Annex 3C: Background on Indian Tax Reform

The various states of India adopted value added taxation between 2003 and 2014. Both direct taxes and indirect taxes are levied in India. Except for taxes associated with professions and property taxes, direct taxes are collected by the central government. Indirect taxes are levied by the central government and state governments. The service tax, customs duties, and union excise duties, including taxes on manufacturing products, are the prerogative of the federal government. The only indirect tax at the state level is the VAT, which accounts for more than half of all state tax revenue.

Prior to the adoption of VAT, the main source of tax revenue among states was the sales tax. This explains the reluctance of states to undertake tax reform despite the frequent commentary on the flaws of the tax system. The sales tax in Indian states was typically a cascading tax even under the two general rules that were aimed at distinguishing between intermediate and final consumption. According to the physical ingredient rule, an input is a material or component that is physically incorporated in goods intended to be sold. According to the direct use rule, items used directly in the production of goods are exempt from the sales taxes. However, these rules were not easy to apply, and they did not guarantee that business inputs would not be taxed.

The tax treatment of inputs is heterogeneous across the states and union territories of India. Raw materials are tax exempt in only a few states and union territories (such as Delhi and Gujarat); however, because of the widespread adoption of the physical ingredient rule in these states, fuel, tools, machinery, and equipment are also not considered inputs. NIPFP (1994) and Ring (1999) estimate that 30 percent to 40 percent of sales tax revenue is collected through intermediate inputs.

The VAT reform has been accompanied by other policies, such as a change in the tax rate, lower registration costs, and a change in the registration threshold (figures 3C.1 and 3C.2). In most Indian states and union territories, the VAT rates after the reform were higher than the sales tax rates before the reform. The threshold of VAT registration was also higher than the sales tax registrations, which suggests that there is greater tolerance of informality under the VAT regime.

West Bengal is a large state with 90 million inhabitants in East India. The total GDP in West Bengal was US$210 billion in 2019–20, which represents 7 percent of the national GDP. West Bengal implemented a VAT with a tax regime border on June 1, 2003 (rediff. com 2003). All firms with a turnover of more than 500,000 INR (threshold) are required to remit tax to the state. Firms with a turnover of less than Rs 5 million (border) can opt to remit the tax under a simplified tax scheme whereby they only pay a 0.025 percent tax on their total sales. However, firms in the simplified scheme cannot deduct from their tax liabilities the taxes paid by their suppliers.