Value-added tax, popularly known as VAT, belongs to the family of sales taxes. A general sales tax and turnover tax can be compared with value-added tax. A general sales tax is a tax on sales transactions but it is applied at only one stage of business activity right from the manufacturer to the retailer.
A turnover tax is imposed at each sale transaction. Consequently, a turnover tax tends to increase the final sale value to the consumer cumulatively.
VAT is a tax not on the total value of the good being sold, but only on the value added to it by the last seller. The seller is liable to pay a tax on the net value added by him in the process of production, i.e. gross value minus the value of inputs or commodities purchased from other firms.
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The basic difference between VAT and a sales tax is that the tax liability under VAT is split up into stages. VAT is distinguished from turnover tax where each transaction is taxed on its gross value, in contrast to tax on net value added as in VAT.
A VAT can be designed to have different forms, exemptions, and rates. The popularity of VAT with authorities is mainly due to its administrative advantages. It is much easier to assess tax liability of a firm by using the credit method. There is also a greater scope for cross-checking of returns submitted by firms hence it helps in checking tax evasion.
A general VAT is supposed to be neutral to the resource allocation forms of production and business organisation. In contrast, a turnover tax encourages vertical integration of production so as to avoid the intermediary sales and taxes, and to acquire a competitive advantage over others.
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It is argued that VAT avoids cost-cascading effect. A conventional sales tax leads to compounding of tax liability, while VAT does not. The use of VAT helps a country in encouraging its exports. In order to get a competitive edge over others, a country may refund the taxes paid on the export goods.
VAT’s applicability has serious limitations especially for underdeveloped countries. VAT is a complicated system and needs honest and efficient government machinery to do cross checking and link up various production activities and the resulting tax liability of each firm.
It is, therefore, necessary that the country adopting should also be sufficiently advanced in its financial and economic structure and the firms should be in the habit of keeping proper accounts. The system is highly uneconomical; especially for the smaller firms it requires them to maintain elaborate and costly accounts.
The Indirect Taxation Enquiry Committee in its report in 1977 examined the feasibility of VAT system. It came to the conclusions that under our administrative and other circumstances, we should be cautious in adopting this tax form.
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It recommended its adoption, on an experimental basis, in a phased manner, to a limited number of manufacturing industries. VAT has been introduced by all States/UTs by now. Uttar Pradesh is the latest which has introduced VAT on January 1, 2008.
To avoid double taxation and tax cascading and have a simple and progressive taxation system for goods as well as services, it is proposed to introduce a combined national level goods and services tax (GST). This is similar in concept to state VAT for goods.
It provides for input tax credit at every stage for tax already paid till the previous transaction. This will also attempt to provide a rational system by subsuming several State and Central level indirect taxes on goods and services. This is targeted to be introduced w.e.f April 1, 2010.