There is considerable euphoria in certain circles about the impending introduction of value added tax -- a move described by Finance Minister Jaswant Singh in his Budget speech as 'a historic reform of our domestic trade tax system' that would take place 'in the highest tradition of cooperative federalism.'
There are obvious advantages of a VAT system vis-à-vis what is commonly called a cascading type tax or CTT system, but the transition from a CTT regime to a VAT regime is fraught with hazards.
The single biggest constraint of a movement from a CTT-based system to a VAT system is simply that it leads to a sudden spurt in inflation. This has been the experience of various countries in different parts of the world.
A detailed study entitled The Modern VAT was published in 2001 by the International Monetary Fund.
The study, conducted by a team of four experts, stated that in order to implement VAT the transition period would exceed 18-24 months.
"Indeed, the effective implementation of a VAT may take several years," it has been stated in the 225-page book written by Liam Ebrill, Michael Keen, Jean-Paul Bodin and Victoria Summers.
What happens during the period of transition? And what has been the experience of various countries in this regard?
Here is a sample of the extent to which prices went up in different countries around the world after the introduction of VAT, culled from IMF reports as well as country reports circulated by the Confederation of Indian Industry.
Month of VAT introduction
Immediate change in prices (in %)
If so many developed as well as developing countries in the world have witnessed a sharp spurt in inflation in the immediate aftermath of the introduction of VAT, will India's experience be any different?
Probably not, say experts.
Unlike CTTs in which there is a marked 'tax on tax' element, a VAT system is supposed to tax value addition. In practice, however, a VAT system is not particularly simple. On the contrary, it is pretty complicated.
The IMF book quoted earlier states: "Despite its name, the VAT is not generally intended to be a tax on value added as such: rather it is usually intended as tax on consumption."
"Its essence is that it is charged at all stages of production, but with the provision of some mechanism enabling firms to offset the tax they have paid on their own purchases of goods and services against the tax they charge on their sales of goods and services."
Acknowledging that there is considerable diversity in the manner in which a VAT system operates in different countries, the book defines VAT as follows:
"A broad-based tax levied on commodity sales up to and including, at least, the manufacturing stage, with systematic offsetting of tax charged on commodities purchased as inputs -- except perhaps on capital goods -- against that due on outputs."
The book admits that such a definition leaves considerable scope for dispute. First introduced less than half a century ago, VAT remained confined to a handful of countries till the late-1960s.
Today, however, over 120 countries accounting for 70 per cent of the world's population have VAT systems in place.
If so many countries have chosen to opt for VAT, obviously there is much to be said in its favour in relation to a CTT regime.
Yet, significantly, the world's two largest democracies -- India and the United States -- do not as yet have a VAT system. There are reasons why this is so.
The IMF publication states that VAT is best suited to relatively small countries with unified markets -- quite unlike the US and India.
Moreover, VAT is essentially a federal or central tax, whereas in India its effective implementation would depend a great deal on state governments.
Given the federal structure of the constitution of India, individual state governments are theoretically free to decide their own VAT rates even if in the initial period there is harmony and uniformity in the tax rates.
In theory, VAT is supposed to be a tax to end all taxes. Many of the countries that have adopted VAT do not levy excise duty, entry tax or luxury tax. This, however, is unlikely to happen in India, certainly not in a hurry.
At the conference of state finance ministers held on January 23, 2002, it was agreed that all 28 states as well as Union Territories would introduce VAT with effect from April 1, 2003.
This position was reiterated during the conference of state chief ministers held on October 18 that was presided over by the prime minister.
The commitment to introduce VAT was repeated again on January 17 at a conference of finance ministers of states and Union Territories.
The empowered committee of state finance ministers -- headed by West Bengal Finance Minister Asim Dasgupta and comprising the finance ministers of Assam, Delhi, Gujarat, Jammu & Kashmir, Jharkhand, Karnataka, Madhya Pradesh, Maharashtra, Meghalaya, Punjab, Tamil Nadu and Uttar Pradesh -- endorsed the suggestion that every state law on VAT should have a minimum set of common features.
It was also agreed that with the introduction of VAT, the origin-based central sales tax would be phased out and that existing laws would be amended to allow states to levy taxes on certain goods like sugar, textiles and tobacco.
In view of the apprehensions expressed by a number of states about possible revenue losses, the Union government agreed to compensate states 100 per cent of their revenue losses in the first year (2003-04), 75 per cent in the second year and 50 per cent in the third year.
The finance minister said in his Budget speech on February 28 that the Union government would be initiating a 'long overdue' amendment to the Constitution to integrate services into the tax net in a 'comprehensive manner' in order to boost revenues and help implement VAT.
Jaswant Singh said: "Apart from avoiding cascading of taxes, the introduction of VAT is expected to increase revenues as the coverage increases to value addition at all stages of sale in the production and distribution chain."
He added that the revenue loss incurred by states would be 'computed on the basis of an agreed formula.' This is where the first hurdle has to be overcome.
The quantification of compensation would prove to be contentious. For instance, Tamil Nadu has estimated its revenue loss to be around Rs 600 crore (Rs 6 billion) while Andhra Pradesh has arrived at a figure half the size.
Finance Minister Singh pointed out that with the introduction of VAT, there was a need to phase out the Central sales tax system and move completely to a 'destination-based' system. He pointed out that this could not be done in one step.
"We must let VAT stabilize; but also recognize that these two -- VAT and CST -- cannot remain in tandem, in perpetuity," Singh said, adding: "Therefore, in the first instance, the ceiling rate of CST for inter-state sale between registered dealers will be reduced to 2 per cent during 2003-04, with effect from a date to be notified."
The finance minister added that the Union government would compensate states for the loss of revenue on account of the reduction in the CST. Interestingly, the budget for 2003-04 has not made any provision on this account!
The problems that would arise out of an eventual phasing-out of the CST have not yet been fully resolved.
State governments are demanding the right to retain and, in fact, widen the tax net by levying a range of taxes, including entry tax.
This would defeat a fundamental objective of imposing VAT, namely, unifying and harmonizing the complex tax structure in the country.
It is evident that state governments are using all sorts of devious methods to increase their revenue losses in the hope of receiving largesse from New Delhi in the form of 'compensation.'
How the Union government would apply the so-called 'agreed formula' for compensation of revenue losses and whittle down the inflated claims that would invariably be made by states, remains to be seen.
Meanwhile, state governments are hoping to enlarge their taxation powers by levying taxes on a host of service providers.
Such services include traditional ones like transport, health-care, insurance and telecommunications as well as new services like information technology.
According to one informed observer, who spoke on condition of anonymity, "the nuts and bolts of the proposed VAT regime could open a veritable Pandora's Box of problems completely undreamt of by dampening inter-state trade and movement of goods."
"The VAT regime is theoretically meant for a unified market in which the VAT levied can always be set off against taxes already paid, irrespective of the state-wise location of the manufacturing or trading entities," this observer added.
He continued by saying that 'in the Indian federal structure, these inter-state adjustments could well prove to be next to impossible.'
Thus, "the consequent inability to realize credit for taxes already paid will ultimately translate into an extortionate cost for the consumer."
In the current dispensation, sales tax is a single-point tax levied at the time of first sale. Subsequent sales do not attract any taxation.
Under the proposed VAT regime, manufacturers and traders will get the benefit of credit on input taxes that have already been paid. As VAT is a multi-point tax, the trade margins at every stage would get taxed.
In certain instances, the proposed VAT rates are higher than the prevalent sales tax rates and this would inevitably be passed on to hapless consumers -- one affected section that has so far not been consulted on the implications of implementing the new VAT.
A background note prepared in October by the Confederation of Indian Industry expressed concern about the denial of set-off of input tax paid in inter-state trade, that is, CST paid on inputs.
With no mechanism for set-off between state governments, as CST continues with VAT, industry would be faced with an additional tax burden. What the CII does not say is that this burden would almost certainly have to be borne by consumers.
The CII note points out that the proposed VAT design does 'not allow the set-off of input sales tax against the output tax simply because there is no sale in stock transfer.'
When the goods are sold in another state, revenues flow to the state in which the goods are manufactured.
Under the proposed VAT regime, 'the effective rate of tax on certain inputs would increase considerably' and could in effect exacerbate regional inequalities.
By increasing the prices of goods under stock transfer, the CII note outlines the negative impact of the new VAT regime: "Denial of tax credit in respect of inter-state stock transfers will prejudice investment in less developed states or states with relatively small 'internal' markets."
Whereas a recent study conducted by the Karnataka government has claimed that retail prices of a range of commonly used items -- including wheat flour, pulses, sugar, edible oil, bread, toilet soap, textiles and ready-made garments -- would not rise significantly after the introduction of VAT, many disagree with this view.
Sections of the trading community may be opposed to VAT because they fear lowering of profits on account of a reduction in tax evasion. But that should not be a reason not to go ahead with VAT.
Virtually each and every state government that has prepared its proposed VAT legislation has made it abundantly clear in its draft law that it would disallow any set-off of VAT already paid in any other state.
This, according to tax experts, may lead to the prices of many fast-moving consumer goods going up by proportions varying between 15 per cent and 20 per cent.
Far from placing money in the purse of the housewife, Jaswant Singh's plans to introduce VAT may actually result in the just the opposite taking place -- that is, reduction in real incomes on account of inflation.
The finance minister would be well advised to hasten slowly while implementing VAT. Inflation, as measured by the official wholesale price index, is already touching 5 per cent.
At a time when elections are not that far away and after having rolled back his proposal to increase fertilizer prices, he would surely not want the monster of inflation to rear its ugly head.
That would not just be bad economics. It would be bad politics as well.
The author is Director, School of Convergence @ International Management Institute, New Delhi and a journalist with over 25 years of experience in various media -- print, Internet, radio and television.