Value-Added Tax (VAT) is a tax on the value added to a commodity or service. It means that the value-added tax is imposed on the value that a business firm adds to the goods and services that it purchases from other firms. It adds value by processing or handling these purchased items with its own labor force or its own machinery, buildings, or other capital goods. It then sells the resulting product to consumers or to other firms. Thus, the difference between the sale proceeds and the cost of the materials, etc., that it has purchased from other firms is it’s value-added, which is the tax base of the Value Added Tax.
The items that a firm purchases from other firms consist of raw materials, semi-manufactured goods, supplies used up in the processes of manufacture or handling of services (for example- banking, insurance, advertisement) finished goods ready for resale to consumers (in case of retailers) finally machinery, equipment, and other capital goods.
The Indirect Taxation Enquiry Committee which is popularly known as the L. K. Jha Committee (1976) defined Value-Added Tax as “Value-Added Tax (VAT) in its comprehensive form is a tax on all goods and services (except export and government services), its special characteristics being that it falls on the value added at each stage from the stage of production to retail stage.”
Merits of Value-Added Tax:
(1) Simple and Single Stage Tax- Some people consider VAT superior to other indirect taxes for its simplicity. Though a multipoint tax, it is very much like a single-point sales tax in its impact.
(2) Neutral in Allocation of Resources- A VAT is said to be perfectly neutral as regards the allocation of resources. It supports the claim that it does not distort relative commodity prices provided, it is levied without any exemption and zero-rated. Since no tax is charged but a trader supplying such goods can reclaim tax on his inputs. When goods and services are exempted, no tax on inputs can be reclaimed.
(3) Minimizes Scope for Tax Evasion- Another advantage of this tax is that it minimizes the scope for tax evasion. Under the VAT system, the major chunk of tax revenue comes from large concerns which are generally not in a convenient position to evade tax. But, this advantage is also possessed by some other taxes- for instance, excise duty-too.
(4) Easy Invigilation of Tax Authorities- The large size of the firms (from which the tax is collected) marks their invigilation by tax authorities easier.
(5) Tax-payers Feel Less Burdened- Since that tax is collected in small fragments at different stages of production and sale, tax-payers feel the burden of tax less and the desire to evade the tax is not pronounced.
(6) Benefit of Cross-Audit- The Value-Added Tax System is based on the principle of cross-audit and cross-checking. If firm X purchases raw materials from firm Y and pay tax on it, it has to keep records about whom it purchased goods from and how much amount it paid towards the tax. Only firms producing these records before tax authorities can reclaim the tax thus paid. Y too has got to keep similar records in its books. This makes tax evasion difficult.
But, the benefit of cross-audit is realized to the extent the administration is efficient to make use of cross-audit opportunities. However, good be the tax system, it is not going to prove beneficial to the exchequer unless tax authorities and tax-payers are honest. In France, it has been observed that dishonest people present before tax authorities false invoices showing spurious tax contents to reclaim refunds. If this be the plight of as developed a country as France, the plight of countries like India can easily be imagined.
(7) It Encourages Investment- The most attractive aspect of the VAT system is that it encourages investment. The Consumption type of Value Added Tax (VAT) allows deductibility of the tax paid on inputs of capital goods, (i.e., under consumption type VAT capital goods are exempted from the tax). This sometimes results in negative tax payments too, (in those cases where the value of capital inputs exceeds the value of output).
(8) It Encourages Exports- The VAT system may also encourage exports, for under it, a commodity costs less since the burden of tax on it is less. This enables the commodity to compete with foreign goods in international markets. Besides, in order to get a competitive edge over others, a country may refund the taxes paid on exportable goods. It is easy to separate the tax from taxes that get mixed up with the cost of production since they are levied at a gross value in each case.
(9) Conductive to Efficiency- It is said that VAT is conducive to efficiency since a firm is not exempted from its tax liability even if it runs into a loss. It pays a tax not on profits but on the value produced. It, therefore, tries to improve its performance, and reduce the cost of production.
It is because of this reason that some economists have advocated that the present system of corporate taxation should be replaced by the VAT system. They hold that a tax on company profits is a tax on efficiency, in that firms earning higher profits- and higher profits certainly result from higher efficiency- have to pay a larger amount of tax; whereas inefficient firms, (i.e., earning smaller profits or no profits) have to pay less or no tax. Consequently equity capital in efficient firms is discouraged. Thus, the present corporate taxation system penalizes efficiency.
As the present corporate taxation system discourages equity capital, it favors the labor-intensive technique of production over capital-intensive techniques. While this may be desirable in labor-abundant and capital-shortage countries like India, but it does kill incentivity and holds back the pace of modernization.
(10) Burden of Tax is Shared by All Factors- The supporters of VAT advocate the replacement of the present corporate tax system by the VAT system, in that the latter falls not only on profits but also on wages, interest, and rent and as such, it is neutral between factor costs. Under it, the burden of tax is shared by all factors of production. Thus, instead of penalizing efficiency, it encourages productivity.
Besides, VAT which carries a number of consequences does not spill over into industrial costs, under other systems spillover and an element of double taxation are inevitable.
In addition to it, VAT has a broader base and a relatively lower uniform rate. It makes the tax more effective as a regulator of demand; as long as there is dependence on a relatively small range of products, there is always the possibility that the following tax increases in these products and consumers will switch over to others. This has a much more distorting effect on the consumer’s choice and on the pattern of production than small tax increases over a wide range of products. The distorting effects arise under other taxes when different tax rates are increased. A uniform VAT would correct this and provide automatically and neutrality for the taxation of services.
Finally, VAT would provide a much surer base for future tax increases, if necessary than the present narrow base of outlay of taxation (as was the case in Great Britain).
Demerits of Value-Added Tax:
The VAT system also suffers from certain limitations because of which it has not yet become popular, especially in underdeveloped countries. Some of the demerits of VAT have been discussed as follows:
(1) The VAT is Inflationary in Character- Some people argue that VAT is inflationary in nature that it leaves its consumers with the largest disposable incomes. As against this, it can be said that in a country like India, inflation is more of a tax-push than of a demand-pull nature. As such, VAT is less inflationary than multi-stage turn-over tax in such economies.
(2) It is not a Simple Tax System- It will be folly to be carried away by some of the simple attractive features of VAT in theory. In theory, it is a simple uniform rate tax without any exemption, but in practice, it has got to be a multi-rate system with exemptions to certain industries. This is necessary with a view to achieving social justice and economic priorities. The so-called simplicity of this system vanishes here.
(3) Additional Burden on Tax Authorities, Producers, and Shopkeepers- It puts an additional burden on tax authorities, producers, and shopkeepers in that it involves the maintenance of accounting records at every stage from the producer to the retailer. It also entails a higher cost of collection. This is supported by the fact that the introduction of VAT was reckoned to require some 8000 more civil servants in England.
(4) It is not a Neutral Tax- Since exemptions to certain industries cannot altogether be ruled out, it cannot be claimed that VAT is a perfectly neutral tax.
(5) Revenue Collected is Less- Another serious drawback of this system is that the revenue collected under it is far less than the revenue collected under the multi-stage turnover tax system.
(6) Possibilities of Tax Evasion- This system depends upon the cooperation of the taxpayers to a very large extent. Each firm itself calculates its tax liability, to begin with, and also finds out the taxes paid by the earlier firms. Once, however, the sellers realized that the administrative machinery of the government is ill-equipped to do all the necessary cross-checking, they will resort to the creation of false purchase invoices showing that these taxes have already been paid by others. To the extent this happens, tax evasion becomes a major possibility and a common practice.
(7) VAT is not Conducive to Efficiency- The argument that VAT induces efficiency is not tenable, especially in an economy of shortages where there are speculative hoarding, non-competitive price rise, and similar practices are quite common. In an economy of shortages, goods will be purchased irrespective of their inferior quality and high prices. Hence, it is doubtful that VAT will prove helpful in improving efficiency.
(8) High Cost- Proper administration of VAT entails high costs than other taxes, both costs to the administration, of assessment, collection, and verification, as also costs to the tax-payer. Virtually all the sales and purchase transactions of businesses would need to be recorded for tax purposes. The strength of the tax administration personnel would need augmentation and the trader would also need to be educated.
Besides, a VAT has a tendency to be more regressive than alternative taxes- though in some cases only fractionally marginal. This regressiveness affects income distribution also adversely.
This disadvantage, however, can be overcome by introducing a rate structure into VAT say 12.5 percent instead of 10 percent, with a wider range of exemptions that would fetch the same revenue. Alternatively, a multiple rate structure might be introduced to allow for heavier taxation on ‘luxuries’. This would have an approximately neutral effect on income distribution.