Cascading tax is more sinned against than sinning

EXPERT EYE

There are many critics of cascading tax but only one famous supporter, a most unlikely one, Ben J. M. Terra, editor of VAT Monitor. It is like the leader of the opposition lending a helping hand to the most criticised action of the ruling party.

The long-standing quarrel is between value-added tax (VAT) and sales tax, much maligned as a cascading tax. The discussion here is about sales tax not retail sales tax.

Now coming to the basics of it, let us see what a cascading tax is. If there is a tax not just on output value but also on the input element, that is to say, at every stage of production and distribution, then it is a cascading tax. It is a tax on tax.

Cascading occurs wherever taxable outputs are produced using taxed inputs. For example resin, rubber and carbon black are necessary for manufacturing a tyre.

All the three inputs paid tax and the final product, namely the tyre, also paid tax. So these three inputs are taxed twice. Then the tyre is used in a car, which also is taxed.

These three inputs are now taxed thrice. So the tax element on these inputs goes on increasing with every production and distribution chain.

The cascading effect of tax makes the tax rate much higher than the original rate""sometimes two and half times more.

A turnover tax of 4 per cent can be equivalent to a total tax burden of 10 per cent (Alan A Tait-Value Added Tax, IMF 1988, page 9). Ben Terra points out that there are some arguments in favour of a cascading tax (Ben JM Terra""Systems of levying sales tax. VAT Monitor Jan, 1990, page 7):

A relatively high yield can be obtained by a relatively low tax rate. However, this advantage exists only when the rate is low and the competition is hardly affected. But then a high rate of VAT also provokes evasion.

These systems are not complicated from the bookkeeping perspective.

Coverage of services does not create difficulties.

On the other hand, there are arguments in favour of the view that cascading of tax is bad for the economy and so is undesirable.

First, it is said cascading leads to reallocation of resources in a distorted manner. For example, where tax is more to where tax is less or not there at all.

But this argument is not correct. Tax is generally there everywhere and the input-output correlations are also fixed. So reallocation of resources to where there is no tax is not practicable.

It is practicable only when there are commodity-based exemptions and geographical exemptions. So it is the exemption, which is distortionary and not the cascading tax.

Second, it is said that cascading leads to higher prices. Since the tax level becomes more after several transactions, the incidence of tax becomes more and so the prices will rise. This argument is also not correct.

The prices rise if the ultimate incidence of tax is higher and not the mere phenomenon of cascading. Moreover, the finding of the economists is that VAT does not make any difference to prices.

Thus, it follows that if giving input credit is neutral to prices, not giving it also should be neutral to prices.

Third, it is argued that cascading tax such as sales tax or excise tax discourages export because the tax element in the exported goods makes the export uncompetitive.

While it is correct that cascading itself discourages export by making it uncompetitive, it is not necessary that in a sales tax or excise duty regime, there cannot be any refund of the tax elements from the exports.

There is nothing inherent in sales tax or excise duty that zero rating cannot be done for export. In fact, this system exists in many countries including India and the US.

Lastly, there is a favourite argument of some economists that a cascading turn-over tax induces vertical integration of business enterprises, while VAT does not favour or disfavour vertical integration. This argument, however, is not fully tenable for the following reasons:

This argument is based on the static assumption that the same high rate of sale tax or excise duty is charged even if no input credit is allowed. In effect, the rate of duty can as well be decreased if no input credit is given.

Self-supply or vertical integration may not be economically very bad either (Liam Ebrill et al""The Modern VAT, p.88, IMF, 2001).

So the theory that cascading tax induces vertical integration is not borne out by facts and nor is vertical integration economically undesirable.

Hence, the case against sales tax on the ground that it is an inefficient and undesirable tax because of the cascading effect is largely exaggerated.