Cascading tax effect is also termed as “tax on tax”. This effect occurs when a good is taxed on every stage of production. Such a good is taxed till it is finally sold to the consumer. This means each succeeding transfer of good is taxed inclusive of the taxes charged on the preceding transfer. As a result, the final consumer bears the burden of the multiple taxes imposed on every stage of production. Such a situation leads to inflationary prices.
Thus, ‘Tax on tax’ plagued the indirect tax structure of India prior to GST. So to understand such an effect, it is imperative to figure out:
- the tax structure in the previous indirect tax regime and
- how stakeholders ended up paying more tax in the supply chain?
Indirect Tax Structure Before GST
The Centre, States and Local Governments had the powers to levy varied taxes under the indirect tax regime. Accordingly:
- Central Government formulated laws regarding issues prescribed in the Union List
- State Legislatures formulated rules regarding issues mentioned in the State List
- And Both Central and State Government framed laws regarding issues mentioned in the Concurrent List.
Accordingly, both Centre and States had the following sources of revenue:
Sources of Revenue for the Centre
The Central government collected a variety of taxes under the previous indirect tax regime.
Central Excise Duty
Central Excise Duty is an indirect tax imposed on the goods manufactured in India. The manufacturer paid the tax and passed it further to the consumer.
Custom Duty
It is an indirect tax levied on import of goods (called import duty). However, such a tax is also imposed on export of goods (called export duty) in some cases .
Service Tax
It is an indirect tax levied by the Central Government on services provided by the service providers. Such a tax is collected by the service providers from the recipients of service and hence paid to the Central government.
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Central Sales Tax
Central Sales Tax is an indirect tax levied by the Central Government on the inter – state sale and purchase of goods. This tax was collected by the Central Government. But it was assigned to the respective states of origin of sale.
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Sources of Revenue for the Centre
The State government collected a variety of taxes under the previous indirect tax regime.
Value Added Tax
It is an indirect tax charged and collected by the respective state governments. It was levied on value added to goods and services at each stage of production or distribution. Such a tax was levied on goods or services until they reached the final consumer.
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Other Taxes
There are a host of other taxes charged and collected by the state governments under previous indirect tax regime. These included:
- excise duty on alcoholic liquors, narcotics and drugs
- taxes on luxuries, entertainment, amusement parks, betting
- octroi or entry tax and
- electricity tax
How Previous Indirect Tax Regime Lead to Tax on Tax?
Meet X Ltd, the Car Manufacturer
X Ltd is a car manufacturing unit that has experienced both the Pre and Post GST times. It had to deal with multiple taxes and compliance under previous indirect tax regime. So let’s try to understand how X Ltd paid taxes under the indirect tax system prior to GST.
X Ltd sold cars to a car dealer in Maharashtra in one of the transactions under previous indirect tax system. Following are the taxes levied by Centre and State Government under the previous indirect tax system:
- The Central Government levied Central Excise Duty on the manufacture of cars
- State government of Maharashtra levied VAT/CST on the sale of bicycles
- Again, the State Government of Maharashtra levied Octroi on the entry of goods into a particular state
X Ltd Sold Cars to a Car Dealer
The first stage in the supply chain is the one when X Ltd sells the cars to a dealer in Maharashtra. Following are the details of such a sale:
- Cost of each car = Rs. 5,00,000
- Excise Duty @ 10% = Rs. 50,000
- VAT @ 12% = Rs. 66,000
- Dealer Invoice = Rs. 6,16,000
Now, the car dealer paid both the excise duty and VAT to X Ltd. Then, X Ltd deposited the excise duty with the Central Government and VAT with the Maharashtra Government.
Car Dealer Sells to End Consumer
The second stage in the supply chain is the one where the car dealer sells the cars to the end consumer. Following are the details of such a sale:
- Cost of car of the car dealer = Rs. 5,50,000 (Cost of the Car + Excise Duty)
- Dealer’s Margin @ 10% = Rs. 55,000
- VAT @ 12% = Rs. 72,000 [5,50,000 + 55,000] * 12%
- Invoice = Rs. 6,77,600
Now, when the car dealer sells the car to the end consumer, he takes cost of car plus excise duty as the total cost of the car. He then adds his dealer margin to the total cost to reach at the sales price. And finally on this sales price, he charges value added tax, to work out the invoice price for the end consumer.
This was the scenario under previous indirect tax regime. If you look carefully, the car dealer takes Rs. 5,00,000 (cost) plus Rs 50,000 (excise) as his total cost, to which he adds his dealer’s margin to get the sales price of Rs. 6,05,000. A VAT amount of Rs 72,600 is further added to this sales price, leading the end consumer to pay tax on tax. [(cost + excise + margin)] * vat%. This is what is called the cascading tax effect. With excise duty included in the cost of the car dealer, to which he adds his margin as well as the VAT amount, the tax on tax effect tends to increase the price of the good under question for the end consumer.
Challenges Under Previous Indirect Tax Regime
Following were challenges faced by the stakeholders in the supply chain under the previous indirect tax regime:
- the car dealer could not take input credit of excise duty paid on purchase of the car
- there was no cross – utilization facility between goods and services. This meant that tax paid on input goods could not be used to set off taxes payable on output services and vice versa.
- Also, car dealer could not use excise duty paid on inputs to set off the VAT payable on output.
As a result, the indirect tax regime meant multiple taxes for manufacturers and dealers in the supply chain and tax on tax for the end consumer.
Now, let’s understand how GST advocates a unified national market and overcomes the cascading tax effect.
Indirect Tax Under GST
Let’s consider the same example and understand the indirect tax under GST.
X Ltd, the Car Manufacturer Sells to the Car Dealer
Now, the first stage in the supply chain under GST regime is the one where the manufacturer sells cars to the car dealer. So following are the details of such a sale:
- Cost of the car Rs. 5,00,000
- Then, Central GST @ 11% = Rs. 55,000
- State GST @ 11% = Rs. 55,000 and
- Dealer Invoice = Rs. 6,10,000.
Now, the car manufacturer charges only GST on the sale of cars to the car dealer. Then, he collects tax from the car dealer and and deposits it with the respective government. Furthermore, the tax amount so collected is divided between Central Goods and Services Tax (CGST) and State Goods and Services Tax (SGST).
Car Dealer To End Consumer
The second stage in the supply chain is the one where the car dealer sells the cars to the end consumer. Following are the details of such a sale:
- Dealer Cost = Rs 5,00,000
- Then, Dealer’s Margin @10% = Rs 50,000
- Sales Price = Rs. 5,50,000
- CGST@11% = Rs. 60,500
- SGST @11% = Rs. 60,500
- Invoice = Rs. 6,71,000
Thus, under GST, the end user is bound to pay Rs.6,71,000 (sales price plus GST) to the car dealer.
So let’s compare previous tax regime with the GST system. As we can see, all the stakeholders in the supply chain suffered under the previous indirect tax regime. However, under GST, only the end consumer bears the burden of tax.
Benefit of GST to the Manufacturer
The manufacturer is not required to collect and charge multiple taxes such as excise duty and VAT.
Benefit of GST to the Dealer
The car dealer paid following Indirect Taxes under the previous indirect tax regime:
- Excise Duty = 50,000
- Then, VAT = 66,000
- Therefore, Total Tax = Rs. 1,16,000
Tax Paid Under GST
- CGST = Rs. 55,000
- Then, SGST = Rs. 55,000
- Therefore, total Tax Payable = Rs 1,10,000
Since input tax credit is available under GST, the input tax can be utilized to offset the tax payable on output.
Therefore, effective GST paid by the dealer to the government will be the difference between GST on Output and GST paid on input.
Thus, Effective GST paid = (60,500 + 60,500) – (55,000 + 55,000) = 1,21,000 – 1,10,000 = Rs. 11,000
Benefit of GST to End User
Price paid under Indirect Tax Structure = Rs. 6,77,600
Price paid under GST = Rs. 6,71,000
Therefore, total price difference = Rs. 6,600