The Pre-GST Indirect Tax Structure and the Cascading Problem

To understand why GST was needed, it helps to see exactly how the earlier system taxed the same value more than once. Suppose a manufacturer buys raw material, pays excise duty when the finished good leaves the factory, and then pays VAT again when it is sold to a wholesaler — and, importantly, VAT under the older system was often computed on a price that already included the excise duty paid earlier. This meant tax was being charged on tax, not merely on the fresh value added at each stage. This defect is called the cascading effect of tax, popularly described as "tax on tax".

A cascading tax structure has two damaging consequences for the economy and for individual businesses. First, it inflates the final price paid by the consumer beyond what the actual value addition would justify, because every stage in the chain adds its own tax on top of a price that already carries tax. Second, it distorts business decisions — a trader may prefer to buy from a supplier in the same state purely to avoid central sales tax on an inter-state purchase, even if a genuinely cheaper or better supplier exists elsewhere, simply because the tax system does not allow that earlier tax to be set off. …