Sharekhan Blog

What is Value Added Tax?

  • Apr 17, 2024

It blends into the price of almost everything we buy, from a morning coffee to a new car. Unlike a straightforward sales tax that's only applied once, VAT is a clever player in the tax game. It's charged at every step of a product's journey from creation to consumption. Let us understand the VAT tax in detail.

What is VAT Tax?

Value Added Tax (VAT) is a consumption tax that is levied on the value added to goods and services at each stage of production. It is an indirect tax that the final consumer of the product or service ultimately bears.

How Does VAT Work?

Let’s understand by an example how VAT actually works.

A farmer sells wheat to a baker for Rs. 30 (including Rs. 3 as VAT @10%). The baker uses the wheat to make bread and sells it to a shopkeeper for Rs. 70 (including Rs. 7 as VAT @10%). The baker pays Rs. 4 as VAT to the government (Rs. 7 VAT charged - Rs. 3 VAT paid). The shopkeeper sells the bread to the final consumer for Rs. 100 (including Rs. 10 as VAT @10%). The shopkeeper pays Rs. 3 as VAT to the government (Rs. 10 VAT charged - Rs. 7 VAT paid).

In total, the government received Rs. 10 as VAT on the entire production and sales chain. This Rs. 10 is included in the final sales price of the bread paid by the consumer. The key benefit of VAT is that it is collected in small amounts at each stage of production, making it easier to track and less prone to tax evasion.

What is VAT Registration?

VAT registration is mandatory for all manufacturers and traders who are involved in the buying and selling of goods in their domestic market once their turnover crosses a minimum threshold limit set by the state governments. Upon VAT registration, a unique 15-digit Tax Identification Number (TIN) is allotted which must be shown on all VAT invoices.

Registered dealers can claim credit for the VAT already paid by them on the purchase of goods, called input tax credits. They only need to pay VAT on the value they have added. VAT returns must be filed by registered dealers periodically, showing VAT collections and taxes paid.

Also Read about Long-term Capital Gains Tax on Shares

How is VAT Different from Sales Tax?

The key differences between VAT Tax and sales tax are:

1. Collection Point - Sales tax is collected at a single point, i.e. from the end consumer. VAT is collected at different points of production - from the manufacturer, wholesaler as well as retailer.

2. Tax Burden - Sales tax leads to tax on tax as it does not provide a set-off for taxes paid previously. VAT avoids this as credit for taxes paid earlier is provided.

3. Coverage - VAT has a broader coverage and applies to most goods and services. Sales tax often excludes several categories.

4. Evasion - VAT makes tax evasion difficult as taxes are collected at multiple points. There are greater chances of tax leakage in sales tax.

VAT and Prices of Goods

The introduction of the Value-Added Tax (VAT) has had a positive impact on the prices of many commodities. Under the previous sales tax regime, the cumulative burden of taxes like excise resulted in higher prices for consumers. However, VAT's lower tax rates have replaced this higher tax burden, leading to a reduction in final prices.

Additionally, the VAT tax has fewer exemptions, bringing a greater segment of goods under the tax net. While this broader coverage could have led to increased prices, the lower rates across the board have actually resulted in a reduced tax burden for consumers.

Conclusion

The implementation of Value Added Tax in India has increased the competitiveness of locally manufactured goods while also contributing to greater tax revenues for the government. By avoiding tax on tax, it has reduced the final prices consumers pay for many commodities. VAT operates through a transparent credit mechanism that enhances compliance and eliminates geographical fragmentation of markets.

Team Sharekhan
by Team Sharekhan

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