A cascading tax is one, which is not just on output value but also on the input element. That is to say it is at every stage of production and distribution. It is a tax on tax. For example resin, rubber and carbon black are necessary for manufacturing a tyre. All the three inputs paid tax and the final products namely the tyre also paid tax. So these three inputs are taxed twice. Then again the tyre is used in a car, which also is taxed. These three inputs are now taxed thrice. So the tax element on these inputs goes on increasing with every production and distribution chain. The cascading effect of tax makes the tax rate much higher than the original rate. It might even become two and half times. A turnover tax of 4% can be ultimately equivalent to a total tax burden of 10%1.
There are many arguments in favour of the view that cascading of tax is bad for the economy and so is undesirable. It is argued that cascading leads to distortions2 of different kinds in the reallocation of resources. First, it is said that cascading leads to reallocation of resources in a distortionary manner. Since cascading gets into the entire production-distribution chain, it tends to induce the producer or distributor to reallocate his resources away from the particular product to those where the tax does not apply. This argument, however, is not all factually correct. It is valid only when there are commodity based exemptions and particularly geographical exemptions. So it is the exemption, which is distortionary, and not the cascading tax by itself. If the cascading tax is uniform with few exemptions, the distortionary effect will not be there. Even a VAT with exemptions and multiple rates is distortionary.
Second, it is said that cascading leads to tax rate to increase several times by the time it is finally sold to the retailer. So the cost of production increases, the argument goes. Here again the argument about increase in cost of production is to be seen in the proper context. If the increase in the cost of production were uniform for all the producer and distributors in a competitive economy, there would be no difference to any particular manufacturer. If a rate of 4% ultimately becomes 10%, then it enjoins on the government to decide if it would charge 10% or less. If the government decides to charge 7 ½ per cent in the ultimate analysis, then it can reduce the rate from 4% to 3% at the initial stage. It is ultimately the decision as to how much revenue the government wants to collect as per its budget estimate keeping the fiscal deficit in mind. A tax rate is not imposed in vacuum. It is a matter of economic policy, which allows for adjustment of the tax rate taking into consideration all these factors.
Third, it is said that cascading leads to higher prices. Since the tax level becomes more after several transactions, the incidence of tax becomes more and so the prices will rise. This argument is also not fully correct. The prices rise if the ultimate tax rate is higher and not on the mere phenomenon of cascading. If the government finds that a certain tax rate of, say, 4% and its ultimate effect of 10% is inflationary, then the tax rate itself can be reduced. That is what budget making is all about. Moreover if this argument were correct, then logically it would follow that if VAT is introduced and therefore input credit is allowed, the prices would fall. But that does not happen. On the other hand, one of the major arguments against VAT is that it increases the prices, though the finding of the economists is that VAT does not make any difference to prices in an overall manner. Thus it follows that if giving input credit is neutral to prices, then not giving it also should be neutral to prices.
Fourth, it is argued that cascading tax like sales tax or excise tax discourages export because the tax element in the exported goods makes the export uncompetitive. While it is correct that cascading itself discourages export by making it uncompetitive, it is not necessary that in a sales tax or excise duty regime there cannot be any refund of the tax elements from the export. A cascading tax within the country can as well give refund of all the tax paid when it comes to export. That is in fact being done by giving draw back and export refund in India and this is in vogue over a long period of time and much before the MODVAT was introduced in 1986.
So the conclusion is that the case against sales tax on the ground that it is an inefficient and undesirable tax because of the cascading effect are largely exaggerated.
1 Alan A. Tait-Value Added Tax, IMF 1988, p.9