S Madhavan: Having a smoke, without lighting a fire

The challenge in levying a state VAT on cigarettes is to do so without disrupting the physical chain or the underlying economics of various participants.

Historically, tobacco products such as cigarettes have been subject to a very high incidence of excise taxation, given their status as demerit goods whose consumption is discouraged. Indeed, revenues from cigarettes form a significant proportion of total excise duty collections. Given this high rate of excise taxes on cigarettes, the current debate on a possible extension of the state VAT to them, in addition to the excise duty, becomes important and an understanding of the key issues relating to the issue is essential. Some of the key issues are:

a) Should tobacco consumption in general and cigarette consumption in particular, be encouraged or discouraged through the fiscal mechanism?

b) What is an appropriate level of taxes for these demerit goods?

c) Are cigarettes amenable to the ad valorem basis of taxation?

The official stand of the government in relation to tobacco products is that their use is injurious to health. On the other hand, the cigarette industry supports a significant amount of economic activity such as the tobacco growing farmer community, the number of people employed in the factories/ companies manufacturing such products and the people employed in the tertiary distribution and retail selling of such products. Therefore, at a fundamental level there continues to be a debate on the merits and demerits, from an economic standpoint, of this industry. This article will not broach this debate. The question is whether fiscal measures are appropriate means by which public policy objectives should be furthered. It is universally the practice to tax tobacco products to a disproportionate degree and cigarettes are consequently taxed in such a manner in a number of countries. It has therefore been the practice in India as well to charge a significantly higher rate of tax on these products. This will most likely continue and it does not appear that aggregate consumption taxes on tobacco products/ cigarettes will anytime soon approach the overall levels of indirect taxes in the country, which are themselves quite high. In this context, let us address the other key questions highlighted above.

In order to answer those two questions, it is useful to understand the manner in which such products have been taxed to date. Till the mid fifties, both excise duty and sales tax were charged on cigarettes. However, it was realised that given the structural nature of the industry, it would be better for the products to be charged to tax by the central government alone, in the form of excise duty of various kinds, and for the revenues to thereafter be distributed to the states. Accordingly, in addition to the excise duty that was then prevalent, additional excise taxes, in lieu of sales taxes, were also levied on cigarettes under The Additional Duties of Excise (Goods of Special Importance) Act 1957.

This scheme of taxation continued for almost five decades, of course, with a progressive increase in the excise taxes through the years. Further, the excise duty regime applicable to these products underwent significant changes over a period of time. The excise duties were initially similar to other products, determined on cigarettes on an ad valorem basis. Given the manner in which the relevant valuation provisions were then framed, there arose a massive surge in disputes concerning valuation of cigarettes and the famous (or infamous?) issue of post manufacturing expenses and their taxability or otherwise under excise law was litigated across the length and breadth of the country. It was quite apparent that the situation needed to be addressed and in 1987, the ad valorem basis of tax was replaced by a scheme where the tax on cigarettes was predicated on their length.

From this year till 2001, cigarettes were charged to the basic excise duty and the additional excise duty in lieu of sales tax on the aforesaid specified basis. In 2001, a third duty called the National Calamity Contingent Duty (NCCD) was imposed, again on the basis of the length of the cigarettes. This three-tier duty structure continued till 2005. In that year, a fourth duty "" also called additional duty "" was imposed on cigarettes, again on the specific basis. Subsequently, in 2006, the additional duty under the Goods of Special Importance Act was discontinued on cigarettes, as a possible precursor to the extension of the state VAT on such products. However, it must be understood that prior to the discontinuance of this additional duty, yet another additional duty had already been imposed in 2005 and consequently, the discontinuance of the additional duty under the Goods of Special Importance Act did not necessarily result in any reduction of central government revenues from the taxation of cigarettes. This is an important point.

To summarise, there is currently a three-tier structure of excise duties, all of which are based on the length of the cigarettes. The cumulative duties, on the aforesaid basis, range from Rs 160 per thousand sticks for the smallest of non-filter cigarettes to Rs 2,060 per thousand sticks for the premium and long-length filter cigarettes. In value terms, the above range of duties is significantly in excess of 100 per cent. It does appear that cigarettes are therefore already highly taxed. It is, however, also the case that the demand for the product is typically price inelastic and hence higher taxes will not result in lower revenues. Therefore, increasing aggregate taxes on cigarettes seems a distinct possibility at all times.

On the related question of whether the ad valorem scheme of taxation, as in state VAT, can be applied to cigarettes, the point is that the state VAT and excise operate differently. Excise duty is on manufacture; consequently the problem surrounding the excise valuation of cigarettes lies in determining their value at the factory gate, taking into account the expenses incurred in relation to distribution and selling of the goods, subsequent to removal from the factory. This problem is not relevant for state VAT since it operates as a pure VAT, by allowing all input taxes to be offset against the output VAT, through the netting off method. Therefore, it is not true that the state VAT cannot at all apply to cigarettes, because of past problems in the excise area. The problem with regard to cigarettes is that their distribution is multi-layered and across state borders. The challenge is therefore to impose the VAT in a manner that the tax is efficiently collected, without disrupting the physical chain or the underlying economics of the various participating entities. This is key. The industry has several apprehensions on this count. These relate, inter alia, to the rate of VAT (4 per cent vs 12.5 per cent), the manner of determination of the tax in the hands of the manufacturers, the taxation of the distributors/wholesalers, together with their eligibility to avail input tax credits, the manner of functioning of the exemption/composition scheme of taxation, and so on. Independently, the loss of input tax credits on stock transfers and with regard to the central sales taxes paid on inter-state supplies are two very major concerns, related to the exceedingly high financial impact in terms of the VAT rates in force.

All of these pose major obstacles and it is imperative that issues are fully thought through before the state VAT is extended to cigarettes.

The writer is leader, indirect tax practice, PricewaterhouseCoopers