TAXATION

A tax is a compulsory payment made by a person or a firm to the government without

reference to any benefit, the payer may derive from the government.

Classification of taxes
Taxes can be classified on the basis of form, nature, method and basis of taxation as
follows:

1. On the basis of tax rates

(a) Progressive tax
(b) Proportional tax
(c) Regressive tax
(d) Degressive tax
2. On the basis of imposition
(a) Ad-valorem tax (b) Specific tax
3. On the basis of the possibility of shifting of tax burden
(a) Direct tax
(b) Indirect tax

1. Classification on the basis of tax rates

(a) Progressive tax:- Under such taxation system, tax rate increases with the increase
in income. It is based on the 'ability to pay principle' of taxation. Their real burden is
more on rich and less on poor. It is an effective tool of fiscal policy to reduce inequalities
of income and wealth in a society.
(b) Proportional tax:- In the proportional tax system, tax rate remains constant
irrespective of the leyel of income.
(c) Regressive tax:- In regressive taxation, tax rate decreases with increase in income.
It is reverse of the progressive tax system. Such system of taxation is against the
objective of a welfare state as it tends to accentuate income inequalities. So, it is only a
theoretical concept, it has not been adopted by any country of the world.
(d) Degressive tax:- The degressive tax system is a mixture of proportional as well as
progressive taxation system, so it is also called mild progressive tax. Under this system,
tax rate increases with increase in income upto a limit than becomes constant.
2. Classification on the basis of imposition
(a) Ad-valorem tax:- Under this tax system, tax is imposed on the basis of the value of
the commodity. Such taxes are equitable in incidence as they conform with the 'ability to
pay principle'
(b) Specific Tax:- Such taxes are imposed on the basis of specific attributes or qualities
of commodities like unit, weight, length, size or volume eg. specific excise duty may be
levied on the cloth in the length units.

3. Classification on the possibility of shifting of tax burden

Direct Tax
1. Direct taxes are those taxes in which the impact (levy) and incidence (final burden)
are on the same person i.e. the tax is borne by the person on whom it is levied.
2. Such taxes are imposed on income and wealth of individuals and firms.
3. Such taxes include personal income tax, corporate tax, wealth tax, gift tax etc.
4. Payment of such taxes is compulsory and can not be escaped.

1
5. Direct taxes are generally progressive i.e. they tends to reduce economic
inequalities.
Indirect Tax
1. Indirect Taxes are those taxes in which impact and incidence of the taxes is on
different people i.e. tax burden can be shifted to others.
2. Such taxes are imposed on production and distribution of commodities (i.e. goods
and services).
3. Such taxes include excise tax, custom duties, service tax, VAT, sales tax,
entertainment tax etc.
4. Payment of such taxes can be avoided by refraining from entering into the particular
transaction that leads to the tax being levied.
5. Indirect taxes are generally regarded as regressive because they fall on all persons
indiscriminately irrespective of their ability to pay.

Surcharge:- It is a tax on tax.

Cess:- It is a temporary tax which is levied for a specific purpose eg. education cess,
Securities transactions tax:- It is levied on the value to stock market transactions.

DIRECT TAXES
(1) Personal Income Tax (PIT) : It is levied on the incomes of individuals and
unregistered firms.
(2) Corporate Income Tax (CIT):- It is levied on the incomes of joint stock companies
and registered firms.
(3) Wealth tax:- It is imposed on accumulated wealth or property of every individual,
Hindu undivided family and closely held companies.
(4) Estate Duty:- It is imposed on the property of a deceased person which is inherited
by his heirs.
(5) Gift tax:- It is imposed on the donor of the gift.
(6) Expenditure tax:- It was imposed in 1987 on expenditure incurred in hotels where the
room charges for a residential accommodation were Rs 400 or more per day per person.
(7) Interest Tax:- It is levied on the gross interest income of financial institutions.

INDIRECT TAXES
(1) Customs Duty:- It is imposed on commodities imported into a country (import duties)
or those exported from a country (export duties).
(2) Sales Tax:- It is imposed on business transactions i.e. sale and purchase of
commodities.
(3) Service Tax:- Service tax was introduced in 1994-95 by virtue of Entry 97 of the
Union List in the VIIth Schedule of the constitution. It was levied on three services (a)
stock-brokers (b) general insurance and (c) telephone services.
(4) Excise Tax:- It is imposed on the commodities which are produced within the
country.

(a) Modified Value Added Tax (MODVAT):-It was introduced in 1986 on the
recommendation of Mr. L.K. Jha Committee. It was also called as Manufacturing Value
Added Tax (MANVAT) because it was imposed only at the manufacturing state. Under
MODVAT, a producer has to pay tax on the value of final output but the excise duty paid
on inputs in earlier stages of production is reimbursed back to the producer on the
presentation of sales invoices.

2
 There were two major advantages of MODVAT. First, reduction of tax evasion if
tax has been evaded on any stage of production then the producers of the latter stages
could not avail MODVAT credit. So, the missed tax could be recaptured. Second,
elimination of cascading effect of taxation i.e., no input is taxed more than once.
However, the implementation of MODVAT resulted in a large number of
classification disputes between tax payers and the authorities on the issue of
reimbursement due to multiple rates of excise duties on inputs. In order to put an end to
these disputes and further rationalize the tax structure, the system of central excise was
drastically once hauled with the introduction of CENVAT.
(b) Central Value Added Tax (CENVAT):- It was introduced in the Budget 2000-01 in
the form of revamped MODVAT. It had all the features of MODVAT, for only exception of
uniform tax rate of 16% and its coverage was extended to include capital goods. It was a
step towards VAT. Beside all the advantage of MODVAT, it reduced classification
disputes significantly. It also enhanced the certainty of tax liability to the producer as well
as certainty of tax revenue for the exchequer.
The introduction of MODVAT in 1986 and its subsequent restructuring into
CENVAT in 2000 were aimed at applying the VAT method in manufacturing, to replace
the central excise. Recently the union government has facilitated the implementation of
state-level VAT by the state governments to replace the sales tax regime. It is envisaged
that in the time to come, the CENVAT and state-level VAT will be restructured into (full-
fledged) VAT, which will replace all the domestic indirect taxes.

Value Added Tax (VAT)

A full-fledged VAT is an ad-valorem tax on domestic final consumption, levied and
collected at all stages between production and the point of final sale. It covers both
manufacturing as well as distribution stages and does away with the multiplicity of
domestic indirect taxes like sales tax, excise duty, wholesale tax, turnover tax etc. At
each stage, the tax is confined to value addition which is the market value of sales minus
purchases i.e. the value of output minus inputs.
Advantages of VAT
• Easy to administer because tax liability of a firm can be assessed by using the credit
method. Cross checking of returns submitted by firms can be made as well.
• Cascading effect of costs is avoided because no longer an input gets taxed twice or
more.
• It promotes efficiency because taxes are paid on value added (not on its profits,
turnovers etc).
Resource allocation is not distorted because VAT promotes neutrality in terms of the
form of production.
• Easy to separate the tax from the cost of production, hence used for promoting
exports (because taxes can be refunded to exporters).
• Greater flexibility towards applying multiple VAT rates (including zero) can be taken
up for achieving different policy objectives.
Disadvantages of VAT
• VAT is complicated system, hence it needs an honest and efficient government
machinery along with sound financial and economic infrastructure at macro and micro
levels.
• States may realize smaller tax revenues (until the VAT rates are very high).
• Small firms find book-keeping uneconomical.
• Multiple rates further lead to the development of vested interests that put pressure for
exemptions and concessions.
Prerequisites for VAT implementation

3
Before the implementation of VAT, the governments should ensure adequate economic,
financial and technical infrastructure. It should meet the following conditions:
1. Enactment of VAT legislation and framing of rules and regulations.
2. Computerisation of dealers falling within the ambit of VAT.
3. Training of tax officials, traders and consumer associations.
4. Publicity for consumers.
5. Assigning VAT identification number to tax payers.
6. Implementing transitional measures for introduction of VAT.

State-level VAT
State level VAT is not a full-fledged VAT as it will be applicable only at the
distribution stage. It will replace sales tax and other local taxes under the purview of
state governments like entry tax, turnover tax, surcharge, special additional taxes etc. It
will not provide set-off against the taxes paid in other states and the central sales tax
(CST) which is envisaged to be phased out by the year 2010.
The State level VAT falls under the purview of the state governments vide entry
54 of the state list of the constitution. The decision to introduce VAT arrived at during the
Conference of Chief Ministers of States held in 1999. The central government in 2000
constituted an Empowered Committee of State Finance Ministers under the
chairmanship of Dr. Asimdas Gupta. was also constituted in July 2000 to monitor the
process of introduction of VAT. At the meeting of the Empowered Committe held in June
2004, it was agreed to implement State level VAT from April 1, 2005.
The proposed VAT is multi-point destination based system of taxation, with tax being
levied on value addition at each stage of transaction in the production distribution chain.
Some other salient features of VAT are:
(a) Uniform schedule of rates of VAT for all States. This would make the tax system
simple and uniform and prevent unhealthy tax competition among States.
(b) The provision of input tax credit would help in preventing cascading effect of tax.
(c) The provision of self-assessment by dealers would reduce harassment.
(d) Introduction of VAT would help avoid cascading nature of sales tax.
(e) Present multiple rates and taxes can converge into a few rates and a single VAT.
(f) Transparency in the system of tax administration through simple self-
assessments and departmental audit.
(g) Rationalisation of taxes to result in lower tax burden and higher tax revenues.
(h) To avoid tax competition, the design of State VAT needs to be harmonized even as
the distinctive needs of individual States are recognized.
Since sales tax/VAT is basically a State subject, the Central Government is
playing the role of a facilitator for successful implementation of this significant reform
measure. One of the concerns expressed by States in adopting VAT relates to the
possible loss of revenue in the initial years. To allay the apprehensions of States and to
provide a measure of comfort, the Central Government agreed to compensate the
estimated loss on the basis of an agreed formula, on account of the introduction of VAT,
to the extent of 100 per cent of the loss in the first year, 75 per cent of the loss in the
second year and 50 per cent of the loss in the third year of introduction of VAT.
The Empowered Committee released a White paper on State-level VAT on January 17,
2005.

White paper on State-level VAT

 State VAT to have two basic rates of 4 per cent and 12.5 per cent and to cover
550 commodities. About 270 commodities will be under 4 per cent rate.

4
  46 items, comprising of natural and unprocessed products in unorganized sector,
legally barred from taxation and items having social implications, are
exempt from VAT.
 Gold and silver ornaments subject to a special VAT rate of 1 per cent and other
commodities to attract a general VAT rate of 12.5 per cent.
 Small traders with turnover up to Rs.5 lakhs would be exempt from the,
provisions of VAT.
 There is a composition scheme for traders having turnover between 5 to 50 lakh.
Such traders are required to pay 1 per cent composition tax and need not pay
VAT or file returns. However, they can not claim set-offs on previous sale.
 The zero rating of exports would increase the competitiveness of Indian exports.

VAT has been successfully introduced by all the States. The introduction of VAT
by States resulted in good growth in State's own tax revenue in the last few years.
During 2008-09, growth in tax revenue in 33 VAT States/UTs was 14.4 percent in the
revenue from VAT items. Under the specific scheme evolved for the purposes to
facilitate introduction of VAT, the Central Government compensated the revenue losses
at the rate of 100 percent of revenue loss during 2005-06, 75 percent during 2006-07
and 50 percent during 2007-08.
Goods and Services Tax (GST)
In the Budget for 2007-08, an announcement was made to the effect that GST would be
introduced from April 1, 2010, and that the Empowered Committee of State Finance
Ministers would work with the Central Government to prepare a road map for
introduction of GST. The Empowered Committee of State Finance Ministers prepared a
report on a model and road map for GST. The comments of Government of India on the
proposed design of GST have been sent to the Empowered Committee of State Finance
Ministers in January 2010. A joint group of officers has been constituted to prepare draft
Constitutional bill, CGST legislation, model SGST legislation and rules required to
introduce GST.
First Discussion Paper on GST in India
Some of the key features of the proposed model as proposed by the Discussion Paper
are as follows:
 The GST is to have two components-Central GST and State GST—with separate
rates, reflecting revenue considerations and acceptability. This dual GST model
would be implemented through multiple statutes (one for the CGST and an SGST
statute for every State).
 The Central GST and the State GST would apply to all transactions of goods and
services (with some specified exceptions).
 The Central GST and State GST are to be paid to the accounts of the Centre and
the States separately.
 Cross-utilization of input tax credit (ITC) between the Central GST and the State
GST not to be allowed except in the case of inter-State supply of goods and
services under the Inter-State Goods and Service Tax (IGST) model.
 Uniform State GST threshold of gross annual turnover of Rs10 lakh both for
goods and services for all the States and Union Territories to be be adopted with

5
 adequate compensation for States (particularly northeastern region States and
special category States) where lower threshold had prevailed in the VAT regime.
 Each taxpayer to be allotted a PAN-linked taxpayer identification number with a
total of 13/15 digits.
The proposed GST, as per the Discussion Paper, subsumes the following
taxes/duties of the Centre: central excise; additional excise duties; service tax; additional
and special additional customs duties; surcharges and cesses. The following State taxes
and levies would also be subsumed under the GST: VAT / sales tax; entertainment tax
(unless it is levied by local bodies); luxury tax; taxes on lottery, betting and gambling;
State cesses and surcharges in so far as they relate to supply of goods and services;
entry tax not in lieu of octroi.
GST Rate Structure
A two-rate structure –a lower rate for necessary items and goods of basic importance
and a standard rate for goods in general—proposed with a special rate for precious
metals and a list of exempted items. Exports would be zero-rated. The GST will be
levied on imports with necessary Constitutional Amendments
CENTRAL SALES TAX REFORMS
Central Government in consultation with the Empowered Committee of State Finance
Ministers chalked out the roadmap for phasing out Central Sales Tax (CST) to coincide
with the introduction of the proposed GST, which included the critical component of
compensating the States for the resultant revenue losses. The scheme finalized in
consultation with the Empowered Committee of States provides for new revenue
generating measures for States as the primary source of compensation.
Direct Taxes Code
The Budget for 2009-10 underscored the importance of continuing the process of
structural change in Direct Taxes and promised a comprehensive code to this effect. A
Discussion Paper (DP) along with a draft Direct Taxes Code was put in the public
domain on August 12, 2009. The Code seeks to consolidate and amend the law relating
to all direct taxes, that is income-tax, dividend distribution tax and wealth tax so as to
establish an economically efficient, effective and equitable direct tax system which will
facilitate voluntary compliance and help increase the tax-GDP ratio. All the direct taxes
have been brought under a single code and compliance procedures unified, which will
eventually pave the way for a single unified taxpayer reporting system. The need for the
Code arose from concerns about the complex structure of the Income Tax Act,
numerous amendments making it incomprehensible to the average tax payer and
frequent policy changes due to the changing economic environment. The DP states that
marginal tax rates have been steadily lowered and the rate structure rationalized to
reflect best international practices and any further rationalization of the tax rates may not
be feasible without corresponding increase in the tax base to enhance revenue
productivity of the tax system and improve its horizontal equity.
A threefold strategy for broadening the base has been articulated in the Code.
The first element of the strategy is to minimize exemptions that have eroded the tax
base. The removal of these exemptions would result in a higher tax-GDP ratio; enhance
GDP growth; improve equity (both horizontal and vertical); reduce compliance costs;
lower administrative burdens; and discourage corruption. The second element of the
strategy seeks to address the problem of ambiguity in the law which facilitates tax

6
avoidance. The third element of the strategy relates to checking of erosion of the tax
base through tax evasion.
Some key features
 The Discussion paper discusses the principles of residence-based taxation of
income and source-based taxation of income in terms of international best
practices that are mixes of the two. Under the Code, residence-based taxation is
applied to residents and source-based to non-residents. A resident of India will
be liable to tax in India on his world-wide income. However, a non-resident will be
liable to tax in India only in respect of accruals and receipts in India (including
deemed accruals and receipts).
 The draft Code simplifies the dualistic concepts of “previous year” and
“assessment year” used in the Act and replaces them with the unified concept of
“financial year” and decrees that all rights and obligations of the taxpayer and the
tax administration will be made with reference to the “financial year”.
 The DP argues for special treatment of capital gains under an income tax regime
for two reasons. Firstly, taxing gains each year, as they accrue, would strain the
finances of an individual who is yet to receive these gains in hand. Second, the
capital gain realized when a capital asset is sold is usually the accumulated
appreciation in the value of the asset over a number of years. The “bunching” of
such appreciation in the year in which the asset is sold pushes the seller into a
higher marginal tax bracket, if the value of the asset is sufficiently high. As such,
if no special treatment is accorded to capital gains, a progressive income tax
would discriminate against those whose income from capital assets is in the form
of capital gains as compared to those whose income is derived from interest or
dividends. The Code also seeks to eliminate the present distinction between
short-term investment asset and long-term investment asset on the basis of the
length of holding period of the asset.
 On tax incentives, the DP argues that they are inefficient, distorting, inequitous,
impose greater compliance burden on the taxpayer and on the administration,
result in loss of revenue, create special interest groups, add to the complexity of
the tax laws, and encourage tax avoidance and rent-seeking behaviour. Based
on a comprehensive review, the Code proposes that profit linked tax deductions
will be replaced by investment linked deductions in areas of positive externality.
 The draft Code argues against area-based exemption through allusion to
economic distortion, that is allocate/ divert resources to areas where there is no
comparative advantage. Such exemptions also lead to tax evasion and
avoidance. It proposes that area-based exemptions that are available under the
Income Tax Act 1961 will be grandfathered.
The draft Code proposes to rationalise the tax incentives for savings through the
introduction of the ‘Exempt- Exempt-Taxation’ (EET) method of taxation of savings.
Under this method, the contributions are exempt from tax (this represents the first ‘E’
under the EET method), the accumulations/accretions are exempt (free from any tax
incidence) till such time as they remain invested (this represents the second ‘E’) and all
withdrawals at any time would be subject to tax at the applicable personal marginal rate
of tax (this represents the ‘T’ under the EET method).