Business Page December 25, 2004

 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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