Vat: Are We Ready For the Big Bang

VAT: ARE WE READY FOR THE BIG BANG VAT: ARE WE READY FOR THE BIG BANG? By Dr. I.A. Khan, Lahore Few fiscal topics are more important than value-added tax (VAT) which has become the single most important source of tax revenue in some countries, and one of the most important source in many more. The VAT has spread around the world more quickly than any other new tax in modern history. According to Alan Tait, the value added tax "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" Now the questions arise, what exactly is a VAT; what are its mechanics; why its growth has been extensive across countries and intensive within countries; what are its merits and demerits and is our country ready at this point to time to implement this tax? Value-added tax is a "broad-based tax levied at multiple stages of production and distribution with---crucially---taxes on inputs credited against taxes on output. That is while sellers are required to charge the tax on all their sales; they can also claim a credit for taxes that have been charged on their inputs. The advantage is that revenue is secured by being collected throughout the process of production but without distorting production decisions. (International Tax Dialogue, 2005) Like the personal income tax, a VAT is not so much a single tax as a set of taxes that share certain characteristics. So, in some countries like Pakistan, the same tax is named as Goods and Services Sales Tax (GST). Richard Bird has put this point in zoological terms, VAT is neither a gorilla nor a chimpanzee but rather a genus like 'primates'. Mechanics of VAT -VAT being indirect tax (i.e. it is levied on consumption rather than on income) is collected at each stage of commercial chain. In the example below a VAT rate of 15% is assumed throughout and, for the sake of illustration, it deals with a single transaction. In reality, VAT is calculated on outputs during given period, not on particular transactions. Costs (Rs) (excluding VAT) Sale (Rs) (excluding VAT) VAT (Rs.) On costs(input) VAT (Rs.) On sale (output) Paid to FBR (Rs.) Producer -- 20,000 --- 3,000 3,000 Manufacturer 20,000 30,000 3,000 4,500 1,500 Wholesaler 30,000 45,000 4,500 6,750 2,250 Retailer 45,000 60,000 6,750 9,000 2,250 Customer 60,000 --- 9,000 --- 9,000 In this example, taxable person in the chain must charge VAT on supplies (subject to certain exceptions) made to customers (outputs). This VAT is termed output VAT and must be accounted for to FBR. Insofar as taxable person incurs VAT on supplies which he has received, this VAT (which is referred to as 'input tax') can be recovered from FBR, provided that it is attributable to taxable supply made or to be made and appropriate evidence is held. If input tax exceeds output, the excess can be recovered in full from F.B.R. provided it is attributable to taxable supply. Output tax is only charged on supplies made in the course or furtherance of a business; input tax is only generally refunded if inputs are used or are to be used for business purposes. The final tax (Rs. 9000 in the illustration) is wholly borne by the consumer (for VAT purposes, this means someone who cannot recover VAT because he is not registered) or who does not make any taxable outputs, e.g. entirely exempt outputs. The VAT mechanism is intended to ensure that, ultimately, the net VAT paid (i.e. the Rs.9000) is exactly 15% of the taxable value (Rs.60,000). However, since supplies of goods or services which are exempt or outside the scope of VAT may have borne VAT which is not identified and not recoverable, this objective is not always achieved. The proliferation of VATS There are number of reasons why VAT has become such a popular source of revenue. Firstly, after the World War II, France was the first country who adopted a primitive version of a VAT. Then, in the Treaty of Rome (1957) France and the other member countries agreed to share some of their national revenue (including revenue from VAT) to finance the operation of the European Economic Community, now the European Union (EU). Over the period of time VAT became a major source of revenue for EU operations hence The Treaty required member States to convert their turnover taxes to a harmonized VAT. All newly admitted members are also required to adopt the harmonized VAT. Secondly, many of the major industrialized countries became signatories to the General Agreement on Tariffs and Trade (GATT), now the World Trade Organization (WTO), after the World War II. They could not subsidize exports, or tax imports more than domestically produced goods. At that time European countries relied heavily on indirect taxes for their revenue. For many countries international trade was a significant factor in their economies. Since, it was easier to identify the indirect tax component, in the price of export than direct tax component buried in the product price hence, GATT permitted signatory countries to rebate indirect, but not direct, taxes on exports. Thus countries that relied on VAT had border adjustable taxes so they were able to rebate these taxes on exports and impose them on imports. Thirdly, the International Monetary Fund (IMF), in the last couple of decades,' has provided technical and financial assistance to the developing countries and emerging economies to convert their turnover taxes, manufacturer's taxes, retail sales tax, and other indirect taxes to VAT. Merits of VAT VAT, an unprecedented fiscal innovation which has spread widely and rapidly, being one of the mainstream taxes is capable of generating 5 to 10 per cent of GDP. This is a consumer based tax so those who support it justify that it is more equitable; those persons, who have more and spend more will pay more tax, so the rich would bear more tax burden compared to the poor. A well-planned and properly administered VAT, where State has excellent database with complete record of producer, manufacturer, wholesaler, retailer and customer, can be good source for broadening the tax base and improving Tax to GDP ratio. VAT can play vital role as an Instruments of Public Policy. It is a destination-based consumption tax so non-taxation of exports, and the taxation of imports, could favor promotion of the export trade. Under the VAT system a Government has leverage to declare certain items Standard rated, Zero-rated or Exempt keeping in view the nature and consumption of item. So the people can buy food, medicines and certain essential items without any VAT. The government can also reduce disparity between haves and have-nots by utilizing the revenue generated through VAT for the better health facilities, and improvement of social life of the low income groups in the society. Challenges Not all is sunshine in 'VAT land,' as Richard Bird has rightly said. Increasingly, clouds of varying sizes and shapes seem to be looming on the horizon. Some problems such as the relatively high compliance cost for small firms and the vulnerability of the refund system to fraud have always been inherent in the structure and operation of VAT. This is a tax which is cumbersome to police and easy to abuse. In most developing countries, as Milka Casanegra says, "tax administration is tax policy" The real tax system is that which is administered, not that which appears in the formal law. For VAT to be successful, in addition to competence of the administration and honesty of both officials and taxpayers, it is important that there should be fair probability of detection (audit) and strict application of penalties. Currently, our audit programs have lower yield- below 1 %, which is far less, compared to other countries in the World. The strict application of penalties is not enforced. The legal system allows long delays in the application of penalties that contributes towards in blockage of government revenues and consequently diminishes the system's effectiveness. The tax compliance is also fairly low in Pakistan. About 70% of registered persons and businesses file monthly tax returns. The data base is very poor which makes it difficult to verify the transactions down the line from producer to consumer and trace the small and the shadowy business. There is rampant corruption in the Tax Department, being not an exception in the society. There is lack of trust between taxpayer and tax collector. The general public considers the tax evasion as sign of power and authority because tax authorities have not been able to tax the income and gains of corrupt politicians, civil servants and army officers. The policies of the previous governments to abolish wealth tax, increase the limit of income for filing of wealth statement and Self-Assessment Schemes without proper monitoring mechanism had discouraged documentation; consequently assets and transaction of billions of rupees have not been declared in the income tax record. VAT is not a cheap tax to administer, much money is collected only to be returned in the form of refunds which is 'Achilles heel' of VAT system; fraud is possible through suppression of sales figures, barter transactions, understated debtors, false invoices, misdescriptions, multiple claims, and fictitious businesses. The costs of VAT administration will vary depending on the exemptions, thresholds, and number of zero-ratings, number of tax rates, frequency of audits, and the role played by other collection agencies (e.g., customs). However, the increasing number of supplies that are either zero-rated or exempted and thereby excluded from the VAT base for tax revenue purposes complicates compliance due to definitional and accounting problems and increases the cost of administration. It leads to misapplication of the tax and at times, outright fraud and abuse. VAT evasion, the size of the underground economy, and corruption are closely linked. Evasion reflects not just weak administration but more systematic structural problems such as prevalence of corruption and large underground economy. In Pakistan, Potential taxpayers have many ways to escape the fiscal system. The taxpayer---or their base- may flee abroad. Or they may remain but hide shadow economy. Or they may secure some form of favourable treatment by exerting influence in various ways (legal or otherwise) to have changes made in tax law or its interpretation. Even if through an oversight they find themselves somehow trapped within the taxation, they may seek forgiveness through amnesty laws or specific grants of relief. This widespread base erosion facilitates evasion and---especially when taxpayers are subject to (bad) 'audit'---corruption. The government hard pressed for revenues have sometimes been driven to discretionary and unpredictable enforcement efforts---collecting money where they can and keeping it when they get it whether they should do so or not . In certain cases the government introduces legislative changes to close the gaps opened by previous political and administrative decisions that result into continual cycle of changes in the effective tax structure, subsequent erosion of the tax base, and unrelenting pressure on the tax administration to meet revenue target. The few unfortunate taxpayers who remain subject to the full rigor of the formal tax system face uncertain tax burdens. Savings and investment are deterred and misallocated. Trade may be discouraged as VAT refunds to exporters are not paid out but are instead kept in the Treasury and used to meet budgetary needs. Trust vanishes, the shadow economy expands, revenues fall, tax pressure is again increased on those who cannot escape, and cycle cotinues. Future prospects Experience in a variety of countries suggests that several conditions are essential for success in such major tax reforms as adopting and implementing VAT. Among the factors commonly mentioned are political commitment, thorough advance preparation, adequate investment in tax administration, and extensive public education program, consideration of local condition---the NOSFA (no one size-fits -all) principle, support from business and by no means least, good timing. In particular, political commitment to reform and the ability to put together sufficient political support are necessary conditions for sustainable success. On the technical level, thorough advance preparation adequate investment in tax administration and extensive public education have all proved critical to success in some countries. Unfortunately, our government has failed to make necessary preparation on political, social and technical fronts so we can encounter many problems in implementing VAT. To overcome this situation, certain fundamental steps are essential. The auditing procedure should be modernized and strengthened. Audit is the core of any tax system. This is especially true with respect to self-assessed taxes such as VAT. In principle, audits should be done both randomly and on a more selective basis, taking into account the risk profile of different types of taxpayers. More emphasis should be laid on key areas such as audit coverage, selection methods, staff training and monitoring. Cost effective audit relying more on short, issue-oriented audits of a limited period of activity, covering a broad range of taxpayers could be more efficient. Automation as well as linkage with other tax systems (Federal and Provincial) will make the audit more effective. Top priority should be given to fairness and integrity throughout the process of audit and greater efforts should be made towards education and facilitation of taxpayer - to evolve an environment of voluntary compliance. At the same time we should not forget that VAT differs from most taxes. VAT delinquency is not simply a matter of tax collection but in effect the embezzlement of public funds. Firms liable for paying consumption taxes have for the most part themselves collected those taxes from others. If they do not remit the funds to the treasury in a timely fashion, they have in fact, stolen the money which requires enforcement of rigorous penalties without exception. If this is not done, no tax, VAT or otherwise, can long withstand the constant erosion of the tax system as 'bad' taxpayers drive out 'good' ones.