Well before the April 8 meeting of the empowered committee of state finance ministers decided to postpone the implementation of Value-Added Tax in the country by three months to June 1, informed observers could read the writing on the wall.

It was evident that most state governments were just not prepared to make a smooth transition to the new VAT regime.

Vested interests

Vested interests among politicians, bureaucrats and traders were hell-bent on resisting the VAT system -- a move that would drastically reduce the scope of evading taxes. Nor were corporate bodies ready to play ball.

On March 17, a team of researchers at UTI Securities -- affiliated to the Unit Trust of India, the country's largest mutual funds organisation -- led by Sandeep Neema observed that "…our discussions with corporates, traders (and) agents indicate that implementation of VAT on a national level may be difficult from April 1, 2003."

Sure enough, the deadline was postponed -- and may well have to be pushed back yet again -- as protesting traders marched on the streets of various cities and politicians expressed fears that the monster of inflation would rear its ugly head before elections.

VAT impact unknown

However, it was not merely traders and politicians who expressed apprehensions about the destabilizing impact of a rapid movement to VAT.

Corporate representatives too were uncertain about what the new tax system would hold in store for them.

As the UTI Securities report stated right up front: "In the short run, corporates will see an increase in their costs and the effect of VAT will vary for different industries. At the state level, we expect VAT to result in redistribution of revenues (among) different states."

While stating that the movement to VAT would be 'one of the most important structural reform' measures that would bring India's tax regime to international levels, what would happen in the near future would not be 'introduction of VAT per se, but a reorientation of the current sales tax structure towards the introduction of VAT.'

The report added that over the longer term when VAT becomes a single-point levy, it would bring about a simplified tax structure that would benefit corporates and reduce costs.

State governments too would gain in the long run as their tax net would widen and, with greater compliance, VAT should result in neutralizing the effect of reduction in revenues for some states.

Regional inequality to grow?

A representative of a large corporate body, speaking to this columnist on condition of anonymity, said the new VAT regime had the potential of widening regional inequalities.

"By hurting certain states more than others, the proposed new VAT system could result in greater social tensions in the country as well as strained relations between the Centre and the states," this person claimed, adding that the transition to VAT would have to be carefully calibrated.

Since VAT will bring the entire distribution chain -- including all categories of wholesalers, retailers and other intermediaries -- into the tax net, sectors with relatively long distribution channels would witness a rise in overall costs.

Such sectors would include most fast moving consumer goods, pharmaceutical products, certain consumer durables and cement.

The UTI Securities report points out that these are some sectors where distribution costs vary between 10 per cent and 20 per cent of gross sales prices.

Depending on logistics and the length of the distribution chain, the rise in costs in the case of these products would range between 2 per cent and 10 per cent, it said.

In many industry segments, the higher costs would be passed on to consumers resulting in higher retail prices.

In the more competitive segments, the higher costs would have to be absorbed by the companies or their distributors thereby squeezing their profit margins.

Prices may rise in short term

Thus, prices would rise in the short run even if the new tax system would, in the long term, eventually bring down costs along the entire production and distribution chain once VAT becomes a single point levy.

The report also said that VAT would have a profound impact on the distribution and sourcing logistics of many companies.

In its current form, VAT encourages local sourcing and local selling.

For example, in an effort to reduce the tax burden, in certain cases companies could do away with central warehousing or cargo forwarding agents and would instead seek to provide supplies directly to its wholesalers or dealers.

On the sourcing side, the UTI Securities report says vendors such as large manufacturers of automobile ancillaries would 'be affected by change in sourcing strategy of companies to manage VAT tax-credits.'

In an ideal situation, VAT should lead to a unified market in which tax paid in one part of the country should be given credit when tax is being charged on the same product or the final product using inputs on which tax has been paid.

"VAT can only be productive if it allows credits for all tax paid and there is no double levy by different states," the corporate source quoted earlier explains.

He adds that in this country, states will not offer credit for VAT paid in other states. This means that if a company sources inputs from other states, it would have to pay VAT in the 'exporting' state but will not get any credit in the 'importing' state.

At present, since inter-state transactions entail a 4 per cent levy of central sales tax -- that is, if a manufacturer in Maharashtra sells in Karnataka, the concerned company only pays 4 per cent to Maharashtra but does not pay tax in Karnataka -- a higher VAT at 12.5 per cent will naturally result in higher inputs costs.

The consequence would be that manufacturers would gain only if they have ancillaries or input suppliers within the same state.

Small units will be hardest hit

In other words, under such circumstances, the economies of scale for input suppliers could diminish greatly or disappear altogether thereby rendering certain large ancillary units unviable.

The corporate source says such a scenario would prevail for large FMCG enterprises and pharmaceutical companies that have traditionally sold a large portion of their output outside the specific state of manufacture.

He thinks that retail prices in states where the products are consumed could go up by as much as 5 per cent due to this reason alone.

The net result would be that companies producing regional brands, which source inputs from the one state, manufacture in same state and sell predominantly in the same state would gain in comparison to large national brands.

Furthermore, VAT would tax the distribution margin for the first time leading to an additional tax component in the final product.

FMCG and pharmaceutical companies have a high component as trade margins -- between 30 per cent and 40 per cent -- due to their multi-tiered distribution systems.

Currently, if a manufacturing company sells a product at Rs 100, the distributor pays 4 per cent central sales tax -- CST (if it is not in the manufacturing state) or the state tax if it is within the state of manufacture. But there is no further tax payable by the retail chain (since sales tax is only levied at the first point of sale).

Under VAT, however, the retail chain will have to pay a VAT of 12.5 per cent on the Rs 40 margin paid in the trade (approximately Rs 5). So under VAT, a product which sells at Rs 140 to the customer under the current sales tax regime would now be available for Rs 155, or thereabouts, because of the relatively high incidence of tax paid.

According to the corporate source, this is the most important reason why the traders are up in arms across the country.

He points out that companies that manufacture products with a high 'brand value' as a part of the price compared to other commodity industries would lose out due to the higher VAT rate.

Since the decrease in input tax due to VAT (provided, of course, that all inputs are procured from the same state and hence are VATable) would not be to the extent of the increase in VAT payable on the final product including trade margins, products with high 'brand value' would stand to lose out to generic products.

Another issue pertains to companies in sales tax exemption zones. Such companies would now have to pay VAT on their inputs on which credit cannot be claimed.

On the other hand, such firms will have to charge sales tax and pay it to the concerned state government, albeit with a deferral period of seven years to make the transition process smooth.

Manufacturing units in sales tax exemption zones currently do not pay tax both on the purchase side as well as on the sales side. Manufacturers of four-wheeled automobiles in such zones are likely to be hit quite hard.

At the same time, the gainers would be companies manufacturing state-specific brands and commodity-based industries like steel as well as players in highly taxed states like Maharashtra (Telco, Bajaj Auto) who will now find the VAT rate lower.

The UTI Securities report has listed the following companies among those that would be affected by a short-term rise in costs: Hindustan Lever, ITC, Nestle, Pfizer, Glaxo, Videocon, LG, Ford and Hyundai.

The report is of the view that these companies would 'to the extent possible' pass on the higher costs to consumers by raising product prices.

Companies that would gain from higher tax credits and a lower incidence of taxes (below what they are currently paying) would include Bajaj Auto, Telco, Mahindra & Mahindra and Hindustan Petroleum.

Uniformity in tax regime a must

As a report prepared by the International Monetary Fund has pointed, VAT has been successful in smaller and more unified countries as only one tax is levied.

Unlike India, such nations do not have a wide variety of federal and local taxes such as excise tax, octroi, entry tax, luxury tax, professional tax, market tax and so on.

If VAT coexists with all these taxes, there would be a cascading 'tax on tax' effect and the very purpose of imposing VAT would be completely negated if not drastically diluted.

VAT can only be successful if all the states adopt uniform laws instead of individual Acts that treat different product categories differently.

Also there is no central government guarantee that states will adhere to a single VAT rate.

If there were no uniformity in the tax regimes, there would be 'cross border' inter-state smuggling from lesser-taxed states to the relatively higher taxed ones.

As the UTI Securities report has warned, states with a higher revenue neutral rate (RNR) than VAT would lose revenues in the short run to states with a lower RNR.

States with a relatively high RNR are Maharashtra and Tamil Nadu, while the ones with a low RNR are Haryana and Delhi.

Companies and consumers in the first category of states would lose, while those in the second category would gain in terms of incidence of tax.

It would take a while before the entire economic system starts generating higher taxes thereby increasing the sum total of the revenues earned by all states.

Why are so many states reluctant to implement VAT?

States (like Maharashtra) that have high tax rates fear they would lose revenue if they implement VAT at the suggested rate of 12.5 per cent.

At the same time, states with low tax rates (like Delhi) apprehend that VAT would raise prices thereby antagonizing consumers and reducing the popularity of incumbent governments.

States with sales tax exemption zones (such as Gujarat, Tamil Nadu and the states in north-east India) fear loss of investments and widespread litigation on account of the imposition of VAT.

Corporates need to change strategy

It is clear that a lot of groundwork remains incomplete before VAT can be smoothly implemented.

The new tax regime would affect more than 30 million small and large manufacturers, ancillaries and retailers.

The sales tax departments of various state governments would have to be beefed up (and modern computer systems installed) before they are able to cope with the administration of the new tax regime.

Managements of companies would have to change their strategies for sourcing raw materials and inputs as well as their strategies for distribution and pricing.

One informal estimate of the VAT compliance costs for corporate India is in excess of Rs 500 crore (Rs 5 billion).

The uncertainties over the implementation of VAT and the eleventh hour postponement of its imposition have created a different set of problems.

The inventories of many companies were affected since distributors abstained from stocking in anticipation of VAT being imposed.

Such companies include those producing FMCGs, pharmaceuticals, tyres, steel and consumer durables.

The biggest hit has reportedly been taken by the pharmaceutical industry, as traders are unwilling to stock up.

The average inventory levels are expected to stay lower than usual till outstanding issues related to VAT are resolved.

(The author is Director, School of Convergence @ International Management Institute, New Delhi and a journalist with over 25 years of experience in various media -- print, Internet, radio and television.)