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Value Added Tax and Sales Tax: A Comparative Analysis

 Preamble

Value Added Tax (VAT) is a system of indirect taxation which is currently employed by nearly 136 countries across the world. In India, VAT, being a current tax reform, captures the existing states sales tax system. Sales tax is a conventional system where in different tax rates prevail in different states.

Definition of Value Added Tax (VAT)

Under VAT, whenever a person pays tax on the purchase of inputs in the course of manufacture or trading, he is entitled to credit of such tax paid on inputs at the time of taxes levied on the sales made by him in the course of business. Whereas, in Sales Tax system, the credit of taxes paid on inputs is not allowed. Hence the taxes on inputs get added to the cost of the product every time the product is value added and sold by subsequent manufacturer or trader.

Features

The key features of the VAT are, one is set-off of input tax and the other is multi-point levy. In real terms, set-off of input tax leads to a situation wherein a dealer pays taxes only on the value addition at end of each chain of transaction. This feature has the capacity of reducing product prices which is not there in the erstwhile system. The other feature is the multi-point taxation. At every sale transaction irrespectively a manufacturer or trader transacts, VAT is levied on sales. In a nutshell, tax under VAT is levied only on value addition but multi-pointedly.

Demonstration

For instance, a product is liable to sales tax @ 10% and passes through chain of three traders for final consumption; the sales tax is levied initially @ 10% by the manufacturer and resale tax @ 1% by those three traders. Had all these same facts being considered under VAT, the product will be levied tax @ 10% at end of each sale transaction by all dealers (Four including manufacturer) on the value, added by the respective person. Thus a question arises that, under VAT, whether taxing every time @ 10% on value addition will lead to reduction in prices after number of cycles. This is explained with the following example:

 

Particulars

Initial Price of a Raw-material

Rs.100/-

Value Addition (Overheads, Profit, etc.)

25%

Sales Tax Rate

5%

Re-Sale Tax Rate

1%

VAT Rate

5%

Number of Cycles in a Chain

6%

Formulae

Ultimate Cost of the product under Sales Tax:

 Ultimate Cost of the product under VAT:

where,

Initial Price - Raw-Material or Inputs Costs

VA%  - Profit Margin%

ST%  - Sales Tax Rate

RST  - Re-Sale Tax Rate

VAT% - Value Addition Tax Rate

n     - Number of Cycles

 

Evaluation

 

By applying the example particulars in the above formulae, the ultimate cost of the product under two systems will follow as:

 

Under Sales Tax - 100 * (1+25%) * (1+5%) * [(1+25%) * (1+1%)] 6-1 equals Rs. 420.97

 

Under VAT  - [100 * (1+25%) 6 * (1+5%)] equals Rs. 400.54

 

There can be witnessed a difference in costs for Rs. 20.43 for the same product under two different tax structures. While evaluating the above example under two different taxation systems more elaborately, it follows as:

(Amount in Rs. P.)

Cycle No.

Product Price under

Value Addition under (25%)

Sale Tax

Resale Tax

Sale price under

VAT

Cost of Product under

 

 

S.Tax

VAT

S.Tax

VAT

5%

1%

S.Tax

VAT

5%

S.Tax

VAT

(1)

(2)

(3)

(4)

(5)

(6)

(1+3+5+6)

(1+4)

(7)

(1+3+5+6)

(1+4+7)

1

100.00

100.00

25.00

25.00

6.25

 

131.25

125.00

6.25

131.25

131.25

2

131.25

125.00

32.81

31.25

 

1.64

165.70

156.25

7.81

165.70

164.06

3

165.70

156.25

41.43

39.06

 

2.07

209.20

195.31

9.77

209.20

205.08

4

209.20

195.31

52.30

48.83

 

2.62

264.12

244.14

12.21

264.12

256.35

5

264.12

244.14

66.03

61.04

 

3.30

333.45

305.18

15.26

333.45

320.43

6

333.45

305.18

83.36

76.29

 

4.17

420.97

381.47

19.07

420.97

400.54

As per sales tax theory, the sale price after each cycle includes price of raw-material, value addition and sales tax vis-à-vis the sale price as per VAT theory, which contents only raw-material price, value addition and VAT paid at the last cycle only. Because VAT paid to previous dealer doesn’t form part of cost as the same can be claimed for set-off against taxes on sales to be made.

 

Assumptions

·    Only One Manufacturing process is assumed which attracts initially sales tax followed by five trade cycles to reach ultimate consumer.

· Subsequent traders do not process the product (Value Addition merely Administrative Overheads, Profit Margin).

· Both the manufacturer and traders takes similar value addition rate.

· Initial Sales Tax Rate of 5% inclusive of Additional Sales Tax and Surcharge.

· Manufacturer is assumed to make his raw-material on his own and no input tax paid.

 

Appraisal

 

In this example the initial tax of Rs.6.25 by compounding @ 25% (VA) and 1% (Re-sale Tax) turns in to Rs.20.05 at end of last cycle. Under VAT, a consumer has to pay Rs.19.07 (5% on Rs.381.47). When both these tax amounts are compared with, it gives only a meager difference of Rs.0.97. The question of where does the difference in tax raised, lies on the facts that, the initial price and value addition gets compounded at every cycle @ 1% of resale tax which is not so in VAT. This absence of cascading effect alone has reduced the product price to the tune of Rs.19.46. At the end of the first cycle, there is no difference in product price [last 2 columns], but at the end of upcoming subsequent cycles, the difference raises to Rs.1.64 at 2nd cycle, Rs.4.12 at 3rd cycle and so on. The difference is expected to increase proportionately with the increase in cycles.

 

But hardly more than five trading cycle is quite uncommon in practice to happen. The above example has got its own restrictions and assumptions. For sake of convenience, the value addition rate assumed same for both the manufacturer and trader, which is likely to be uncommon. Moreover, only one manufacturing cycle is taken for consideration but a product is expected commonly to pass through more than one manufacturer.

 

Hence it can be appraised that VAT is the multi-point taxation which levy tax at every time value is added to a product whether by manufacturer or trader. This is in contrast to the sales tax system, where tax is levied initially for one time and on the initial product price only. There is no levy of tax at subsequent point of sale transactions (except nominal Re-sale tax rate of 1%) on the sale price. This seems to be that product price under VAT would be probably higher than the one under sales tax system, due of its unique feature of multi taxation on value additions repeatedly. But it is not so. From the above example, it can be appraised that, despite of multi taxation as said earlier the price under VAT remains lesser to the price under sales tax at every end of cycle for the given similar tax rate (5%) and value addition rate (25%).

 

 

Conclusion

 

Therefore the product price under VAT will ever be lesser than the one under Sales Tax even after numerous trade cycles, despite of multi point taxation on value addition and of similar tax rates. The merits of VAT system outdo merits of erstwhile states sales tax system and even the demerits of VAT system are argued as defeat able. In brevity, Value Added Tax system is a good replacement of erstwhile taxation system.

 

 

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