VAT (Value Added Tax)


By

Ankita Agrawal
Management Student
NSB, NIILM School of Business
New Delhi
 


Value Added Tax, or VAT, is levied on top of the cost of a product or service and generates revenue for a government.

Value Added Tax, popularly known as 'VAT', is a special type of indirect tax in which a sum of money is levied at a particular stage in the sale of a product or servi In 1954, the value added tax system was initiated by the then joint director of the tax authority of France, Maurice Laure. VAT came into effect for the first time on 10th April, 1954.

From its inception, the value added tax system was imposed on all major sectors of France - the first country to use this system. Once instituted, it was immediately clear that revenues collected from the VAT system constituted a substantial share of the government's revenue in the French economy.VAT is intended to be levied - or charged - whenever there is some value addition to raw material. The taxpayers on the other hand, will get credit for the amount of tax paid off at the stages of procurement. The value added tax system has proven to be effective in avoiding problems that normally might arise out of the double taxation of goods and services.

Benefits of VAT

  • Set –off will be given for input tax as well as tax paid on previous purchases.
  • Other taxes, such as turnover tax,surcharge.additional surcharge,etc will be abolished.
  • Overall tax burden will be rationalized.
  • Prices will  in general fall.
  • There will be self assessment by dealers.
  • Transparacy will increase.
  • There will be higher revenue growth.

Need for introducing Tax

  • VAT is more equitable way of taxing as all dealers share the tax burden
  • VAT is more transparent as easy procedures exist under it and only two rates are there
  • Simpler-easy computution and easy compliance.
  • Credit for input taxation leading to cost efficiency
  • Better compilance through self-policing
  • Prevents cascading effect by providing input rebate
  • Avoids distortions in trade and economy due to uniform tax rates.

Principle of VAT

The standard way to implement a VAT involves assuming a business owes some percentage on the price of the product minus all taxes previously paid on the good. If VAT rates were 10%, an orange juice maker would pay 10% of the £5 per litre price (£0.50) minus taxes previously paid by the orange farmer (maybe £0.20). In this example, the orange juice maker would have a £0.30 tax liability. Each business has a strong incentive for its suppliers to pay their taxes, allowing VAT rates to be higher with less tax evasion than a retail sales tax. Behind this simple principle are the variations in its implementations

Comparision with a sales tax

The value added tax system is designed to address various problems associated with the conventional sales tax system. In sales tax, there is no provision for input tax credit, which means that the end consumer may pay tax on an input that has already been taxed previously. This is known as cascading and leads to increases consumer tax and price levels, which increases the rate of evasion and can be detrimental to economic growth.The value added tax system allows for input tax credit, or ITC, on the amount of tax levied at the preceding stage of the value addition chain. The allowance for ITC is normally appropriated from the value added tax liability imposed on the following stage of the sale of the product

In many developing countries such as India, sales tax/VAT are key revenue sources as high unemployment and low per capita income render other income sources inadequate. However, there is strong opposition to this by many sub-national governments as it leads to an overall reduction in the revenue they collect as well as a loss of some autonomy.

A general economic idea is that if sales taxes exceed 10%, people start engaging in widespread tax evading activity (like buying over the Internet, pretending to be a business, buying at wholesale, buying products through an employer etc.) On the other hand, total VAT rates can rise above 10% without widespread evasion because of the novel collection mechanism.[citation needed] However, because of its particular mechanism of collection, VAT becomes quite easily the target of specific frauds like carousel fraud, which can be very expensive in terms of loss of tax incomes for states.

A supply- demand analysis of a taxed market

In the above diagram,

* Deadweight loss: the area of the triangle formed by the tax income box, the original supply curve, and the demand curve
* Governments tax income: the grey rectangle that says "tax revenue"
* Total consumer surplus after the shift: the green area
* Total producer surplus after the shift: the yellow area

Different modes of computation of VAT

  • Addition method – this method is based on the identification of value added, which can be estimated by summation of all the elements of value- added(i.e. wages ,profits , rent and interest). This is in line with the income method of calculating national income. The chief drawback of this method is that it does not require matching of invoices in order to check tax evasion.
  • Subtraction method – the subtraction method estimates value added by means of difference between outputs and inputs.this is also known as product approach and has further variants in the way subtraction is attempted from among (a) direct subtraction method (b) intermediate subtraction method (c) indirect subtraction method
  • Tax- credit method – under tax credit method, the tax on inputs is deducted from the tax on the sales to arrive at the VAT payable by dealer. The indirect subtraction method entails deduction of tax on inputs from tax on sales for each tax period.

Disadvantages of VAT

    1. VAT is regressive
    2. VAT is difficult to operate from position of both administration and business
    3. VAT is inflationary
    4. VAT favors capital intensive firms

Importance of VAT in India

India, particularly being a trading community, has always believed in accepting and adopting loopholes in any system administered by State or Centre. If a well-administered system comes in, it will not only close options for traders and businessmen to evade paying their taxes, but also make sure that they'll be compelled to keep proper records of sales and purchases.Under the VAT system, no exemptions are given and a tax will be levied at every stage of manufacture of a product. At every stage of value-addition, the tax that is levied on the inputs can be claimed back from tax authorities.

At a macro level, two issues make the introduction of VAT critical for India

Industry watchers believe that the VAT system, if enforced properly, will form part of the fiscal consolidation strategy for the country. It could, in fact, help address issues like fiscal deficit problem. Also the revenues estimated to be collected can actually mean lowering of fiscal deficit burden for the government.

International Monetary Fund (IMF), in the semi-annual World Economic Outlook expressed its concern for India's large fiscal deficit - at 10 per cent of GDP.Moreover any globally accepted tax administrative system would only help India integrate better in the World Trade Organization regime.

Items covered under VAT

  • All business transactions that are carried on within a State by individuals/partnerships/ companies etc. will be covered under VAT.
  • More than 550 items are covered under the new Indian VAT regime out of which 46 natural & unprocessed local products will be exempt from VAT
  • Nearly 270 items including drugs and medicines, all industrial and agricultural inputs, capital goods as well as declared goods would attract 4 % VAT in India.
  • The remaining items would attract 12.5 % VAT. Precious metals such as gold and bullion will be taxed at 1%.
  • Petrol and diesel are kept out of the VAT regime in India.

Tax implication under Value Added Tax Act

Seller

Buyer

Selling Price (Excluding Tax)

Tax Rate

Invoice value (InclTax)

Tax Payable

Tax Credit

Net TaxOutflow

A

B

100

4% CST

104

4

0

4.00

B

C

114

12.5% VAT

128.25

14.25

0*

14.25

C

D

124

12.5% VAT

139.50

15.50

14.25

1.25

D

Consumer

134

12.5% VAT

150.75

16.75

15.50

1.25

Total to Govt.

VAT CST

16.75 4.00


Criticisms

The "value-added tax" has been criticized as the burden of it relies on personal end-consumers of products. Some critics consider it to be a regressive tax, meaning the poor pay more, as a percentage of their income, than the rich. Defenders argue that excising taxation through income is an arbitrary standard, and that the value-added tax is in fact a proportional tax in that people with higher income pay more at the same rate that they consume more. The effective progressiveness or regressiveness of a VAT system can also be affected when different classes of goods are taxed at different rates. To maintain the progressive nature of total taxes on individuals, countries implementing VAT have reduced income tax on lower income-earners, as well as instituted direct transfer payments to lower-income groups, resulting in lower tax burdens on the poor.[4]

Revenues from a value added tax are frequently lower than expected because they are difficult and costly to administer and collect. Certain industries (small-scale services, for example) tend to have more VAT avoidance, particularly where cash transactions predominate, and VAT may be criticized for encouraging this. From the perspective of government, however, VAT may be preferable because it captures at least some of the value-added. For example, a carpenter may offer to provide servicesfor cash (i.e. without a receipt, and without VAT) to a homeowner, who usually cannot claim input VAT back. The homeowner will hence bear lower costs and the carpenter may be able to avoid other taxes (profit or payroll taxes). The government, however, may still receive VAT for various other inputs (lumber, paint, gasoline, tools, etc.) sold to the carpenter, who would be unable to reclaim the VAT on these inputs (unless of course the carpenter also has at least some jobs done with receipt, and claims all purchased inputs to go to those jobs). While the total tax receipts may be lower compared to full compliance, it may not be lower than under other feasible taxation systems.

Because exports are generally zero-rated (and VAT refunded or offset against other taxes), this is often where VAT fraud occurs. In Europe, the main source of problems is called carousel fraud. Large quantities of valuable goods (often microchips or mobile phones) are transported from one member state to another. During these transactions, some companies owe  VAT, others acquire a right to reclaim VAT. The first companies, called 'missing traders' go bankrupt without paying. The second group of companies can 'pump' money straight out of the national treasuries.] This kind of fraud originated in the 1970s in the Benelux-countries. Today, the British treasury is a large victim.[5] There are also similar fraud possibilities inside a country.

References

* http://www.economywatch.com/business-and-economy/vat.html
* http://en.wikipedia.org/wiki/value_added_tax
* http://www.tax4india.com/vat/vathtml
* Income tax - Dr. vinod k. singhania & Dr. monica singhania, 41st edition 2009-2010 (Taxmann Publications Ltd.)
 


Ankita Agrawal
Management Student
NSB, NIILM School of Business
New Delhi
 

Source: E-mail August 25, 2010

 

           

 

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