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Thursday, August 27, 2015

What is GST (Goods and Service Tax)?

The Goods and Service Tax Bill or GST Bill, officially known as The Constitution (One Hundred and Twenty-Second Amendment) Bill, 2014, proposes a national Value added Tax to be implemented in India from April 2016. "Goods and Services Tax" would be a comprehensive indirect tax on manufacture, sale and consumption of goods and services throughout India, to replace taxes levied by the Central and State governments. GST would be levied and collected at each stage of sale or purchase of goods or services based on the input tax credit method, irrespective of State.

Image courtesy: Kashmir Reader

India has a dual tax system for taxation of Goods And Services. The tax system is described by Central Taxes and State Taxes, which may be further subdivided into Excise Duty, Service Tax, VAT and Customs Duty. In 2005 VAT was introduced for intra-state transactions, using the input tax credit principle.

Until a few years ago, there were only three countries that did not have GST - India, US and Brazil. Brazil has it now. So that leaves US and India.

Current status of taxation in India:

Every state has its own tax rate.

  • Rather than say one rate- sales tax of x% on all goods, literally sales tax on every product is different.This can lead to corrupt lobbying by companies.
  • Unlike other countries, Indian states also impose taxes based on the manufacturing location rather than point of sale. This introduces big distortion. When states promise 5 years tax free status to new factories, this is what they mean. Indian mid-size companies move their entire factories to take advantage of this. Some of my friends have done that. This doesn't lead to any growth, just a movement of factories from one state to another every five years.
  • There is an entry tax at every state. If you have travelled by road in India, you would have noticed a long line of trucks at every state border (for Delhiites - Delhi-Faridabad border). The truckers spend hours and sometimes days in that line to pay entry tax. This entry tax is based on the value of the load they are carrying. Needless to say, it adds a lot of scope of bribing and also inefficiency.Another point - Say you had a truck load of 1cr and a working loan at 13% to finance it until you get paid by the buyer. If because of bad roads and entry tax, it takes you 7 days to transport the goods, you pay an interest of Rs. 27,083 for that week. Instead, if you had transported that good in just one day, you would have paid only Rs. 3869 in interest. So you see, in spite of having low salaries, how expensive India becomes.
  • All these taxes are incredible easy to fudge. India is a cash economy. You can choose not to declare sales and not pay any sales tax. You can fudge the value of the truck load and pay lesser entry tax. You can make false receipts of goods that you sell and thus show an inflated cost of business.
  • There is cascading of taxes. Say you have your factory in Gujrat and you make bicycles and your cost of manufacturing was Rs. 100. And you paid a excise tax(manufacturing tax) of 10%. So your cost is now Rs. 110. You load it on the truck and transport it to WB. Your truck moves through maybe five states and you pay an entry tax of 5% at every state border. Now, your cost is Rs. 135 plus transportation cost. You sell it to a buyer in WB at some profit for say Rs. 160. The retailer adds his own profit and sells it to consumer at Rs. 180. The consumer pays a 9% sales tax so his cost is Rs. 196.20. So you see, the consumer pays almost double the cost of manufacturing because we keep paying taxes on previous taxes.
  • In the above example of making bicycles, I said your manufacturing cost was Rs. 100. Lets analyze this cost. You probably bought tyres,, handles, frames,break-pads from someone else. All of those factories also paid excise tax, entry tax etc. Lets say they paid Rs. 20 in all taxes. When you pay taxes on Rs. 100 of your manufacturing cost, you are also paying tax on Rs. 20 tax that were paid by your suppliers.This cascading tax has a debilitating effect on manufacturing by increasing your cost.
  • It's the absence of these obstacles and inefficiencies that makes west and China competitive in manufacturing compared to India despite their higher salaries. In any factory, whether east or west, salary is a small part of manufacturing cost.
image courtesy: India Briefing

How does GST solve all this?

  • It will reduce the million different tax rates(based on products and states) to just three - based on essential, neutral and luxury goods. With one stroke of pen, you increase efficiency (no more waiting at state borders,simple tax planning) and corruption (no more lobbying to decrease tax rates on just your product) and no more relocation of factories every five years just to take advantage of temporary tax reliefs.
  • GST avoids cascading tax by taxing only value-add and will help India in becoming low-cost economy. What does value-add mean? In my previous example, you paid a 10% excise tax. So, if your manufacturing cost was Rs. 100, you paid Rs. 10 tax on it. But say, your input cost was Rs. 90. That means the value you added was Rs. 10. Your tax under GST regime may be 30% on this value add, which is Rs. 3 in this example. A retailer will not charge you a sales tax of 10% on the price but rather, say 20% on value added. So if a retailer gets a phone at Rs. 10,000 and sells it for Rs. 11,000, he charges you 20% of Rs. 1000 and not 10% of Rs. 10,000. Thus GST helps in making an economy low cost.
  • Under sales/excise tax, you declare your sales and manufacturing to pay taxes. Under GST, you pay estimated taxes in advance and then get a refund from the govt. based on your value add. So you have to declare your input costs to the govt. These input costs will be verified against the receipts from your supplier. This induces honesty and not fake receipts. How? The higher your input costs, the less your value-add and hence you pay low taxes. Thus you have an incentive to ask your supplier to inflate the bills. Under current system of Sales/Excise tax, its done by every company in India to reduce their profits on paper. Under GST, your suppler will refuse to inflate their bills because that increases their value-add and thus the tax that you save, will end up being paid by your supplier. Thus GST forces you to be honest.
  • GST increases tax revenue of the Govt. by forcing honesty in tax declaration and plugging major loopholes. At the same time, it reduces the end price of goods to the consumers. Thus increased consumption leads to more jobs and more tax collection leads to more infrastructure creation. It sets a virtuous cycle of growth.


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