While the jury is still out on the feathers that the three-weeks-old Value Added Tax has collected, the hissing is loud and clear for all to see. There has been an immense amount of heat and dust raised both in the punditocracy and the public at large about the form and shape the new VAT regime has taken.

Why the hissing? Any major tax reform entails its set of gainers and losers through the redistribution of the tax burden. VAT has also got its fair share of both. There are two main types of losers in VAT. There is the trader, and then there are the states.

A prime reason for trader resentment over VAT is the cost of compliance. It is understood that the cost of compliance for VAT has a significant fixed component to it. This fixed component expectedly bites deeper into the economies of smaller traders than the larger ones. A survey conducted in Britain in 1986 (the UK adopted VAT in 1973) found that the compliance cost for the smallest VAT-able businesses (those with turnovers of over 20500 pounds) was 1.94% of turnover whereas the cost for larger businesses (with turnovers in excess of 10 million pounds) was 0.003% of turnover.

Under the new system, all traders with revenues less than Rs 5 lakhs per annum are exempt from VAT. A trader with an annual turnover of Rs 5 lakhs would have a turnover of about Rs 1370 a day. At that threshold, VAT-able traders would include petty shops, small traders and even pan-walahs in large parts of India. At that size of business the cost of compliance in terms of book keeping, maintenance of invoices, etc tends to be significant.

Also by the very design VAT, tends to reduce informal transactions, bringing them into the taxable domain. Thus traders would now have to pay larger amounts as tax (than they used to pay as Sales Tax) or in many case taxes for the first time (given the wide-spread avoidance in the pre-VAT system). Their vehement opposition is partly related to this new 'cost of doing business' for them. Expectedly, in states with a drastic fragmentation of trade and a large numbers of small traders - like Uttar Pradesh - it is a political suicide for the government to implement VAT.

This brings us to the second set of losers - the states. VAT as a system benefits states where most value is added. Since the most value is normally added at the manufacturing stage, states with large manufacturing bases tend to gain more. For e.g. Uttar Pradesh has a 10% sales tax on matches, so if a match box is sold at 50p - the government of UP makes 5p as taxes. Under VAT if a match box costs 30p to make, the state where it is made (and first sold) tends to collect 10% (assuming a VAT of 10%) of 30p where as the state where it is last sold tends to gain only 10% of 20p. So UP where matches are not made tends to lose potentially 3p on each match box.

Add to the fact that UP is a huge state with heavy consumption products of made elsewhere, the potential revenue loss starts hitting it hard. Although the Union government has pledged to make up any loss of revenue on account of VAT, it isn't politically convenient for the Government of UP to rely so heavily on a Union government opposed to it for money.

But why are the pundits hissing?

The short answer is that the pundits have no quarrel with VAT itself, but they're not happy with the particular method and motive behind India's version of the VAT.

The driver of VAT around the world is the non distortionary nature of the tax. The cost added due to the tax at each stage of transaction is proportional to the value added at that stage. Consequently the tax burden is distributed in proportion to the value added at each stage. This prevents distortion of prices between intermediaries. Thus corporate decisions can be based on business efficiencies and not on taxation benefits. This in itself will hugely benefit corporate India, considering the fact that the current business landscape is strewn with examples of companies having to distort their policies to reduce tax burdens.

The second set of VAT benefits comes from the integration of India into one common market and boosting trade within the country. Since VAT would replace all other state levies (like entry tax, luxury tax and sales tax) goods shipment across state lines needn't involve either extra taxation or delays arising out of verification and collection processes. Also since the VAT white paper has set Uniform Floor Rates (into 4 slabs of 0%, 1% for gold and silver, 4% and 12.5%), the race to the bottom amongst states on tax rates would have ended, and a uniform tax regime would be in place across the country.

India has adopted the Tax credit method of VAT collection. Under this system, tax is calculated on the sales invoices and the tax paid in the purchase invoices set off against that. Since to claim credit for tax already paid, an invoice is required, a "trail of invoices" would be generated whitening a series of transactions. This would bring nearly the complete gamut of transactions into the taxable domain and increase tax collections.

Like so many things, VAT in India is not what it is elsewhere. In other countries, VAT is administered by a single authority with uniform rates of taxation. Also the credit against purchase invoices discussed above (known as Input tax credit) is provided to tax paid anywhere in the country. But the system which came into effect in 21 states on April 1 doesn't have the pre-requisites for a good VAT system. In unilateral violation of the white paper some states (like Delhi) have created an 8% slab. Consequently goods across India would be differentially taxed. Also, the states aren't obligated to do away with other distortionary taxes (like entry and luxury taxes). This makes VAT just another levy, amongst numerous others and not a new taxation system.

The Central Sales Tax, by which taxes are paid to the state of origin of goods, will co-exist for the time being with VAT, which is a destination tax. This could subject each transaction to double taxation - by the state of origin as well as the state where the goods are sold.And even worse. tax paid on purchases made in a state cannot be set off against taxes due in another. With these contradictions, the VAT in India is not designed to produce a common market and boost corporate efficiency. Instead, with the pre-requisites for economic benefits absent, VAT in its present form is all about the Tax Credit method of collection and the "trail of invoices" so generated. It is an anti-evasion mechanism more than an attempt to modernize taxation. And that is why the pundits are hissing.

Is VAT doomed?

Amongst 120-or-so countries that have adopted VAT, very few have federal structures to match India's. In fact, VAT has not really taken off in any big federal country in the world. The USA doesn't have VAT (it has a complicated system of sales and use taxes). Canada has VAT but then it is worse than what India has. They have federal VAT and a provincial VAT. The Central government operates the federal VAT in all states except Quebec (which runs it own provincial and federal VAT). The states run the provincial VAT except in the smaller ones like New Foundland and Nova Scotia (where the federal government runs it). And in some states like Winnipeg there is not VAT at all. Elections have been won there on the issue of VAT removal.

Brazil, the other big federal state, also has VAT administered at three levels - federal, state and municipality. The Brazilian system is immensely complicated. Here again tax credit is specific to the authority it has been paid to, but systems have evolved to accommodate the poor states. Take an example of the poor Northeastern state of Sierra and bigger richer state of Sao Paolo. When exports happen from a rich state to a poor state, the exporter pays a lower tax to the rich state while the poor state collect the higher tax. But this has led to the industrialists in Sierra complain that since Sao Paolo will always be a cheaper state to buy in and thus no industries will ever get set up in Sierra. Also the 'origin state-destination state' conundrum hasn't been resolved there. And now Brazil is also considering unifying their three tier VAT system. This after 40 years of VAT and the complete lack of the democratic humbug that characterizes India (Brazil adopted VAT in 1965 after the military took over and dictated the tax reforms)!

However, one mustn't forget that India herself has a very successful implementation of VAT in place - the CENVAT. Although it took 20 years, the example of this success provides some hope that the VAT wrinkles will be ironed out. Perhaps one should reconcile to the fact that like in all aspects of the economy, India is doomed to be the big, bulky and slow elephant in tax reform as well. But if the current, even if somewhat limited, spirit of "Co-operative Federalism" were to prevail in this key economic arena, India would surely be better off for that.