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Why VAT is a cauldron of confusion

March 17, 2003

At first glance, India does not seem to have much in common with Ghana.

However, if the sequence of events during the countdown to the implementation of  value added tax is any indication, the two countries could have something in common very soon.

Ghana is the only country in the world that has tried its hand at implementing a VAT regime but subsequently scrapped it.

The principal problem, it appeared, was the government's failure to communicate the nuances of VAT to trade and industry, the ultimate beneficiaries of the new system.

After two successive postponements in two years, India's tryst with the VAT regime is in danger of going the Ghana way.

For one, several states -- Delhi prominent among them -- have categorically said that they will not implement VAT in a hurry.

For another, less than a month ahead of D-day on April 1, the legislative groundwork is yet to be complete -- states are rushing en-masse to get presidential assent for their VAT bills by the middle of March, as the Union government has requested.

As of now, apart from three states -- Kerala, Maharashtra and Madhya Pradesh -- none of the other states have had the legislation okayed by their respective cabinets or Assemblies.

Another three -- Delhi, Tripura and Himachal Pradesh -- have not even submitted their draft bills to the Centre.

The upshot of all this is that the all-important notifications and procedures that industry needs to ready itself for the transition are not yet in place.

"Everything has been done in a rush. Industry was not even consulted when state governments were preparing their draft VAT legislations. At the end of the day, it is industry that has to implement the new tax regime," complains Praveen Khandelwal, general secretary, Confederation of All India Traders, which has been spearheading the protest against VAT across the country.

Of course, there are few doubts about the benefits of the VAT regime.

In the long run, it is expected to trigger overall economic growth and integrate India with the world -- apart from the US all the major global economies have a value-based system of taxation.

If VAT fails in India, it will be a pity because, after last year's problems, the countdown to joining the club of 120-odd countries that have VAT in place seemed to look promising till about February this year.

A good deal of progress was made mainly because of the constructive attitude principally on the part of the Centre. For instance, the Centre agreed to compensate the states for any losses as a result of the transition.

This despite its stated position that there would be no losses from the transition. This seriousness is reflected by the fact that finance minister Jaswant Singh has set aside Rs 700 crore (Rs 7 billion) in the Budget to compensate the states for possible revenue losses accruing from the switch to the VAT regime.

The Centre has undertaken to compensate states of up to 100 per cent of the revenue loss in the first year, 75 per cent of the loss in the second year and 50 per cent of the loss in the third year from the introduction of VAT.

This loss is to be computed on the basis of an agreed formula.

The Centre also introduced a Bill allowing states to tax services and will permit states to directly tax such items as sugar, textiles and tobacco to boost revenues.

These items earlier attracted additional excise duty which is collected by the Centre and shared with the states. By allowing the states to tax these items directly, the Centre is, in effect, foregoing a certain amount of revenue.

Over and above this, the Centre has also agreed to give a two-year compensation to states in lieu of the abolition of central sales tax once VAT is in place.

In the build-up to the transition this fiscal, the empowered committee of state finance ministers, which is overseeing the exercise, had persuaded the states to levy a single median VAT rate of 12.5 per cent on all items, a move that could put an end to the inter-state tax rivalry aimed at attracting business.

States were also persuaded against imposing entry tax which would have had a similar effect.

Earlier this year, the committee decided -- and the states agreed -- that the general VAT rate of 12.5 per cent would be applicable to all items, apart from industrial inputs (which would be taxed at 4 per cent) bullion and precious stones (1 per cent) and demerit goods (20 per cent) following the implementation of VAT from April 1.

“The governments are definitely much better prepared this time around. If you consider the amount of preparation they had done last time around, this time looks much better,” says Rajiv Dimri, partner, Ernst & Young, which has been advising several state governments and industry on the transition.

Experts says some of the residual issues have also been handled well.

For instance, all states have decided to treat tax exemptions extended to industries on a deferral basis and have agreed to hand out cash compensation to companies against phase-out of sales tax exemptions following VAT.

Unfortunately, major hurdles remain. The biggest and most basic one is how industry will collect refunds on inputs sourced from other states -- since this will require synchronising inter-state tax administration regimes.

Most of the less-developed states that specialise in manufacturing intermediate goods could turn out to be losers if a system is not worked out to smoothen the inter-state refund system.

The response of industry to the new tax regime has been conflicting.

While the larger industry chambers and the organised sector have welcomed VAT, it's the small and medium traders who are against the move. The biggest worry for this segment is that VAT would result in squeezing of retail margins.

If a February study conducted by the Karnataka government on the effect of VAT on commodity prices is anything to go by, prices of commodities are not likely to increase much despite a higher rate of taxation under VAT, a pointer to the fact that retail margins could tighten.

As a result of all this confusion and doubt, government officials reckon that the implementation of the VAT regime across the country could take place in a staggered manner, with a large number of states planning to change only by July 1, 2003.

This looks like the most likely outcome.

Rushing through with the legislative process would definitely leave traders with little time to understand the procedures.

There could be chaos from April 1, and even much before since the closing stock on March 31 will carry products meant to be sold in April.

The fact that 2003 is an election year makes it all the more difficult. The lessons from Ghana need to be remembered well.

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