As opposed to a retail sales tax where the tax is collected at the final stage i.e. at the retail stage, value added tax (VAT) is collected from different stages in the production-distribution chain. There is a significant merit of VAT. It makes VAT more resistant to tax evasion as the collection of VAT is spread over production-distribution chain.
THE ROLE OF BUSINESSES: The role of businesses in collecting consumption taxes is crucial. Though in most countries, for example, Australia and Bangladesh, the liability to pay VAT is imposed on the person who makes taxable supplies, a business in fact collects the tax from its buyers and remits it to the government. Effective use of credit mechanisms can make sure that a business as an agent between the buyer and the government is not affected by VAT. This can be seen as a motivation for a business to play the role of an 'honorary' tax collector.
No tax should be examined in isolation from other kinds of taxes as one tax compliments another. Thus the information flows generated with the operation of a VAT are considered by many as a check on evasion of income tax.
These are some general motives that underpinned the adoption of VAT in most cases but there are also socio-economic reasons that serve as driving forces. Some authors have examined how against the backdrop of increasing globalisation and the growing integration of world's economies the way was paved for re-structuring the tax structure that showed unambiguous bias towards the adoption of VATs which spread like 'wildfire' during the past two decades. The most important rationale for the original adoption of VAT in Europe was to facilitate trade. For developing countries, the urgency of maximising revenue through expanding the tax base and the concern of trade facilitation inspired the adoption of VAT.
These aside, the rapid spread of VAT throughout the world is attributed to two factors: the early adoption of VAT by the EU countries and its demonstrated success; and the role the International Monetary Fund (IMF) played in spreading the success stories to the developing countries and making strong persuasion for the adoption of a VAT for more efficient revenue mobilisation.
The effectiveness of transferring VAT experiences from developed-country settings to countries characterised by fragmented economies, large informal sectors, low tax morale, rampant evasion, and total distrust between tax administrators and taxpayers has been seriously questioned by some. But, like the good governance agenda, the idea of adopting VAT in the efforts of tax reform has been 'exported' from the Western world to the developing countries. It is not a coincidence that the international organisations such as the World Bank and IMF who advocate good governance also advocate the adoption of VAT.
However, the adoption of VAT did not seem to be seen so much as a promoter of good governance as the economic consideration of raising tax to gross domestic product (GDP) ratio in developing countries did. The World Bank prescribed the adoption of VAT as early as 1988 in its report on the public finance issues in developing countries (World Bank 1988) in which it only implicitly referred to the role of public finance mechanisms in ensuring the quality of government.
REGRESSIVITY AND COMPLEXITY: While there are many proponents of VAT in both academia and among international development organisations, there is no dearth of critiques of VAT as well. While there are academic scholars who are not ready to consider VAT as a more acceptable or desirable tax than any other form of consumption tax, many others who approve of VAT as a more acceptable tax are aware of its shortcomings, or 'generic weaknesses'. The criticism of VAT has mainly been based on its regressivity and complexity.
On the issue of whether the US should substitute a VAT for a personal income tax, some scholars strongly argue that as the VAT is a tax on consumption, it would almost certainly be regressive because consumption as a percentage of income falls as income rises. This is a conventional wisdom in economics that the proportion of income spent on consumption of goods and services tends to decrease with the level of income. In plainer terms, the spending on consumption and hence the amount of tax paid on consumption do not increase with the increase of income. And hence, any broad based tax with a single rate - VAT included - is 'inherently regressive'. Such scholars look at the regressivity concern from another point. They maintain that 'since an individual's consumption is one of the best observable indicators of their living, consumption is potentially one of the most equitable of tax bases'. This implies that though spending on consumption does not rise proportionately with the increase of the level of income, it rises with the rise of income.
A charge that has often been brought against VAT is its complexity: 'an intrinsically complex tax, cumbersome to both authorities and the tax payer'. In response to a US Congress request for a report on the important lessons learned from selected countries' experiences administering a VAT, the US Government Accountability Office (United States 2008) reports that information indicates that a VAT may be less expensive to administer than an income tax. It provides a report of the New Zealand Inland Revenue Department telling the auditors that administering the VAT was easier than administering some of their other taxes. The Report, however, does not find a VAT better than any other tax in terms of its compliance risk and compliance burden through exemptions, exclusions, and reduced rates, which can exist in other tax systems. Particularly the reporters express their worries about the fraudulent claims of input tax credit in a VAT.
In contrast to the simplicity argument, the VAT has not been seen nearly as simple as is sometimes argued. The involvement of everyone in the production and distribution chain has been noted by some authors as the major disadvantage of VAT as it imposes a substantial administrative cost both on the authorities and enterprises. Some other common problems identified include complexity in compliance, extensive book keeping, treatment of small businesses, delays in the payment of credits, the opportunity cost of funds that are tied up until rebates are paid, the impossibility of getting refunds in some countries, and the inclusion of VAT paid by non-registered traders in producer prices.
The need to maintain written records of all sales and purchases in order to reclaim payments on intermediate transactions is the most irritating feature of VAT which tends to impact especially heavily on smaller businesses unused to keeping extensive records.
But seeing the complexity argument in an isolated manner does not portray the total picture. This is also a matter of comparative advantage. While some experts show with econometric analyses that VAT performed less well in less developed economies, the predecessors of VAT in many VAT-adopting developing countries were no less complex than a VAT. On another count, the revenue raising potential of VAT has been seen as outweighing its complexity problems. Thus considering the pros and cons, the worst form of VAT has been considered a better choice for raising revenue than most traditional forms of taxation.
In fact, the relative advantage of a VAT as compared to its equivalents seems to be its greatest defence. It has been found that the problems noted are not quantitatively significant in most developing countries especially if compared with the problems associated with a possible substitute form of consumption taxation. Better still, there are ways of neutralising, if not totally eliminating, the impact of some generic weaknesses. A common argument in neutralising the impact of regressivity in VAT is that VAT has the mechanism to offset a great deal of regressivity impact through rate differentiation and exemptions. In line with this approach, most of the VAT-adopting countries have introduced progressivity by exempting basic products such as food, medicine and primary agriculture products and also by subjecting luxury or socially undesirable goods and services to higher rates of tax in the form of supplementary tax. Empirical studies of VAT in developing countries have also shown that exemption and rate differentiation measures have been successful in mitigating the regressivity impact to a great extent and make the tax more progressive.
VAT, however, should not be judged in isolation but as a part of the whole tax structure existing with its counterparts such as income tax, sales tax or excise duty. Hence, the more important question to ask is not whether a VAT is regressive, but whether it is more regressive than the alternative indirect taxes, namely, sales, excise and turnover tax.
The satisfactory implementation of VAT requires sophisticated and capable tax administration which many developing countries, including Bangladesh, are currently lacking. This leads to questions like whether the VAT in developing and transitional economies could be as good in economic, equity, and administrative terms. Can this be administered sufficiently effectively by hard-pressed revenue administrations? Judging the pros and cons and taking the cost and benefits into account, some authors contend that 'VAT is almost without exception still the best form of general consumption tax available.' This conclusion seems to have been strengthened from earlier findings that governments all over the world, in developing and developed countries alike, were attracted to the productivity of VAT, even when they were relatively poorly administered.
Despite arguments for and against VAT, the fact remains that it has swept the world in a short span of time. And the literature amply shows that the VAT has proved, almost without exception, to be a more effective and efficient tool for maximising revenue than the tax it replaced in both developed and developing countries. The unabated progress of this indirect tax in different regions throughout the world led some to remark, 'The rise of the value added tax (VAT) is an unparalleled phenomenon… VAT may be thought of as the Mata Hari of the tax world - many are tempted, many succumb, some tremble on the brink, while others leave only to return, eventually the attraction appears irresistible.' He mentions the flirting of some developed countries such as Australia, Japan, Canada and Iceland with VAT who resisted the its adoption until 1988 on the grounds that a VAT is regressive, administration- and compliance-wise costly, prone to evasion, specially to fraudulence of refunds. Interestingly, all of these countries adopted VAT in course of time - Japan in 1989, Iceland in 1990, Canada in 1991 and Australia in 2000.
A close study of the phenomenal spread of VAT throughout the world shows that the administrative and economic inefficiency of the sales taxes with their complexity, cascading effect, narrow base and multiplicity of rates led fiscal policy makers to switch to a VAT in an attempt to modernise their tax structure. Not only as a 'fashionable tax,' VAT with its visible success in many countries in generating buoyant revenues, created its own demand among both developed and developing countries. Thus, it seems to be a valid question if a VAT has the equal potential to contribute to improved governance.
Jamaluddin Ahmed PhD FCA is the General Secretary of Bangladesh Economic Association and a member of the Board of Directors of Bangladesh Bank.
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