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Revenue raising potential of VAT

FE Team | Published: May 08, 2017 20:26:41 | Updated: October 21, 2017 22:48:45

Revenue raising potential of VAT

There is a notion that the VAT is hidden in overall prices. This gives rise to a concern about spending growth. As a result, the argument goes, taxpayers won't notice the VAT the way they do income, sales, or payroll taxes, enabling parliament to increase the VAT rate without much taxpayer resistance. 
This problem is easily addressed. The VAT doesn't have to be invisible. For example, Canada requires that businesses print the amount of VAT paid on a receipt with every consumer purchase. This is essentially identical to the standard U.S. practice of printing sales taxes paid on each receipt. The growing literature on tax visibility offers mixed results. Mulligan et al. (2010) find that the proportion of payroll taxes paid by employees has no significant effect on the size of the public pension programme. Finkelstein (2009) finds that the adoption of electronic toll collection results in higher tax rates and reduced short-run elasticity of driving with respect to toll rates. Similarly, Chetty et al. (2010) find that posting tax-inclusive prices reduces demand for some goods. Another way to make the VAT transparent is to link VAT rates and revenues with spending on particular goods. Aaron (1991) and Burman (2009) propose a VAT related to health spending. Under such a system, the additional health insurance coverage would help offset the regressivity of a VAT and make the costs of both the VAT and government spending more transparent.
INFLATION: There is no theoretical or empirical reason to think that the VAT would cause continuing inflation. Research has found only a weak relationship between the VAT and continually increasing prices. In a survey of 35 countries that introduced the VAT, Tait (1991) found that 63 per cent exhibited no increase in the consumer price index (perhaps because they were replacing existing sales taxes) and 20 per cent had a one-time price rise. Among the remaining 17 per cent, the introduction of the VAT coincided with ongoing acceleration in consumer prices, but Tait believes it is unlikely that the VAT caused the acceleration.
UNDERSTANDING VAT: VAT is a consumption tax imposed on the sale of goods and services. The VAT Directive of the European Union defines VAT as 'a general tax on consumption applied to commercial activities involving the production and distribution of goods and the provision of services… The tax is calculated on the basis of the value added to goods and services at each stage of production and of the distribution chain' (European Union 2006).The youngest member of the sales tax family, VAT is considered a phenomenal twentieth century innovation in the arena of taxes. 
Dr. Wilhelm Von Siemens first conceived the idea of VAT in 1919 in Germany (Khadka 2005). The problem of tax-on-tax that prevailed in the existing taxes inspired him to conceive what he called an 'improved turnover tax' or 'refined turnover tax' (Schenk and Oldman 2007:4). After about thirty-five years of experimentation with the concept, France adopted the VAT in 1954 for large businesses and extended it in an incremental way to other business sectors. Theoretically, VAT is a tax on value addition. With the exception of the import stage, VAT is levied on the value addition made at each stage in the process of 78 production and distribution. It is defined as 'a tax on the value added by a business firm, through its own activity, to the goods and services it buys from other business firms' (Shoup 1990:3). Theoretically, at each stage of business, a value is added in the increase of the value of output over inputs; VAT taxes this value added. VAT is a type of general consumption tax as it is assumed to be fully shifted forward to consumers (Bickley 2003). In the process of what is known as credit mechanism, businesses get back the VAT paid on their input and the final burden of tax rests on the consumer who does not have any opportunity of shifting it because the life cycle of a good or service ends with consumption. 
Unlike other taxes, VATs followed around the world show a great deal of resemblance and uniformity. As Thuronyi (1996:312) notes that, despite differences in VAT from one country to another, compared with income tax, VAT laws are remarkably similar. A review of the VAT literature reveals some of the salient features of a VAT. These include: (i) VAT is a multi-stage, self-assessment and self-clearance-based tax the core feature of which is an input tax credit mechanism that enables a business to take back the VAT that was paid on the purchase of its input at the prior stage and tax the value added only. The problem of tax-on-tax or cascading is avoided by the credit mechanism. (ii) VAT is generally non-cascading. Cascading refers to a situation when a commodity or service is taxed more than once under one tax as it passes through various stages of the production distribution chain Zee (1995).   (iii) The rate of VAT is generally single along with a zero rate for exports. (iv) A threshold of annual turnover for mandatory VAT registration is made, which leaves small businesses outside the VAT net for reasons of administrative and compliance cost.(iv)  VAT is an ad valorem tax i.e. the tax is imposed on the basis of the value of goods or services. It is assessed on transaction value. Transaction value, basically referring to the GATT principles of customs valuation, is the fair market value at which goods or services are actually sold in a situation where the buyer and the seller are independent of each other.   (v) VAT is generally a regressive tax; in many countries, the regressivity is neutralised to some extent through differentiated rates, preferential treatment of pro-poor sectors and exemptions and zero-rating. Exemption and zero-rate are quite different. Exemption in VAT implies that no tax is chargeable on the supply of the product and hence, no input tax credit can be claimed. On the other hand, zero-rate is a rate in VAT. In this instance, no VAT is practically chargeable but the business is entitled to input tax credit on its zero-rated supplies. (vi) A comprehensive VAT (a single rate broad-based VAT with no or very few exemptions) is self-policing as motivation for input tax credit automatically safeguards the confirmation of payment of VAT at an earlier-stage.  And (vii) VAT is trade friendly and trade neutral as businesses having the opportunity of shifting the tax incidence to the next buyer are not affected by it (see Due 1970; Tait 1988; Shoup 1990; Ebrill, Keen et al. 2001). 
THE GLOBAL SCENARIO: Since its introduction in France in 1954, VAT has been adopted as the main form of indirect taxation by many countries in different parts of the world and at different stages of economic development (Williams 1996). Over the last few decades, consumption taxes have become one of the most important revenue mobilising instruments in the advanced industrialised countries as well as in the developing countries (Eccleston 2007). It has become the standard element of national fiscal systems in industrialised countries. According to Sandford (2000:77), by the late 1990s over 100 countries used VAT systems, leading to the conclusion that VAT 'is probably unique in fiscal history. A generation ago, it was virtually unknown. Now it is approaching universal.' The journey forward of VAT has continued unabated and now more than 140 countries use the tax as a major source of revenue (Keen 2007).
VAT is required to be adopted as general indirect tax in order to gain membership of the European Union. Of the large industrial nations, only the United States does not levy a VAT. Region-wise, 33 Sub-Saharan African, 18 Asian and Pacific, 17 European Union, 27 Central European, nine North African and Middle Eastern, and 23 American countries are among those that adopted VAT by 2005 (ITD 2005). Though VAT was not adopted in any of the Asia-Pacific countries before 1976, by 2005, 18 of the region's 24 countries have a VAT. The fact that VAT has raised $18 trillion in 2007, accounting for almost a quarter of global taxation, led the IMF's senior economists to regard VAT as 'probably the most important tax development in the latter part of the twentieth century, and certainly the most breath-taking' (cited in Eccleston, 2007). 
An update on adoption of Value Added Tax as revenue raising tool by the different regions of countries up to 2014 is shown in Table-I. This shows that 141 countries adopted VAT since its first adoption in 1954 by the French Government. 
Most countries have concentrated on revenue collection from internal sources using VAT as a tool to get out of foreign loan syndrome to a self-reliant economy. Bangladesh can be cited as an example that its leadership is trying hard to get out of the vicious circle of foreign aid-dependent development finance to self-reliant financing.    
REVENUE RAISING POTENTIAL: VAT has been generally appreciated for its great revenue raising potential for financing governmental services, and the efficiency with which it may be imposed on imports and waived from exports (Williams 1996). Though some may argue if the ability to raise more revenue should make VAT a desirable tax as raising more tax means paying more by taxpayers, the revenue/efficiency implications of a tax are an important determinant in choosing a tax (Ebrill, Keen et al. 2001). Again, though there is debate about the efficiency gains with VAT in terms of economic considerations, seen from the comparative view of efficiency of the taxes that VAT replaces in developing countries, VAT has proved to be more efficient (Bird and Gendron 2007). The revenue raising potential is embedded in its capacity to broaden the tax base and to apply it to any goods and services in the production distribution chain. 
Table-II demonstrates the share of indirect tax including VAT as a percentage of total tax revenue of some lower and middle income countries including Bangladesh. It shows that Bangladesh has more opportunity to collect indirect taxes, including VAT, compared to its neighbouring and regional comparators. The domestic indirect tax ratio of Bangladesh as a percentage of total tax revenue (2014) is 29.28 per cent; India (1997): 36.04 per cent;  Bhutan (1997): 36.79 per cent; Pakistan (1995): 46.74 per cent; Nepal (1998): 47.55 per cent; Sri Lanka (1997): 61.65 per cent; Maldives (1997): 32.20 per cent; and Ethiopia (1995): 21.26 per cent. Among the middle income countries the ratio for Philippines (1997): 32.36 per cent; Indonesia (1996): 34.36 per cent; Thailand (1997): 47.42 per cent; and El-Salvador (1997): 57.42 per cent. 
ADMINISTRATIVE CASE: VAT is adopted in different countries as a replacement of some other taxes, it can be administered by the same tax administration. While in many countries it is being administered by the income tax department, some countries, for example, Bangladesh, have assigned the responsibility to their customs department. That is to say, adoption of VAT does not generally necessitate the creation of a new tax administration. 
The widespread popularity of VAT sweeping both the developed and developing world owes much to its adaptability. Tait (1988) argues that a VAT can be tailored in different ways to suit a country's needs without fundamentally deviating from the standard principles on which the tax system rests. This freedom of adaptation, however, has, in some cases degenerated VAT into a hybrid tax, retaining very little of the standard VAT principles. 
SELF-ASSESSMENT, SELF-ENFORCEMENT: VAT is a self-assessed tax. Self-assessment in taxation means that 'taxpayers comply with their basic tax obligation without the intervention of a tax official' (Ebrill, Keen et al. 2001:138). The idea of self-assessment is related to the imperative of increasing voluntary compliance which in turn forms the core of the efficiency of a tax system. Ebrill, Keen et al. (2001) note that in many countries the development of self-assessment is closely connected with the adoption of VAT. 
Along with the idea of self-assessment goes self-enforcement. In order for a business to claim input tax credit, it has to possess an invoice from whom the input is purchased. The proof of purchase in the form of invoice handed over to a buyer obligates the seller to account for his/her sale properly to the tax authority. 
Jamaluddin Ahmed PhD FCA is the General Secretary of Bangladesh Economic Association and a member of the Board of Directors of Bangladesh Bank. 
 jamal@emergingrating.com
 

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