The Allure of the Value-Added Tax

Updated on July 20, 2022

The VAT has extended from Europe and Latin America to a wide range of emerging and transitional countries over the past 25 years.

As recently as last year’s IMF research shows, however, the VAT can be a useful tool for raising revenue and modernizing the country’s tax structure as a whole.

It was the most dramatic—and perhaps the most important—taxation evolution of the twentieth century, and it continues to this day. In the early ’70s, most people had never heard of the tax outside of academic circles and treatises. One-quarter of the world’s tax revenue is generated by this system, which is used in over 120 nations.

What is the value added tax (VAT)? It is a levy placed on all goods sold, regardless of where they are in the production process.

In a nutshell, the tax credit is a way for businesses to offset the taxes they have to pay on their own sales. Revenue is collected throughout the production process, unlike a retail sales tax, in which tax is only collected at the time of sale to the final consumer. When compared to a simple turnover tax, producers are able to recoup the tax they have paid on their inputs. No “cascading”—the “tax on tax” that occurs when tax is imposed on both an input into a process and the result of that process—is created by the VAT because it does not impact the prices firms ultimately pay for inputs. Additionally, the VAT’s impacts can be clearly seen.

There are no exceptions to this rule: every company with an annual revenue exceeding a predetermined threshold must take part.

VAT is, if it works as intended, a tax on final consumption because the tax is based solely on the net value of those final sales.

Other methods of taxing consumption exist, such as the retail sales tax, but the VAT has the advantage of being collected at every step of the manufacturing process.

To keep things simple, let’s imagine that Firm A sells its output for $100 (excluding tax) to Firm B, which then sells its output to ultimate customers for $400 (again, excluding tax). In this scenario, a 10% VAT is in place.

Firm A will then bill Firm B $110 and pay $10 in taxes to the government.

Output tax of $40, minus a $10 tax credit, will be sent by Firm B, which will charge ultimate customers $440.

As a result, the government collects $40 in taxes. Firm B does not have a financial incentive to change its manufacturing methods or merge with Firm A to avoid this tax, but the manner of collection ensures that the income is collected more successfully. In the event where Firm A omitted to charge tax to Firm B, for example, the government would still collect $40 from Firm B. (which would have no credit to set against its output tax).

At the very least, the government would collect $10 from A if Firm B did not charge tax. One of the advantages of the VAT over a retail sales tax is illustrated by this last point. Imagine that B is a retailer and somehow manages to dodge tax. The $10 paid by A is still in the hands of the government under the VAT, but it is gone under the retail sales tax.

Sales and turnover taxes were often the only types of domestic indirect taxes that applied until the advent of the VAT.

There was an incentive to look for less distorting alternatives because of distortions connected with turnover taxes and governments’ desire to boost their revenues, notably in many cases to replace import tariff revenues lost as the result of trade liberalization.

However, countries were slow to implement the VAT. It wasn’t until 1948 in France that the first clearly visible VAT developed, despite early ideas dating back to the 1920s. As the first Latin American country to implement VAT in 1967, Brazil also marked the beginning of VAT’s widespread implementation in Europe with its 1967 implementation by Denmark (see Table 1).

Industrial countries and South America quickly embraced VAT in the late 1970s, but it took another decade for developing and transition economies to follow suit. There has been a remarkable increase in the number of African countries that have a VAT since the 1990s, from two to 30.

Since its inception, the IMF has played a significant role in global affairs, providing guidance to its member countries on tax policy and implementation. As a result, a comprehensive investigation on the tax’s efficacy and best practices was recently undertaken.

This investigation was surprising in its scope. Overall, the findings were promising, suggesting that a wider implementation of VAT was probably a good idea. A VAT’s success, however, cannot be taken for granted: solid design and implementation are required not only when it is first introduced but also for many years afterwards.

Judging efficiency and fairness

Do you think the VAT has lived up to its early promises of efficiency and fairness in raising revenue? Our goal is to circumvent the difficulty of calculating the efficiency gains of a VAT by examining whether countries that have implemented it have higher total tax receipts as a percentage of GDP. Since a VAT lowers the efficiency cost of generating revenue, governments should be able to raise more money this way. There is evidence that the general government revenue and grants to GDP ratio is raised by the VAT, but the general government tax revenue alone is not, and there is no evidence that it boosts (or decreases) the central government tax revenue ratio when all other parameters are held constant. While it is difficult to make sense of these numbers and it is obvious that more research is required, this result shows that the VAT may be effective in increasing revenues.

 

Table 1: The lure of the VAT
Taxes can be raised by using VAT in specific circumstances.
A country’s VAT income generation efficiency has traditionally been assessed using a metric known as the “efficiency rate,” which is calculated by dividing its GDP by the normal VAT rate. Because it was derived from a faulty GDP statistic, this number is riddled with inaccuracies. Total consumption (the best feasible VAT base) should be utilized instead of gross domestic product as a criteria (GDP).
Because of an administrative error, the efficiency ratio would improve even if the VAT were raised. By dividing the VAT revenue by the standard tax rate, we were able to avoid this issue (see Table 2). If the International Monetary Fund (IMF) enforced consistent consumption taxes, the economy would be 100 percent efficient. During our analysis, we discovered various risk factors for a high C-efficiency.
percent of the country’s total domestic product (apparently because it is easier to collect VAT at the point of import than domestically; high literacy rates; and the age of the VAT collectors) The impacts of a tax are amplified when it is in place for an extended period of time.

Not just for rich countries

Is it a good idea for countries that are still developing to have a VAT? Many people argue that the VAT is an unwelcome burden on developing countries because of its inherent complexity.

Though underdeveloped countries may gain more from VAT implementation than developed countries, the most relevant question isn’t whether VAT works better in countries with more advanced administrative systems. VAT isn’t better or worse than other solutions available in developing economies; it’s just different. Does this scheme in fact outperform other taxes that would have to be used to raise the same amount of money?

Before and after the introduction of Value Added Tax (VAT), the tax systems of six francophone and six anglophone countries in Africa were examined (VAT). When it comes to taxes, consider the French model, which had a similar sales tax structure to that of its predecessors in the British colonies. Tax rates varied widely, often significantly, as did exemptions and unequal treatment of imports and domestic sales, all of which were used to build the tax base.

Multistage crediting mechanisms of the VAT are excellent for this purpose because turnover taxes have a built-in cascading effect. In many poor nations, it would be much simpler to manage a standard VAT with a high registration threshold than to deal with the tax(es) it would replace.

Table 2: How Effective?

Since most countries without a VAT are small and over a quarter have populations under one million, does this also apply to small countries? There was a noticeable similarity between tiny countries with a VAT and the European Union countries when it came to C-efficiency ratios, with an average of 65 percent. This is in line with the preceding finding that transparency has a significant impact on VAT performance. One must, however, reexamine the question of “good relative to what?” Even if VAT is the most straightforward tax to collect in open economies, that does not mean it is the best option. It’s possible that alternative taxes would do better.

What we did to address this question was comparing the VAT to a uniform tariff on all imports as a tiny country would prefer to levy no trade taxes but raise revenues by taxing consumption in the absence of collection costs. According to preliminary calculations, the costs of changing to a VAT would have to be fairly high in order to exceed the benefits of doing so.

However, where domestic production has few phases, the VAT may give minimal advantage over a retail sales tax or, in particular, a uniform tariff. The benefits of the VAT would be greater if imports made up a smaller percentage of GDP, if imported consumption was smaller, and if intermediate items were more prevalent in imports. The advantages of the VAT grow as the economy grows.

Best practices in design

It’s critical to understand the primary challenges to VAT development.

A study by the IMF of tax policies and administration in 37 countries concluded that it was not controversial.

Adding insult to injury, the IMF’s recommendations were followed uniformly by all countries, although only partially.

Despite the fact that exports are not taxed and input taxes can be reclaimed, zero-rating is more commonly employed in practice.
As a result, capital purchase input credits are regularly delayed.
In order to avoid input decisions from being skewed and damage its openness, the VAT allows for more exemptions than is advised.

This undercuts the VAT’s efforts to keep input decisions transparent.
A single tax rate is typically preferred by the International Monetary Fund (IMF), however in the 1990s, numerous countries veered away from this preference.
Registrant turnover thresholds are frequently set lower than what is considered optimal by governments.
Because of its practical significance, some countries have viewed the VAT’s low starting barrier as a weakness.

So Ghana’s 1995 introduction of VAT was considered a failure because the registration threshold was lower than the $75,000 on its successful reappearance in 1999. When Uganda’s VAT was first introduced in 1996 (at $20,000, subsequently raised to $50,000), it nearly failed because of this. Zero would be the most cost-effective threshold if there were no administrative or compliance expenditures. This is obviously not the case. Rule of thumb: When the savings in collection costs outweigh the losses in income, establish a minimum threshold.

Many countries have rejected this strategy for different reasons, including the belief that excluding smaller enterprises would be unfair and the belief that covering more firms would result in more revenue, given that the value-added base in most countries is concentrated among a limited number of firms. Despite the fact that some of these concerns are well-founded, we feel that the advantages of concentrating VAT on a select group of wealthy taxpayers outweigh the disadvantages.

A tool for poverty reduction

Is the VAT fundamentally regressive, or is it a powerful tool for alleviating poverty? The VAT is often believed to have a negative impact on the distribution of actual income. In fact, rather than a single tax, it is the overall tax system, coupled with public spending decisions, that influences poverty and equity. Regressive taxes may be the best way to raise money for pro-poor spending, which would more than outweigh the tax’s own negative impact on the poor. When it comes to most developing countries having a VAT, how does the issue play out in practice?

There are relatively few studies of the VAT in developing nations, but there is increasing evidence that the VAT is not a particularly regressive tax. Poor people pay less than their share of total VAT receipts in countries such as Côte d’Ivoire, Guinea, Madagascar, and Tanzania, for example.

According to a study, the VAT outperformed trade taxes in several cases.

Those who see the VAT as particularly regressive may be tacitly comparing it to a progressive personal income tax—a comparison that has little relevance given the challenges developing nations have in implementing an efficient personal income tax.

There are just a few taxes that can be used to achieve equitable goals.

Even while well-targeted spending measures are generally relatively restricted in many low-income nations, spending policies are often a far superior means of achieving these goals. The ability to pursue distributional goals in spending is not taken for granted,

but history has shown that taxation’s primary role is to produce required revenues with the least amount of distortion to economic activity as possible.

Simple is best

What are the administration’s most pressing concerns? Creating more integrated tax administrations and implementing cutting-edge procedures based on voluntary compliance are made easier with the implementation of VAT. However, there have been severe faults in the VAT’s application in poor and transitional countries:

The difficulty of implementing workable self-assessment systems, in which taxpayers declare and pay taxes based on their own calculations, with the possibility of later audit, and the necessity of effective audit programs based on risk-analysis selection methods are all factors that must be taken into consideration. Exporters will be allowed to claim a refund of tax paid on purchases, but there will be no obligation to pay export taxes.)
The process of getting a refund has become more onerous in recent years in various countries.

As important as prompt VAT refunds are, governments must protect their income streams against fraud and have an incentive to increase revenue streams by simply delaying refund payments. Refunds are, in fact, the Achilles heel of the VAT. To implement best practice (reimbursing all excess credits) is impossible in countries with low administrative capacity, thus tax policy guidance in this area has been impacted by this lack of administrative capability.

Problems with the VAT system may be related to a deficiency of effective audit mechanisms, and this may have been understated in VAT guidance and assistance.

The International Monetary Fund (IMF) offers easier procedures and faster reimbursements to exporters and businesses importing considerable amounts of capital equipment, while other taxpayers face delays and credits that must be carried forward.

Next steps for the VAT

Decentralized governments and regional trading blocs, where there are no formal border controls, are likely to face major challenges in implementing the VAT, as well as the right treatment of the financial sector under the VAT, and the minimization of the damage caused by numerous rates and exclusions.

Even more essential, but as of yet underappreciated, are the ties that bind the VAT to income taxes on a national and international scale. Although the VAT has made significant progress, its potential has yet to be completely realized or even fully comprehended.

The Modern VAT, written by the authors and published by the IMF in 2001, is the basis for this essay.