A Simple Guide to the GST

GST! The one tax reform we all want but don’t really understand why. The government finally passed the bill in the Rajya Sabha after missing numerous deadlines. The following article attempts to explain the tax legislation and breaks down its implications.

INTRODUCTION

For an economy, especially as large, diverse and complex as ours, the wheels of reforms must roll continuously. This becomes all the more accentuated when it comes to tax reforms as taxes directly affect the economy, disposable incomes and fiscal policy. We started our tax reforms journey with the infamous sales tax and thereby moved on to the Value Added Tax (VAT) system. The next much-needed step in this journey is the Goods and Service Tax (GST).

GST is a comprehensive tax levy on the manufacture, sale and consumption of goods and service at a national level. It will mostly substitute all indirect taxes levied on goods and services by the Central and State governments in India.

In a slight departure from my usual practice, I have simply tried to create an informational bridge for the reader, instead of also walking along with him on this bridge. It is an attempt at experimenting with different styles. Regular readers of my blog would understand. Therefore, the article unlike earlier times, assumes the knowledge of a few concepts hyperlinked below:

  1. Basics of VAT
  2. Input Tax Credit
  3. Cascading Effect of Tax

NEED FOR THE GST

The need for the GST arises from the inefficiencies in the present system of indirect taxation as illustrated below:

  1. Cascading Effect: 
  • Even today VAT/CST is charged on the Sale Price + Excise amount leading to double taxation.
  • Input tax credit for several taxes such as  Additional Excise Duties, Additional Customs Duty, Surcharges etc is still not available.
  • In case of CST paid on goods later sold within the same state, set off for CST against the amount of VAT is not available since tax collection is done on the ‘place of origin’ basis. This is illustrated below:

Say, A residing in Andhra Pradesh purchases goods worth Rs 10,000 from D residing in Delhi. A adds value to the goods and sells them to P who also resides in Andhra Pradesh for Rs 15,000. Let CST rate be 5% and VAT rate be 12.5%:

A) If input tax credit is not available (present system):

Cost of input: Rs 10,000
CST payable: Rs 500
Total Cost: Rs 10,500
Value Added (Profit): Rs 5000
Sale price: Rs 15,500 (10000+5000+500)
VAT: Rs 1937.50 (12.5% of 15,500)
Total Sale Price: Rs 17437.50
VAT Payable: Rs 1,937.50

B) If input tax credit is available (GST):

Cost of input: Rs 10,000
CST payable: Rs 500
Total Cost: Rs 10,500
Input Tax Credit: Rs 500
Profit: Rs 5000
Sale price: Rs 15,000 (10000+5000)
VAT: Rs 1875 (12.5% of 15,000)
Total Sale Price: Rs 16,875
VAT payable: 1,375 (1875-500)

As it can be seen from these two cases, in case input tax credit is not allowed, the final VAT payable inflates due to double taxation.

2)  Distinction Between Goods and Services: 

Presently, we have two separate laws for taxing goods and services: VAT/CST and collected by States and Service Tax collected by the Central Government, respectively.

  • The rates of taxation are different for the two, general VAT+excise rate is 12.5%+12.5% and service tax is 15% as from 1/6/16. Why should services be taxed lower than the tax on manufacture+sale of goods?
  • Then there are definitional problems: a software downloaded from the internet is taken to be a service and the same software within a CD is considered to be a ‘good’. Indeed, in the present times, the distinction between a service and good has been eroded and there is a need to treat them as one in the eyes of the tax authorities.

3)   State Wars:

The VAT rates are decided by individual states applicable within their jurisdiction. Relatively lower rates in a particular state translates to that state appearing more lucrative for a seller/investor. Therefore, it is often seen that states compete by lowering their respective VAT rates to maximise the economic activity in their states in this zero-sum game. VAT then also becomes a tool for appeasement of the masses. People long for tax cuts and the state government that lowers these rates for them becomes their subject of adulation. This spirals into a classic Game Theory situation where every player (State Gov) would benefit from higher taxes but everyone ends up reducing the rates.

That being said, some States which enjoy an inelastic supply of investments may be shielded from this tussle.

4) Compliance Cost and Complexities:

One of the most sought feature of any tax system is simplicity, minimal costs of operations. This is the one area where the VAT system has miserably failed. Each State has different rates of VAT, different registration requirements, different Negative Lists for exempt goods and different compliance rules. For businesses, navigating through this giant web takes considerable time, money and effort. With a uniform set of rules and rates for every state we can expect the following benefits:

  • Simplified and rational tax structure
  • Reduced Costs for businesses in compliance
  • Reduced Costs for Tax Authorities for administration
  • Reduced litigation from easier to follow tax laws
  • Widening of the tax base as simpler, cheaper compliance makes it easier to catch defaulters.
  • Reduced corruption

WORKING OF THE GST

India will adopt a ‘Dual GST’ system where both CGST and SGST will be levied as explained below, in place of the taxes charged by the Centre (Excise, Service Tax) and those charged by the States (VAT) respectively.

  • For Intra-State Transactions: 
  1. Central GST (CGST)— levied by the Centre
  2. State GST (SGST)— levied by the State

The seller will collect both CGST & SGST from the buyer and CGST will be deposited with Central Government and SGST with the State Government.

  • For Inter-State Transactions: 
  1. Integrated GST (IGST) – destination based, levied by Central Government
  2. Additional GST (AGST) – origin based, levied by the Central Government

[Note: The BJP government in order to gain the support of the Congress removed the AGST in the amended bill passed by the Rajya Sabha]

IGST will be based on the destination principle. Tax gets transferred to the importing state. This shall open the doors for the importing state to allow input tax credit for the subsequent sale of those goods. This is because of the following:

The FUNDAMENTAL RULE followed by the states while allowing or disallowing input tax credit is—if the said state received the tax on the sale of the good at one stage, only then will it allow input tax credit on the tax payable in the next stage.

Consider the example that was discussed earlier:

  1. In the origin based VAT/CST structure, Delhi would collect the tax in the sale from D to A. Then, when A sells to P, Andhra Pradesh will collect this tax. But since it did not collect the tax at the earlier stage, it will not allow P to avail input tax credit. Therefore, P has to pay the full amount of tax first to Delhi then to Andhra Pradesh. This is tax on tax.
  2. In a destination based GST, Andhra Pradesh would have collected the tax in the sale from D to A. Therefore, when A sells to P, Andhra Pradesh will allow P to avail the input tax credit. P ends up paying tax only on the value added portion of the sale.

Due to this change, there will be a movement of revenues from the producer states to the consumer states. In the short-term, this might impact regional balances and is therefore resisted by the producer states. To placate them, a temporary AGST was proposed to the extent of 1% of the value of goods will be charged extra and this AGST will go to the producer state. But again, there would have been no set off for this 1% levy (from the example) as Andhra Pradesh did not collect this tax (Delhi did). This would have again lead to a cascading effect of double taxation. Albeit, this was to be a temporary feature and meant to smoothen the transition to the GST regime. As proposed by the government, the AGST was to be abolished after two years. Though, in the version of the bill passed by the Rajya Sabha, the AGST has been removed.

Setoff of IGST, CGST & SGST will be as follows in the below mentioned chronological order:

Credit for IGST set off against:
1)   IGST
2)   CGST
3)   SGST

Credit for CGST set off against:
1)   CGST
2)   IGST

Credit for SGST set off against:
1)   SGST
2)   IGST

WORKING OF THE IGST:

Now, IGST will not be a third tax in addition to the SGST and CGST. Indeed, it is only a mechanism to monitor the interstate trade of goods & services and further to ensure that the ultimate SGST goes to the consumer state since the GST is a destination based tax. The rate of IGST will be the rate of CGST+SGST.

Now say A pays IGST to D. D will collect this IGST and submit it to the Centre. But he will first set off his input tax credit of CGST and SGST from it. Since the Centre collected the initial CGST and is now collecting the IGST, the CGST set off is not a problem. But, since the Centre is also providing the SGST set off but did not actually collect the SGST, Delhi would be required to transfer the amount of input credit that D availed on account of SGST to the Centre. Now, the Centre has the net amount of IGST after set-offs. It keeps the CGST portion of it with itself and remits the SGST portion to Andhra Pradesh.

In this way, the destination principle remains intact with a uniform input tax credit available at every stage.

VAT  VS  GST 

  1. VAT is levied on goods whereas GST will be levied on both goods & services
  2. GST would have a uniform rate in all the states which VAT lacks as each state levies its own rate of duty for each good.
  3. Input credit can be set-off only against the goods sold within the state whereas in the case of GST not only you can set-off input credit against goods sold within the country but also against the services.
  4. VAT will be split into CGST and SGST whereas CST will now be IGST.
  5. Unlike the old system, the GST will ensure uniformity in procedures, registration requirements and filing protocols.
  6. GST will change the place of collection of taxes from ‘place of origin’ to the ‘place of destination’

To understand the implications of the GST read the next articles in this series: GST: The Great and The Scary (I) and GST: The Good and The Scary (II)

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3 thoughts on “A Simple Guide to the GST

  1. Sir, in the first example, in case of GST, why is the VAT chargeable 1375 (1875-500) when 500 are already reimbursed to the manufacturer?

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