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Value
Added Tax (VAT) Part III
Advantages and disadvantages
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 are:
1) VAT is
regressive
It is claimed that
the tax is regressive, ie 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 allows for steep rates of tax on luxury items, although this
can create problems for administration and open opportunities for evasion by
way of deliberate misclassification, 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. 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, to 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 exemptions, 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.
3. VAT is
inflationary
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.
4. VAT favours the
capital intensive firm
It is also argued
that VAT places a heavy 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.
Advantages
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 VAT it is only buyers at the final stage who 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 undervaluation 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 underdeclaring 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 emphasises
and simplifies it and is likely to make firms more careful not to evade
because they know of the possibility of cross check.
Selectivity
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.
Co-ordination of
VAT with direct taxation
Most taxpayers
cheat on their sales not to evade VAT but to evade personal and corporate
income taxes. The 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.
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