Why VAT on cigarettes may go up in smoke

There is a distinct possibility that in Budget 2006 the additional excise duties (AED) on textiles, sugar and cigarettes will be transferred to the states to impose VAT on them, most likely at the rate of 12.5 per cent.

The 12th Finance Commission has recommended this transfer and the white paper on VAT submitted on January 17, 2005 by the empowered committee of the state finance ministers also suggested that the existing arrangement on AED should continue but "the position will be reviewed after one year." This review should be done thoroughly, bringing out all the implications, which is the precise purpose of the present treatise.

It is important to know that both Raja Chelliah's report of 1993 (Final Report, Part-I, page 39, para 4.15) and Vijay Kelkar's report of 2002 (Chapter 9, para 6.4, page 212) argued that while textiles and sugar may be transferred, cigarettes should not be. Kelkar reiterated this in his next report (in 2004) of the task force on the Fiscal Responsibility and Budget Management (FRBM) Act, 2003.

This differentiation has not been taken into account in the 12th Finance Commission's Report, 2004 (Page 76-77, para 4.57), which says laconically, "We recommend that the tax rental arrangement regarding the additional excise duty items, viz, textiles, tobacco and sugar should be formally revoked and these items should be integrated into the overall design of state VAT."

The only reason given is the integration into the overall VAT design of the states. The detailed implications have not been gone into and it has also not been explained why the elaborate arguments given by Chelliah and Kelkar to leave out cigarettes has not been taken into account. The fact is that what is true for textiles and sugar is not true for cigarettes.

Cigarettes are out and out a finished product where the value addition is at about 90 per cent at the manufacturing stage, 2 per cent at the wholesale stage and 8 per cent at the retail stage. Millions of roadside pan shops are involved in the retail sale of cigarettes. In the case of textiles and sugar, they are partially intermediate and partially finished products because of which the value addition is all along the subsequent manufacturing stages and also the wholesale and retail stages.

The value addition at the retail stage in respect of textiles and sugar can come into the VAT net. For cigarettes value addition at the retail stage will invariably escape the VAT net. The net revenue increase, therefore, will be only on the value addition of 2 per cent at the wholesale stage. This consideration alone should discourage the introduction of VAT on cigarettes at the state level.

Moreover, in a VAT arrangement, some states will lose and some will gain revenue in comparison with the shares of AED they were getting. This unevenness happens because VAT collection increases if consumption increases, whereas AED disbursement depends largely on population weight. The states, which lose, are those where the consumption is less and the population weight is high and vice versa.

This dichotomy must be brought into the open before a decision is taken. Another point is that it should also be realised that state VAT on cigarette would be a cascading tax. If the ex-factory price is, say, Rs 100, the excise duty is Rs 130, VAT of 12 .5 per cent on Rs 230 comes to Rs 28.70.

This amount is more because of the higher excise duty element than because of the ex-factory price, which prompted Kelkar to comment in his 2002 report (page 211) that "VAT on cigarette would chiefly be a tax on excise". So it is a "tax on tax" -- precisely what a cascading tax is defined as. Moreover, there is a distinct possibility that at the second stage, wholesalers will fragment themselves into small entities in large numbers and go below the threshold.

In any case, the millions of retailers will always be below the threshold. So the actual value addition, which will be within the VAT net in case of cigarettes, will be quite low and quite possibly equal or even less than what the AED devolution is bringing to the states in an over all manner.

Nothing prevents the states from imposing different and higher rates of VAT in a competitive manner. This will create differences in the invoice prices between wholesales and retailers. The MRP being the same, this will make the dealer's margin vary. There will be a clamour for buying from that state where the dealer's margin is less.

This will encourage clandestine inter-state movement of cigarettes by unethical members of the trade. Moreover, different rates of VAT will make maintenance of a countrywide fixed consumer price (MRP) impracticable and a common market in India unachievable. In any case, such an MRP will be meaningless.

The conclusion is clear that the aforesaid implications of transfer of AED on cigarettes have not so far received the attention that it deserves.

The recommendations of Chelliah and Kelkar (that AED on cigarette should remain with the Centre while textiles and sugar should be given away to the states for imposing VAT) should not be discarded lightly. The 12th Finance Commission's report did not go into all these considerations and, therefore, the Central government or the empowered committee of finance ministers should not take a decision without considering these implications. For the first time in the country wholesale dealers and large retailers will have to be subjected to tax on cigarettes.

Considering the fact that highly taxed products like cigarettes are prone to tax evasion, adoption of unethical practices like off-the-books cash transactions and so on by some of these dealers is a distinct possibility. This will erode revenue collection across the value chain.

It would be a better alternative to increase the rate of AED marginally and distribute it to the states by a newer devolution formula than to launch upon a system of VAT where some states will gain and some will lose, which may start a competitive tax war that VAT avowedly wanted to banish.