[Goods and Services Tax] Part 1: Past system of indirect taxation

The Goods and services tax has come into effect from 1^st July 2017 after the relevant bills were passed in the Parliament and the State legislatures. In this post, I will try to decipher GST and address some complexities associated with it. For that, we will also have to look at the indirect tax system which we have recently overhauled. This will be of great help to understand why we actually need GST and what its potential benefits are. Only then will we be in a better position to understand GST in detail.

So what was system of indirect taxes in India before 1^st July 2017?

Indirect taxes are those in which the burden of paying the tax can be shifted. This means that the entity responsible for paying the tax to the government does not actually bear the tax on itself, rather charges it from the final consumer. Currently, both the central and state governments levy indirect taxes on different goods. Central Indirect taxes include excise, customs, central sales tax, CENVAT, etc. State level indirect taxes are sales tax (Or VAT), entertainment tax, etc. Goods may be taxed according to their value, dimensions or quantity, etc.

The producer pays excise duty to the center on production. On selling to the wholesaler, he pays VAT to the state government, if the wholesaler is located in the same state or a CST to the central government otherwise. The wholesaler makes some profit while selling to the retailer, and pays the tax on his sale in the same manner. Finally, the retailer sells it to consumer after making a profit, collects the VAT from the consumer and pays it to the state government. And since all these are indirect taxes, they are ultimately borne by the consumer.

Note that if the sale is from one state to another, the state government cannot levy a sales tax on this sale as this will distort the free movement of goods in course of inter-state trade. This is a constitutional requirement. In order to compensate the selling state for loss of sales tax, the central government levies a Central Sales tax and transfers the entire amount to the selling state.

Since 2005, sales tax in the states is levied in form of Value added Tax. This reform was meant to check the evasion of taxes and correct the double taxation system. The term 'value addition' implies the increase in value of goods and services at each stage of production or transfer. VAT is a multi-stage tax with the provision to allow 'Input tax credit (ITC)' on tax at an earlier stage, which can be appropriated against the VAT liability on subsequent sale. This input tax credit means setting off the amount of tax paid on inputs by the dealer against the tax to be paid at the output stage.  In case the good is a final good, this value added can simply be considered as the profit which everyone in the supply chain is making.

Let us take an illustration. Assume that the rate of excise duty, CST and VAT is 10% each. Also assume each person in the supply chain wants to make a profit of 100 rupees. Now, suppose a cricket bat was manufactured in Meerut (UP) sold to a wholesaler in Nagpur, Maharashtra, who sells it to retailer in Mumbai. 1^st, an excise duty of Rs. 10 is paid by the producer to the central government. Next, the producer charges a Central Sales tax on Rs. 210 @10% from the wholesaler and pays it to Central government, which pays the entire amount to the UP government. Next, the wholesaler, who has brought it for Rs. 210+21, equals 231, makes 100 rupees profit and charges Rs. 331 +tax @10%, which is Rs.33. He pays this to the Maharashtra government. Finally, the retailer, who has bought it for Rs. 331+33, equals 364, earns a profit of rs. 100 and sells it to the consumer for Rs. 464 + tax, which is 10% of 464 minus the tax already paid, which is Rs. 33. Hence the consumer finally gets it for Rs. 464 + 46-33=477 rupees.

Now, this existing system of indirect taxes has number of problems: 

-  It adds to cost of the products, leaving them uncompetitive, especially in course of inter-state trade

- There are number of local level levies such as entry tax and octroi

- There is time delay and complexity in administration due to multiple authorities which collect taxes.

These problems result in increased costs – monetary as well as human, and therefore the system does not inspire compliance. As such, there is tendency to evade taxes. Key to increasing tax revenues of the country is to incentivize people to comply with the tax laws. Simplifying the indirect tax system holds the key here.

From what we have seen above, it is clear what should the basic objectives of new tax architecture be:

- It should be easy to administer as well as easy to comply. For that, it must be able to combine all the central and state taxes together into one single tax.

- It should make evasion difficult.

- If any kind of indirect tax has been paid on a certain value to any authority, that value should not be taxed again. In other words, Central and state level taxes should be able to be offset against each other.

- The shares of central and state governments must be clearly defined in order to minimize disputes.

With these drawbacks in mind, we will see how the GST system tries to address them in the next part.