How does GST work (How to work GST) and does it work on VAT principle only? The answer will be found in this article with a simple and easy example. Before reading this article What is GST and why it was needed to be introduced? Read it, it will make it easier to understand this article.

**Types of GST**

**There are four types of GST.**

**CGST i.e. Central GST**

SGST **i.e. State GST**

IGST **i.e. Integrated GST or Integrated GST**

UTGST i.e. **Union Territory GST or Union Territory GST**

| GST is levied on the supply of goods and services or both at each stage of the supply chain, starting from manufacturing or importing to the retail stage. Since India is based on a federal structure, the state also has the power to levy taxes independently. **SGST** is levied by the states and the entire amount of recovery belongs to the state. Similarly, **UTGST** is for the entire center.

| **IGST replaces** the earlier ongoing **Central Sales Tax** which is applicable on interstate transactions**.** In IGST, the state gets its share only, if something becomes the share of the center, then it gets it according to the **Finance Commission**.

Similarly, **CGST** which is under the Central Government; The state also gets some part of it, but the **finance commission** decides how much it will get.

**Remember here that **under the **GST Council**, CGST, SGST, UGST and IGST are collected by the Center and the states at mutually agreed rates.

**How to work GST?**

VAT i.e. Value Added Tax system was introduced in 2005, this improved the system to a great extent but it could not eliminate all the problems. The reason for this is that (1) the cascading effect (ie, tax on tax) has not ended. (2) The introduction of service tax further broke the uniformity of the tax system. (3) Different state tax inputs for the same item further complicated the input credit. (4) Filing so many returns became a problem for the people. (5) Tax collection was not happening as expected. So, Due to various reasons, the policy makers understood that reforms in the existing tax system were very important. (This is discussed in detail in What is GST?)

It was finally implemented in 2017 and was mainly divided into three parts, where GST works differently within a state as there is only CGST and SGST. At the same time, when there is a state-to-state transaction, there is CGST, SGST and IGST as well.

That’s why it can be divided into two parts to understand first **, how GST works within a state** and second **, how GST works in interstate transactions** , let’s look at both one by one and try to understand that how it works.

**How to work GST Within a state**

**Like before, let us understand this with an example.**

Let’s say a person **A** bought raw material for Rs.100. To understand, let us assume that the rate of GST is currently 20 percent.

That is, 10 percent CGST and 10 percent SGST. This is because in reality the rates of both are equal. But collectively it will be called 20 percent GST.

So after paying 20 percent GST, that person will have to spend a total of 120 rupees. That is, he paid 120 rupees to the raw material person. Now suppose that by investing 50 rupees in this raw material, he produced a new item.

Now that 50 rupees is called **value addition**. Because the cost of that article of joining the same is Rs 170.

The price of the article has become Rs 170, but when person **A** sells that article to person B, instead of selling it for Rs 170, he will sell it only for Rs 150. why so?

This is because GST is applicable only on **value addition** and not **on tax** . If you have read the article on VAT then you must be understanding.

Now B will also have to pay 20% GST on that. That is, 20 percent of 150 which is 30 rupees. Accordingly, Rs 15 is for CGST and Rs 15 for SGST. 30 rupees in both.

B will have to pay Rs 180 accordingly. Thus B will pay Rs 180 to A. But A will pay only Rs 10 as tax. Because he has already paid Rs 20. Now he will get that 20 rupees as input credit. How to get

Because A has already paid Rs 20, out of which Rs 10 was CGST and Rs 10 was SGST.

These will be deducted from CGST and SGST respectively. The CGST of B is Rs.15, out of which Rs.5 will be left after reducing the CGST of Rs.10 of A. Similarly SGST of B is also Rs.15. Out of this, even after reducing the SGST of A by Rs 10, there will be Rs 5 left.

Meaning that a total of Rs 10, A will have to be paid as tax. Now if you remember, you must be understanding that this is also like VAT.

Here also the amount of tax which is Rs 30 is the **output tax liability** . At the same time, what has already been paid i.e. 20 rupees is the **input tax credit** . To calculate the total VAT, we used to do the **output-input** , then VAT would come out. It is happening here too.

| Now again when person B sells that article to someone else, then obviously he will take some profit on it. Let’s assume that he takes a profit of Rs 50 on that article.

So now the price of that item is Rs 200. You must be thinking that just now 180 rupees have happened. So that 30 rupees was his GST. That is why now only Rs 50 will be added to the value addition of 150. Thus the value of that article will be Rs.200.

**So if 20 percent GST will be levied on it again. Remember that this will take place until the item reaches the consumer.**

Now if we assume that the consumer is getting this item, then after levying 20 percent GST, it has become a total of 240 rupees. Hope you understand how it happened.

The consumer will have to pay only 240. But since Person B has already paid GST of Rs.30. So when this 40 rupees comes to him, he will pay only 10 rupees because out of that he has already paid 30 rupees when he bought this item.

Overall, on that one item, the total tax has to be paid 40 rupees. how that? 20 was paid by A while buying the raw material.

Then he paid Rs 10 after value addition and finally person B paid Rs 10. And since the total value addition is Rs 200, 20% of which is only 40. That means the calculation is correct.

In this way you must have understood that GST is applicable only on value addition like VAT. First A did a value addition of Rs.50, then if you see 20% of it, then it is Rs.10. Similarly, if B did 50 rupees value addition in it, then 20 percent of that too is 10.

Remember here that the place from where the raw material is purchased does not get anything as input credit. Only those who do **value addition** get it .

### IGST in interstate transactions

As we know, IGST is levied on inter-state transactions and it is the GST version of the earlier **Central Sales Tax. **Which is part of **Article 269A .**

Understand this much that even in this system, the state gets the full tax for the transactions that take place between the state and the state. But when IGST works, that money is divided between both the state and the center, but in what proportion it will be divided by the Finance Commission.

| Let’s assume there are four people A B C and D and the rate of GST is 20%. A buys raw material worth Rs 100 from someone. Due to levy of 20% GST, A will pay Rs 120 to that person. Because 10 rupees CGST and 10 rupees SGST.

Now A adds value of Rs 50 to it and sells it to B. Now as we have already seen that tax is not levied on tax, so now the price of that item will be Rs 150. Let’s assume that till now this transaction is happening in the same state, hence CGST and SGST will be applicable again.

Since both of these are 10 – 10 percent i.e. 20 percent, then 30 rupees will be added to the person B who will pay to A. Rs 15 for CGST and Rs 15 for SGST.

So now it will be 150+30=180 rupees. Remember the SGST of Rs.15 charged here. Later on, C will get Rs 15 here.

Remember that we have also discussed above that out of the 30 rupees that is being paid to A, only 10 will be paid as tax. Because he has already paid 20 rupees.

Till now the transactions between A and B have taken place within the same state, so IGST has not been entered till now.

| But now when let’s assume that person B is selling an article to person C from another state. At present the cost of that article is Rs 150. Why is this?

Because person A had only added value of Rs 50. The rest was tax. Now when B sells that article, he will also take some profit.

Let’s say that he takes a profit of 50 rupees, then the price of that article now becomes 200. Since it is selling to other state, hence IGST will be levied here.

After levying 20 percent IGST, the price of that article became 240. Means person B will take 240 rupees from person C. And this is Rs 40 IGST.

Now the question is, how much input credit will person B get? Because as we know, input credit of CGST is available from CGST and input credit benefit of SGST is available from SGST.

But here person B has done business through IGST. So the arrangement for this is that the input of IGST will be seen first. Then of CGST and SGST.

When B had bought that article from A, there was no IGST that is why no credit will be available in IGST. But CGST and SGST were imposed. That too was 10% CGST and 10% SGST. That is, it was 15 – 15 rupees.

Therefore, B will get this Rs 30 as input credit. That is, person B paid only Rs.10. **This is Rs 10, this is IGST. **Remember this.

Now that item is with person C. It has already reached him after levying CGST of Rs.15, SGST of Rs.15 and IGST of Rs.10.

Suppose person C also takes a profit of Rs 50 and sells it directly to the consumer. After removing the tax, the price of that article was Rs 200, now after adding Rs 50 to it, the price of that article became Rs 250.

Now if we see here, person C is selling the same to the consumer of his own state. That is why IGST will not be applicable here. Because when a transaction takes place within the same state, then IGST is not charged but CGST and SGST will be charged as before.

Now if 20% GST is here also i.e. 10% CGST and 10% SGST, then the value of that item will be Rs.300.

He will take 300 rupees from the consumer. Now again here is a problem that it was thought that there was IGST on that article but when it was sold, it was charged CGST and SGST.

How will it get the benefit of input credit? Now if you remember, C has Rs 15 for CGST, Rs 15 is for SGST. And Rs 10 is of IGST. Why that?

Because when person B sold to C, then C paid IGST of Rs.10. Because the transaction was interstate.

Now the person C got Rs.300 from person D, out of which Rs.50 is tax. Person C paid Rs 40 as lump sum IGST.

That is why out of that 50, he will pay only 10 rupees as tax. He will get input tax credit of Rs 15 from CGST, Rs 10 credit from IGST.

And SGST of Rs.15 will also be available but that credit will first go to the center and then the center will transfer that credit to C. Because the matter is of IGST.

Thus, out of that Rs 50, C will have to pay only Rs 10. After that, he will get input credit tax of remaining Rs 40.

And here this chain will end because now the consumer has got that item.

| Now a question may come in your mind that since SGST is for the entire state. Then why would person C get that credit? Because he is from another state.

It will be available because GST is a **destination based tax** . That is why the SGST of Rs 15 with B would be sent to the center and the center would send that Rs 15 to the state where the whole chain ended.

Now if you want to check then check it. A had done a value addition of Rs.150 (Rs.100 was the raw material and Rs.50 was added to it himself). So its 20%. 30 rupees. And he has also paid 30 rupees.

B added a profit of Rs.50. Its 20% is Rs.10 and B has paid only Rs.10.

Similarly C also added a profit of Rs.50. And he had also paid 20% tax, i.e. Rs.10. If all three are added then it becomes 50 rupees.

That is, there has been a total value addition of Rs 250. And if you take out 20 percent of it, then it is only 50 rupees. That is, the calculation is absolutely correct.

| This was the way GST worked. If you do not understand at once, then read it again, but understand because, after understanding this, **the financial relationship between the center and the state** will be easier to understand. Now you can read Centre-State Financial Relations by clicking below.