Value Added Tax was first introduced in France in 1954. France became the first European country to implement VAT. Initially it was not a complete system of VAT, since it applied only to transactions entered into by manufacturers and wholesalers. After that, it was supplemented by a separate tax on services. In addition, there were special excises which were levied on services and distribution in lieu of the tax surplus prostrations services. The retailers and agriculturists were not included in the coverage of VAT.
VAT was extended to other activities such as energy and construction during 1954 to 1963. However, the reforms initiated in January 1968, were essentially for generalizing VAT to all industrial, agricultural and commercial activities. It was extended to all transactions formerly subject to the local tax and to the tax on services, which were then abolished. In addition, VAT was imposed on goods transport and other transactions formerly subject to a tax unique.
In 1971, the then prevailing buffer rule was discontinued. Accordingly, the enterprises could benefit from the refund of their tax credit. However, there was a ceiling on tax credit that disappeared in July 1978.
Development of VAT in other countries has been gradual. Most of the countries were not adopted VAT till sixties. The VAT has come to occupy an important place in the fiscal storage over the years nearly all industrialized countries. and large number of Latin American, Asian. This has brought many number of countries to adopt VAT as their major form of consumption tax. Thus, the augmentation of interest in VAT has been the most remarkable event in the evolution of commodity taxes in the present century. Over 120 countries worldwide have introduced VAT over the past three decades and India is amongst the last few to introduce it.
And, as of today VAT is fairly evenly distributed throughout the world.
What is VAT
VAT is a multi-point sales tax unlike present Sales Tax , no concept of taxation at FIRST / LAST POINT. Tax charged at every step of the chain at each transaction in the production distribution system. It Provides mechanism for setoff for Tax paid on purchases. It does not have cascading effect due to the system of deduction or credit mechanism.
Introduction of VAT
It is a tax on consumption. The final and total burden of the tax is fully and exclusively borne by the domestic consumer of goods and services. It being a tax on domestic consumption, no VAT is charged on goods exported. It is an alternative mechanism of collection of Tax. In many respects it is equivalent to a last point retail sales tax. Value added tax is, therefore, a muti-stage sales tax levied as a proportion of value added (i.e. sales minus purchaes, which is equivalent to wages plus profits). To illustrate,
Example 1
You purchase goods of a value = Rs 1,00,000
Your INPUT TAX CREDIT = Rs 1,00,000 X 10 / 100= Rs 10,000
You make sales worth Rs 3,00,000
OUTPUT TAX on sales = Rs 3,00,000 X 10/100 = Rs 30,000
NET TAX = Rs (30,000 10,000) = Rs 20,000
You need to deposit Rs 20,000 in this TAX PERIOD
Example 2
Example 3
This indicates that VAT is collected at each stage of production and distribution process and in principle, its burden falls on final consumers only. Thus, it is a broad-based tax covering the value added of each commodity by a firm during all stages of production and distribution.
Variants of VAT
VAT could be levied with three specific variants, viz., (a) Gross Product Variant, (b) Income Type Variant, and (c) Consumption Type Variant. These variants, as shown in Exhibit 1.2, could be further distinguished through their methods of calculation, viz., addition method and subtraction method. The subtraction method could be further analysed into (a) direct, (b) intermediate, and (c) indirect subtraction method.
Gross product Variant:
This variant allows deductions for all purchases of raw materials and components but no deduction is allowed for business inputs. That is, capital goods such as plant and machinery are not deductible from the tax base in the year of purchase and depreciation on the plant and machinery is not deductible in the subsequent years. Thus, the economic base of gross product variant is equivalent to Gross National Product. In this variant of VAT, capital goods carry a heavier tax burden as they are taxed twice. Modernisation and upgrading of plant and machinery is delayed due to this dual tax treatment.
Income Variant:
Unlike the gross product variant, in this variant of VAT, deductions are allowed for purchases of raw materials and components as well as depreciation on capital goods. It provides incentive to classify purchases as current expenditures to claim set-off. Net investment (i.e. gross investment minus depreciation) is taxed and, therefore, the economic base of the income variant is equivalent to net national product. In practice, however, there are many difficulties connected with specification of any method of measuring depreciation, which basically depend on the life of an asset as well as on the rate of inflation.
Consumption Variant:
This variant allows deduction for all business purchases including capital assets. That is, gross investment is deducted in calculation of value added. The economic base of the tax, therefore, is equivalent to total private consumption. It neither distinguishes between capital and current expenditures nor specifies the life of asset or depreciation allowance for different assets. This form is neutral between different methods of production; there would be not effect on tax liability due to the method of production. The tax is also neutral between the decision to save or consume.
Amount the three variants of VAT mentioned above, the consumption variant is widely used. Most countries of Europe and other continents have adopted this variant. The reason for preference of this variant is that it does not affect decision regarding investment because the tax on capital goods is also set-off against VAT liability. The tax is neutral in respect of techniques of production. The consumption variant is more in harmony with the destination principle. In the foreign-trade sector, this variant relieves all exports form taxation while imports are taxed. Finally, this variant is convenient from the point of administrative expediency as it simplifies tax administration by obviating the need to distinguish between purchases of intermediate and capital goods on the one hand and consumption goods on the other.
Methods of computation of VAT
VAT can be computed by adopting three different methods. These are (i) Addition method, (ii) Subtraction method, and (iii) Tax-credit method. These methods can be used to arrive at the VAT liability.
Addition method:
This method is based on the identification of value-added which can be estimated by summation of all the elements of value-added (i.e. wages, profits, rent and interest). This method is known as addition method or income approach. This is in line with the income method of calculating national income.
Subtraction method:
The subtraction method estimates value-added by means of difference between outputs and inputs [(i.e. T = t (output-input)]. This is also known as product approach and has further variants in the way subtraction is attempted from among (a) direct subtraction method, (b) intermediate subtraction method and (c) indirect subtraction method. Direct subtraction method is equivalent to a business transfer tax whereby tax is levied on the difference between the aggregate tax-exclusive value of sales and aggregate tax-exclusive value of purchases. Intermediate subtraction method is based on deduction of the aggregate tax-inclusive value of purchases from the aggregate tax-inclusive value of sales and taxing the difference between them.
Tax-credit method:
The indirect subtraction method entails deduction of tax on inputs from tax on sales for each tax period, [i.e., t (output) t (input)]. This method is also known as tax credit method or invoice method. In practice, most countries use this method and employ net-consumption VAT. A comparative picture of the three methods of calculating VAT is presented in Table 2.
Table 2
Although all the methods are identical, these are not likely to yield the same revenue when tax rates vary according to commodities. That is, the rates are different for inputs and that for outputs. As shown in Table 3, the yield would be Rs.30 under the subtraction method while it is Rs.25 only under the invoice method when the tax rate is 15 percent at wholesale stage, keeping 10 percent at all other stages.
The invoice method is widely used in most VAT countries because of its inherent advantages in calculating tax liability. First, it makes crosschecking of tax paid at earlier stages more amenable, as dealers are required to mention the amount of tax on invoices. Second, tax burden being dependent upon the tax rate at the final stage, dealers at intermediate stages do not have any incentive to seek special treatment in tax rate. And finally, it facilitates border tax adjustments. If exports are zero-rated, it is very easily done with this methods.
Table 3
This method has been employed in Delhi VAT also.
Reasons for Growing Popularity of VAT
In addition to superiority of VAT in terms of allocative efficiency, neutrality and other economic effects that would be analysed in the following chapter, there are several arguments that are put forth for the adoption of VAT by a large number of countries and its consequent growing popularity.
First, VAT helps simplifying the indirect tax system. In most countries, the pre-VAT commodity tax systems are found to be very complicated. For example, in Korea, there were 11 different kinds of indirect taxes before the adoption of VAT. Eight indirect taxes that were replaced by VAT had, among the, 53 different rate brackets.
The gross business receipts tax in the Republic of China (ROC) called Taiwan was a multistage turnover tax.2 VAT replaced it. However, VAT also replaced the stamp tax and the commodity taxes on some products such as paper, plastic, leather and steel bars. In fact, all the countries that have gone in for VAT had a genuine need for simplifying their tax systems.
Seconds, the adoption of VAT helps in reducing evasion of tax. The existing systems of single-point or cascade type sales tax had considerable amount of evasion. Studies related to evasion of sales tax in India, for example, indicate that evasion ranges between 5 and 85 percent of the tax base depending upon the type commodity.3 As against the system of administration of sales tax, VAT requires that tax invoices must be issued by all the dealers. The subsequent dealer would maintain these invoices in order to benefit from tax deduction. This would enable the tax authority to cross check the declared transactions between taxpayers, consequently reducing the propensity to evade tax. In fact, the requirement of maintaining the vouchers (invoices) works as self-policing the evasion of tax.
Finally, VAT has a novel feature of tax transparency. That is, the total burden of tax on a particular commodity is clearly seen from the transactions. Hence, the economic analysis of the tax structure is convenient. Also, in international trade, this enhances tax neutrality. Under the sales tax system it is difficult to estimate the exact amount of refund for export. In most cases, the statistical evidence suggests that the tax on inputs and raw materials or on capital goods is under-compensated.
VAT in Comparison to Retail Sales Tax and Business Turnover Tax
The growing popularity of VAT could be further analysed by comparing the characteristics of VAT with those of retail sales tax (RST) and business turnover tax (BTT).
VAT being a multi-stage levy, it is collected on sales at all stages of production and distribution process. It fulfills the criterion of neutrality because it is levied only on value-added, i.e. on the difference between sales and purchases at each stage. It allows registered firms to take credit for the tax paid on purchases from registered suppliers against the tax payable on sales. Thus, the cascading phenomenon does not take place and the same value is never taxed twice. The method of giving credit is usually employed through invoices issued by the dealers. As each seller issues as a documentary proof for the credit claimed by registered buyers.
In contrast to VAT, RST levied by the state governments in the United States of America and Canada is a single-stage tax levied at the time of last-sale by retailer to consumer. That is, the tax is levied when the commodity passes into the hands of final user or consumer. This tax achieves neutrality through the suspension rule, which permits tax-free purchases by registered dealers from other dealers for resale. The suspension rule permits the seller to sell goods without charging any tax. In turn, the buyer gives a certificate giving his registration number and stating that he would pay the tax. Thus, the liability to collect tax is suspended from the first to the second and to the later dealer until the goods are sold to the consumer. Under RST the exemption certificate of the next dealer performs the role that is accomplished by the invoice under VAT. However, the system of administration of VAT does provide some self-policing mechanism, which is crucial to smooth tax management, especially in developing countries. This has given a clear administrative advantage to VAT over RST.
Unlike RST and similar to VAT, business turnover tax (BTT) is a multistage tax levied on the value added a t each stage in the production distribution process. Under BTT, instead of ascertaining net VAT by first taxing sales ( to obtain Gross VAT) and then subtracting tax on purchases from the gross VAT ( to obtain net VAT through allowing tax credit on purchases), the system of ascertaining value added is direct. That is, we deduct purchase value from sales value and the tax rate is applied to the value added portion of the transactions. The tax amount under BTT would however be equal to the tax under VAT. Notwithstanding the similarity in the VAT and the BTT, the difference in tax liability would arise between these two taxes if the tax rates were different at the manufacturing and the other stages. As shown in Table 1.3, the variation would be similar under the two taxes, as under the subtraction and the invoice method. Thus, the VAT has earned the distinction of being the forerunner among all the commodity taxes and has spread throughout the world.
VAT was extended to other activities such as energy and construction during 1954 to 1963. However, the reforms initiated in January 1968, were essentially for generalizing VAT to all industrial, agricultural and commercial activities. It was extended to all transactions formerly subject to the local tax and to the tax on services, which were then abolished. In addition, VAT was imposed on goods transport and other transactions formerly subject to a tax unique.
In 1971, the then prevailing buffer rule was discontinued. Accordingly, the enterprises could benefit from the refund of their tax credit. However, there was a ceiling on tax credit that disappeared in July 1978.
Development of VAT in other countries has been gradual. Most of the countries were not adopted VAT till sixties. The VAT has come to occupy an important place in the fiscal storage over the years nearly all industrialized countries. and large number of Latin American, Asian. This has brought many number of countries to adopt VAT as their major form of consumption tax. Thus, the augmentation of interest in VAT has been the most remarkable event in the evolution of commodity taxes in the present century. Over 120 countries worldwide have introduced VAT over the past three decades and India is amongst the last few to introduce it.
And, as of today VAT is fairly evenly distributed throughout the world.
What is VAT
VAT is a multi-point sales tax unlike present Sales Tax , no concept of taxation at FIRST / LAST POINT. Tax charged at every step of the chain at each transaction in the production distribution system. It Provides mechanism for setoff for Tax paid on purchases. It does not have cascading effect due to the system of deduction or credit mechanism.
Introduction of VAT
It is a tax on consumption. The final and total burden of the tax is fully and exclusively borne by the domestic consumer of goods and services. It being a tax on domestic consumption, no VAT is charged on goods exported. It is an alternative mechanism of collection of Tax. In many respects it is equivalent to a last point retail sales tax. Value added tax is, therefore, a muti-stage sales tax levied as a proportion of value added (i.e. sales minus purchaes, which is equivalent to wages plus profits). To illustrate,
Example 1
- Lets say your TAX PERIOD is 3 MONTHS
- Assume TAX RATE @ 10%
- In these three months
You purchase goods of a value = Rs 1,00,000
Your INPUT TAX CREDIT = Rs 1,00,000 X 10 / 100= Rs 10,000
You make sales worth Rs 3,00,000
OUTPUT TAX on sales = Rs 3,00,000 X 10/100 = Rs 30,000
NET TAX = Rs (30,000 10,000) = Rs 20,000
You need to deposit Rs 20,000 in this TAX PERIOD
Example 2
Example 3
This indicates that VAT is collected at each stage of production and distribution process and in principle, its burden falls on final consumers only. Thus, it is a broad-based tax covering the value added of each commodity by a firm during all stages of production and distribution.
Variants of VAT
VAT could be levied with three specific variants, viz., (a) Gross Product Variant, (b) Income Type Variant, and (c) Consumption Type Variant. These variants, as shown in Exhibit 1.2, could be further distinguished through their methods of calculation, viz., addition method and subtraction method. The subtraction method could be further analysed into (a) direct, (b) intermediate, and (c) indirect subtraction method.
Gross product Variant:
This variant allows deductions for all purchases of raw materials and components but no deduction is allowed for business inputs. That is, capital goods such as plant and machinery are not deductible from the tax base in the year of purchase and depreciation on the plant and machinery is not deductible in the subsequent years. Thus, the economic base of gross product variant is equivalent to Gross National Product. In this variant of VAT, capital goods carry a heavier tax burden as they are taxed twice. Modernisation and upgrading of plant and machinery is delayed due to this dual tax treatment.
Income Variant:
Unlike the gross product variant, in this variant of VAT, deductions are allowed for purchases of raw materials and components as well as depreciation on capital goods. It provides incentive to classify purchases as current expenditures to claim set-off. Net investment (i.e. gross investment minus depreciation) is taxed and, therefore, the economic base of the income variant is equivalent to net national product. In practice, however, there are many difficulties connected with specification of any method of measuring depreciation, which basically depend on the life of an asset as well as on the rate of inflation.
Consumption Variant:
This variant allows deduction for all business purchases including capital assets. That is, gross investment is deducted in calculation of value added. The economic base of the tax, therefore, is equivalent to total private consumption. It neither distinguishes between capital and current expenditures nor specifies the life of asset or depreciation allowance for different assets. This form is neutral between different methods of production; there would be not effect on tax liability due to the method of production. The tax is also neutral between the decision to save or consume.
Amount the three variants of VAT mentioned above, the consumption variant is widely used. Most countries of Europe and other continents have adopted this variant. The reason for preference of this variant is that it does not affect decision regarding investment because the tax on capital goods is also set-off against VAT liability. The tax is neutral in respect of techniques of production. The consumption variant is more in harmony with the destination principle. In the foreign-trade sector, this variant relieves all exports form taxation while imports are taxed. Finally, this variant is convenient from the point of administrative expediency as it simplifies tax administration by obviating the need to distinguish between purchases of intermediate and capital goods on the one hand and consumption goods on the other.
Methods of computation of VAT
VAT can be computed by adopting three different methods. These are (i) Addition method, (ii) Subtraction method, and (iii) Tax-credit method. These methods can be used to arrive at the VAT liability.
Addition method:
This method is based on the identification of value-added which can be estimated by summation of all the elements of value-added (i.e. wages, profits, rent and interest). This method is known as addition method or income approach. This is in line with the income method of calculating national income.
Subtraction method:
The subtraction method estimates value-added by means of difference between outputs and inputs [(i.e. T = t (output-input)]. This is also known as product approach and has further variants in the way subtraction is attempted from among (a) direct subtraction method, (b) intermediate subtraction method and (c) indirect subtraction method. Direct subtraction method is equivalent to a business transfer tax whereby tax is levied on the difference between the aggregate tax-exclusive value of sales and aggregate tax-exclusive value of purchases. Intermediate subtraction method is based on deduction of the aggregate tax-inclusive value of purchases from the aggregate tax-inclusive value of sales and taxing the difference between them.
Tax-credit method:
The indirect subtraction method entails deduction of tax on inputs from tax on sales for each tax period, [i.e., t (output) t (input)]. This method is also known as tax credit method or invoice method. In practice, most countries use this method and employ net-consumption VAT. A comparative picture of the three methods of calculating VAT is presented in Table 2.
| Sl. No. | Methods | Manufacturer | Wholesaler | Retailer | Total Economy |
| 1 | 2 | 3 | 4 | ||
| 1 | Addition method
| 150 50 25 25 250 25 | 300 100 75 25 500 50 | 200 20 20 10 250 25 | 650 170 120 60 1000 100 |
| 2. | Substraction method
| 350 100 250 25 | 850 350 500 50 | 1100 850 250 25 | 2300 1300 1000 100 |
| 3. | Invoice method
| 350 35 100 10 25 | 850 85 350 35 50 | 1100 110 850 85 25 | 2300 230 1300 130 100 |
Table 2
Although all the methods are identical, these are not likely to yield the same revenue when tax rates vary according to commodities. That is, the rates are different for inputs and that for outputs. As shown in Table 3, the yield would be Rs.30 under the subtraction method while it is Rs.25 only under the invoice method when the tax rate is 15 percent at wholesale stage, keeping 10 percent at all other stages.
The invoice method is widely used in most VAT countries because of its inherent advantages in calculating tax liability. First, it makes crosschecking of tax paid at earlier stages more amenable, as dealers are required to mention the amount of tax on invoices. Second, tax burden being dependent upon the tax rate at the final stage, dealers at intermediate stages do not have any incentive to seek special treatment in tax rate. And finally, it facilitates border tax adjustments. If exports are zero-rated, it is very easily done with this methods.
| Calculation of VAT | Manufacturer | Wholesaler | Retailer | Total Economy |
VAT under Subtraction method Invoice method Rate of Vat is 15% at wholesaling level and 10% at all other stages Subtraction method Invoice method | 100 100 10 10-0=10 10 10-0=10 | 200 100 100 10 20-10=10 15 30-10=20 | 250 200 50 5 25-20=5 5 25-30=5 | 550 300 250 25 55-30=25 30 65-40=25 |
Table 3
This method has been employed in Delhi VAT also.
Reasons for Growing Popularity of VAT
In addition to superiority of VAT in terms of allocative efficiency, neutrality and other economic effects that would be analysed in the following chapter, there are several arguments that are put forth for the adoption of VAT by a large number of countries and its consequent growing popularity.
First, VAT helps simplifying the indirect tax system. In most countries, the pre-VAT commodity tax systems are found to be very complicated. For example, in Korea, there were 11 different kinds of indirect taxes before the adoption of VAT. Eight indirect taxes that were replaced by VAT had, among the, 53 different rate brackets.
The gross business receipts tax in the Republic of China (ROC) called Taiwan was a multistage turnover tax.2 VAT replaced it. However, VAT also replaced the stamp tax and the commodity taxes on some products such as paper, plastic, leather and steel bars. In fact, all the countries that have gone in for VAT had a genuine need for simplifying their tax systems.
Seconds, the adoption of VAT helps in reducing evasion of tax. The existing systems of single-point or cascade type sales tax had considerable amount of evasion. Studies related to evasion of sales tax in India, for example, indicate that evasion ranges between 5 and 85 percent of the tax base depending upon the type commodity.3 As against the system of administration of sales tax, VAT requires that tax invoices must be issued by all the dealers. The subsequent dealer would maintain these invoices in order to benefit from tax deduction. This would enable the tax authority to cross check the declared transactions between taxpayers, consequently reducing the propensity to evade tax. In fact, the requirement of maintaining the vouchers (invoices) works as self-policing the evasion of tax.
Finally, VAT has a novel feature of tax transparency. That is, the total burden of tax on a particular commodity is clearly seen from the transactions. Hence, the economic analysis of the tax structure is convenient. Also, in international trade, this enhances tax neutrality. Under the sales tax system it is difficult to estimate the exact amount of refund for export. In most cases, the statistical evidence suggests that the tax on inputs and raw materials or on capital goods is under-compensated.
VAT in Comparison to Retail Sales Tax and Business Turnover Tax
The growing popularity of VAT could be further analysed by comparing the characteristics of VAT with those of retail sales tax (RST) and business turnover tax (BTT).
VAT being a multi-stage levy, it is collected on sales at all stages of production and distribution process. It fulfills the criterion of neutrality because it is levied only on value-added, i.e. on the difference between sales and purchases at each stage. It allows registered firms to take credit for the tax paid on purchases from registered suppliers against the tax payable on sales. Thus, the cascading phenomenon does not take place and the same value is never taxed twice. The method of giving credit is usually employed through invoices issued by the dealers. As each seller issues as a documentary proof for the credit claimed by registered buyers.
In contrast to VAT, RST levied by the state governments in the United States of America and Canada is a single-stage tax levied at the time of last-sale by retailer to consumer. That is, the tax is levied when the commodity passes into the hands of final user or consumer. This tax achieves neutrality through the suspension rule, which permits tax-free purchases by registered dealers from other dealers for resale. The suspension rule permits the seller to sell goods without charging any tax. In turn, the buyer gives a certificate giving his registration number and stating that he would pay the tax. Thus, the liability to collect tax is suspended from the first to the second and to the later dealer until the goods are sold to the consumer. Under RST the exemption certificate of the next dealer performs the role that is accomplished by the invoice under VAT. However, the system of administration of VAT does provide some self-policing mechanism, which is crucial to smooth tax management, especially in developing countries. This has given a clear administrative advantage to VAT over RST.
Unlike RST and similar to VAT, business turnover tax (BTT) is a multistage tax levied on the value added a t each stage in the production distribution process. Under BTT, instead of ascertaining net VAT by first taxing sales ( to obtain Gross VAT) and then subtracting tax on purchases from the gross VAT ( to obtain net VAT through allowing tax credit on purchases), the system of ascertaining value added is direct. That is, we deduct purchase value from sales value and the tax rate is applied to the value added portion of the transactions. The tax amount under BTT would however be equal to the tax under VAT. Notwithstanding the similarity in the VAT and the BTT, the difference in tax liability would arise between these two taxes if the tax rates were different at the manufacturing and the other stages. As shown in Table 1.3, the variation would be similar under the two taxes, as under the subtraction and the invoice method. Thus, the VAT has earned the distinction of being the forerunner among all the commodity taxes and has spread throughout the world.
