Indirect Taxes: Pre GST Era | Goods and Services Tax (GST) - B Com PDF Download

Introduction

India is a socialist, democratic, and republic country. The federal structure of India consists of both central and state-level governments. These two levels of government share primary responsibilities, including addressing the country's growing development needs. The main source of revenue for these governments is taxation. To stimulate economic growth and achieve socio-economic objectives, taxes are considered the most crucial revenue source for the government.

A tax is a compulsory contribution from individuals to cover the state's expenses for the common good, without providing specific benefits to any individual. It is not a voluntary payment or donation but an enforced contribution exacted through legislative authority. The term "tax" is derived from the Latin word “Taxo,” which means to touch sharply or charge.

According to Wikipedia, “A tax is a mandatory financial charge or some other type of levy imposed upon a taxpayer (an individual or other legal entity) by the government to fund various public expenditures.” It is important to note that tax is a mandatory payment, and failure to pay, evasion, or resistance to taxation is punishable by law.

Types of Taxes

Taxes are generally classified into direct and indirect taxes.

• Direct Tax: A direct tax is paid directly by an individual or organization to the government. In this type of tax, the incidence and impact of taxation fall on the same entity, meaning the taxpayer cannot pass the burden of a direct tax onto someone else. The most significant direct tax imposed in India is the Income Tax.
• Indirect Tax: Indirect taxes are imposed on goods and services. Although the initial liability to pay indirect taxes falls on the manufacturer, service provider, or seller, the burden is ultimately passed on to consumers. Since the tax is indirectly borne by the consumer, it is known as an indirect tax. An intermediary collects this tax from the person who bears the ultimate economic burden. It is important to note that the burden of an indirect tax is transferred as part of the price of the goods or services rather than as a separate tax.

Features of Indirect Taxes

The following are the basic features of indirect taxes:

• Taxable Event: Indirect taxes are levied on the purchase, sale, or manufacture of goods and the provision of services.
• Incidence & Impact: In the case of indirect taxes, the incidence and impact fall on two different entities. This means that the tax burden is shifted from the supplier to the buyer or recipient of the goods or services.
• Regressive Taxation: Indirect taxes do not depend on the payer's ability to pay, as the tax on a commodity is the same whether it is purchased by a poor person or a rich one. Therefore, indirect taxes are considered regressive. However, there are exceptions, as higher taxes may be imposed on luxury goods.
• Impact on Prices: Indirect taxes increase the prices of goods and services, leading to inflationary trends.
• Promotes Welfare: Higher taxes may be imposed on harmful or "sin" products like alcohol and tobacco. This practice discourages the consumption of such goods and increases state revenue.
• Major Source of Revenue: In India, indirect taxes contribute more than 50% of the total tax revenue, making them a major source of government revenue.

Taxation Powers of union & State Government

In India, the constitution is Supreme and all laws and actions of the Government are sub-ordinate to it. The constitution provides that no tax shall be levied or collected except by authority of law. The Structure of Government in India is federal in nature. As per article 1(1) of constitution, India shall be union of States. There is a bifurcation of powers between union and states. Government of India (Central Government) has certain powers in respect of whole country. Each state (and union territory) has certain powers in respect of that particular state (Union territory).

Indian constitution

India has a three-tier federal structure, comprising the following:-
(a) The Union Government
(b) The State Government
(c) The Local Government

The power to levy taxes and duties is distributed among the three tiers of Government, in accordance with the provisions of Indian Constitution. The constitution consists of a preamble, 25 parts containing 448 articles and 12 Schedules.

 Provisions of constitution regarding taxation

The power to levy and collect taxes emerges from the constitution of India. The following are the significant provisions of the constitution regarding taxation:

1. Article 265: It states that no tax shall be levied or collected except by authority of law. In fact, it prohibits arbitrary collection of tax.
2. Article 246: The authority to enact law and levy taxes and duties is given by constitution vide Article 246. The Parliament may make laws for the whole of India or any part of the territory of India, the State legislature may make laws for whole or part of the State.
3. Seventh Schedule (to Article 246): The Seventh Schedule contains three lists which enumerate the matters under which the union and the State Governments have the authority to make laws.
   (a) List I (Union List): The Central Government has the exclusive right to make laws in respect of any matter covered in this list. Parliament makes law in this regard. Some of the items in List I are defense of India, naval, military and air forces, atomic energy and mineral resources, central bureau of intelligence and investigation, railways, highways, currency, RBI, post office saving bank, taxes on income other than agricultural income, duties of customs, corporation tax, etc.
   (b) List II (State List): It contains the matters in respect of which the State Government has the exclusive right to make laws. These matters include public order, police, local government, public health and sanitation, hospital, burials and burial grounds, cremation ground, libraries, water, fisheries, betting and gambling, etc.
   (c) List III (Concurrent List): It contains the matters in respect of which both Central & State Governments have powers to make laws. This list includes criminal laws, criminal procedure, marriage and divorce, contracts including partnership, agency, bankruptcy and insolvency, trust and trustees, trade unions, industrial and labour disputes, etc.

Concept of value added tax (VAT)

The value added tax (VAT) was introduced in India in 2005. It is a multi point system of taxation on sale of goods wherein a mechanism is provided to grant credit for tax paid on inputs. Under VAT, the tax is collected in Stages an transactions involving sale of goods. The input tax (i.e. paid on purchases) is rebated against output tax (i.e. tax payable on sales).
Under the VAT system, the net tax payable is calculated in the following manner:

• VAT = Tax collected on sales - Tax paid on purchases

What is Cascading Effect

The cascading effect implies charging tax on tax. In other words, at the time of levy of tax, the total value is considered which is inclusive of all taxes paid up to that point. In this manner, if the tax is always charged on the selling price of the product, the burden of tax keeps on increasing at each point of sales. In this process, the effect of taxation magnifies as at each level tax is calculated on  value, which includes taxes already levied and paid. The charging of tax on tax is called as ‘Cascading Effect of tax’.

VAT has eliminated cascading effect

VAT has been developed to avoid cascading effect of taxes. This has become possible as tax is effectively charged only on value addition at each stage and not on the entire sale price. The cascading effect has been prevented through tax credit system, called as Input Tax Credit.

Input Tax Credit

If any registered dealer is purchasing goods within a particular state and has paid value added tax and subsequently the goods were sold in the same state, in that case such registered dealer shall be allowed to take credit for input tax, subject to certain conditions. In other words, the tax is imposed at each stage on the entire Sales value and the tax paid at the earlier stage is allowed as set off. This credit availability is called as “Input Tax Credit”. For example: Mr. Bhuvan is a registered dealer and has purchased inputs worth ₹ 5,00,000 (plus VAT @ 4%). The actual sales in the month were ₹ 9,00,000 (plus VAT @ 10%). It means
VAT paid on purchases = ₹ 20,000 [Calculated as ₹ 5,00,000 × 4%]
Output VAT payable = ₹ 90,000 [Calculated as ₹ 9,00,000 × 10%]

Since, VAT paid on purchases can be adjusted against output VAT payable; the net VAT payable for the month shall be ₹ 90,000 minus ₹ 20,000. It means after adjusting ITC, the net VAT liability is ₹ 70,000.

Scope of input tax credit under VAT

In Pre-GST era, the concept of ITC was prevailing in VAT, Excise and Service Tax. The following important points may be noted about the entitlement of ITC under VAT:
(a) It is allowed to a registered dealer.
(b) It is also allowed in respect at VAT paid on purchase of capital goods.
(c) The Central Sales Tax (CST) paid on purchases made from outside state is not allowed as ITC.
(d) It is allowed only if the purchases are made from a registered dealer.
(e) The ITC is not available in respect of purchases from a dealer who has opted for composition scheme.
(f) It goods have been used to manufacture the exempted goods, ITC is not available.

Variants of VAT

The various possibilities of credit for VAT paid on purchase is called as variants of VAT. The VAT has three variants:
(a) Gross Product Variant
(b) Income Variant
(c) Consumption Variant

Constitutional Framework of Indirect Taxes before GST

Before the implementation of GST, the taxation system in India was governed by the Constitution, which outlined the powers of the Union and State governments regarding taxation. Here's a breakdown:

1. Article 265: This article states that no tax can be imposed or collected without the authority of law. In simple terms, it means that taxes can only be levied if there is a specific law allowing it.

2. Article 246: According to this article, Parliament (Union government) has the exclusive authority to make laws on matters listed in the Union List, while State governments have this authority for matters listed in the State List. For matters listed in the Concurrent List, both the Union and State governments can make laws.

3. Important Taxes for the Union and States: Certain taxes were exclusively under the jurisdiction of either the Union or State governments. For example, taxes like customs duty, central excise duty, and service tax were levied by the Union, while VAT tax, excise duty on alcohol, and taxes on luxuries were levied by the States.

Major Defects in the Structure of Indirect Taxes before GST

Before GST, the indirect taxation system in India had several drawbacks, which led to inefficiencies and complexities:

1. Tax on Tax: One significant issue was the cascading effect of taxes, where taxes were charged on top of other taxes, leading to higher prices for goods and services.

2. Conflict between State Revenues: Different states had different tax rates and systems, leading to conflicts of interest and competition between them.

3. Lack of Coordination in Input Tax Credit: There was a lack of coordination in providing input tax credit across different stages of production, leading to inefficiencies and increased costs for businesses.

4. High Administrative Expenses: The administration of multiple taxes required significant resources and manpower, leading to high administrative costs for both businesses and the government.

5. Tax Evasion: The complex tax structure provided opportunities for tax evasion, as businesses could exploit loopholes and inconsistencies in the system.

6. Competitive Challenges: Businesses faced challenges in competing both nationally and internationally due to the complexities and uncertainties of the tax system.

7. Difficulty in Determining Goods and Services: Determining the classification of goods and services for taxation purposes was often challenging, leading to confusion and disputes.

Overall, these defects highlighted the need for a comprehensive reform of the indirect tax system, which eventually led to the introduction of the Goods and Services Tax (GST) in India.