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VAT: Populism is a path to fiscal disaster
November, 07th 2011

The latest news about VAT is that the Delhi Government has agreed to withdraw VAT component from items being sold at thirty eight stores run by forces in Delhi if the goods are bought by Police and Central Para-military personnel. This largesse has been granted following a request by the Union Minister of State for Home and Director Generals of CRPF, ITBP, CISF and SSB. The proposal has so far not got the approval from the Delhi Cabinet. I do hope the Cabinet does not give the approval.

If we have to have a VAT, then it must be a proper VAT and not a perforated one. VAT should not be riddled with exemptions and administrative imbroglio. The reason why we shifted from the old system of sales tax was because there were too many exemptions and too many rates leading to cascading effect. We will be going backwards towards the same system if we give too many exemptions. Imagine the problems that will arise now if police, CRPF, ITBP, CISF and SSB also get exemptions. Why not BSF? Why not Customs? Why in Delhi alone?

The only reason why these organisations are getting exemptions is because they handle weapon. So does Customs. Particularly there is a wing in Customs which handle not only rifles but SLR just like BSF or SSB does. It is easy now for Customs to represent that they also should get exemptions. And what is this so special about handling weapon?

Exemptions feed one another giving rise to exemption creep. Once the exemption is given to edible oil which is sold to paramilitary forces, the inputs for the edible oil will not get credit and they will ask for exemption. Such instance is also in the case of food. The exemption for basic food stuff leads to demand for exemption for agricultural inputs, the justification is that otherwise they have to pay tax which is not credited.

Exemption breaks the VAT chain. Once there is an exemption at an intermediate stage, no further input credit will be admissible. The result is that the cascading effect will come back and the consequence is actually in net revenue.

Universal experience has been that the introduction of exemptions and lower or zero-rates vastly complicates the task of administration, opening up avenues of tax avoidance and evasion. It is, therefore, to be avoided as far as possible1.

Exemption of a particular commodity complicates the administration of VAT. Additional record keeping is required to segregate taxable from exempt sale. To facilitate administration, exemptions should be kept at a minimum. Where exemption has been almost entirely eliminated, as in Chile, New Zealand and Japan, VAT has been much easier to administer and therefore quite successful. Although, case can be made out for exempting certain basic commodities on distributional grounds, it is difficult to justify the exemption of particular regions or industrial activities from the VAT2.

In the light of the administrative complexities created by such exemptions, developing countries, where tax administration is generally weaker, should refrain from introducing them.

The conclusion is that exemptions are given in most countries but only to basic food, health care, water sewerage, drainage etc but not to a specific class of people. Already there is a tax exemption to the military which has also created administrative problems. Cars bought by Military Officers are found on the street with temporary numbers because the VAT fund had been exhausted by the dealer. Research on Value Added Tax system all over the world has proved certain universally accepted principles which are the following:

Exemptions potentially undermine a VAT and therefore the number of exemptions should be kept at the minimum. If it is a federation, all the States should have common exemptions. Minimum exemptions may include unprocessed food articles, life saving drugs, goods and services of social implications such as health and education.

There should be a threshold below which there should be exemption. Hard to tax services should be exempted. If the military or the para-military have to be shown special favour, let there be a special pay or a subsidy (shrouded in suitable language) but let not the VAT system be subverted. VAT should not be killed by kindness.

1 Peggy B. Musgrave International Aspects of VAT, VAT Monitor, May/June 2001, p. 105.

2 Milka Casanegra de Jantscher Administering VAT, VAT in Developing Countries edited by Malcom Gillis, Carl S. Shoup and Gerardo P. Sicat, World Bank, 1990.

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