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Finance & Development, December 1974
Article

Value-added tax in developing countries: What are the conditions for successful implementation?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1974
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George E. Lent

With the adoption of value-added taxes (VAT) by Western European countries, many developing countries have been giving increased attention to them as a way of rationalizing their sales taxes and improving revenue. Several French speaking countries, including Algeria, Ivory Coast, the Malagasy Republic, Morocco, Senegal, and Tunisia have replaced turnover taxes with a VAT along the lines of the 1954 French model. Brazil (where it is levied by the states) in 1967, Ecuador in 1970, and Uruguay in 1968 have instituted more general VAT systems, and other developing countries such as Argentina, Chile, the Republic of China, Colombia, Korea, Mexico, and Peru have been examining its feasibility.

The VAT is the most productive form of sales tax employed in developing countries. Its revenue varies between 10 and 30 per cent of government tax revenue, and in 1970 exceeded 2 per cent of gross domestic product (GDP) for all countries except Ecuador, ranging up to 8 per cent in Brazil. With few exceptions (and Brazil is one), a substantial part of the revenue is derived from imports (almost uniformly 60 per cent in the African countries). As in the case of sales tax revenue in developing countries generally, VAT revenues can be expected to increase at a faster rate than the growth rate of the economy.

Unlike a multistage turnover tax, which is applied to the value of a product every time it is sold in the process of production and distribution, a VAT is assessed at each stage only on the increment in value acquired by the product since the last taxable transaction. According to the system universally used, the tax due by a business firm is computed by applying the relevant rate to total sales during a given period, and deducting from the result the amount of tax already paid by the firm in buying intermediary products and capital equipment. To permit this procedure it is compulsory to show on invoices the amount of tax charged to other than final consumers. A continuous chain of tax credits therefore accumulates as an item moves through production and distribution up to the finished product stage, and into the hands of the final consumer. What has been collected in fractional payments is equivalent to that of a single-stage tax on the value of the product through that stage.

In principle, a VAT is generally conceived as one that extends to the retail stage and to virtually all sectors of the economy, including services. This is the model that has been accepted by European countries. Only with a comprehensive and uniform coverage is it possible to achieve a truly neutral sales tax and to minimize its administrative complexity.

Restricted scope

Value-added taxes in developing countries, however, depart considerably from the European model of a comprehensive, relatively uniform, neutral tax on the consumption of goods and services. But it is significant that all of them employ the tax credit device in applying the value-added principle.

The scope of the VAT is narrowest in Ivory Coast, Morocco, and Senegal, and somewhat broader in the Malagasy Republic. Only the Latin American countries and the Malagasy Republic (in part) attempt to follow the distribution circuit all the way to the retail stage. Services are taxed in all of these countries except in Brazil and Ecuador, where they are covered by other taxes.

The scope of the VAT in developing countries is likely to be restricted by the exclusion of sectors that pose enforcement problems. Farmers, for instance, are exempt in virtually all these countries. This also provides a simple way of granting tax relief to the lowest income group, even if no other measure is taken to exempt processed foodstuffs and other basic necessities, or to tax them at a reduced rate. On the other hand, luxury goods are mostly imported, and may be assessed a higher tax rate directly at the customs point.

The developing countries are less concerned than industrial countries with removing investment expenditures from the tax base. Where this is done, they commonly exempt producers’ goods from the tax when this method is easier to apply than the tax credit method. This results not only in the widespread exemption of agricultural producers’ goods, but also the exemption of industrial equipment in Brazil, and the exemption of construction materials in Uruguay.

Administrative considerations

Administering a VAT efficiently in developing countries depends on many factors, including the modalities of the tax to be introduced, the economic structure and social environment in which it is to be applied, the revenue that it is expected to produce, and experience with the sales tax that it is intended to replace.

The fundamental difficulty in administering this type of tax in these countries is the problem of coping with small taxpayers, who include a large percentage of retailers and service enterprises. Various methods for dealing with this problem have been devised in industrial as well as developing countries. Most provide for the exemption of very small businesses, and others, such as Brazil and the African countries, provide for their taxation on a forfait basis; that is, payments are based on an agreed level of presumptive sales.

Clearly, a VAT with multiple rates and exemptions is more difficult to administer and pay than a single-rate tax with few exemptions. Except for Uruguay, the value-added taxes in Latin American countries have uniform rates, while in Africa, as shown in the table, they differ with the class of consumption expenditure.

The administrative requirements for the efficient control and auditing of a VAT are closer to those of an income tax than to other types of sales taxes. Those countries which have successfully administered taxes on income are, therefore, in a better position to administer a VAT. Even though a VAT contains a built-in system of cross-checking, the administration in developing countries cannot always be relied upon to apply a computerized or manual system of cross-checking information, nor does the incentive that a VAT gives to purchasers to require invoices from sellers always work. Other audit techniques must complement such cross-checking and self-enforcing features of the tax in order to enforce compliance.

Alternatives

The choice of a sales tax technique rests on a variety of considerations that must be weighed by each country in the light of its own economic and social conditions. Three alternative techniques have proved successful: (1) a single-stage manufacturers/importers tax that exempts purchases of licensed dealers; (2) a hybrid retail/wholesale tax modeled on that of Honduras; and (3) a tandem system, including a tax on sales of manufacturers or wholesalers, and a separate tax on retail sales. A single-stage retail sales tax would have serious enforcement problems, and a multistage turnover tax brings discriminatory effects arising from its accumulation of tax on each transaction. Neither, therefore, appears to be a viable alternative.

Table 1.Value-added tax rates in selected developing countries(In per cent)
ReducedNormalIncreasedServices
Applied to sales exclusive of tax
Ecuador4.0not taxed
Malagasy Republic6.012.0
Uruguay5.014.0
Applied to sales with tax included
Brazil (states)16.0–17.0not taxed
Ivory Coast7.515.030.0
Morocco12.015.020.07.5
Senegal4.09.025.08.5

Most developing countries have limited their general sales taxes to the manufacturing stage, with a compensatory tax on imports. Two different techniques may be employed to eliminate double taxation: the exemption of purchases by licensed manufacturers and importers (the suspensive method) and the value-added technique, which provides either for a deduction from taxable sales of taxable purchases, or a credit for sales tax paid on purchases against tax chargeable on sales.

Both systems have merit and have been applied successfully. The suspensive technique avoids tying up funds in tax that is added to the cost of inventories, with resulting pyramiding of the tax in higher prices. On the other hand, there is greater opportunity for evasion, and it may require both more administrative effort as well as higher compliance costs in its enforcement. The value-added technique permits greater precision in the elimination of tax accumulation on each transaction (including the remission of taxes on exports) and is less subject to tax evasion.

A hybrid retail/wholesale tax system has also been successfully applied in several Latin American countries, including Honduras. Under this system, tax is collected only on sales made by registered firms to unregistered buyers. Since only firms with annual sales above a specified amount are registered, small retailers, artisans, and suppliers of services are taxed only on their purchases; the larger firms are taxed on sales other than those to registered firms. The suspensive principle rather than the VAT principle is applied. This provides greater possibilities for evasion than under a manufacturers’ sales tax; on the other hand, the number of taxpayers is considerably less than would be covered by a VAT. Small retailers, etc., are not taxed on their value added and they, therefore, enjoy some tax advantage as against larger retail firms. It is possible, however, to assess these retail margins by an annual tax, as in Honduras.

Another realistic alternative would be separate taxes at the manufacturing or wholesale level and the retail level. Once a manufacturers’ sales tax has been established, it could be supplemented by a lower tax rate on retail sales of goods and services. Such a tandem system has successfully operated in Ireland, and has been proposed for replacement of multistage turnover taxes in Chile and Peru. It is claimed to offer greater flexibility of taxation at the manufacturing or whole-sale stage so as to permit variation of rates with classes of consumer goods. A tax at the manufacturing or wholesale level, however, encourages retailers to absorb wholesaling functions to minimize tax, and this discriminates against the small-scale retailer.

Conditions of feasibility

The choice of a VAT over other forms of sales tax in a developing country rests on a number of conditions. Both the greater complexity and greater number of taxpayers comprehended by a VAT through the retail level are the main features that set it apart from other sales taxes at this stage. It would not appear advisable for any developing country to adopt a VAT at the retail level without previous experience with a sales tax. All value-added taxes now in effect have evolved out of different forms of preexisting sales taxes and the introduction of a VAT was only a short step. There would also be some advantage if retail sales were previously taxed.

A necessary condition of any retail sales tax is the development of retail units of a sufficient size to facilitate its administration at this point. The fact that retail distribution in many developing countries is in the hands of small traders makes effective enforcement of a retail tax difficult, and a VAT in itself offers no solution to this problem. Optional assessment methods such as forfait are available, but there are limits to their toleration in a VAT system.

Another indispensable condition is the adequacy of records maintained by firms. Since a true record of purchases and sales is a minimum requirement for application of a VAT, the system could break down when proper invoices are not used. Artisans, farmers, shopkeepers, and small service firms are notoriously lax in keeping accounts, and frequently make no distinction between household and business transactions; this situation makes it virtually impossible to enforce accounting for tax. Even when accounts are kept, they are often unreliable. On the other hand, because a VAT requires invoices to support claims for tax credit, the tax is bound to enforce better accounting discipline.

Although a VAT imposes a somewhat greater burden on both taxpayers and the administrative service than other forms of sales tax, it is still less complex than an income tax. But unless the administrative service is strong or can be strengthened, it would not be advisable to take on the additional burden.

Another important consideration is the level of the tax rate that would justify introduction of a VAT as against an alternative form of sales tax. If rates are low, the discriminatory effects inherent in a turnover or hybrid tax may not be sufficiently great to warrant a more complex and comprehensive tax, and the incentive for evasion may be minimal. As tax rates are increased, however, they may reach a critical point when a VAT technique of fractional payment is required to minimize loss on evasion and avoidance. A VAT not only imposes greater discipline by reason of its so-called self-checking features, but it also is self-correcting in “catching up” with tax that may have been escaped at a previous stage. In this respect it has some advantage in reducing the risk of revenue leakage.

Table 2.Selected developing countries: general sales taxes as a per cent of gross domestic product, recent years
Type of

tax 1
Fiscal

year
Per cent

of GDP
Brazil
(states)419708.1
Chile119707.2
Tunisia419706.3
Ivory Coast419705.4
Morocco419704.5
Senegal419704.0
China1 and 319693.9
Peru119703.3
Mali219702.9
Malagasy
Republic419702.7
Korea1 and 319692.7
Thailand219692.6
Costa Rica519702.4
Philippines219712.4
Uganda219702.3
Chad219692.2
Uruguay419702.1
Tanzania219702.1
Mauritania219702.0
Pakistan
(West)219711.6
India
(states)1 and 219701.6
Ghana219691.4
Indonesia219711.3
Ecuador419711.1
Colombia219711.1
Argentina219701.1
Nicaragua519711.1
Mexico119701.0
Honduras519700.9
Bolivia1 219700.8
Sources: Government reports and IMF, International Financial Statistics.

Type of sales tax: (1) multistage turnover tax; (2) sales by manufacturers and importers, and usually selected services; (3) tax on sales of a broad range of selected commodities; (4) value-added tax; and (5) hybrid tax, on sales by licensed manufacturers and merchants.

With effect from June 1, 1971, revised to single-stage manufacturers’ tax (2).

Sources: Government reports and IMF, International Financial Statistics.

Type of sales tax: (1) multistage turnover tax; (2) sales by manufacturers and importers, and usually selected services; (3) tax on sales of a broad range of selected commodities; (4) value-added tax; and (5) hybrid tax, on sales by licensed manufacturers and merchants.

With effect from June 1, 1971, revised to single-stage manufacturers’ tax (2).

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