Indirect taxes before GST and the reform path

Detail

Basic terms first

• Indirect tax: a tax charged on goods and services, not on income. The seller pays it to the government but passes the cost on to the buyer in the price. Examples are excise, customs, service tax, VAT and GST.
• Direct tax: a tax paid by the same person who bears it, such as income tax or corporation tax. It is given here only for contrast.
• Product tax vs production tax (Class 12, National Income Accounting):
• A product tax is charged per unit of output, such as excise duty or sales tax.
• A production tax is paid whether or not anything is produced, such as a stamp duty or a registration fee.
• Excise, VAT and GST are product taxes. In national accounts they separate GDP at market prices from GDP at factor cost.

The pre-GST maze: who taxed what

• Before 2017, the Centre and the states each ran their own separate indirect taxes. The same good was taxed several times, by different governments, at different points.

Level	Tax	What it was / key facts
Centre	Excise duty	Tax on the manufacture of goods, collected when goods leave the factory. MODVAT 1986 → CENVAT 2000 → cross-credit with service tax from 2004
Centre	Service tax	Tax on services. Started in 1994 on the Chelliah Committee's advice. Negative list from 2012
Centre	Customs duty	Tax on goods crossing India's border, mainly imports. Customs Act 1962
Centre (collected by states)	Central Sales Tax (CST)	Origin-based tax on inter-state sales. The state the goods came from kept the money
States	State VAT	Haryana 2003, most states 2005. Replaced the old state sales tax
States/local	Entry tax, octroi, luxury tax, entertainment tax	Collected at check posts and city limits, which split up the national market

Central excise: from MODVAT to CENVAT

• MODVAT (Modified Value Added Tax), 1986: manufacturers could deduct the excise already paid on their inputs from the excise due on their output. This was India's first step towards VAT.
• CENVAT (Central Value Added Tax), 2000: MODVAT was renamed and widened into a broader credit system.
• Cross-credit, 2004: credit could now flow both ways between excise and service tax.
• A factory could use service tax paid on (say) transport to reduce its excise bill.

• A service firm could use excise paid on goods it bought to reduce its service tax bill.

• Principle of excise rates (Class 12, Government Budget and the Economy):

• Necessities are exempt or taxed lightly.
• Comforts and semi-luxuries are taxed moderately.

• Luxuries, tobacco and petroleum are taxed heavily.

• Excise after GST:

• Union excise now survives mainly on the five petroleum products and tobacco.
• States still levy excise on alcohol.
• Alcohol for human consumption stays outside GST [2][3].
• Article 279A(5) says the GST Council will recommend the date from which GST applies to petroleum crude, high speed diesel, motor spirit (petrol), natural gas and aviation turbine fuel (ATF). Until then, these five stay outside GST [6].

Service tax

• Introduced in 1994 on the advice of the Chelliah Tax Reforms Committee. Services were a fast-growing part of GDP but were mostly untaxed.
• It started with a positive list, which meant only the services named in the law were taxed.
• Negative list (2012): the method was turned around. All services were taxed except those on a "negative list" of exemptions [7].
• Benefit: a wider tax base, fewer disputes about definitions, and new services taxed automatically.

Customs duty

• Customs duty: a tax on goods imported into (or exported out of) India. It comes under the Customs Act, 1962.
• What an importer pays today:
• Basic Customs Duty (BCD): the main tariff.
• IGST on imports: the GST part. It replaced the old CVD (additional customs duty) and SAD (special additional duty), which were both subsumed into GST [2][3].
• Social Welfare Surcharge (SWS): a surcharge calculated on the customs duty.

• AIDC (Agriculture Infrastructure and Development Cess): a cess (a tax earmarked for one purpose) on certain imports.

• Customs revenue after 1991:

• Tariffs were cut to open up trade.

• Class 11 (Liberalisation, Privatisation and Globalisation: An Appraisal) says this "curtailed the scope for raising revenue through custom duties".

• Fewer tariff slabs (latest):

• Budget 2025-26 proposed removing seven customs tariff rates for industrial goods.
• This came on top of seven rates removed in Budget 2023-24.
• Only eight tariff rates, including zero, now remain [5].
• (NCERT scaffold: "Budget 2025-26 cut the number of tariff rates (verify current)". The PIB figure above confirms it.)

Central Sales Tax and state VAT

• Central Sales Tax (CST): the Centre levied it on inter-state sales, but the exporting (origin) state collected and kept it.

• Buyers in another state could not claim credit for it, so it added to cost at every border.

• State VAT: replaced the old single-point state sales tax.

• Haryana was first, in 2003. Most states followed in 2005.
• The Empowered Committee of State Finance Ministers (2000) coordinated the move.
• Limits of state VAT:
  • It covered only goods, not services.
  • No credit was given for central excise or CST.
  • Each state had its own rates.

Local and state levies

• Entry tax was charged when goods entered a state. Octroi was charged when goods entered a city.
• Luxury tax and entertainment tax were charged on hotels, cinemas and similar services.
• Effect:
• Trucks queued at check posts, which wasted time and fuel.

• The market was split into state-level pieces.

• Subsumed into GST [2][3]:

• State VAT, CST, purchase tax, luxury tax and entry tax (all forms).
• Entertainment tax, except where it is levied by local bodies.

• Taxes on advertisements, and taxes on lotteries, betting and gambling.

• Central taxes subsumed [2][3]:

• Central excise duty, and excise duties on medicinal and toilet preparations.
• Additional excise duties on goods of special importance and on textiles.
• CVD, SAD and service tax.

The core defect: cascading

• Cascading effect of taxes: a "tax on tax". Tax is charged on a price that already includes tax paid at an earlier stage.
• Why it happened (Class 12, Government Budget and the Economy, Box 5.3):
• The old system taxed the full value of a good at every stage, including taxes already paid on inputs.
• Credit for tax paid on inputs was minimal.

• Credit could not flow between the Centre's taxes (excise, service tax) and the states' taxes (VAT, CST).

• Results:

• Taxes piled up, so final prices rose.
• The market was split along state borders, because CST and entry tax were not creditable.
• Trucks lost time at check posts.

The fix: value added tax (VAT)

• VAT (value added tax): each stage pays tax only on the value it adds, meaning its sale price minus the cost of its inputs.
• Invoice-credit method:
• The seller charges tax on the full sale value.
• The seller then subtracts the tax shown on purchase invoices, called the input tax credit (ITC).
• Formula: Net tax payable = Tax on output − Tax paid on inputs (ITC)

• Invoices leave a paper trail. A buyer wants a proper invoice to claim credit, so each stage helps check the one before it.

• Worked example (10% tax):

Stage	Sale price	Tax on sale (10%)	Credit for input tax	Net tax paid (VAT)	Net tax paid with no credit
Cotton grower → spinner	₹100	₹10	₹0	₹10	₹10
Spinner → weaver (yarn)	₹150	₹15	₹10	₹5 (= 10% of ₹50 value added)	₹15
Total tax to government				₹15 (= 10% of final ₹150)	₹25

• What the table shows:
• Under VAT, total tax equals the tax rate × the final price (₹15), however many stages there are.
• Without credit, the spinner pays ₹15 on a price that already includes ₹10 of tax. The tax cascades.

• A longer supply chain means more cascading.

• GST extends this principle to all goods and services, with credit flowing across the whole chain and across states.

Tax reform milestones (1991 → 2017)

• Aims of tax reform after 1991:
• A broader base, meaning more people and activities pay tax.
• Fewer and lower rates.
• Simpler procedures.

• A common national market.

• Class 11 says indirect-tax reform aimed "to facilitate the establishment of a common national market". Simpler rules and lower rates would "encourage better compliance".

Year	Milestone	What it did
1986	MODVAT	First input credit for central excise
1991-93	Chelliah Tax Reforms Committee (headed by Raja Chelliah)	Fewer and lower rates, a broader base, VAT, and service tax
1994	Service tax	Services brought into the tax net
2000	Empowered Committee of State Finance Ministers; CENVAT	Steered state VAT and later GST; widened excise credit
2002	Kelkar Task Forces on direct and indirect taxes (headed by Vijay Kelkar)	Tax simplification
2003 / 2005	State VAT (Haryana / most states)	Replaced state sales tax
2004	Kelkar Task Force on FRBM implementation; excise–service tax cross-credit	Proposed a national GST
2006-07	Union Budget speech	GST announced
2012	Negative list for service tax	Wider service tax base [7]
2014	122nd Constitution Amendment Bill	GST Bill introduced
2016	101st Constitution Amendment Act	Let both the Centre and the states tax the same supply; replaced excise, service tax, sales tax, entry tax and entertainment tax with GST [4]. Passed after 17 years of consensus building [2]
1 July 2017	GST launched	"One Nation, One Tax"

• FRBM (Fiscal Responsibility and Budget Management Act, 2003): the law that sets targets for cutting the government's deficit. The 2004 Kelkar Task Force saw GST as a way to raise revenue efficiently and meet these targets.

Prelims Hooks

• Cascading = tax on tax. It happens when tax paid on inputs cannot be set off against tax due on output.
• VAT (invoice-credit method): Net tax = Output tax − Input tax credit. The tax falls only on value added.
• MODVAT (1986) → CENVAT (2000). Excise and service tax cross-credit came in 2004.
• Service tax: introduced in 1994 on the Chelliah Committee's advice. Negative list approach in 2012.
• State VAT: first state was Haryana (2003). Most states adopted it in 2005.
• Central Sales Tax was origin-based. GST is destination-based, so the consuming state gets the tax (a common trap).
• National GST was first proposed by the Kelkar Task Force on FRBM (2004) and announced in the 2006-07 Budget.
• 122nd Amendment Bill (2014) became the 101st Constitution Amendment Act (2016). Don't confuse the bill number with the Act number.
• Article 279A(5): the GST Council recommends the date for GST on crude, HSD, petrol, natural gas and ATF [6]. Alcohol for human consumption is kept outside GST [3].
• CVD and SAD (on imports) were subsumed into GST. Basic customs duty was not [2]. After Budget 2025-26, 8 customs tariff rates remain, including zero [5].

Mains Points

• Cascading was a structural cost, not just a tax issue:
• Taxes piled up inside prices → Indian goods became costlier at home and abroad.
• CST and entry tax were not creditable → firms set up warehouses in every state for tax reasons, not to save cost.
• Check posts → slower trucks and higher logistics costs.

• GST's input tax credit across the whole chain answers all three problems.

• Federal bargain: reform took from 2000 (Empowered Committee) to 2016 (101st Amendment) because states had to give up taxes they controlled, such as VAT and entry tax, and move to shared taxing power.

• This shows the trade-off between fiscal autonomy (a state's freedom to set its own taxes) and a common national market.

• It also explains why petroleum and alcohol stay outside GST: they bring the states large amounts of revenue [6].

• Tariff simplification vs revenue:

• After 1991, lower customs duties cut revenue (NCERT).
• Fewer slabs, down to 8 after Budget 2025-26 [5], make classification disputes less likely and trade easier.

• The government now relies more on surcharges and cesses (SWS, AIDC). These are not shared with the states through the divisible pool, which raises a fiscal federalism concern.

• Base-broadening lesson:

• Service tax moved from a positive list to a negative list (2012) [7], and then into GST.
• Using an exemption list instead of an inclusion list widens the base and cuts disputes. Chelliah (1991-93) argued for exactly this: a broad base with low rates.