Uttar Pradesh - VAT’s happening

There is something remarkable about the way Uttar Pradesh fell in line with other states to implement Value Added Tax last week. On April 1, 2005, when most states agreed to switch over to VAT from their sales tax regime, their dominant concern was a possible loss of revenue. The Union finance ministry had to promise several sweeteners including a calibrated compensation formula. Despite the sops, UP stayed away from implementing VAT, citing the possible loss of revenue and opposition from traders as obstacles to the roll-out.

Those concerns were turned upside down as the BSP government in Uttar Pradesh took an in-principle decision to switch to VAT. The state realised it was missing out on an annual 20 per cent rise in tax receipts recorded by other states, plus a gradual loss of business by India’s most populous state to others. State cabinet secretary, Shashank Shekhar Singh, said due to absence of VAT credit, traders and manufacturers in UP were being denied input tax credit. As a result, goods produced in UP were becoming uncompetitive in other states. The state has therefore followed Tamil Nadu to complete the Indian experiment for a nation-wide state-level VAT regime.

After UP, what would the indirect tax landscape look like? Indian and European Union citizens now work under a similar tax format. All goods manufactured and sold in the same state, anywhere in India, will pay a tax only on the value addition. All goods, which attract a central excise duty, too get a VAT refund. The only segment where VAT is not applicable is central sales tax levied for inter-state movement of goods. This is the reason why the current VAT format is called a state-level VAT, and not a national-level VAT.

The action on tax reforms will naturally focus on elimination of this 4 per cent central sales tax, before 2010. For mega cities like Delhi and Mumbai, this is a big deal as they depend a lot on inter-state movement of goods. The other scene of action would be service tax. States have to harmonise their service tax with the VAT rates on goods. At the central level, business already gets seamless credit for taxes paid, whether on service or excise. But the rates of tax on goods and services are different. Since the current excise duty is 16 per cent and service tax at 12 per cent, watch out for a median rate emerging in the next budget.

These would be the ingredients for the Centre to introduce a Goods and Services Tax (GST) to replace the current excise and services duties by 2010, as promised by finance minister P. Chidambaram. There would be two stages to it. At one level would be a tax to replace all central excise and services levy to a common rate. At the other level, states would also amalgamate their VAT on goods and services tax into a state-level GST. Thus there would be only two slabs of indirect tax, across the country.

Already in less than two years, VAT has become the biggest success story of Indian public finance. But this is not just because it has helped the states to shore up their fiscal muscle considerably. There is scope for more. Before the introduction of VAT, the annual collection from sales tax and central sales tax by all states was about Rs 1,05,000 crore. But all estimates were sure this was just about 50 per cent of the potential revenue. Since tax evasion was widespread, the states lost out.

Since VAT is a multi-level tax that gives inputs to sellers for their raw material costs, it acts as a counter check for the tax paid by each preceding trader. India has a large un-organised market, especially agro-based industries, and here a large number of transactions went unrecorded. The menace of stock transfers added to the problem of tax evasion. VAT cleaned up the format. But that is still a side story.

The big success has been the way VAT has led to the emergence of a national-level common market for almost all non-agricultural products. Commodities for consumers are now taxed at a uniform 12.5 per cent, while only some intermediate goods attract a 4 per cent rate. Since every state is on the VAT platform, manufacturers, domestic and foreign, do not need to wrestle with different rates of tax for products moving across states. This in turn reduces inventory and warehouse costs for them and makes companies respond to demand conditions faster, while making the states richer.

Most countries have introduced VAT to reform their indirect tax systems. The US remains one of the rare exceptions to the rule. Indian businessmen have also found that without VAT, they cannot get a tax refund for their products from abroad. The lack of a VAT network had hurt the growth potential of the domestic companies. The UP government’s decision has made it certain that the time table for the next change in tax reforms would be maintained.