Rate and base are the two most important aspects while designing any tax mechanism because they define the character and effectiveness of the taxation and the elegance of its design.
A fundamental reason for adopting a goods and services tax (GST) is to get rid of the current patchwork of indirect taxes that are partial and suffer from infirmities, mainly exemptions and multiple rates.
Exemptions breed complexity, corruption, non-compliance and competitive distortion. Further, in business to business supplies, exemptions cause cascading. No credit is allowed for tax on inputs acquired in making exempt supplies. This blocked input tax becomes a cost that discourages investment and makes businesses uncompetitive.
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With target revenues being constant, tax rate becomes a negative function of the base on which it is imposed. Where the base is narrow, the tax rate would be higher to compensate for the revenue not collected on the exempt or non-taxable goods or services.
Some successful models of modern value-added tax (VAT) or GST can be found in New Zealand, Singapore, Australia and Japan, where the tax is imposed at a lower rate on all products. In Japan and Singapore, GST was introduced at 3%. In New Zealand, GST was introduced at 10%. In Australia, it was initially proposed to apply at a single rate of 10%, but at the time of implementation, food was made non-taxable.
The basic rules in the European Union for VAT allow member countries to have a two-rate system and an agreement on the list of products that will benefit from the reduced rate. However, under the system of derogations, nations are allowed to retain additional exemptions or rates which they had before the VAT system was adopted.
Food has always been one of the most controversial items for tax. In Europe, countries impose varying degrees of VAT on food, with significant variations from one country to another.
In India, there is strong aversion to tax food because food accounts for a significant portion of consumption basket of the lower income group. Thus, by exempting food, the burden on the lower income groups could be minimized. Also, there is a social discomfort on taxing a basic necessity such as food, regardless of the distribution of food consumption by income groups.
In developing countries such as India, the food sector is large but unorganized. Bringing the farmers into the tax net is complex and increases cost of administration.
However, food accounts for one-third of the consumer basket in India. Thus, an exemption of food narrows the base and results in an increase in the tax rate on other products by a third. Estimates by various agencies suggest that the combined centre-state revenue neutral rate in India could be 12% provided the base is kept comprehensive. With an exemption on food, the rate would increase to 18%.
From the perspective of designing a taxation system, proper treatment of food involves many complex considerations. The following options are available to tax food in India.
* Exempt only the first sale of farm produce by the farmer. By doing so, farmers can be kept outside the registration system. Where the food is bought by consumers directly from the farmers, the tax burden on such consumers would be minimal. However, this would create distortion between the first sale of farm produce and subsequent sales. While the fruit and vegetables sold by farmers would be exempt, they would be taxable when sold by the distributors or retailers. Such distortions are undesirable and need to be avoided.
* Exempt unprocessed food at all points in the supply chain. However, this solution will give rise to additional distortions. There would be disparity of tax treatment of unprocessed food and processed food. For example, while peanuts as such would be exempt, tax would be applicable on roasted and salted nuts. In another case, wheat would not be exempt, but flour would be made liable to tax. Even the definition of unprocessed food would be problematic. For example, would white rice, which goes through de-husking and polishing, be considered processed or unprocessed?
Further, in many situations, the dealers in the supply chain may have a mixture of exempt sales and taxable sales. Thus, they would be required to maintain separate inventory and records for unprocessed and processed food. Even tax credits on inputs used in unprocessed food have to be determined separately and will become a supply chain cost.
* Zero rate all food sales. This method has been adopted by Canada and Australia. While it is conceptually elegant, it may not be viable in the Indian context. It would encourage registration of farmers and small dealers for claiming refund of the input tax credits. As a result, the administrative costs would be high. A broad zero-rating of all processed and unprocessed food would also entail significant revenue cost and consequently a significant increase in the tax rate—20% or more— applicable to other goods and services. A tax at such a high rate would encounter significant consumer resistance and deter compliance.
* Exempt first sale of unprocessed food by the farmer and apply tax at a reduced rate on subsequent sales of both processed and unprocessed food. This would minimize registration of farmers and small dealers and result in uniform taxation of both types of food at subsequent points in the supply chain at a reduced rate. The revenue costs of this option can be managed by setting the tax rate on food at an appropriate level.
These options illustrate the complexity in proper treatment of food. Many social, political and tax policy considerations will impinge on the choice. A delicate balance is required.
Satya Poddar is tax partner, policy advisory group, Ernst & Young.
This is the third in a four-part series on the goods and services tax.
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