VAT works on the principle that when raw material passes through various manufacturing stages and manufactured product passes through various distribution stages, tax should be levied on the Value Added' at each stage and not on the gross sales price. This ensures that same commodity does not get taxed again and again and there is no cascading effect. In simple terms, value added' means difference between selling price and purchase price. VAT avoids cascading effect of a tax. Basically, VAT is multi-point tax, with provision for granting set off (credit) of the tax paid at the earlier stage. Thus, tax burden is passed on when goods are sold. This process continues till goods are finally consumed. Hence, VAT is termed as consumption type' tax. VAT works on the principle of tax credit system'. 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. This product then goes to distributor/wholesaler, who sells it to retailer and then it reaches the ultimate consumer. If a tax is based on selling price of a product, the tax burden goes on increasing as raw material and final product passes from one stage to other. For example, let us assume that tax on a product is 10% of selling price. Manufacturer A' supplies his output to B' at Rs. 100. Thus, B' gets the material at Rs. 110, inclusive of tax @ 10%. He carries out further processing and sells his output to C' at Rs. 150. While calculating his cost, B' has considered his purchase cost of materials as Rs. 110 and added Rs. 40 as his conversion charges. While selling product to C, B will charge tax again @ 10%. Thus C will get the item at Rs. 165 (150+10% tax). As stages of production and/or sales continue, each subsequent purchaser has to pay tax again and again on the material which has already suffered tax. This is called cascading effect. Cascading effect of conventional system of taxes
A tax purely based on selling price of a product has cascading effect, which has the following disadvantages (a) Computation of exact tax content difficult
(b) Varying Tax Burden as tax burden depends on number of stages through which a product passes (c) Discourages Ancillarisation
(d) Increases cost of production
(e) Concessions on basis of use is not possible
(f) Exports cannot be made tax free.
VAT was developed to avoid cascading effect of taxes. In the aforesaid example, value added' by B is only Rs. 40 (150110), tax on which would have been only Rs. 4, while the tax paid was Rs. 15. In VAT, the idea is that B will pay tax on only Rs 40 i.e. value added by him. Then, it makes no difference whether a product passes through 5 or 10 stages or even 100 stages, as every person will pay tax only on value added' by him to the product and not on total selling price. VAT removes these defects by tax credit system. Under this system, credit is given at each stage of tax paid at earlier stage. Illustration - In the example we saw above, B' will purchase goods from A' @ Rs. 110, which is inclusive of duty of Rs. 10. Since B' is going to get credit of duty of Rs. 10, he will not consider this amount for his costing. He will charge conversion charges of Rs. 40.00 and sell his goods at Rs. 140. He will charge 10% tax and raise invoice of Rs. 154.00 to C'. (140 plus tax @ 10%). In the Invoice prepared by B', the duty shown will be Rs. 14. However, B' will get credit of Rs. 10 paid on the raw material purchased by him from A'. Thus, effective duty paid by B'...