Business Page – August 20, 2000

In his response to the 1993 Budget renowned economist Dr. Clive Thomas called for consideration to be given to the introduction of Value Added Tax (VA T) in Guyana. This drew a hasty and inadequate response from the Advisor to the Minister of Finance, Mr. Samuel Singh who felt it necessary to note that a tax should cost no more to collect than it raises in revenue suggesting that VAT is unproductive as a revenue source. Perhaps he is unaware that one of the chief attractions of VAT, described in Fortune Magazine of May 17, 1993 is its proven ability to produce gushes of revenue. 

Dr Thomas ' position has merit since it is supported by sound, responsible research and irrefutable evidence. Value Added Taxes should therefore be considered not as an addition to the plethora of taxes which already exist but as a possible replacement for some of them. Many prominent persons in the private sector have raised concerns over the negative effect of the current rates of consumption taxes on production. In every quarter there are protests over those who escape the tax net, and the recent increase in corporate rates of tax to compensate for this has met with widespread disapproval. Value Added Taxes may certainly present an alternative which would eliminate or significantly reduce the existing inequities in the distribution of the burden of taxation.

The summary dismissal of the suggestion by Dr. Thomas ignores the potentially significant benefits which can be derived from a system of Value Added Taxes. Primarily it will achieve the Finance Minister's oft stated objective of broadening the tax base. In many countries including Jamaica it has also proven to be an acceptable alternative to Consumption Taxes. Mr. Singh, with his breadth of experience, must surely be aware of the potential of value added taxes as a means of attaining another of Minister Ally's goals - an overall reduction in tax rates.

We believe that tax reform is of such fundamental importance that it requires serious and informed discussion, particularly by those persons holding key positions in this country.

VAT has evolved out of a number of earlier attempts at various forms of sales tax and it is constantly being refined from experiences in a number of countries having their own peculiarities. Before looking at the mechanics of VAT let us trace the development of some of the principal forms of sales taxes.

As the name implies this was a tax on sales which applied at all stages thus the description cascade tax. The tax penalised independent firms in favour of integrated businesses encouraging the business unit to produce and sell direct rather than purchase from specialists or self to retailers. This tax favoured imports since they are unlikely to pass through as many hands in the economic chain, and led to widespread evasion.

The final ratio of the tax burden was determined by the number of transactions through which the items passed and this distorted the economic allocation of resources. Accordingly the countries of the EEC, Africa, Asia and Latin America have abandoned the Tax in favour of other forms of sales tax principally VAT.

Our own Consumption Tax is one form of this tax which applies on the sale by the manufacturer on the first or last wholesale transaction or at the port of entry on the case of imports. Interestingly enough the earliest use of this tax was in Canada (1923} where it has been replaced by a Goods and Services (Value Added} Tax.

Like the cascade tax, consumption tax also has a number of disadvantages and although not as objectionable as the turn-over tax it is not efficient in allocating resources. The forward integration by the manufacturer is penalised and businesses must often alter their distribution channels to minimise the effects of the tax. Where goods pass through different manufacturers cascading results and the impact of the tax on expenditure varies according to these channels and manufacturers t mark up. One further drawback is that the tax whether at the manufacturing or wholesale stage favours one business form over another thus contributing to a misallocation of resources.

One of the major advantages of this form of tax is that it is accountable for by the small number of manufacturers and wholesalers characteristic of most developing, open economies.

The retail sales tax is a tax applied to the entire retail price so that the ratio of the tax to consumer spending is consistent. Because It takes place at the point of final sale the business form is irrelevant and allocation efficiency is better realised.

It is generally a policy maker's dream since he can so easily calculate the what if possibilities. The purchaser on the other hand knows exactly the tax element of the purchase.

The major drawbacks are that the number of persons accountable are much larger thus restricting the use of multiple rates necessary to introduce a measure of progressiveness in the system.

There are a number of systems of retail sales tax which have general advantages but which also have disadvantages. Three forms of this system which have been applied in various parts of the world are worthy of mention. The first is the Universal Retail Sales Tax in the USA. The second one imposes the tax on sales by large retailers to small retailers thus removing the need and cost of applying it to sales by small retailers in communities where, owing to the standard of education and record keeping, it would be inoperable. Even if there is revenue leakage at this stage it will not be much worse than any of the alternatives including income tax since those involved in evasion will be difficult to police anyway.

A third alternative though not widely used is a Retail - Wholesale Tax operating under the value added principle whereby the retailer deducts from his liability any taxes which he has bome on his purchases.

Next week we will look at VAT and how It works.

VALUE ADDED TAX {VAT)

INTRODUCTION

In the first part of this article published last week we noted that there is increasing pressure on policy makers around the world for a system of taxation which encourages rather than penalises effort which taxation of income and savings is claimed to do. We also noted that a number of countries have indeed sought to tax expenditure rather than income.

There are a number of reasons why these attempts were not as successful as they could be, among which is the ease with which income tax may be withheld at source, as in the case of MYE on emoluments and withholding tax on bank interest.

Expenditure taxes proper have failed badly in the few countries where they were tried principally in Asia and have all but been abandoned. The next best altemative to the expenditure tax - sales taxes - has proved immensely popular and last week we identified a number of forms of sales taxes and discussed their merits and de-merits.

Today we address what is now regarded as the best form of Sales taxes - Value Added Tax and in a closing article next week we will identify its strengths and weaknesses.

In the previous articles on the topic we responded to comments made by a Finance Ministry adviser and 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.

DISADVANTAGES

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

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.

Further there is now a tendency in most 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 VA T 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. Each of the previous indirect taxes such as customs duties, purchase tax and excise duties replaced by VAT had Its own rate structure as well as a different tax base and separate administrative procedure. 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, thereby eliminating the overlapping auditing practices that had plagued those systems.

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, Jo justify deductions} are likely to prove serious.

However it is often overlooked that businesses already function with considerable administrative responsibility for a number of laws including the National Insurance Act and the Income Tax Act.

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. Compliance with this will certainly ensure compliance with VAT Regulations and since there is an actual benefit to be derived from accounting for VAT paid on input there is an incentive for proper record keeping.

As we have noted before VAT also allows for the exemption of small businesses from the system.

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 hardly ever noticed.

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.

In any case any price consequence is one time only and prices should stabilise  thereafter.

VAT Favours Capital Intensive firms

It is also argued that VAT places a heavier direct impact of tax on the labour-intensive firm 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 economies and industries.

ADVAN7AGES

Against these disadvantages are the considerable and weighty advantages. These include:

Coverage

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 and 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 gives the new government the opportunity to bring back into the tax system all those persons and entities who were given tax exemptions in one form or another by the previous regime.

Revenue Security

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 VA T 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. Under a retail sales tax, on the other hand,, retailer and consumer have a mutual interest in under declaring the actual purchase price.

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. If evasion takes place under a sales tax, on the other hand, all the taxes due on the product are lost to the government.

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. Cross audit is possible with any form of sales tax, but the tax-credit feature emphasizes and simplifies it and is likely to make firms more careful not to evade because they know of the possibility of cross check.

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.

Most taxpayers cheat on their sales not to evade VAT but to evade personal and corporate income taxes. Operation of a VAT resembles that of the income tax more than that of other taxes and an effective VAT greatly aids income tax administration and revenue collection. It is interesting to note that when Trinidad and Tobago set out to introduce VAT it chose one of its top income tax administrators as the VAT Commissioner.

It must be stressed once again that if properly implemented VAT can ultimately lead to a reduction in overall rates of tax. Revenues will not be sacrificed but would in fact be enhanced as a consequence of the broadened tax base. This does not seem to be a bad idea at all.