Business Page – December 12, 2004

Reviving the value added tax debate (A tax to reduce taxes)

Part I

In view of the heightened interest in Value Added Tax (VAT) recently, Business Page is re-running a three-part series on the subject first carried in 1993; this is Part I.

In his response to the 1993 budget renowned economist Dr Clive Thomas called for consideration to be given to the introduction of Valued Added Tax 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 permanent 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 VAT. Primarily it will achieve the Finance Minister's off-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 VAT 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.

A very influential paper published recently on the subject noted that "VAT is clearly the tax of choice in many developing countries. Indeed, the only phenomenon comparable to the rapidity of its spread in recent years was probably the implantation of the income tax earlier in this century, largely under colonial aegis."

Business Page decided to do its own independent research on the use of VAT around the world, and it was a revelation to learn of the increasing popularity of this form of taxation not only in the developed countries but also in the developing ones as well. The source was a 1992 International Survey of 82 countries; of these exactly 41 or half had VAT whilst another 31 had some other forms of sales tax. Only 10, ie 12% did not have a sales tax.

VAT is a form of taxation which is charged on the invoice price of chargeable goods and services. It is recognition that taxation should not act as a disincentive to effort, production and saving as income tax does. It is a response to the call for a system which taxes expenditure, and by extension encourages savings and investment. VAT is not a panacea, neither is it a perfect form of taxation, but countries which have adopted it generally do not regret its introduction.

VAT is of relatively recent origin in the Caribbean, having been introduced in Trinidad & Tobago and Jamaica in the past five years. It has, however, been around in the developing world as well as all major and not so major developed countries for decades. The possibility of its introduction in the United States has been raised, and the prediction is that the prospects for VAT or a similar tax will increase in future.

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.

Turnover 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 sell to retailers. This tax favoured imports since they were 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 abandoned the tax in favour of other forms of sales tax principally, VAT.

Single stage sales tax at per-retail levels

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 turnover 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' mark up. One further drawback is that the tax whether at the manufacturing or whole sale 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.

Retail sales tax

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 at 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-whole sale tax operating under the value added principle, whereby the retailer deducts from his liability any taxes which he has borne on his purchases.

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

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