A study by the Comptroller and Auditor General of India (CAG) has brought out startling details of the manner in which several states are operating the value-added tax (VAT) system. Over half of the hundred thousand dealers covered under the CAG audit in 23 states were engaged in tax evasion.

Tax evasion of Rs 873 crore was detected from the scrutiny of only 2,600 returns in 15 states. Dealers obtained tax exemption worth Rs 1,000 crore on a turnover of Rs 25,000 crore from the sale of tax-paid goods, without any proof of documentation.

In some states, tax-exempted manufacturers collected taxes from the purchaser of their goods, but the states did not collect these taxes. Consequently, the states incurred a sizeable revenue loss as the purchaser of those goods also claimed input tax credit on those transactions. The CAG report lists many more such instances of blatant misuse of the VAT system in several states.

Most of these cases had a common set of shortcomings arising out of flaws in the automation process, scrutiny of returns, tax audits, input tax credit mechanism, cross-verification of returns and the operation of the incentive schemes.

The only argument the states can possibly put forward in defence of their failure to plug such revenue leakages is that the CAG study covers only the first four years after the introduction of the new tax in 2005.

Admittedly, therefore, the period under study reflects the teething troubles of a new taxation regime that replaced the much older system of levying sales tax constituting several rates and accounting for well over half of the Indian states total tax revenues.

Nevertheless, as the CAG report shows, it is a serious indictment of the new regime that has allowed rampant duty evasion, the very ill it was supposed to have rooted out with the help of a simpler and foolproof system of tax collection.

For the Centre, which is busy putting in place a far more complex process involving the launch of the goods and services tax (GST) system across the country, the CAG study could not have come a day too soon.

Since the state VAT system, which is now suffering from several loopholes, would be subsumed in the state goods and services tax regime, it is important that the operational flaws detected by the CAG report should be understood and steps taken to prevent their recurrence when the state GST becomes operational from April 2011. The way forward is not to go back to the old system of sales tax, but to embrace the state GST system, along with a robust information technology network that prevents its misuse.

The transition from sales tax to state VAT and finally to the GST system can be smooth only if the information technology backbone is made stronger and foolproof so that matching or cross-verification of returns does not have to depend on manual intervention.