Business Page – September 3, 2000

Last week the first part of the Business Page article revisiting the debate over the introduction of Value Added Tax (VAT) discussed the economic and fiscal logic of sales taxes generally and looked at how Value Added Tax (VAT) in particular operates. Today in our concluding piece we discuss the advantages and disadvantages, perceived and real, of VAT.

The main disadvantages which have been identified in connection with the Value Added Tax are:

1) VAT is Regressive

It is claimed that the tax is regressive, i.e. its burden falls disproportionately on the poor since the poor are likely to spend more of their income than the relatively rich person. There is merit in this argument particularly if it attempts to replace direct or indirect taxes with steep, progressive rates. However observation from around the world and even Guyana has shown that steep tax rates lead to evasion and, in the case of income tax, act as a disincentive to effort. The steep rates may therefore be evaded except in extremely limited circumstances.

Further there is now a tendency in some countries to reduce this progressivity of taxes as has been done in Guyana where a flat rate of income tax has been introduced. In any case VAT recognises and makes room for progressivity by applying no or low rates of tax on essential items such as food, clothes and medicine. In addition it also allows for steep rates of taxes on luxury items although this can create problems for administration and open opportunities for evasion by way of deliberate mix-classification, a problem incidentally not peculiar to VAT and which takes place extensively in the area of customs duties.

2. VAT is too difficult to operate from the position of both the administration and business.

(a) The Administration

It is often argued that VAT places a special burden on tax administration. However it is worth noting that wherever VAT was introduced one of its effects was the rationalisation and simplification of the previous indirect tax system and its administration. Several indirect taxes such as customs duties, purchase tax and excise duties replaced by VAT had their own rate structure as well as a different tax base and separate administrative procedures. The consolidation and incorporation of numerous indirect taxes into the VAT would simplify the rate structure, tax base and administration of the indirect tax system.

In addition, the abolition of a number of alternative indirect taxes releases experienced personnel to focus on a single tax. It also means reduction in the number of forms used, legislation to be applied and returns and accounts with which the business person has to contend.

(b) Business

It is true that the VAT is collected from a larger number of firms than under any form of income tax or single state sales tax; to the typical smaller firms the complexities of the tax and the need for more extensive records (for example, to justify deductions) are likely to prove serious.

Under the Income Tax (Accounts and Records) Regulations of 1980 every person, without exception is required to maintain detailed and extensive records of all its transactions. There is widespread non-compliance with this requirement and there is no obvious reason to believe that the introduction of VAT will meet with a higher degree of compliance. This could create immense problems for the administration and the revenues of the country. However since there is an actual benefit to be derived from accounting for VAT paid on input there is an incentive for proper record keeping.

Under any form of sales taxation, small businesses have to be granted special treatment because of their inability to cope with the requirements of keeping adequate records which larger enterprises can handle at a reasonable cost. The intent of the special treatment is to reduce the administrative burden on small enterprises, but not the taxes that normally would be charged on the goods and services they supply. The revenue loss at the final link in the commercial cycle is limited only to the value added at that stage whereas in the case of income tax or sales tax the entire tax is lost. To recover the loss from exemption a flat tax on turnover may be applied.

In the larger businesses with proper staff and computers the task is really one of double entry book-keeping and any additional work is easily absorbed into the routine.

Some businessmen seize almost any opportunity to raise prices and the introduction of VAT certainly offers such an opportunity. However, temporary price controls, a careful setting of the rate of VAT and the significance of the taxes they replace should generally ensure that there is no increase if any in the cost of living. To the extent that they lead to a reduction in income tax any price increases may be offset by increases in take home pay.

It is argued that VAT places a heavier direct impact of tax on the labour-intensive business compared to the capital-intensive competitor, since the ratio of value added to selling price is greater for the former. This is a real problem for labour intensive businesses and industries which should be a focus of direct attention as we consider how best to structure the system.

Against these disadvantages are some considerable and weighty theoretical advantages. Whether the benefits they offer actually materialise will depend on the quality of the administration and enforcement procedures.

If the tax is carried through the retail level it offers all the economic advantages of a tax that includes the entire retail price within its scope. At the same time, the direct payment of the tax is spread out over a large number of firms instead of being concentrated on particular groups, such as wholesalers or retailers.

If retailers do evade, tax will be lost only on their margins because customers that are registered firms gain nothing if their suppliers fail to collect tax except delay in payment; they will pay more to the government themselves. Under other forms of sales tax both seller and customer gain by evading tax.

One particular advantage is that of the widening of the tax base by bringing all transactions into the tax net. Specifically VAT offers the opportunity to bring back into the tax system all those persons and entities who enjoy a range of hard to justify tax exemptions in one form or another.

VAT represents an important instrument against tax evasion and is superior to a business tax or a sales tax from the point of view of revenue security for three reasons.

In the first place, under VAT it is only buyers at the final stage that have an interest in undervaluing their purchases, since the deduction system ensures that buyers at earlier stages will be refunded the taxes on their purchases. Therefore, tax losses due to under valuation should be limited to the value added at the last stage.

Secondly, under VAT, if payment of tax is successfully avoided at one stage nothing will be lost if it is picked up at a later stage; and even if it is not picked up subsequently, the government will at least have collected the VAT paid at stages previous to that at which the tax was avoided, while if evasion takes place at the final stage the state will lose only the tax on the value added at that point.

A significant advantage of the value added form in any country is the cross-audit feature. Tax charged by one firm is reported as a deduction by the firms buying from it. Only on the final sale

to the consumer is there no possibility of cross audit.

In Guyana many businesses which do their own importing sell a large proportion of their goods direct to the final user. Many such businesses are among the group with significant leakages. VAT will not do much to change this. Professionals and contractors are another hard to tax group which the introduction of VAT will not address.

VAT may be selectively applied to specific goods or business entities. We have already addressed essential goods and small business. In addition the VAT does not burden capital goods because the consumption-type VAT provides a full credit for the tax included in purchases of capital goods. The credit does not subsidize the purchase of capital goods; it simply eliminates the tax that has been imposed on them.

The call for VAT is partly driven by the IMF and its ubiquitous and apparently omniscient consultants. The private sector, particularly manufacturers, considers it a solution to the Consumption Tax problem which inhibits their growth. They need to realize however that VAT generally increases overall taxation, which explains its popularity with governments,

Business Page considers VAT inevitable. It cautions however against rushing into it without careful study and preparation. VAT requires an infrastructure of tax administrators, tax practitioners, judiciary, reasonably honest businesspersons and an informed public. The Revenue Authority is still some way from being fully capable of its mandate and meeting public expectations. It would not be fair to impose on it a completely new form of taxation for at least another couple of years. We should use that time to carry out meaningful tax reform and preparing the nation for the revolution in taxation which VAT entails.