Sukumar Mukhopadhyay: Why VAT will not increase revenue

The reason the states are certain to introduce value-added tax (VAT) in the next fiscal is that they expect it to augment revenue. They apparently believe that any revenue shortfall will occur only in the short run and the Centre will compensate them for it. But in the long run, the thinking goes, revenue will improve substantially. VAT, thus, is expected to be a money-spinner.

Will VAT really augment revenue? My answer is that it is doubtful. An empirical study in 2001 by Liam Ebrill, Michael Kien, Jean Paul Bodin and Victoria Summers of the International Monetary Fund (IMF) in a book called, Modern VAT has shown the revenue difference between VAT and its predecessor, the sales tax, by region.

As the reader will see from the data, the difference to revenue due to introduction of VAT is negligible. In some countries the revenue has, in fact, shown negative growth.

On the basis of these data and other empirical studies, the authors have then observed, "There is ...limited sense in which the supposed ability to bolster revenue in an efficient manner is borne out by the data. The extent of effect, however, cannot be estimated with any precision."

There is no doubt that the ability to bolster revenue depends largely on the efficiency of a country's tax administration. In this respect India's record is not exactly shining. India ranks amongst the most corrupt states according to Transparency International, the Berlin-based anti-corruption watchdog.

Arun Kumar in his book Black Economy in India has shown that 40 per cent of India's GDP is black compared to 4.5 per cent in the US, 6 per cent in France, between 3.7 and 12.6 per cent in Germany and 7.2 per cent in the UK.

Though VAT has been successful in the EU or Canada, there is no reason to presume that it will also succeed in India. This is because VAT is more evasion-prone than sales tax due to the input credit system. Automatic input credit is as good as giving dealers and manufacturers a blank cheque.

False input credit will eat up the revenue. That is the main reason revenue will suffer. Checking false invoices will be difficult because they will run to millions. Austria tried to check invoices by computer but gave it up as a lost case.

Susceptibility to evasion poses the biggest threat even in other countries that have apparently been successful with VAT. The European Commission has said that in the EU, VAT has become "susceptible to fraud, and complicated" (VAT Monitor, September 2001, page 232). In South Africa a real possibility has arisen of "VAT being a source of dirty money and money laundering" (VAT Monitor, July, 2002, page 258).

Those who have been used to praising EU's VAT experiment would do well to read the following conclusion reported on April 25, 2001, by the Economic and Social Committee appointed by the European Commission: "The history of VAT legislation in Europe can be summed up in one word: Failure." (VAT Monitor, September 2001, page 232.)

The Committee also reported that, "The transitional VAT system provides opportunity for fraud because...goods are in circulation on which no tax is imposed. Temptation is therefore great to divert such untaxed goods to the black market."

In India, the National Institute of Public Finance and Policy (NIPFP) conducted a study on the basis of data for 19 months (January 1994 to July 1995).

The study found that out of 5,480 offences 87 per cent cases were of the procedural type, 7 per cent were substantial type and 6 per cent were fraudulent mainly based on false invoicing. If 6 per cent of fraud cases have been detected, the actual incidence must be much higher.

In comparison to the present Cenvat and sales tax regimes, the VAT regime is more vulnerable. Misuse is limited under modvat because it is basically a tax on manufacturers, which are more established organisations.

In state VAT, however, the majority of the taxpayers will be traders, who have a long tradition for doing business without documents on a cash-and-carry basis.

The theory that VAT is "self-policing" does not account for the fact that once the goods are not entered in the accounts book and are sold in a parallel black market on a cash-and-carry basis, the resultant evasion of state VAT, Cenvat and income tax is much greater than the input credit. Besides, if the self-policing theory holds good so much evasion would not have taken place in all the countries in which VAT has been introduced.

Those who argue that evasion takes place even now do not reckon with the fact that present system of sales tax does not have the input credit system.

An increase of revenue is also difficult to identify, as the total revenue is a sum of the increases due to inflation, tax rates and production and improvement in compliance. But we can broadly conclude from the general nature of VAT that it is unlikely that revenue will increase for the following reasons:-

• The system of input credit makes VAT more evasion-prone than sales tax and Cenvat;
• false invoicing for taking input credit is likely to be widespread;
• a parallel black market will continue to run as evading VAT, Cenvat and income tax will still be more profitable than taking input credit;
• there is a distinct possibility that traders will showing low value addition since they can partly be paid in cash;
• the authorities' inability to check records and verify invoices due to the increase in the number of assessees in a VAT regime;
• there will be still be many populist exemptions which will compromise revenue.

All in all, when VAT is designed for the states, expectations should not be pitched too high.