While continuing to block the introduction of GST, the states are making changes to the Value Added Tax (VAT) laws which are a blow to the economy. The most recent change is an amendment by Tamil Nadu, which severely restricts the tax credits in respect of inputs used in inter-state sales. It denies credit for the first 3% of the tax on any inputs for use in inter-state sales—which attract the 2% Central Sales Tax (CST)—and the first 5% on tax on inputs for inter-state branch transfers.
Effectively, inter-state shipments become subject to a tax of up to 5% in the exporting state. Similar restrictions apply in Gujarat. It blocks 2% of input taxes on inter-state sales and 4% on inter-state branch transfers.
These changes are retrograde and amount to the states shooting themselves in the foot. They increase the cost of production and investment and discourage location of production in the state. The economy suffers, so do the states as, without production, they would have no revenue to collect. It is strange for Tamil Nadu and Gujarat to implement such policies while they have been aggressively wooing manufacturers to locate production facilities in their jurisdictions.
When VAT was introduced in 2005, it was levied in a harmonised manner across the states with a uniform base, tax rates and rules and regulations. Full credits were allowed for input taxes, including those for inputs used in inter-state sales. The only blockage was for inputs going into inter-state branch transfers which were not subject to the CST. This model simplified compliance, provided boost to investment and economic growth, reduced tax-cascading and significantly improved voluntary tax compliance through proper tracking of inputs and outputs. Thanks to the massive deviations over the last few years, the current system bears little resemblance to the original model.
The system has now degenerated into a tax jungle of 30-plus different VATs. The changes negate the very objective of having VAT, viz. harmonisation of tax rates and base, full input tax credits to minimise tax-cascading, and simplification of rules and procedures to facilitate voluntary compliance.