Even before a debate began on how exclusion of petroleum products and a high revenue neutral rate (RNR) among other regressive proposals could sully the image of the proposed Goods and Services Tax (GST), several major states had already impaired the structure of its precursor, the Value Added Tax. While experts vouch for the principles that must guide the GST/VAT design, namely levy at every transaction of businesses above a threshold and input tax credit for every buyer except the final consumer, these state governments have over the past few years violated them, almost recklessly.
The state VAT launched about a decade ago has been deprived of its ability to produce incremental economic growth. The states’ policies that run contrary to the tenets of the VAT system began as they hiked tax rates by a quarter post-2009 when the Centre was still to withdraw a fiscal stimulus.
The stimulus was meant to prevent a drastic fall in growth on the heels of the global economic crisis.
graph-VAT-mess In the more recent years, some states, in their anxiety to protect revenue growth despite a prolonged economic slowdown, have also imposed a disguised tax on inter-state stock transfers and truncated the input tax credit (ITC) by various means.
At least one of these states has even restricted the levy to the easy-to-capture first point of sale in case of a number of items of great currency, negating the concepts of multi-point taxation and a wider tax base.
Instances of states’ VAT-distorting policies are many. Punjab, in December 2013, introduced a system of levy only on the first point of sale for a large variety of items – from electronic goods and packaged foods to mineral water and medicines – at substantially higher rates of 7-25% (as against the weighted average of about 12% in case of other items). This meant the tax is paid at either the manufacturer’s or first importer’s stage and an absence of tax on the value added downstream, including at wholesale and retail points. The logic was simple: levy the tax where it is easy to do and protect immediate revenue streams by raising the rates; avoid the pain of keeping a trail on the value chain if the value addition to be captured is relatively small (20-25% in this case). As a result, the VAT system in the state had collapsed.
Also, some states have amended rules on tax credits that punish large companies having outfits in different parts of the country and have to transfer part of their stock across state borders before they are sold. In theory, there is no tax on moving products within a group company across borders as this does not amount to sale. However, thanks to the change in Tamil Nadu’s VAT rules in November 2013, a taxpayer in that state says a car manufacturer, cannot fully utilise the tax credit on the raw materials purchased within the state to meet the VAT liability on the cars sold in the state, because a part of those raw materials are used to manufacture cars moved to neighbouring Karnataka.
The restrictive rule by Tamil Nadu is that in such cases (here the sale of cars within Tamil Nadu), input tax credit shall be allowed only if the tax paid on inputs sourced within the state is more than 5% of their value. In most cases, this is not the case and the ITC gets denied. This goes against the ITC’s rationale that a buyer, if not a final consumer, should not pay a tax on the tax content of his input price.
Although this amounts to a virtual tax on stock transfers from a state, itself a bad impost given that it seeks to undermine the freedom of firms to conduct their businesses in the most economical way, an unintended victim is the consumer in the same state, as truncated input tax credits for the manufacturer/dealer could inflate consumer price. Tamil Nadu also restricts input tax credit for dealers unable to claim the concessional 2% Central Sales Tax (CST) on inter-state sales, and is therefore liable to pay VAT even on items exported to other states. CST being an origin based tax is the right of the exporting states and no credit is available on this.
Some states either do not allow or severely restrict input tax credit when petroleum refineries sell their outputs. In September 2014, Gujarat restricted credit on input tax incurred on purchase of crude oil, natural gas and petroleum products. Maharashtra also does not allow petroleum refiners like BPCL and IOC to use ITC from crude purchases, for instance from ONGC’s Bombay High fields, to pay output taxes.
The economic cost of these distortions are considerable. Rahul Renavikar, executive director at EY, says there is a growing tendency amongst key states to tweak the VAT system. For businesses with pan-India operations, this is a big irritant, he adds. Also, most states try to milch petroleum products to augment revenue, again an unwholesome practice. For instance, revenues from petroleum, oil and lubricants, or POL, accounted for 30% of Gujarat’s revenue from tax on sales in FY14, up from 27% in FY11; in Maharashtra’s case, POL’s share rose to 33% from 28% in the same period. Over 60% of the states’ own tax revenue comes from sales tax (VAT).
While most states have more or less managed to keep the revenue growth in the post-crisis period similar to the preexisted levels due to these misadventures and a help from sustained high inflation (VAT is ad valorem), experts warn that the states’ purblind tax policies could now start backfiring. These policies, they say, have aggravated the economic conditions. As a result, the higher and firmer revenue buoyancy relative to the Centre’s that most states have seemingly enjoyed in post-crisis years is wearing off. A vicious cycle may have been created.
Maharashtra, for instance, saw flat growth in VAT revenue in FY14 from 20% in the previous year and 23% in the year before that. While some faulty revenue-augmentation steps helped Gujarat achieve VAT revenue growth of 52% in FY12, it dropped to 17% (budget estimate) in FY14.
A moderation in the overall state-VAT revenue growth is also increasingly visible, with growth declining from 26.4% in FY11 to 23.7% in FY12 and further, to 19% in FY13. The budget estimate for growth in FY14 was even lower at 17.2%.
The trend in the Centre’s indirect tax revenue has been more erratic, thanks to post-crisis fiscal stimulus, its gradual withdrawal and a longer-than-expected economic slowdown. During FY09 and FY10, the growth in the Centre’s indirect tax collections was negative – minus 3.4% and -0.2% respectively – but jumped to 41% in the subsequent year helped by the low base, but could not sustain the tempo and dipped to just 9.5% in FY14, and further to 5% in the first half of the current fiscal. States’ VAT revenue, it seems, are now to follow this trend as their faulty strategies are proving to be of only transient help.
In terms of size, the Centre’s indirect tax collections (at Rs 5.19 lakh crore in FY14) is slightly higher than the combined revenue of states from VAT (estimated Rs 4.8 lakh crore for FY14).
“Since states have the authority to change VAT laws, they are making irrational changes without understanding the implications. Transparency and removal of tax cascading, the purposes of introducing VAT, get defeated if this levy is collected from the first point of sale itself, no matter the convenience of collecting slightly more revenue from limited number of dealers at this stage,” says Mahesh C Purohit, director at Delhi-based Foundation for Public Economics and Policy Research. GST, by design, will not allow states to make changes in tax rates or in the relevant rules, he adds.