I wonder how long we Indians will be taken for granted. We have a tendency to get attracted to lower prices (well, we consider overpaying as a personal insult). Yet we allow some practices to run with alacrity.

Consider this trend: There is  a product, say a pair of jeans with an MRP of Rs 1000. The retailer (online or offline) announces a discount of, say 20% and then clarifies (in small font) that VAT would be applied on discounted products. At 5% VAT, the tax component comes to 800 x 0.05 = Rs 40.

The retailer charges Rs 840 after giving a discount of 20% on Rs 1000. A third grader can calculate that we are getting only 16% discount and not 20% as marketed. In what kind of mathematics impaired world do we live?

VAT is already built in the MRP. They calculate the price by discounting it, and then add the VAT again. Do they pay double tax? Hell, no! They just like to give us lower discounts but promise higher.

Unfortunately, retailers have been successfully running this show for some 4 years now.

Coming to formulas, let’s assume V is the VAT rate and D is the discount rate. The calculations would be:

Final price: MRP x (1 – D) x (1 + V)

Hence the discount is MRP – final price, or

MRP – MRP x (1 – D) x (1 + V), which comes to

MRP x (D-V+DV)

The effective discount rate = (D-V)+DV

The loss of discount due to the above strategy = V (1 – D)

So, in our above example, the effective discount rate = 20% – 5% + 1% = 16% and our loss is 5 (1-0.2) = 4%

 

I have plotted a graph comparing the advertised discount and the impact on VAT on the effective discount. I have considered 5% and 14.5% considering the two VAT rates are applied across India.

table

impact of VAT on effective discounts

We can observe the following:

  • When VAT exists, the effective discount is lower than the advertised (as expected, since we lose V(1-D).
  • A lower discount and a higher VAT would make the effective discount negative, which means the prices would be higher than MRP which is not possible since that would be illegal
  • A higher VAT implies greater loss (directly proportional to V). This can make the difference substantial (and raise eyebrows).Hence you will probably not find this technique with consumer durables (which are taxed at 14.5%) but with textiles (lower 5% VAT)
  • When discounts are higher, the difference is not really much. This is probably why high discounted merchandise (say end of season sale on apparel where discounts can go up to 60%) is a wonderful opportunity to play this game.

In short, businesses are cashing in on the consumer’s behavior: treating values smaller than 5% as loose change. 

The ideal consumer products for this discounting and tax game are those which have

  • Higher margins (to allow discounts)
  • Lower VAT
  • Inelastic demand (People don’t mind paying more)

This includes branded apparel, footwear, electronics and many more (I am no tax expert). No wonder Shoppers Stop and its competitors are cashing in making this an industry norm.

There is a point at which the effective discount can be 0. At this point, we will have (D – V) + DV = 0 or D = V / (1+V)

When V = 5%, we can have a discount of D =  4.76% from the above equation.

Imagine a marketer saying “We are giving you a blockbuster discount of 4.76%, but unfortunately you have to pay VAT”. The final charges will be the MRP, then hopefully consumers will wake up and ask, “Where is my discount?”

 

 

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