National Value Added Tax (NATVAT)

Introduction

   A 2002 policy paper, outlined a vision of National Value added tax (NATVAT) that it suggested could be put in place by 2010 through a constitutional amendment, after creating genuine Central VAT (CENVAT) and States VATs (STATVAT) within the existing constitutional limits.[i] Given the degree of interest in the Goods and Service Tax (GST) among industry, financial participants, economists and the general public, a version of the NATVAT, which differs somewhat from the GST  is outlined below.  The two differ in relatively minor but critically important details.  In my view these difference would have made it easier to get political acceptability for the NATVAT  from States.

Indirect Taxes

Tax theory provides us a number of insights into the nature of indirect taxes that are best for a country.  The most important insight is that there should effectively be no tax (i.e. zero rate) on raw materials, intermediate goods, capital goods and services used for production of goods & services.  The second insight is that efficiency considerations drive the differentiated structure of consumer taxes towards higher rates on goods & services with low demand elasticity.  In the case of de-merit goods like cigarettes & tobacco products and (perhaps) hard liquor this proves easy to apply.  However, as necessities have lower elasticity of demand than luxuries this runs contrary to the equity objectives that tend to drive the tax structure in the opposite direction (assuming a reasonably strong desire for social equity as commonly professed in India).  The net result depends on the detailed elasticity.

There are two other lessons that involve a greater element of judgement:  That efficiency and equity considerations tend to balance each other and that a near-uniform structure of indirect taxes may be a useful starting point for a reasonably efficient and equitable tax system.  Another is that there is a case for taxing at a somewhat higher rate goods & services that are complementary with leisure (e.g. goods & service for entertainment), though the force of this argument is diluted in a large population countries (like India) with substantial or ‘hidden unemployment’ or ‘under-employment.

Why VAT

This is the appropriate point in which to bring in the problems of tax administration, evasion and corruption that loom so large in developing countries (emerging markets) and which this theoretical exercise has totally ignored.  Logically the structure of optimal taxes based on reality (varying administrative costs, evasion costs & corruption possibilities) would differ markedly from that given by the “ideal.” There is wide agreement among tax experts who advise governments on tax reform that these problems argue strongly for having an indirect tax structure that is simple and as close to uniformity as possible.  Complexity facilitates and encourages tax evasion and corruption.  It also provides an incentive for lobbying by powerful organised groups to obtain special favours for themselves.   This sets in motion a spiral of complexity, evasion & corruption that is not based on any empirical knowledge (of elasticity) and results in a tax structure that bears no relationship to the so-called ideal “optimal.” 

The second implication of this reality (administrative costs, evasion, corruption) is that the best way to implement a uniform structure of indirect taxes is through a value added tax.  A uniform value added tax (VAT) has the same efficiency & equity properties as a uniform sales tax on final finished consumer goods, but by collecting the tax at multiple points and in smaller doses it minimises the incentive for evasion.  It also has (in principle & if implemented properly) the property of catching at a later stage the tax evasion that has taken place at earlier stages of production/ value added.  These considerations have led an overwhelming majority of countries (not just developing but even developed) to replace their existing indirect taxes by a Value Added Tax.

An indirect tax structure for the country (Centre & States) that will be simple, efficient and equitable should ideally replace all central and state government taxes on goods and services.

National VAT

An ideal indirect structure for the country would consist of two sets of indirect taxes:  A single uniform rate National VAT on all goods and services (except for a limited number of pre-specified exemptions) and State (final) sales taxes on a dozen specified goods with a pre-specified upper limit on the sales tax rate for each of these goods.  The Central government would have the responsibility of setting the national VAT rate in consultation with the States and for administering it with the help of the States as needed.  Calculations done in the 2000s suggested that a VAT of 15% may be sufficient to ensure revenue neutrality with respect to existing Central & State indirect taxes.  The proceeds from this tax would be shared between the Central government and the States in the proportion necessary to ensure that there is no diminution of the States’ indirect tax revenues.  To ensure that the indirect system is equitable, and to support positive externalities, the following goods and services could be exempt from the VAT: Food, including processed (cereals, pulses, vegetables, fruits, milk & products and possibly sugar), Drugs, Medical Equipment & medical services (Diagnostic; Disability compensating or Disease preventing/curing), Environment friendly fuels (solar), Educational services and Knowledge services (Educational material, R&D, Testing, Consultancy).  There would also be a sales volume exemption of Rs. 5 lakh (say) based solely on the need for minimising compliance & administrative costs.  All other exemptions should be abolished.  Administration of the system for transactions up to some limit (Rs. 10/20 lakh say) could perhaps be decentralised to the States. States would also have to abolish Octroi one of the most inefficient taxes know,

Final Sales Taxes

In addition, the State government would have the right to levy sales taxes on a limited set of final, finished consumer goods (to ensure that there is no cascading & no taxation of intermediate goods).   The maximum total tax on any good or service should not exceed 50%. At this point, the incentive for tax evasion becomes so strong that corruption is sure to follow. This means that with a VAT rate of 15%, the sales tax must not exceed 35% (upper limit/maximum).  Such a high rate could however be applied only to de-merit goods such as tobacco products (cigarettes, cigars, chewing tobacco) and hard liquor.   Fuels with negative environmental externality, such as petrol & diesel, could be subject to a maximum sales tax of 25%.  The same maximum rate could also apply to cars and low (< 5%) alcohol beverages like beer & wine.  A few other items such as Air travel, Air Conditioners, Motor cycles/scooters & home entertainment products (excluding radio & TV), Entertainment services like cinema, Hotels & Restaurants service, could be subject to a maximum sales tax of 15% (i.e. 0% to 15%), as the VAT would replace the existing set of entertainment taxes, expenditure tax, sales tax etc.

 Across the world, Sales taxes are normally levied at the point of sale to the consumer.  Because of evasion & related problems, India follows the practice of “first point sales tax,” where the tax is collected at the point of sale by the producer.  Strictly speaking this is better termed as an excise tax.  However, as long as cascading and multiple taxation are avoided and all States follow the same method, either method can be adopted. Both the national VAT and the State Sales taxes would apply to imported consumer goods & services in the same way as they do to domestically produced ones.  The final point of sale collection (of sales tax) has the merit that each State can collect its own sales tax on imported goods.  If the first point Sales tax (excise) methodology is adopted then an excise/sales/SAD tax will also have to be collected (on the specified set of goods) at the customs point on behalf of the States.  This creates undue complexity if the States have different rates of tax on the same good. Imported goods would enter the VAT chain at the point of entry into the country and from there on be treated exactly as if they had been produced in India.

Administration & Evasion

 The single rate NATVAT allows a drastic simplification in administration & compliance,  which is the great advantage of a true VAT.  This simplification is based on a complete transformation of the collection and administration machinery.  It has the following related elements:

·         An invoice and accounts based system of checking in place of routine physical checking.

·         Basic data on the company (and its production units, warehouses, depots etc) would be entered once given an appropriate code number (VAN on the lines of PAN) and stored on the computer.   It would not have to be entered on every invoice as at present.

·         A simplified invoice form that focuses on values of inputs and outputs subject to the single VAT rate, and the source and destination of the inputs and outputs respectively (again represented by VAN).  This is most effective if there is a single uniform base NATVAT rate with all goods treated equally on both the input and output side with respect to this rate.  In this case the sale or invoice form would only require the total value of goods sold and the code number (VAN) of the originating and destination units.

·         Monthly, quarterly or annual aggregation of the sales and purchase slips depending on volume of business (i.e. SSI have to do only annual aggregation, and only the largest units have to do monthly aggregation).  The aggregation would involve showing total value of purchases and sales by seller & buyer respectively, during the relevant period.

·        A comprehensive computerisation of these aggregate returns, which allow cross checking of inputs, outputs value added and CENVAT paid, so as to detect evasion. Direct e- filing could be required for VAT payers above a certain size (Rs. 10 crore say).

·         This could be supplemented by industry wide database, which can be used to identify flow of goods and services entirely outside the VAT chain.

Conclusion

   In comparison to a Goods and Services Tax (GST) as proposed, the National VAT (NATVAT) greatly simplifies administration of the national system of indirect taxes, and would help in drastically reducing tax evasion. At the same time gives some flexibility to states to levy a half a dozen final sales taxes, so that they can meet fluctuations in revenues and expenditure by varying some taxes under their direct control.

---

[i] Arvind Virmani, “Towards a Competitive Economy: VAT and Customs Duty Reform,” Planning Commission Working Paper No. 4/2002-PC, April 2002.  http://www.planningcommission.nic.in/reports/wrkpapers/wp_vat