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It's time to rethink excise exemptions
February, 19th 2007

Bharat Sanchar Nigam Ltds decision to evaluate its purchase options, adjusting price for available cenvat credit, has thrown a host of small scale suppliers into deep trouble.

These vendors price competitiveness depends on the excise duty (cenvat) exemption available to them owing to their small-scale status. Their buyers cannot avail of any cenvat credit for the simple reason that their produce bears no cenvat. Once buyers factor in the cenvat credit available on their purchases, a component maker from the small scale sector, which does not pay cenvat, is on par with a component maker from the organised industry that pays cenvat, as far as the duty element of the price is concerned. Cenvat credit neutralises the effect of excise exemption.

BSNL cannot be faulted on its decision. It makes perfect commercial sense. What is at fault is industrial promotion using a concession that is incompatible with the emerging tax structure. Once the economy moves fully to an integrated goods and services tax, excise duty exemption would be of use to a small scale enterprise only if it manufactures final consumption goods that are sold directly to end consumers the final consumer bears the goods and services tax and cannot claim any tax credit. Duty exemptions are positively injurious to the tax administrator, as any break in the VAT chain makes evasion easy.

Small scale vendors, whose survival has become doubtful in the wake of BSNLs new procurement policy, are also not to blame for their plight. By engaging in a manufacturing activity whose viability depended solely on excise exemption, they were only responding to official policy. When the state changes its policy on taxation, it should think through implications for its concessions and those who live by them. The state failed to do so in the present case and should clean up the mess it has created. But how?

Duty exemption is subsidy by another means. Substituting a direct subsidy for the duty exemption should do away, for the moment, with the problem created for the small producers by cenvat credit. But this is not a solution that is either desirable or sustainable in the long term. Small scale should not spell either inferior quality or inefficiency in production.

Such an ideal small-scale producer would not need subsidy. Some lines of production are best carried out in the small sector, say engineering components, while some lines of production are best carried out in the large sector. Scale economies should decide which activity is small-scale and which one is not. If someone decides to manufacture airliners in the small-scale sector, there is no reason why the government should step in to subsidise that operation with either tax exemptions or cash transfers.

Small entrepreneurs need institutional support. Better banking so that credit is available and a good credit history fetches lower interest rates. Uninterrupted power supply. Relief from the burden of corruption. Speedy administrative action. Swift enforcement of contracts. Factoring services.

Only tiny and village industries that act as vehicles for the rural economys transition away from farming deserve fiscal sops. What the government can do is to offer a short roadmap to such an overhaul of its policy of industrial promotion, starting with direct substitution of cash subsidies for duty exemptions and ending with zero subsidies after traversing through steadily whittled down subsidies and enhanced institutional support.

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