Cascading effect of taxes
To understand the concept of goods and service tax (GST), it’s important to learn about cascading effect of taxes or commonly known as taxes on taxes. Suppose A sell goods to B after charging sales tax and B re-sells the same to C, again after charging sales tax. Assuming sales tax is 10%, below diagram explains this process
While calculating the tax liability, base price considered by B is INR 1100 which includes INR 100 taxes paid on purchase from A. Thus, instead of INR 100, this time the sales tax liability is INR 110. This includes INR 10 of taxes paid @ 10% on the INR 100 already paid as tax while purchasing from A. This is called cascading effect of taxes or tax on tax. As can be seen in the above diagram, this system results in higher prices for retail clients and higher tax liability for traders. This taxation system was practiced in India till a few years ago. In order to avoid the cascading effect of taxes India adopted the value added tax (VAT) system.
Under the VAT system, a dealer will get credit against his tax liability for the tax paid at the earlier stage. In simple terms, he can offset the taxes paid while purchasing the product against the total tax that he owes to the Government. Under the VAT system, tax liability of a dealer is equal to the tax rate charged only on the value added by him
Current indirect tax structure in India
Now let’s look at various types of indirect taxes currently charged by Central and State Governments. Below table gives a summary of the same
|Type of Tax||Description||Levied By||Set-off Against|
|Service tax||Tax levied on services provided by an entity. It is collected from the recipient of the service||Central Government||Service tax and excise duty|
|Excise duty||The tax on manufacturing. When manufacturing any product in India, manufacturer needs to pay excise duty to the government||Central Government||Service tax and excise duty|
|Custom duty||Tax charged on imports. Whenever goods are brought into the country, custom duty needs to be paid on the same||Central Government||-|
|Central sales tax||Tax charged on inter-state sale of goods||Central Government||VAT|
|Value added tax||Sales tax charged on sale of goods inside the state when they were purchased||State Government||VAT|
Service tax and excise duty are both levied by Central Government and allow tax credit system. Hence excise duty paid / service tax paid on the input transaction can be used to set-off the excise duty / service tax paid on output transaction. Moreover, cross credit utilization is also possible between service and excise taxes i.e. excise duty paid on input products can be used to set-off service tax liability. This is possible because both are managed and controlled by the Central Government.
Below are some of the problems with the current indirect tax system in India:
- Input VAT cannot be set-off against output excise duty and vice-versa. This because both are collected and managed by different entities, VAT is levied by Sate Government whereas excise duty is paid to the Central Government.
- VAT is calculated on the value which includes excise duty and no credit is provided for the same, this leads to tax on tax.
- Multiple tax systems, different tax rates, dissimilar tax set-off conditions and multiple tax collection agencies all combine to increase compliance cost.
- Countries within a country – currently various states have different tax rates for various types of taxes. These taxes are levied at state borders at the time of transportation of goods. This obstructs easy movement of goods and increases transportation, compliance and labour cost.
Proposed Goods and Service Tax (GST)
GST will act as a comprehensive tax that will subsume all other indirect taxes like service tax, excise duty, sales tax, etc. All goods and services will be taxed at the same rate. Proposed GST model is a dual model with both State and Central Government taxing every transaction. As per the current provisions of the constitution, only states can tax the sale of goods within their borders. In contrast the GST bill proposes to allow Central Government also to levy tax on such intra state transactions. Thus a constitutional change needs to be implemented before GST can be enforced. Any constitutional change needs to be passed in both houses of parliament by at least ⅔ majority. In addition to this, the bill needs to be ratified by at least half of the state assemblies. Currently the bill has been passed only in Lok Sabha.
Now let’s look at the advantages of GST
- Tax structure will be made lean and simple: The current indirect tax structure in India allows multiple types of taxes at different rates. After implementation of GST all these different taxes will be withdrawn and there will be a single GST tax rate.
- One single unified market: Currently different states have different tax rates. This results in business decisions taken based on tax advantage. This also hampers the movement of goods across state borders – these taxes are collected at state borders – resulting in delays, high transportation and labour cost. Implementation of GST will allow free movement of goods and services across states making the whole country one single unified market.
- Lower tax liability for businesses: As per the present tax structure excise duty paid while buying the products from the manufacturer cannot be set-off against sales tax liability arising while reselling the products. This results in tax on tax which is passed onto the end consumer. Compliance cost for businesses are high as well. GST provides a robust tax off-set system. This will significantly lower the cost of doing business and might also result in lower prices in long term.
- Widening of tax base: Under GST regime businesses will be motivated to comply with tax laws, as they would be able to claim tax credits on purchases. Further the cost of compliance is expected to come down which will act as an added incentive for businesses to comply.
- More money to under-developed states: Currently states with manufacturing and production hubs are richer as they are able to collect higher taxes compared to other states. GST is a consumption based tax, and the origin of the good/service is not of importance. States with large population have higher consumption because of the sheer number of people consuming goods and services. Given the consumption nature of GST, underdeveloped states with high population are expected to receive higher taxes. Thus, GST can give the much necessary monetary boost to states like Bihar and UP.
GST is the most important tax reform in decades. It looks like GST will soon be a reality, as all concerned parties recognise the benefits that GST will bring to the Indian economy and there are only very few points that still needs to be resolved. To know which sectors will benefit most by the implementation of GST, read our blog on our smallcase The GST Opportunity.