Business Page – December 19, 2004

 Value Added Tax (VAT) Part II

How it works

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 PAYE on emoluments and withholding tax on bank interest.

Expenditure taxes proper have failed badly in the few countries where they have been tried, principally in Asia, and have all but been abandoned. The next best alternative 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.

Value Added Tax (VAT)

Value Added Tax, which has become known popularly by its acronym, VAT, has the unique feature of being able to extend through all channels of production and distribution from the initial production of materials to the final sale to the consumer, each seller paying on his value added only. It is immediately apparent that the base of the tax is exactly the same as that of a retail sales tax, since the retail selling price equals the sums of values added at all stages of production and distribution. However the impact of the payment of the tax is spread throughout the economy, unlike a retail sales tax which is charged only at the point of sale, a system in which both the seller and the buyer gain by the understatement of the tax.

Scope of VAT

VAT is a cumulative consumer tax on the commercial supply of goods and services and also on the importation of goods, whether by way of business or not. It is a multi-stage tax collected, in the case of goods, at all stages in their passage from raw material to finished article throughout the chain of primary producer, manufacturer, wholesaler, retailer and eventually final consumer, which is the general public upon whom the entire burden of the tax falls. In the case of services it is chargeable when the service is rendered, although in practice it is charged when the invoice is issued.

Like other taxes VAT is subject to abuse and evasion, though as we shall see later it provides a system of cross audit that mitigates the incidence of evasion. Also, like other forms of taxes VAT may be selectively applied consistent with government's fiscal, economic and social policies, including the control of the cost of living through certain reliefs consisting of zero rating and exemption.

In the case of zero-rated goods or services the effect is that a taxable supplier charges VAT on them, but since the rate at which VAT is chargeable in those cases is nil, those goods are effectively free of VAT.

He will have no output tax but is able to recover his input tax. This is in contrast to the case of goods or services which are exempt. The person supplying them cannot charge VAT to his customers and therefore VAT on supplies to him such as electricity, telephone, etc, are effectively a cost which he cannot recover except by an increase in his prices.

How the system works

The system requires the registration of persons dealing in chargeable goods and services although in practice the small retailer and artisan are exempt.

This complements and renders more effective other systems and laws which require registration such as the National insurance and Income Tax Acts which require all employers to register. An integral part of the system is the VAT registration number and the use of a VAT invoice which offers consistency and uniformity.

The essence of the tax lies in the right of each taxable person to recover from the tax chargeable on his sales, called 'output tax,' taxes paid by him on goods and services which he bought, called 'input tax.'

At the end of each accounting period, which may vary according to circumstances, he will pay to the VAT authority the total amount of tax which he has charged to his customers on the supply to them of goods or services, or for which he has become accountable in respect of imported goods, less his input tax. If the latter figure exceeds the former he is entitled to be reimbursed to the extent of that.

Depending on the balance, the whole or any part of any reimbursement may be permitted by law to be held over to be credited in the subsequent accounting period either at his option or in accordance with general or special decisions given by the authorities.

Incidence of VAT

Ironically, the normal taxable person who buys and sells goods or who receives and supplies services, all in the course of his business, is the one person in the scheme of the tax who does not bear the burden of it.

Instead, he is an unpaid tax collector who charges tax on supplies of goods and services by him in the course of business and, whether he is paid the amount of the tax so charged or not, accounts for it at the end of each accounting period to the VAT authority which is usually the Customs and Excise Department.

There are two other situations where the business person 'bears' the cost of VAT, meaning that he cannot be reimbursed.

1. In the case of exempt goods and services the business person is charged tax on his purchases, but he is unable to recover such input tax, and is also not required or permitted to charge tax on his sales. He is therefore in the same position as a member of the general public and bears the burden of the tax.

2. Those persons such as small retailers whose annual turnover of taxable supplies is less than some minimum figure will have to bear the burden of the tax because they are outside the system.

The principle of VAT is, of course, easily stated, but its application is far from simple. However, proper planning, education, a simple structure and a single rate with as few exemptions as possible will certainly help in its implementation.

(To be continued)

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