natural incidence of tax based on value addition done. It also prevents double taxation and reduces tax for end user. Let us use the same above example for VAT

Example for Vat transaction

As you can see from above, there is a flat rate across states for VAT making for easier compliance. Here, the total tax incidence is Rs58, much lesser than individual sales tax. Here, the compliance is also much easier since it is spread across different functions. For instance, the raw material provider will pay Rs15 tax to government. The Whole seller would send his contribution of Rs19 tax to government as will the retailer for Rs24 worth of tax. In the end, the consumer pays the total tax but compliance is happening from all the people involved in the value chain! Sometimes what happens is under regular sales tax, a lot of intermediaries just do not pay the requisite tax citing exemptions – both genuine and otherwise, which reduces compliance and gives rise to black money, VAT is a step in that direction to ease indirect tax hassles.

We will all be awaiting the implementation of GST (Goods and Service Tax), which, if passed by parliament and made into a law, would act as uniform VAT across India and replace other multitude of indirect taxes imposed by states and center.

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