Sukumar Mukhopadhyay: Serving no purpose

Tractor exemption is more ephemeral than real.

The exemption for tractor in the mini Budget of 20041 was given apparently and avowedly to give a boost to agriculture. The real purpose has not been served. It had to be so since it was an exemption and not a zero-rating. When tractor is fully exempted, the input tax has to be paid, but the credit of the tax paid on the inputs used for manufacturing the tractor is not allowed. So, what the manufacturer gains in the swings, he loses in the roundabouts. Inevitably, the manufacturers of tractor did not find the market for tractor booming or buoyant but rather dull after the exemption was doled out.

Immediately after the Budget, tractor prices were reduced marginally by about 3 cent, but within a few months they were revised to the pre-Budget level. The central excise duty was 16 per cent, while the input duties on raw materials and capital goods used in manufacturing tractors were 16 per cent, too. The combined input duty works out to a substantial percentage nearing 8 to 12. So, the actual burden was reduced only by 4 per cent. This margin is getting reduced due to a steep rise in steel price, education cess and service tax.

At the same time, the manufacturers cannot recover the input tax suffered from the buyer because if they do it, they lose the exemption as has been held in the case of Tamil Nadu Petro Chemicals vs CCE, Chennai "" 2005-T10L-983-CSTAT-MAD.

As against the marginal gain of about 4 per cent, there are other hitches the manufacturers have to face relating to maintenance of separate accounts or combined accounts under the Cenvat rules for availing exemption. They have to maintain separate accounts for exempted and non-exempted goods to distinguish between the inputs used, and this is a huge drain on their resources. Also, there is no facility to get the job done for intermediate products from ancillary units under duty exemption. All these difficulties created for day-to-day administration in case some of the final products are exempted, makes their transaction cost mount.

No wonder many tractor manufacturers have come up with the idea of imposing a smaller duty to avail the input credit. They also want a zero rating of duty on tractor. This would not have been necessary if all exemptions were optional. The government has stopped that route by making all exemptions compulsory in the Budget of 2005-06 through the amendment of Section 5A of Central Excise Act. Thus, if there is a full exemption, no duty can be paid. Earlier, even if there was an exemption, duty could be paid and the VAT chain could be continued. If the chain breaks then down the line, nobody can claim the credit. That would bring back the cascading effect, which the VAT intends to avoid.

The conclusion is that while making the Budget, the government should consider the effects of an exemption, such as the loss of input tax credit for the manufacturers, the complications in maintenance of accounts, difficulties in interpreting different terminologies used in the exemptions, extra hassles used in the procedure brought in by such an exemption, damage done to the avowed theory of convergence of duty to one rate of 16 per cent and, finally, the breaking of VAT chain. That the so-called beneficiaries have come back to the government expressing unhappiness over the operation of the exemption only proves that the hype did not last long. That agriculture has not made any substantial headway after the Budget is also proof that this exemption route has not been helpful.

This brings to the fore the general question of the desirability of giving exemption in a VAT or CENVAT situation. The predominant view amongst economists is that exemption compromises the neutrality of VAT, which is one of its well-accepted virtues. The universal experience has been that the introduction of exemptions and lower or zero rates vastly complicates the task of administration, opening up avenues of tax avoidance and evasion and should, therefore, be avoided2. Exemption, somewhere in the chain of production and distribution, causes cumulation of input credit. This happens because while the output does not pay the duty because it is exempted, the input credit is not utilised and so gets accumulated. Exemption creates cascading and all its bad effects come back.

Exemptions feed one another, giving rise to an exemption creep. A typical instance is in the agricultural sector. The exemption of basic foodstuff leads to a demand for the exemption for agricultural inputs, the justification being that otherwise they have to pay tax, which is not credited. Exemption breaks the VAT chain. Once there is an exemption at an intermediate stage, no further input credit will be admissible. The result is that the cascading effect will be back. One way of removing the cascading effect of exemption is to make it optional, so that if any dealer or manufacturer does not want to avail of the exemption but pay the tax and avail of the input credit, he can do so. This has been held as legally valid in the judicial pronouncements in India3.

1 Notification No.23/2004-C.E, dated 9.7.2004
2 Peggy B. Musgrave "" International Aspects of VAT, VAT Monitor, May/June 2001, p.105.
3 Kinjal Electricals vs CCE-2004(165)ELT300 (Tribunal "" Larger Bench)