Cascading tax is more sinned against than sinning

These are the heydays of VAT but not everywhere in the world. Not in the USA. The indirect tax in the USA is not VAT but the good old turnover tax. A turnover tax is usually deprecated as a cascading tax. A cascading tax is one, which is not just on output value but also on the input element. That is to say it is at every stage of production and distribution. It is a tax on tax. For example resin, rubber and carbon black are necessary for manufacturing a tyre. All the three inputs paid tax and the final products namely the tyre also paid tax. So these three inputs are taxed twice. Then again the tyre is used in a car, which also is taxed. These three inputs are now taxed thrice. So the tax element on these inputs goes on increasing with every production and distribution chain. The cascading effect of tax makes the tax rate much higher than the original rate. It might even become two and half times. A turnover tax of 4 per cent can be ultimately equivalent to a total tax burden of 10 per cent.

 

Let us examine the arguments in favour of the view that cascading of tax is bad for the economy and so is undesirable. First, it is said that cascading leads to distortion in reallocation of factors of production. Since cascading gets into the entire production-distribution chain, it tends to induce the producer or distributor to reallocate his resources away from the particular product to those where the tax does not apply. This argument, however, is not all factually correct. It is valid only when there are commodity based exemptions and particularly geographical exemptions. So it is the exemption, which causes distortion, and not the cascading tax by itself. Exemption in VAT also causes the same distortion.

Second, it is said that cascading leads to tax rate to increase several times by the time it is finally sold to the retailer. So the cost of production increases, the argument goes. Here again the argument about increase in cost of production is to be seen in the proper context. If a rate of 4 per cent ultimately becomes 10 per cent, then it enjoins on the government to decide if it would charge 10 per cent or less. If the government decides to charge 7 ½ per cent in the ultimate analysis, then it can reduce the rate from 4 per cent to 3 per cent at the initial stage. It is ultimately the decision as to how much revenue the government wants to collect as per its budget estimate keeping the fiscal deficit in mind. A tax rate is not imposed in vacuum. It is a matter of economic policy.

Third, it is said that cascading leads to higher prices. Since the tax level becomes more after several transactions, the incidence of tax becomes more and so the prices will rise. This argument is also not correct. The prices rise if the ultimate tax rate is higher and not on the mere phenomenon of cascading. If the government finds that a certain tax rate of, say, 4 per cent and its ultimate effect of 10 per cent is inflationary, then the tax rate itself can be reduced.

Fourth, it is argued that cascading tax like sales tax or excise tax discourages export because the tax element in the exported goods makes the export uncompetitive. While it is correct that cascading itself discourages export by making it uncompetitive, it is not necessary that in a turnover tax type of sales tax or excise duty regime there cannot be any refund of the tax elements from the export. Much before the MODVAT was introduced in 1986 system of giving export refund for taxes paid was in vogue.

On the other hand the possibility of evasion in VAT is great because of false input credit taken by the assesses which is not easy to detect.

So the conclusion is that the case against turnover tax on the ground that it is an inefficient and undesirable tax because of the cascading effect is largely exaggerated. A low turnover tax has much to commend itself compared to VAT.

Email: smukher2000@yahoo.com  Alan A. Tait-Value Added Tax, IMF 1988, p.9