--- type: faq question: How does GST work? topic: gst topic_title: Goods and Services Tax topic_url: 'https://liberty-lighthouse.vercel.app/topics/gst/' canonical_url: 'https://liberty-lighthouse.vercel.app/topics/gst/faq/how-does-gst-work/' markdown_url: 'https://liberty-lighthouse.vercel.app/topics/gst/faq/how-does-gst-work.md' --- # How does GST work? The GST is a value-added tax in design. This means it is levied at multiple stages of production and distribution, but tax paid on inputs is credited against tax due on output. So each firm effectively pays tax only on the value it adds. The difference compared to a usual sales tax is that while sellers are required to charge the tax on all their sales, they can also claim a credit for taxes that they have been charged on their inputs. This should not be confused with India's earlier state VAT regime. State VAT was also a value-added tax in design, but it was much narrower. It was a state-level tax on the sale of goods within a state. It did not apply to services, and it did not create a seamless credit chain across inter-state trade. Inter-state sales were generally subject to the Central Sales Tax, which often broke the input tax credit chain and led to cascading. GST is more comprehensive because it brings goods and services into a common value-added tax framework and creates a mechanism for taxing both intra-state and inter-state supplies. In intra-state transactions, GST is split between the Centre and the state through CGST and SGST. When goods cross a state line, a single Integrated GST is collected by the Centre, which passes the states' share to the destination state. (See 'When you buy from another state, which government gets the tax?') Here is how VAT is designed to work. Suppose Firm A sells its output (assumed, for simplicity, to be produced using no material inputs) for ₹10,000 (excluding tax) to firm B. Firm B sells its output for ₹40,000 (excluding tax) to firm C. Firm C then sells to final consumers for ₹90,000 (excluding tax). Assume there is a VAT at 10%. Firm A charges firm B ₹11,000 and remits ₹1,000 to the government. Firm B charges firm C ₹44,000 (₹40,000 + 10% VAT). It collects VAT of ₹4,000 on its sale, but claims an input credit of ₹1,000 for the VAT paid to firm A, so it remits ₹3,000. Firm C charges consumers ₹99,000. It collects output VAT of ₹9,000, claims an input credit of ₹4,000 for the VAT paid to firm B, and remits ₹5,000. The government thus collects a total of ₹9,000, equal to 10% of the final pre-tax price of ₹90,000.
Stage Seller → Buyer Value added Pre-tax sale price VAT rate Invoice total (price + VAT) Input VAT credit claimed Net VAT remitted to govt
1 Firm A → Firm B 10,000 10,000 10% 11,000 0 1,000
2 Firm B → Firm C 30,000 40,000 10% 44,000 1,000 3,000
3 Firm C → Final consumers 50,000 90,000 10% 99,000 4,000 5,000
Totals 9,000
In its economic effects, the tax is equivalent to a 10% tax on final sales: total VAT paid to the government equals 10% of the final pre-tax price. But because it is collected throughout the supply chain, with credits for tax paid on inputs, it secures revenue more effectively than a tax collected at the final sale alone. Two useful ways to think about this: - Businesses are mostly tax collectors. They charge GST, subtract the GST they paid on inputs, and pay the difference. - The final consumer bears the tax. The customer cannot claim input tax credit. GST works by taxing each sale and letting firms claim credit for the GST paid on their inputs. Stage by stage the credits net out, so the tax settles on final consumption instead of lodging inside the cost of production.