Making VAT system robust: Introducing multiple rates

Md Abdur Rouf | Published: February 06, 2019 21:07:56 | Updated: February 09, 2019 21:00:01

The idea of Value Added Tax (VAT) was conceptualised by a German industrialist, Von Weildheim Siemens, in 1918. In those days, tax on tax was a major concern in the taxation arena. To remove the problem of tax on tax, he gave the idea of crediting tax paid on inputs and paying tax on outputs, that is, at each stage tax shall be paid on value addition only. Thus, the concept of credit mechanism developed which has been the backbone of the VAT System. Credit mechanism in the VAT system ensures shifting of the incidence of VAT to the next stage, thus the burden of VAT falls on the ultimate consumer. VAT is a consumption tax. 

In Bangladesh, a faultless credit mechanism in the VAT system could not come into operation even after so many years. This is why a chunk of potential VAT-payers could not be brought under the VAT net yet. Additionally, there are as many as 11 distortions in the VAT system today. Though a new VAT law titled Value Added Tax and Supplementary Duty Act, 2012 (the new VAT law) was enacted in November 2012, this faced many challenges resulting in suspension of its implementation. Recent newspaper reports suggest that the new VAT law may be implemented from the coming fiscal year with changes in the law as desired by the business community. It should be mentioned that the business community was demanding from the beginning multiple rates, continuation of package VAT, enhancement of VAT threshold etc. to be included in the new VAT law.

This article will present some ideas which may be of interest at this juncture of the new VAT law implementation in a bid to bring policy and business together and develop a consensus about VAT implementation in Bangladesh-a detail that was needed from the very beginning.

Without going into details of the background and rationale of multiple rates, let's assume that we have to accommodate multiple rates in our VAT system. With multiple rates, the basic problem involved is non-functioning of credit mechanism. Presently, we have a standard VAT rate of 15 per cent. Those who pay output VAT at 15 per cent rate can enjoy input tax credit. But those who pay output VAT at truncated rates (below 15 per cent), they can not avail input tax credit. Thus, the credit mechanism stops for them. It can be mentioned here that now we have six VAT rates on services and three VAT rates on goods. We need to make credit mechanism broadly functional because it ensures payment of VAT only on value addition and shifts VAT burden on the ultimate consumer. Recent newspaper reports suggest that the new VAT law shall be implemented after incorporating multiple rates. So, say three VAT rates are being considered, then allowance of input tax credit at the same proportion will ensure multiple rates and ensure exhaustive operation of credit mechanism.

For example, three VAT rates are being considered. Suppose the rates are 12 per cent, eight per cent and four per cent on goods and services alike. Those goods and services where 12 per cent VAT is applicable, shall avail 100 per cent input tax credit; those goods and services where 8 per cent VAT rate will be applicable, shall avail 66.67 per cent input tax credit and those goods and services where 4 percent VAT rate is applicable, shall avail 33.34 per cent input tax credit.

Credit mechanism needs to be precise. At present, in the country's credit mechanism, there are numerous disallowance, some of them are obscure resulting in manifold complications in VAT implementation. Credit has to be kept less than output VAT. Presently, an important criterion for input tax credit is that VAT is given credit on those inputs that are directly related to the production of final goods or delivery of service. Direct relationship is again a vague term. So, I would like to propose that in addition to direct relationship, credit should not be given to goods and services which were consumed prior to VAT being paid on them. Goods and services which are forwarded to the next stage shall be given credit. If this can be done, credit will remain lower than output VAT, thus not threatening revenue.

It should not be difficult to develop a precise input tax credit mechanism. We have 27 years of history and data of operating input tax credit mechanism in VAT. All the items on which input tax credit has been allowed so far can be jotted down. From among them, items which are directly related to the provision of goods and services and which are not finally consumed at this stage can be taken and a list can be prepared. A general order can be issued stating that only these items shall get input tax credit. It can be revised from time to time, if required. Thus, we can have precise list for which input tax credit can be taken. This will make it easier to implement and certainly, it shall be less than output tax.

This will ensure existence of multiple rates which should be accommodated. It will also ensure operation of credit mechanism on all VAT-able goods and services which is the basic of VAT implementation. Under these circumstances, everyone will take VAT invoice to avail input tax credit as there shall be incentive to make a broad-based VAT system operational.

However, under the proposed scheme, a small portion of goods and services should be exempted from VAT. Implementation has to be exhaustive, i.e. tax-gap has to be sharply reduced. A completely automated VAT system is a sine qua non to implement VAT exhaustively. In the proposed scheme, input tax credit and exemption should be conservatively designed. Multiple rates and proportional input tax credit can ensure a robust VAT system generating enough revenue without a hue and cry from the business community.

We have a tendency to try to see international best practices, when we propose anything new. Surely, we need to follow best international practices. But we need to keep in mind that there may be no previous practise, in case of new initiatives. When credit mechanism started its journey in France in 1937, there was no international best practice for it. Later on, it became international best practice. So, proportionate input tax credit may be a new strand in the VAT implementation which can be considered.

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

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