Is VAT always a good tax?
Rapid spread of VAT (value-added tax) across the globe signifies that it may be a good tax. However, VAT can be problematic when the economy has a large informal sector. The basic concept behind the levy of this consumption tax was that the legal incidence of VAT would be on sellers, including importers, manufacturers and distributors and, eventually, retailers. And the effective incidence would be upon consumers according to their capacity to consume. However, a considerable number of manufacturers in an informal economy failed to shift the tax burden to consumers, as several intermediate distributors and retailers between manufacturers and consumers are not registered for VAT. Therefore, the major burden of VAT (legal and actual incidence) has been borne by the manufacturers. This aspect adversely affected manufacturing activity and economic productivity.
Moreover, in informal economies, the registered taxable persons find it difficult to compete in the market due to higher prices, inclusive of VAT, as non-registered suppliers commonly offer inputs of similar quality for lower tax-exclusive prices. Therefore, informal economies discourage taxable persons to operate under VAT by encouraging them to keep turnover below VAT registration threshold. Taxable persons intentionally keep turnover below VAT registration threshold by under-reporting turnover in economies where prescribed turnover is the basis for VAT registration; or by splitting the utility bills among different taxable persons (largely manufacturers) where certain value of utility bills is prescribed as yardstick for VAT registration.
These could be reasons for extremely narrow VAT bases in informal economies/developing countries. Furthermore, in the large informal economies, VAT is susceptible to evasion and fraud. Unsurprisingly, as informality has at least three faces, i.e. evaders, avoiders and outsider, VAT evasion and VAT fraud is much more in informal economies as compared to documented economies. VAT evasion and VAT fraud occur in different forms whereby taxable persons remain out of VAT net by keeping turnover below VAT registration threshold; continue supplying taxable goods and services without charging VAT; establish shell companies and involve in non-existent/paper transactions; use fake and flying invoices to enhance input tax in order to reduce output tax liability; understate the value of supplies or overstate the value of purchases; may register dummy units using fake identity just for the purpose of issuing sales tax invoices to enable other registered taxable persons to reduce their tax liability or to claim illegal refunds; and or remit to the government less sales tax amount than they have charged their customers by submitting fraudulent VAT returns.
VAT is a regressive tax being charged on goods and services. Hence, VAT is not justified on equity grounds. VAT may be problematic in tax jurisdictions facing high level of income inequalities and poverty rates. VAT is considered harmful for the poor and low income earners. Moreover, increase in VAT will have greater negative impact on inequality than an increase in personal income tax or corporate income tax.
VAT appears to be ineffective and inefficient where VAT design is not perfect/standardized but riddled with too many rates, excessive exemptions, reduced rates and zero-rated schemes on domestic supplies apart from exports. Other things being constant, imperfect VAT design diminishes merits associated with good VAT by inducing taxable persons to evade VAT by misclassifying taxable goods as exempt or by applying reduced rate on goods which otherwise subject to standard rate or by manipulating zero-rating schemes; increasing cost of VAT collection as tax authorities require to apply additional human and technological resources to counter VAT evasion; and or providing incentives to taxable persons to print fake and flying invoices to facilitate other taxable persons to inflate input tax or claim illegal refunds.
Last but not least, VAT is operated on self-assessment basis where taxable persons themselves declare taxable supplies and purchase and pay to the government amount exceeding input tax. This system of self assessment may encourage taxable persons to indulge in VAT evasion, which occurs by means of under reporting taxable supplies for a tax period; misclassifying taxable supplies as exempt supplies; claiming input tax on exempt supplies; adjusting input tax on flying invoices; and or paying less amount of VAT than due, etc.
To prevent VAT evasion, tax authorities require to be well equipped with sufficient human resource to trace taxable persons liable for VAT registration; professionally competent to conduct investigative audits to create deterrence against VAT evasion by imposing correct VAT and penalties; legally skilful to initiate prosecution proceedings against VAT fraudsters; and resourceful technologically to prevent use of fake and flying invoices.
In Pakistan, sales tax is also operative in VAT mode and is a leading source of tax revenue. In 2017/18, combined collection of sales tax on supply of goods and services was Rs 1,715 billion. However, considerable sales tax gap- difference between the sales tax revenue to be collected theoretically by the tax authorities and the sales tax revenue actually collected in a tax period – is significant. Using data of total consumption (household plus government), total sales tax revenue (federal and provincial) and by applying average standard rate calculated from provincial standard rates on services and federal standard rate on goods for the period 2010/11 to 2017/18, average sales tax: GDP ratio of 4.7, collection efficiency of 0.31 and sales tax gap of Rs 2,565 billion has been estimated. The estimated sales tax gap is nearly 67% of the total sales tax collection of Rs 1,715 billion. The estimated sales tax gap is close to the FBR’s estimated sales tax gap of 65% based on the sectoral analysis of different sectors including sugar, cement and steel. The sales tax gap in Pakistan could be attributed to the factors including large informal economy, agro-based economy, imperfect tax design and limited and weak enforcement due to limited tax capacity of tax authorities.
The writer serves as Additional Director at the FBR.
What is VAT?
VAT is levied on goods and services while sales tax is imposed generally on goods. It is a multistage tax, levied only on the value added at each stage in the chain of supply of goods and services with the provision of a set-off for the tax paid at earlier stages in the chain. Thus, VAT eventually becomes a single point tax. VAT is more broad-based, equitable and efficient and is without cascading (tax over tax) and hence, is preferable to narrow-based and cascading-ridden traditional sales tax.