CHAPTER-3 THEORY OF VALUE ADDED TAX

Transcription

1 CHAPTER-3 THEORY OF VALUE ADDED TAX 3.1 Introduction Value Added Tax, which is popularly known as VAT is the finest fiscal instrument. It is a well established fact that the emergence of the VAT as a highly buoyant and elastic source of revenue in a period of about last forty years is something unprecedented in the history of taxation. The VAT has been rightly described as the Mata Hari of the tax world: many are tempted, many succumb, some tremble on the brink, while others have only to return, eventually the attraction appears irresistible...the history of taxation reveals no other tax that has swept the world in some thirty years, from theory to practice, and has carried along with it academics who were once rejected it (Tait, 1988). From an economist point of view, a properly implemented Value Added Tax is equivalent to a corresponding single stage tax. Unlike the expenditure tax, the Value Added Tax is not a genuinely new form of taxation but merely a sales tax administered in a different form (Musgrave and Musgrave) (Srivastava, 2005). Value Added Tax is universally acclaimed as the most effective remedy for all sorts of tax created problems in developing as well developed economies. More than 120 countries in different continents have adopted some form of VAT. Before introduction, domestic indirect taxes were typically limited to narrowly defined products. The distortions created by the sales tax, combined with rising revenue requirements, provided an incentive to seek alternative less distortionary taxes. The basic idea of the VAT appears with a German businessman, Von Siemens, writing in the 1920s. Early proposals to introduce the tax were made in France in the 1920s definition used in this report, the first VAT appeared in France in 1948 which initially applied up to the manufacturing stage and gave no credit for tax on capital goods. It was converted to a type VAT by Manufacturing level VATs were adopted by Coted Ivore in 1960 and Senegal later in the 1960s. Michigan introduced the single business tax in 1953.

2 Brazil introduced the tax to South America in In the same year the adoption by Denmark began its widespread introduction in Europe. The pace of VAT implementation remains rapid until the late 1970s and again the latter part of the 1980s and well into the 1990s. The early phase was dominated by adoption of the VAT in: 1. Western Europe, following the decision of the European communities. 2. Latin America, following the initiative in Brazil. Of the 24 member countries of the Organization for Economic Co-operation and Development (OECD), 21 have accepted the VAT as their main tax. Switzerland and Australia are the only OECD area, which have not yet done so. The choice of VAT, the design, the rates and the type varies from country to country. Some countries use the value - added technique for sales taxes. These taxes are restricted to the manufacturing industries. Indonesia imposes a tax using the value added technique on manufacturers and importers; on firms that act as the main distributor. Sweden and Norway used the VAT to replace retail sales tax. The out standing feature of VAT is its flexibility to adapt itself to the diverse socio - economic conditions, legal frame works and administrative institutions of any adopting country. Introduction of VAT requires certain initial adjustments in the constitution of the country to legalize its basic features. While exempting certain products and sectors for the sake of progressivity, care has to be taken to keep the Vat rate at such a level that will yield sufficient revenue. Fortunately, VAT is capable of meeting all these requirements. Besides it gives total transparency to the tax system as the computation of the actual tax payable on a commodity is easy. Apart from the introduction, this chapter has 2 sections. Section 3.2 presents the principles of Value Added Taxation. The advantages, problems, choices and the different possibilities for VAT design have been discussed. Section 3.3 draws conclusion based on the above discussion. 1.2 What Is VAT? The Value Added Tax is exactly what its name implies. It is a tax on the Value Added at each stage of the production and distribution of goods and services. For any firm paying the VAT, the value added for a particular item is the 37

3 amount by which the sales price of the product exceeds the cost of all the products purchased to make that item. Because the tax is paid at each level of production, and often not itemized on the final bill to consumers, some try to characterize the VAT as a tax on business. But most analysts agree that the Value Added Tax is essentially a sales tax on consumer purchase that is collected in stages. The following example shows how a VAT would apply to the production and sale of a chair: Table3.1: How a Value Added Tax Works Price Value Added Tax at 5% Raw materials Manufactured product Wholesale sale sale Total First, a supplier sells raw materials to a manufacturer for use in producing the chair. If the raw materials are sold for 40 Rs, the materials supplier pays tax on the whole 40 Rs. A 5% tax rate on the 40 Rs of value added equals 2 Rs tax. Second, the manufacturer builds the chair and sells it to a wholesaler for Rs.140. The manufacturer pays a VAT only on the value it has added to the chair. Since the manufacturer has taken raw materials worth Rs.40 and made a chair worth Rs.140, the manufacturer s value added is Rs.100. A 5% tax on the Rs.100 value added is Rs.5. Third; the wholesaler sells the chair to a retailer for Rs.200. The wholesaler bought the chair for Rs.140 and sells it for Rs.200, so the wholesaler s value added is Rs.60. The 5% tax is Rs.3. Finally, the retailer sells the chair for Rs.300. Since the retailer bought chair for Rs.200 and sold it for Rs.300. The retailer s value added is Rs.100 and the 5% tax is Rs.5. At the end of this process, the outcome from the consumer s perspective is just the same as if the state had imposed a retail sales tax on the Rs.300 sales price. But the main difference is that the VAT is collected a little bit at a time at each stage of the production process, rather than being collected in one lump sum at the time of the final retail sale. 38

4 In general, VAT is a tax, which is charged on the increase in value of goods and services at each stage of production and circulation. VAT is levied on the difference between the sale price of the goods produced or the services rendered, and the cost there of - that is the difference between the out put and inputs. In other words, VAT is nothing but multipoint sales tax. It is charged and collected at each stage of the production. 3.3 POSSIBLE COMBINATION OF CHOICES As mentioned earlier, VAT in some form or other is in operation in more than 120 countries. Because the Value Added Tax can take many forms, a country has to make a number of choices. According to Shoup, there are as many as 576 nominally possible combinations (Shoup (ed), 1990), all claiming to be VAT. The basic decisions that need to be kept in view while designing VAT are: 1. Types of VAT: Consumption, Income and Gross Product. 2. Principles of VAT: the Origin Principle and the Principle. 3. Methods of calculation: Subtraction, Tax credit or Invoice and Addition Method. 4. Exemption and zero rating. 5. A single rate VAT or a VAT with two or more rates. Moreover, the countries that have introduced the comprehensive VAT have shown a remarkable degree of unity in selecting among the possible combinations. Virtually all have adopted for the Consumption type of VAT based on destination principle with tax credit method and with multiple rate and tax exclusive method Consumption, Income and Gross Product VAT The first and important decision is whether to introduce a tax on consumer goods only and not on capital goods. This is called as Consumption VAT. Another type strikes increases in the stock of capital goods. Its tax base is total of all income. Hence it is called as Income VAT. A still broader VAT includes outlays to replace old capital goods. This is Gross Product VAT. Consumption VAT (C- VAT) If VAT is confined to consumer goods, it is known as Consumption type of VAT. In this case, the Value added by the firm to the goods and services purchased 39

5 from others is subject to tax. The value addition can be on raw materials, intermediate goods or manufacture goods. It can also be extended to value addition at wholesaling or retail points. The final price, the price paid by consumers, has to cover all the values added at the successive stages. The base of the VAT is the total private in the country which is the chosen target for any form of indirect taxation. The type of value - added however, can in the process of computing the base, give rise to the possibility of obtaining a negative value-added for a given assessment period. Under such circumstances, the problem of refunding the taxes previously paid by the firm on its purchases arises. As an alternative, and in order to gain the administrative advantage of avoiding refunds of taxes previously paid, carry forward is some times allowed. In a closed and static economy, the sum of values added at various stages equals the aggregate of all retail sales. Since the stock of inventories remains constant in such an economy, the total value of sales to consumers at the retail stage can be fully captured through Consumption type of VAT. However, in a dynamic economy all economic activities are not reflected in this type of VAT. Since VAT is confined to, it does not interfere with capital formation in any manner. In an open economy, the value added on goods produced abroad is not reflected in the value addition in the consuming country. Since the value added in abroad can not be directly taxed, a tax on imports or on the wholesale transaction immediately after importation becomes necessary. As a result of this the value added domestically exceeds the retail sales because of the of imported goods. Similarly, in the case of exports, the value added by the producing country is not reflected in the retail sales. To strike a convenient balance, the normal practice is to impose a VAT on imports and exempt exports. The most attractive feature of Consumption VAT is that it is totally neutral to various methods of production, capital and current expenditure, savings and. This quality of VAT enhances economic efficiency as it does not distort consumer s preference or producers choice. This feature would perhaps justify the world wide popularity and acceptance of Consumption VAT. 40

6 Income VAT (I-VAT) The second important form of VAT is the Income variant which allows deduction only to the extent of depreciation on capital goods. The base of Income VAT is the same as that of a comprehensive income tax which imposes tax on including investment and gives deduction for deprecation on capital goods. The Income VAT is used by Argentina, Peru and the State of Michigan and is approximated by Turkey s recently enacted VAT. Otherwise most of all the countries adopting the comprehensive VAT have chosen the Consumption type of VAT. Gross Product VAT (P- VAT) In the Gross Product VAT, subtraction is given only for purchases of current goods and not allowed for the replacement of capital goods. The value added in the case of Gross Product VAT, far exceeds the retail sales in a particular year. At present Finland, Morocco and Senegal impose a modified version. The main draw back of this form of VAT is, it disallows deduction of both purchases of capital goods and depreciation and discriminates strongly against the use of capital goods. A Comparison Of The Three Variants It is clear that the P-VAT has the broadest base among the three variants and the C-VAT has the narrowest. The broadness of the P-VAT base is bought, however, at a potentially high economic price. By imposing a tax burden on gross purchases of capital goods without giving any relief even on depreciation, the P-VAT discourages investment. To the extent that business succeed in shifting at least part of their capital costs forward, taxing capital goods would result in cascading if the P-VAT uses the credit invoice method. By similar reasoning, these shortcomings, albeit to a lesser extent, are also present with I-VAT. While, the C-VAT, being a general tax on, is economically the most neutral and is, therefore, generally regarded as the superior variant among the three. It is also the most widely adopted variant in countries that have a VAT Origin and Principle A VAT can be implemented under either the Origin or the Principle. Under the Origin Principle, value added domestically on all goods whether they are exported or internally consumed is subjected to tax. Consequently, 41

7 tax can not be levied on value added abroad and this principle confines VAT only to goods originating in the country. In short, exports are taxable under this principle while imports are exempt. In contrast, a VAT is said to use the principle when it taxes all value added at home and abroad, to all goods. Exports are exempt, imports are taxable. principle is normally used along with Consumption type of VAT. In a federal set up, principle is preferred for taxation of products consumed within the various states of the country. Obviously, the two principles are identical in a closed economy but in an open economy, the difference between them lies in their treatments of imports and exports. It is important to note that the distinction between the two principles is based on the location of production and, and not on the type of products being produced or consumed. A matrix of the tax treatment of capital goods under the four combinations of the two VAT variants and two tax principles is given below (Howell, 1995): Table 3.2: Combinations of the two VAT variants with two tax principles Origin Based Consumption - VAT Taxed if exported: not taxed otherwise. Production - VAT Not taxed if imported: taxed otherwise. Based Not taxed Not taxed if exported: taxed otherwise. Hence, capital goods completely escape taxation only under the combination of C - VAT and principle. Almost all countries in the world that presently have a VAT on the base of principle. The reason is that die Origin principle, which allows imports entering a country to bear the VAT burden of exporting countries, is likely to lead to undesirable tax competition with the clear implication that flexible prices and exchange rates are not being viewed as adequate mechanisms for alleviating such behavior among tracking countries. But the principle, in contrast, is regarded as effective in ensuring that traded products contain no VAT elements of the exporting countries. 42

8 3.33 Methods Of Computation Of VAT There are several methods to calculate the value added by a firm. The three commonly used methods are Addition, Subtraction and Tax. Addition Method This method aggregates all the factor payments including profits to arrive at the total value addition on which the rate is applied to calculate the tax. This type of calculation is used mainly with Income VAT. This method is not suitable for exempting exports and valuation of imports under the principle. Another drawback of this method is that is does not facilitate matching of invoices for detecting evasion. Subtraction Method The value added by the firm is arrived at by subtracting total purchases from sales. This is the simplest method and at first sight it looks just like the Tax method. In this method tax is collected by applying the rate on the value addition Tax or Invoice method Tax method is generally preferred to subtraction method for the facility it offers for calculating export refund. It allows for deduction of taxes paid on inputs from the taxes payable on sales. The tax payable is calculated by deducting the aggregate of the taxes indicated on the invoices received for the purchase of inputs from the tax to be paid on the sales. This method is also suitable even if intermediate firms in the chain of transactions are zero - rated. An important advantage of this method is that it readily allows matching of invoices preferably through computers which can detect tax evasion more efficiently. The various methods of computation of VAT are illustrated in the below table: 43

9 Table 3.3: Computation of VAT with a tax rate of 10% The Economy Raw materials Manufacturer Wholesaler er Total supplier economy Purchases Value Added Sales Input Tax credit method Sales Taxes collected Purchases Taxes paid VAT (ii-iv) Price of the good = = = = Subtraction Method =110 =385 =935 =1210 Sales Purchases Calculation of tax due =n io-ovo.i =f385-l 101*0.1 =f w0.1t wo. n (i.i) (1.1) (1.1) (1.1) Tax due Source: Primer Of Value added Tax, Dr.Raja Chelliah (ed), NIPFP, In the above table we may note that subtraction method estimates value added by means of the difference between outputs and inputs. But the tax credit method entails deduction of tax on inputs from tax on sales for each tax period. In a situation in which different tax rates (depending on the sector or goods or services) are used, the guarantee of yielding the same revenue can not be made by all methods. In fact, the credit method of computation would be superior to the other two methods. The credit method is more conducive towards making later stage firms keep track of the record of tax payments made by sellers; there is some element of cross checking that is done only under the credit method, the final tax liability is dependent on the tax rate at the final stage so that the intermediate stages would have less incentive to seek special tax treatment. This is not the case in the subtraction or addition methods, because the tax base is the value added at the specific stage of production. 44

10 3.3.4 Exemption and Zero - Rating According to Tait a linguistic quirk of the VAT is that exemption actually means that the exempt trader has to pay VAT on his inputs without being able to claim any credit for this tax paid on his inputs. On the other hand zero - rating means that a trader is folly compensated for any VAT he pays on inputs and, there fore, genuinely is exempt from VAT (Tait, 1998). Exemption is usually given to an entire sale of a firm which is below a certain size. A trader whose goods are exempted has to pay all taxes on the inputs he purchases. But, he is not eligible to get Tax on the inputs. Hence, this trader falls outside the VAT chain and treated as the final purchases. Thus, under VAT system exemptions do not provide complete relief from the tax. Exempt traders need not register with the tax authorities nor keep records for VAT. So, exemption helps simply the administration of VAT. Exemption relieves the exempt traders value added from the tax, but all his purchases including capital goods are taxed. Exemptions will there fore, increase the amount of tax finally paid on intermediate goods - opposite effect that the exemption was supposed to provide. In the case of final goods, exemption eliminates the tax on value added in the final stage only. Zero-rating adopts a different approach by relieving the firm or product entirely of the tax burden which includes the taxes on the inputs which are collected at earlier stages. A zero - rated trader claims all the VAT on his inputs and bears no tax on his outputs and the purchaser of such a trader s sales buys the good or service free of VAT. The use of zero rates is justified when a good genuinely is to be freed from VAT. Across the country, when examined, it is found that zero rating is used much less extensively. Study by Tait shows that some of the essential goods like food, medical services, drugs, education, housing, clothing, books, and news papers were zero rated. Thus, the zero rate technique is often applied to basic necessities as a way of relieving low income households of some of the tax burden Rate Structure Of VAT VAT can operate either with a single rate or with multiple rates. Higher the number of rates, the more complicated the operation of VAT. The introduction of 45

11 several rates complicates the administration of VAT. So, the easiest form of VAT to administer would be one with a single rate. But for various socio-economic reasons governments have found it necessary to introduce multiple rate. But the number of rates should be limited. Many countries employ multiple rates in their Value Added Taxes. When multiple rates are used, in addition to zero rate, low rates prescribed for granting concessions. Generally, luxuries are taxed at a rate higher than the normal to curb and make the tax structure more progressive. Such rate differentiation can achieve the objective of tax policy only at retail level in Tax method when the commodity or service is finally passed on to the consumer. Multiple rates have no impact if they are applied at earlier stages as they only make the producer or wholesaler pay lesser tax on the value addition. The retailer subsequently gets a smaller tax credit against the standard rate which is invariably higher than the tax liability at earlier stages. In contrast, under the Subtraction method, it is possible to apply different rates at each stage of transaction. With multiple rates there is a heavy burden on the retailer as he is required to keep a complete account of exempted goods, goods having concessional rates, standard rates etc. which increase the cost of compliance and even induces unintended evasion. Some countries prefer single rate despite its inherent regressivity. About a half of the total number of VAT operating countries now uses two to four rates. In place of a lower rate on a particular good, the taxable amount of that good, its tax base, can be set at a fraction of the actual value. The standard rate is applied then to that fractional value. Writing in 1972, Tait noted that in Sweden this is the method adopted to lower the rate of VAT on buildings. The tax base for buildings is reduced to 60% of the market price and similarly the base for services, for example, water supplies, roads, bridges etc is reduced to 20% of normal. The table 3.4 shows the features of VAT in different countries. From the table we may see that there is no uniformity across countries with regard to the rate structure. There have been significant changes both in the levels of tax rate and number of rates in most of the countries. Most of the countries have gone for multiple rates ranging from two to four. 46

12 T a b le 3.4: V A T : C ro ss-c o u n try S elected F e a tu re s Country ASIA China peoples Republic of Indonesia Japan Korea Republic of EUROPE Belgium France Germany Italy Netherlands United Kingdom Bulgaria 1991 Hungary 1980 Turkey 1985 WESTERN HEMISPHERE Argentina 1975 Brazil 1967 Canada 1991 Chile 1975 Colombia 1975 Mexico Year VAT introduced VAT form Production Income type Stage Manufacturing Wholesale Tax Base Selected industrial goods taxed selectively No of G&S - Goods and Services states use origin principle, though some rate accommodations are made to approach the destination principle. **Not all provinces have as yet opted for the VAT. 12 Rate 12 VAT principle Origin/* ** Method of Calculation Subtraction 47

13 Multiple rates are relatively better to monitor under the first point sales tax system, as dealers at that level deal in a limited number of goods and have the resources to track various categories of their purchases and sales. We can also see that there are strong arguments against large number of multiple rates. The arguments are overwhelmingly in favor of using a single rate with zero rates for exports and very few exemptions. Should multiple rates be necessary the fewer, the better (Rao Hemalata, 2002). Often, the use of multiple rates is justified on the grounds of enhancing progressivity. For example, the zero rating of food is thought to make the tax less regressive. 3.4 Conclusion A country aiming at switching over to Value Added Tax from the traditional sales tax system has to decide carefully which variant of VAT it is going to adopt. The VAT both in theory and practice may take a wide variety of forms. A variety of exemptions, rebates, deductions and zero rates, sectors and goods to be covered under VAT, sectors to be left outside the tax net or exempted, treatment of hard to tax items, can shape the tax base in different ways. Moreover, the countries that have introduced the comprehensive VAT have shown a remarkable degree of unity in selecting among the possible combinations. Virtually all have opted for, 1. Consumption type 2. principle 3. Tax credit method 4. Multiple rate (in addition to the zero rate) 5. Tax exclusive VAT The VAT in these countries have for the most part differed only with respect to the kinds of sectors or products that are tax-free, the technique of exemption or zero-rating used to achieve that end the extent of special regimes designed for one or another sector or group of firms. 48

14 Reference Tait Alan, 1988, Value Added Tax: International Practice and Problems, International Monetary Fund, Washington D C. Shoup Carl, 1990, Choosing among types of VATs, in Value Added Taxation in Developing Countries, edited by Malcom Gillis, Carl Shoup and Gerardo Sicat, World Bank, Washington D.C. Zee Howell, 1995, Value Added Tax, in Tax Policy Handbook, Shome Parthasarathy (Ed), Fiscal Affairs Department, IMF. Rao Hemalata, 2002, Value Added Tax: Design and Policy Issues, Sun Publishing House, Bangalore. Purohit M C, 1993, Adoption of Value Added Tax in India: Problems and Prospects, Economic and political weekly, Vol 28, No 10, March 6. Burgess Robin, Stem Nicholas, 1992, A VAT in India: Problems and Options, London School of Economics, London. Sijbem Cnossen, 1998, Global Trends and Issues in VAT, International Tax and Public Finance, Vol 5, No 3, July, pp Saravane M, 1976, Tax on Value Added for India: Issues and Alternatives, RBI Bulletin, March, pp Aggarwal and Bhatia, 2001, Fundamentals of Value Added Tax, The Charted Accountant, October, pp Metcalf E Gilbert, 1995, Value Added Taxation: A Tax Whose Time Has Come? Journal of Economic Perspective, Vol IX, No 1, pp Mukhopadhyay Sukumar, 2002, Task Force Report on Indirect Taxes: A Critique, Economic and political weekly, Nov 16, pp Raja Chelliah, et al, 2001, Primer on Value Added Tax, NIPFP, Har-Anand Publications, New Delhi. Pillai G.K, 2005, VAT: A Way Out of the Indian Tax Muddle, Jaico Publishing House, Mumbai. 49