Pre-Post GST: - Cascading Effect

A tax that is levied on a good at each stage of the production process up to the point of being sold to the final consumer. A cascade tax is a type of turnover tax with each successive transfer being taxed inclusive of any previous cascade taxes being levied. Because each successive turnovers includes the taxes of all previous turnovers, the end tax amount will be greater than the cascade tax rate.[1]

One of the primary goals of a taxation regime is always avoidance of “taxation over taxes” or “cascading-effect” of the incident taxes as it adds to the deadweight loss i.e. slump in total surplus of supply chain consisting of supplier, manufacturer, retailer and consumer. These cascading caused due to levy of variety of charges by state and union governments has raised the tax-burden on Indian products and made them less competitive in the International market. The gargantuan-sizes of corporate-taxes owe much to this taxation structure and have led to adoption of tax-evasive practices. The common man finds himself strangled in a Gordian knot of multiple tax-rates, laws and elaborate processes and often fails to comply with these complex legislations. The extra tax paid due to taxation of the already taxed amount is finally bore by the end consumer which is common man and strikes them badly in addition-to inflation.[2]

Generally, any tax is related to selling price of product. In modern production technology, raw material passes through various stages and processes till it reaches the ultimate stage e.g., Steel Ingots are made in a steel mill. These are rolled into plates by a re-rolling unit, while third manufacturer makes furniture from these plates. Thus, output of the first manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third manufacturer. This process continues till a final product emerges. The current indirect tax has one major problem - the cascading effect. When you buy something, you pay a tax on tax itself. Let’s understand this with a hypothetical numerical example:-

STAGE 1

Say a shirt manufacturer pays INR 100 to buy raw materials. If the rate of taxes is set at 10%, and there is no profit or loss involved, then he has to pay INR 10 as tax. So, the final cost of the shirt now becomes INR (100+10=) 110.

STAGE 2

At the next stage, the wholesaler buys the shirt from the manufacturer at INR 110, and adds labels to it. When he is adding labels, he is adding value. Therefore his cost increases by say INR 40. On top of this, he has to pay a 10% tax, and the final cost therefore becomes INR (110+40=) 150 + 10% tax = 165.

STAGE 3

Now, the retailer pays INR 165 to buy the shirt from the wholesaler because the tax liability had passed on to him. He has to package the shirt, and when he does that, he is adding value again. This time, let’s say his value add is INR 30. Now when he sells the shirt, he adds this value plus the VAT he has to pay the government to the final cost. So the cost of the shirt becomes INR 214.5 Let’s see a breakup for this:

Cost = INR 165 + Value add = INR 30 + 10% tax = INR 195 + INR 19.5 = INR 214.5

So, the customer pays INR 214.5 for a shirt the cost price of which was basically only INR 170. Along the way the tax liability was passed on at every stage of transaction and the final liability comes to rest with the customer. This is called the Cascading Effect of Taxes where a tax is paid on tax and the value of the item keeps increasing every time this happens.

Action

Cost

10% Tax

Total

Buy Raw Material

100

10

110

Manufactures@40

150

15

165

Add Value @30

195

19.5

214.5

Total

170

44.5

214.5

GST aims to solve this problem by introducing seamless Input Tax Credit (ITC). Today, the tax that you pay on material purchases cannot be claimed from output tax. This is set to change with ITC.

In our example, when the wholesaler buys from the manufacturer, he pays a 10% tax on his cost price because the liability has been passed on to him. Then he adds value of INR 40 on his cost price of INR 100 and this brings up his cost to INR 140. Now he has to pay 10% of this price to the government as tax. But he has already paid one tax to the manufacturer. So this time what he does is, instead of paying INR (10% of 140=) 14 to the government as tax, he subtracts the amount he has paid already. So he deducts the INR 10 he paid on his purchase from his new liability of INR 14, and pays only INR 4 to the government. So the INR 10 becomes his input credit.

When he pays INR 4 to the government, he can pass on its liability to the retailer. So, the retailer pays INR (140+14=) 154 to him to buy the shirt. At the next stage, the retailer adds value of INR 30 to his cost price and has to pay a 10% tax on it to the government. When he adds value, his price becomes INR 170. Now, if he had to pay 10% tax on it, he would pass on the liability to the customer. But he already has input credit because he has paid INR 14 to the wholesaler as the latter’s tax. So, now he reduces INR 14 from his tax liability of INR (10% of 170=) 17 and has to pay only INR 3 to the government. And therefore, he can now sell the shirt for INR (140+30+17) 187 to the customer.

Action Cost 10% Tax Actual Liability Total

Buy Raw Material 100 10 10 110

Manufactures@40 140 14 4 154

Add Value @30 170 17 3 187

Total 170 17 187

In the end, every time an individual was able to claim input tax credit, the sale price for him reduced and the cost price for the person buying his product reduced because of a lower tax liability. The final value of the shirt also therefore reduced from INR 214.5 to INR 187, thus reducing the tax burden on the final customer. So essentially, GST is going to have a two-pronged benefit. One, it will reduce the cascading effect of taxes, and second, by allowing input tax credit, it will reduce the burden of taxes and, hopefully, prices.[3]

Disadvantages of Cascading Effect of Taxes

A tax purely based on selling price of a product has cascading effect, which has the following disadvantages:

Real tax content in the price of a product cannot be known, as a product passes through various stages and tax is levied at each stage. Tax burden on any commodity will vary widely depending on the number of stages through which it passes in the chain from first producer to the ultimate consumer. Ancillarisation is discouraged and manufacturer tries to manufacture all parts and do all processes in his plant itself. This increases manufacturing costs. End use based exemptions and concessions (e.g. exports or goods consumed by poor) cannot be given since it is not known what were taxes paid in earlier states.

This is just one example and a very small value chain, in contrast usually movement of goods takes longer channel. Thus, it will not be unfair to say that end consumer are going to get most out of GST, and once these prices fall, demand will rise and the economy will blossom. However, there should be single unified GST in order to overcome the cascading effect. If there are dual GST at Central and State level, the cascading effect will continue as the Central GST might not be allowed for setoff as input tax credit against State GST and vice versa. There is also a big question mark as to whether the local taxes like entry tax/octroi, property tax would be covered under the GST net. But something is better than nothing. We should also focus on positive outcome of the GST which could be better tax administration, less litigation, more tax collection, and more competitiveness of Indian products abroad. These outcomes collectively should result in making India a developed nation economically. With the introduction of GST it can be hoped that it will resolve the long standing distortions which are continued in indirect taxation. However, measures needs to be taken to avoid cascading effect of tax in direct taxes also. Some of the provisions of direct taxes which need more focus of the government are with regard to fringe benefit tax, dividend distribution tax, tax collection at source and tax deducted at source etc.[4]

[1] Cascade tax, https://www.investopedia.com/terms/c/cascade-tax.asp accessed on 18/04/2018

[2] The Cascading Effect Of Taxation; What Do We Understand By It? By Ashish Kumar, https://www.youthkiawaaz.com/2012/03/the-cascading-effect-of-taxation-what-we-understand-by-it/ accessed on 18/04/2018

[3] Clear tax GST E-book, www.cleartax.com/gst assessed on 18/044/2018

[4] Mahadev R., https://www.caclubindia.com/articles/cascading-effect-of-taxes-2321.asp accessed on 18/04/2018