Designing an efficient VAT System

There have been plenty of discourses about designing a value added tax (VAT) system in the country. There were enough talks on exemption, standard rate, truncated rates, tariff value, threshold, treatment to the Small and Medium Enterprises (SMEs) etc. These continue to appear inconclusive. The new VAT law (Value Added Tax and Supplementary Duty Act, 2012) is reportedly going to be implemented from July 01, 2019 with amendments through Finance Act, 2019. Prior to the amendments, it is pertinent to dwell upon how a VAT system needs to be designed particularly in an economy like ours.

The basic principle of VAT system is: lowest possible single rate and widest possible coverage. In VAT system, rate has to be single, not multiple and the single rate has to be the lowest possible so that it becomes tolerable for the payers. Coverage of VAT i.e., base has to be widest possible so that almost everyone pays VAT. Although the payments may be small in amount, the aggregate amount is immense. To ensure this, exemption has to be kept at a minimum as the backbone of VAT system is input VAT credit mechanism. Operation of input VAT credit mechanism requires issuance of VAT invoice at every point of sale, so that at the next stage of sale, input VAT credit can be obtained. If in the chain of supply, at one stage there is VAT exemption and therefore there is no VAT payment and no VAT invoice, then at the next stage input VAT credit cannot be obtained and the chain i.e. the system gets halted. Therefore, exemption must be kept at a minimum to operationalise a broad-based VAT system. Input VAT credit ensures that at each stage, burden of VAT shifts to the next stage and thus ultimately falls upon the final consumer. It can be mentioned here that VAT is a tax on consumption which is ultimately paid by the final consumer. 

In standard VAT system, to keep exemption at a minimum, few principles are generally followed. The authority to allow exemption is not upon the regulatory agency of VAT law but on any higher stage of government. Generally, exemption is given through Finance Act and once given, it is not changed. Very basic necessities of the poor segment of society, items of religious importance, items related to basic rights ensured by constitution are given exemption. However, exemption has to cover a small segment of the economy and such exempt supply do not generally fall under the mainstream economy.

To facilitate the poor segment of society and to ensure the aforementioned objectives, apart from exemption, lower rate is a better option. There should be one or two lower rates in addition to the standard rate. However, to apply lower rates, the threshold should be kept low as well. If threshold is higher and lower rates are too low, then an uneven competition with the entities paying at standard rate will be created. Under short rates mechanism, entities become habituated to pay and keep records not practiced in exemption. Some of them graduate to the standard rate bracket. Supplies involved in the exemption and lower rate categories are meant not to fall within the mainstream of the economy.

In a standard VAT system, the overwhelming portion of the economy remains under standard rate where every entity issues VAT invoice and takes input VAT credit. The economy becomes a cobweb of VAT invoice and input VAT credit. A small portion of the economy remains under exemption and short rate regime.

So, we find two spheres here. One is exemption and reduced rates and the other is standard rate. The two spheres are distinct and operate almost independently. Interactions between these two spheres are minimal. The short rates operate under sub-stream economy and the standard rate operates under mainstream economy.

Under standard VAT system, the penal measures are punitive and exemplary. It is assumed that maximum number of entities will obey the law. It does not become possible for the regulatory authority to audit the business activities of 100 per cent of the entities. So, audit is done on risk management basis and if any irregularities or evasion is detected, these are severely dealt with. To operate a good VAT system, implementation has to be rigorous. Otherwise the basic spirit of VAT system fails. In the standard sphere, if some entities do not issue VAT invoice and are treated casually, then an uneven competition is created with the regular entities. Then the VAT machine faces trouble. So, to ensure full compliance, rigorous measures are employed in standard VAT system. 

VAT Deduction at Source (VDS) needs to be accommodated in any VAT design. Although VDS is considered a distortion of the standard VAT system, it has been an easy method of collecting overwhelming portion of revenue. Presently, about 40 per cent of Bangladesh's domestic VAT is collected through VDS mechanism. A simpler and wider VDS mechanism can contribute more revenue to the government treasury without hassle.

Export is kept at zero-rate because government needs to give incentives to the exporters. All duties and taxes paid to procure inputs for making exportable supply either face drawbacks or are not taken first hand under bond license facility. However, exporters require keeping books of records. Export, deemed export and backward-linkage industry forms a distinct regime within the VAT domain. This needs to be ensured. For every sector paying VAT, standard operating procedure (SOP) needs to be developed so that it is easier for the entities to comply with the regulations. The legal provisions need to be kept updated with the changing nature of economic activities, which is seldom done in our system. A skilled intermediary can be the professional community including consultants that can bridge the gap between the VAT payers and VAT officials in a manner where there shall be no evasion and no harassment.

In the present VAT system (1991 VAT law), there is 15 per cent standard rate, 5 per cent VAT rate on traders and there is package VAT for small traders. There is tariff value on a good number of goods at manufacturing stage. There is 3 per cent Turnover Tax with threshold of Tk 8.0 million. On services, in addition to standard rate, there are 6 lower rates. There is no blanket exemption threshold. Under the new VAT system (2012 VAT law), there is 15 per cent standard rate and 3 per cent Turnover Tax with BDT 8.0 million threshold. Only on one service, Joint Venture for Property Development, there is lower VAT rate of 7.5 per cent. There is BDT 3.0 million blanket exemption threshold.

So, it appears that having an understanding about the design of a standard VAT system with the above basic features is not very challenging. The differences between the existing and the new VAT systems are not challenges either. The challenge lies in developing a consensus among the stake-holders regarding the basic features of the VAT system that we really need and then, go for instituting mechanisms for rigorous implementation of the same. All stake-holders need to focus their attention on this issue now.

Dr. Md. Abdur Rouf currently works at a World Bank-financed VAT-related project as a Specialist.

Opinions expressed in this article are his own.

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