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The Myth Of Indirect Taxes

The Delhi Government recently withdrew the subsidy on LPG, and increased the Value-Added tax on many items. Rs 40 subsidy on LPG cylinders was withdrawn.  VAT was raised from 12.5% to 20%. It was estimated that the price of diesel will rise from Rs32.92 per litre to Rs35.29 per litre. A tax of 5% was imposed on CNG. An increase in VAT was proposed on various household utensils, beverages and fertilizers. An additional revenue generation of Rs.850 crore was expected. The VAT on all mobiles, mobile accessories and aerated drinks were raised from 5% to 12.5 %. The opposition pressure forced the Delhi government to withdraw the 4% VAT on cooking gas. The 5 % VAT on Compressed Natural Gas (CNG) was also withdrawn.

In nearly all the discussions on the subject, it was said that the customers will have to bear the burden of the tax. The same was said of Goods and services tax (GST). (The Indian Government will introduce common goods and services tax (GST) next year.) S Madhavan wrote in Mint, that “From a philosophical standpoint, such an ideal GST would tax all consumption, whether of goods or of services, at a single moderate rate and would also ensure that such a tax is only borne by the ultimate consumer and that there are no input taxes which are either intentionally or otherwise borne by any of the economic entities operating at all intermediate stages of economic activity prior to such final consumption.” Harish Bhat, in the same publication, went to the extent of saying that “Consumers will obtain better quality [When GST is imposed]. As much as—or more than—it will help government coffers or companies, GST is going to benefit the ordinary consumer in every part of the country.”

There is a tissue of fallacies involved in all these view points. Firstly, the so called “indirect taxes” doesn’t penalize consumption and consumption alone. The income of original factors too is reduced. It is a myth that sales taxation taxes consumption but not savings-investment. Just like an income tax hampers savings-investment, a tax on consumption would do the same. Second, there is nothing sacrosanct about savings. A person might prefer present consumption over savings in accordance with his time preference. As some economists have pointed out, those who value savings over consumption should demand more Government intervention in the economy to serve that purpose.

It should also be obvious that taxes can’t be shifted forwards to customers, though many economists would state otherwise. Many of them naively believe that it is the ultimate consumer who pays the taxes. This is far from the truth. What lies beneath this belief is the notion that prices are determined by cost of production. This tenet held by classical economists was refuted long time ago. The exact opposite is true. The cost of production is determined by the price of a particular good. The price of a good is determined by the demand schedule for and supply of it. When Government imposes tax, there won’t be an immediate effect on any of these factors.

It is usually assumed that if the Government introduces a VAT of 12.5%, businessmen would raise the price by 12.5%, and in this manner, shift it to customers. But, if that is possible, why didn’t they do it before the introduction of tax? Why should they wait for the Government to impose the tax? For this premise to hold, it should be the case the businessmen deliberately charge the lowest possible price for good. Apparently, that is not the case. Surely, something is missing. One might ask: What if all the producers raise the price at the same time? It is not that easy. If that is the case, why would a union induced raise in wages lead to unemployment, and not inflation? Why can’t businessmen pass this rise in wages to the customers in the form of higher prices?

It should be noted that all this doesn’t mean that taxation won’t have any effect on the price of goods. When taxation reduces the total produce, the prices of goods might rise. But, this is not a shift. Some businessmen would even go out of business. If it was possible to shift forwards with no cost to the producers, this would not have happened. To put it simple, the price rise should be considered an effect of taxation, rather than a shift to the consumer. The tax, however, can be shifted backwards. Lower revenues accrue to wages, rents and original factors of production, which earn less that it’s discounted marginal value productivity.

The fact that tax can only be shifted backwards, has profound implications-The main one being that taxation discourages and hampers production. If taxes could be shifted to the producers, it wouldn’t have had any impact on production. Production, however, doesn’t remain untouched. The consumer would be affected, and his living standard lowered, only to the extent that production is discouraged. This is a crucial point to be noted in the discussion of “indirect” taxes.

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