GST VS CURRENT INDIRECT TAX STRUCTURE

GST VS CURRENT INDIRECT TAX STRUCTURE

To understand GST, it is important that we understand the current indirect taxation system. Direct taxes such as income tax are borne by the person liable to pay the tax; this means that the tax burden cannot be shifted to anyone else. The liability of an indirect taxes on the other hand, can be shifted to another person. So, the person liable to pay the tax can collect the tax from someone else and then pay it to the government; thus shifting the tax burden. The GST tax falls in this category. The current indirect tax structure, which comprises of so many different taxes, can be classified as: Central taxes: levied by the Central govt (includes Central Sales Tax, Excise Duty etc.) State taxes: levied by the various state govts (VAT, Service Tax, Octroi)

The current indirect tax has one major problem - the casacading effect. When you buysomething, you pay a tax on tax itself. Let’s understand this with a hypothetical numerical

example

STAGE 1

Say a shirt manufacturer pays INR 100 to buy raw materials. If the rate of taxes is set at 10%, and there is no profit or loss involved, then he has to pay INR 10 as tax. So, the final cost of the shirt now becomes INR (100+10=) 110.

STAGE 2

At the next stage, the wholesaler buys the shirt from the manufacturer at INR 110, and adds labels to it. When he is adding labels, he is adding value. Therefore his cost increases by say INR 40. On top of this, he has to pay a 10% tax, and the final cost therefore becomes INR (110+40=) 150 + 10% tax = 165.

STAGE 3

Now, the retailer pays INR 165 to buy the shirt from the wholesaler because the tax liability had passed on to him. He has to package the shirt, and when he does that, he is adding value again. This time, let’s say his value add is INR 30. Now when he sells the shirt, he adds this value plus the VAT he has to pay the government to the final cost. So the cost of the shirt becomes INR 214.5 Let’s see a breakup for this: Cost = INR 165 + Value add = INR 30 + 10% tax = INR 195 + INR 19.5 = INR 214.5 So, the customer pays INR 214.5 for a shirt the cost price of which was basically only INR 170. Along the way the tax liability was passed on at every stage of transaction and the final liability comes to rest with the customer. This is called the Cascading Effect of Taxes where a tax is paid on tax and the value of the item keeps increasing every time this happens.

Action	Cost	10% Tax	Total
Buys Raw Material	100	10	110
Manufactures @ 40	150	15	165
Adds Value @ 30	195	19.5	214.5
Total	170	44.5	214.5

GST aims to solve this problem by introducing seamless Input Tax Credit (ITC). Today, the tax that you pay on material purchases cannot be claimed from output tax. This is set to change with ITC.

In our example, when the wholesaler buys from the manufacturer, he pays a 10% tax on his cost price because the liability has been passed on to him. Then he adds value of INR 40 on his cost price of INR 100 and this brings up his cost to INR 140. Now he has to pay 10% of this price to the

government as tax. But he has already paid one tax to the manufacturer. So this time what he does is, instead of paying INR (10% of 140=) 14 to the government as tax, he subtracts the amount he has paid already. So he deducts the INR 10 he paid on his purchase from his new liability of INR 14, and

pays only INR 4 to the government. So the INR 10 becomes his input credit. When he pays INR 4 to the government, he can pass on its liability to the retailer. So, the retailer pays INR (140+14=) 154

to him to buy the shirt. At the next stage, the retailer adds value of INR 30 to his cost price and has to pay a 10% tax on it to the government. When he adds value, his price becomes INR 170. Now, if he had to pay 10% tax on it, he would pass on the liability to the customer. But he already has input

credit because he has paid INR 14 to the wholesaler as the latter’s tax. So, now he reduces INR 14 from his tax liability of INR (10% of 170=) 17 and has to pay only INR 3 to the government. And therefore, he can now sell the shirt for INR (140+30+17) 187 to the customer.

Action	Cost	10% Tax	Actual liability
Buys Raw Material	100	10	10
Manufactures @ 40	140	14	4
Adds Value @ 30	170	17	3
Total	170	44.5	17

In the end, every time an individual was able to claim input tax credit, the sale price for him reduced and the cost price for the person buying his product reduced because of a lower tax liability. The final value of the shirt also therefore reduced from INR 214.5 to INR 187, thus reducing the tax burden on the final customer. So essentially, GST is going to have a two-pronged benefit. One, it will reduce the cascading effect of taxes, and second, by allowing input tax credit, it will reduce the burden of taxes

and, hopefully, prices.