2 Basic Design Issues
- Liam Ebrill, Michael Keen, and Victoria Perry
- Published Date:
- November 2001
The diversity of VATs observed around the world reflects the wide range of choices that must be made in designing and implementing a VAT. Some of these choices are more controversial than others. This chapter reviews some core features of the VAT for which there is widespread agreement on what constitutes “best practice.”
VAT as a Tax on Consumption
Economists generally favor designing the VAT so that it is a tax on consumption, in the sense that its key effect is to drive a wedge between the price that consumers pay for their purchases and the price that suppliers receive from the corresponding sales. That said, and contrary to the view often held by policymakers, the real burden of the tax is not necessarily borne only by consumers. The real loss of income that is the counterpart to—indeed, because of the distortion of activity, generally exceeds—the revenue raised by government, may also be felt by the owners, employees, and/or financiers of the firms whose output is being taxed. The effective incidence of a VAT, like that of any other tax, is determined not by the formal nature of the tax but by market circumstances, including the elasticity of demand for consumption and the nature of competition between suppliers.
Since it is levied, ultimately, on consumption and not on intermediate transactions between firms—while tax is charged on such purchases it is, in effect, fully refunded—a VAT does not distort the prices that producers face in buying and selling from one another. Accordingly, the tax has the desirable feature of not violating production efficiency (the condition that the economy be on its production possibility frontier, unable to produce any more of any good without producing less of some other).20 Taxes on intermediate transactions, in contrast, if not offset will drive a wedge between the buying and selling prices of producers.
A related but distinct phenomenon is that of “cascading.” This refers to the “tax on tax” that arises when tax is charged both on an input into some process and on the output of that same process.21 As a result, the tax embodied in any given item will depend on the number of production stages that are subject to tax. In addition to resulting in arbitrary variations in effective tax burdens across the range of goods sold, this also creates an obvious incentive for firms to vertically integrate their activities in order to eliminate taxable stages, with a consequent distortion in the choice of firms’ organizational forms that may involve real efficiency losses.
Production efficiency is generally accepted as a useful guiding principle in tax design, the intellectual basis for this being discussed in Box 2.1. The multistage nature of the VAT implies that two features are essential to ensure that it is indeed only a tax on consumption, without any induced production inefficiency or cascading:
at each stage, net tax must be payable only on the difference between sales and purchases (an effect—eliminating tax on inputs—that can be achieved in a number of ways, as discussed below); and
there must be no breaks in the VAT chain.
A third but more problematic feature, that the destination principle be used in handling international trade—under which goods and services crossing jurisdictional borders are taxed in the jurisdiction where they are consumed—is discussed in Chapter 17.
Eliminating Tax on Inputs
Under the VAT, output is taxed at each stage of production, irrespective of the use to which it is put. To ensure that only final consumption is taxed, the tax on all goods and services subsequently used as inputs to production must in effect be refunded to purchasers of those inputs: a VAT with unrestricted crediting of this kind, including of tax on investment good purchases, is a “consumption-type” VAT. There are a number of ways in which restrictions are imposed in practice, some deliberate (which we focus on now) and some a consequence of imperfect administration (discussed in a later chapter).
Box 2.1.Production Efficiency and the Diamond-Mirrlees Theorem
The fundamental—at least, the best articulated—economic rationale for the pursuit of production efficiency as an object of policy is provided by a theorem of Diamond and Mirrlees (1971): under competitive conditions, if any pure profits are fully taxed and the government is unconstrained in its ability to deploy distorting taxes, then any Pareto inefficient allocation is characterized by production efficiency. Intuitively, eliminating production efficiency means, by definition, that one has more of some outputs and no less of any other—which one would generally expect to be a desirable outcome.
The conditions of the theorem are restrictive, however. If they fail to hold, it may be good policy for the tax system to distort production decisions. For example, if the government is for some reason unable to tax directly a commodity that would otherwise be a suitable object for taxation, then it may be desirable to tax it indirectly, by taxing inputs into its production (Newbery, 1986). Input taxes may also be useful in raising revenue from groups that would otherwise be difficult to tax.
One set of restrictions intended to ensure that the tax bears on final consumption is the denial to businesses of a tax credit in relation to purchases whose use for consumption rather than production purposes is hard to monitor. Prominent in this category are cars and entertainment, for which many countries deny credit. There are more exotic examples too. In New Zealand, prostitutes can claim input tax credit in relation to “frilly” or “lacey” underwear, but not for flesh colored.22
Restrictions have also often been imposed in relation to investment goods.23 Under a “product-type” VAT, taxes on investment goods are not refunded while under an “income-type” VAT tax is effectively refunded only on the depreciated part of capital. The first of these systems implies that part of the tax levied on inputs is unrecovered; the latter, that it is recovered but with a lag. Both distort producer decisions, encouraging less capital-intensive methods, and raise the relative prices of more capital intensive goods. While most countries accept the principle of full refunding of taxes on investment goods, there are and have been important exceptions. China and (at the state level) Brazil, for example, currently operate a product-type VAT. So, initially, did the states of the BRO—practice in these states has since diverged, but generally now includes the crediting of capital inputs.
New or expanding firms may pay more tax on their purchases of investment goods than they charge on their own sales, with the result that they are due a refund from the authorities. Many more countries impose what are in effect administrative restrictions on the refunding of taxes on investment goods. This may reflect simple revenue concerns or fear of fraud. The most common limitation is a requirement that excess credits be carried forward rather than immediately refunded; this is common practice, for example, in Latin America. By reducing the present value of credits attached to investment expenditures, such practices render the VAT closer to an income type.
A rare restriction on input credits is to grant credits only on material inputs used directly in the production process: VAT on adhesives used in producing furniture would thus be refunded, for instance, but that on advertising space bought, or legal services used, would not. This was the case, for example, of the initial VATs of the BRO countries. Such restrictions not only reintroduce an element of cascading, they also distort production and marketing decisions and relative consumer prices.
Breaks in the VAT Chain
The VAT will cease to be a tax on consumption if it is not levied, and appropriately recovered, throughout the production chain. The precise consequences of breaks in this chain depend on how the VAT is implemented, as discussed further below. In particular, if the “invoice credit” method is used—under which each trader passes to the purchaser an invoice showing the amount of tax charged—a break in the chain will mean that part of the tax paid on intermediate inputs is not recovered, so that part of the value added in final consumption is taxed more than once.
It has already been observed that the effective incidence of the VAT can differ from its formal or legal incidence. In the same vein, a VAT can be economically equivalent to some other combination of taxes, and understanding those equivalencies can clarify the distinctive features of a VAT. The focus here is on equivalencies for a consumption-type VAT.
The first equivalency is obvious: a consumption-type VAT is economically equivalent to a pure retail sales tax. This emphasizes, in particular, that it is not only the VAT that is conducive to production efficiency: that is simply a feature of its being a tax on consumption.
For a VAT levied at a uniform rate on all commodities, more subtle equivalencies arise. In a closed economy, an instructive example of an equivalency for such a VAT is:
A cash flow business tax and a tax on wage earnings, both levied at the same rate. To see this, recall that value added (VA) is simply sales (S) less non-factor current inputs (N) and investment (I). Adding and subtracting the wage bill W then shows:
where the first term is exactly the base of a cash flow tax: sales minus all nonfinancial expenditures. Adding to such a system a personal tax-free allowance, this is essentially the “flat tax” of Hall and Rabushka (1995).
If, further, the VAT rate is constant over time, then equivalency also holds between a VAT and:
A tax on pure profits, a capital levy, and a tax on wage earnings, all levied at the same rate. This equivalence follows directly from the first since, over time, the revenue from a cash flow tax comes from two sources: pure profits from past and future investments, and the normal return on capital already in place (with the latter equal, in present value, to the value of the capital itself). This way of thinking about the VAT emphasizes that—like any tax on consumption—it is in part a retrospective tax on past savings, a feature, which is of some importance in considering the distributional effects of a VAT (discussed in Chapter 10 below).
The presence of international trade renders the equivalencies somewhat less transparent, because of the exclusion of exports from a consumption-type VAT. This means, for instance, that a destination-based VAT at a uniform rate is equivalent to the sum of a cash flow business tax—with all sales of domestic firms taxable—a wage tax (as before) and uniform export subsidy/import tax.
Methods for Determining VAT Liability
As noted, it is a key feature of the VAT that tax is charged—in effect, if not in form—only on the difference between purchases and sales. There are three main ways in which this can be done:24
Under the “invoice credit” method, each trader charges output tax at the specified rate on each sale and passes to the purchaser an invoice showing the amount of tax thus charged. The purchaser, if subject to VAT on his own sales, is in turn able to credit such payment of input tax on his own purchases against the output tax charged on his sales, remitting the balance to the authorities and receiving a refund when there are excess credits.
Under the “subtraction” method, tax is levied directly on an accounts-based measure of value added calculated for each firm by subtracting allowable purchases from revenues.
Under the “addition” method, tax is levied on an estimate of value added calculated by summing (and adjusting as needed) factor incomes.
Practice and consensus heavily favors the invoice credit method. The only national VAT currently implemented using the subtraction method is that of Japan.25 The Italian IRAP, introduced in 1998, is also in effect—though not in name—a VAT (of the income type) levied by the subtraction method. In addition, a notable variant of the subtraction method is the “gross margin” method used by some in the BRO region at retail and wholesale stages, and by Belarus (until January 2000) for all transactions. This method taxes firms on the difference between their revenues and costs, but with both these items calculated in ways that reflect the conventions and methods of past planned economies rather than market-oriented notions of value added: sales might be valued at notional accounting prices, for example, rather than those actually realized.26
Michigan and New Hampshire have had addition-based VATs since 1976 and 1993, respectively.27 Maharashtra for some while had a VAT that combined elements of addition and subtraction. No broad-based national VAT has been implemented by the addition method, but it has been applied to financial services (in Israel and Argentina, for example), a sector that has proved problematic (as discussed in Chapter 8).
The rest of this section compares the subtraction and invoice methods, the alternatives that have received widest attention. The invoice and subtraction methods have important features in common. Both are robust to the omission from taxation of any intermediate transaction: if a vendor fails to tax or report a sale, the loss of tax revenue will be exactly corrected if the purchaser also omits to claim the credit (under an invoice method) or deduction (under the subtraction method). Indeed, in a closed economy, and with a single rate of tax, there is little to choose between the two methods. Outside such an idealized world, however, several differences emerge.
Most of these differences reflect the central feature that the invoice-credit method is transaction-based and the subtraction method entity-based. This in turn means that while the invoice-credit method has a tentative aspect to it—tax at each stage is preliminary, being an input into another calculation further downstream—the subtraction method gives rise to a final tax at each stage. Prominent among the specific differences to which this gives rise are:
By explicitly linking the tax credit on the purchaser’s inputs to the tax paid by the purchaser, the invoice method may do more to discourage fraudulent undervaluation of intermediate sales. Thus, in principle, invoices could be cross-checked to pick up any overstatement of credit entitlement. Under the subtraction method, in contrast, the seller might simply fail to report sales that the purchaser nevertheless claims as costs. Under the invoice credit method, the same effect could be achieved only by failing to forward tax shown as withheld on the invoice issued to the purchaser.
The invoice method is better suited for dealing with differential rate structures.28 For example, assume that sales of some good are zero-rated—meaning that no tax is charged on output but input tax is credited (if necessary, refunded) in the usual way—while all other goods face the standard rate. Under the invoice method, this is accommodated by allowing sales of the good to be tax-free. Under the subtraction method, achieving the same effect requires omitting sales of such goods from taxable revenues, which requires traders to distinguish between different kinds of sales on their books, after the fact. In the same way, one could in principle accommodate multiple rates under a subtraction method. This would transform the subtraction method, however, into something like the invoice method, since traders would presumably be required to keep documentation verifying their claims as to the nature of their sales; the only difference from an invoice system is that invoices need not be matchable between buyer and seller.
A particular instance of the previous difficulty arises in connection with international trade. If the VAT is levied on the destination principle, as generally recommended, exports should be zero-rated, which, as just noted, is somewhat more naturally done under the invoice method. In contrast, the subtraction method accommodates the origin principle (that is, taxes are levied in the jurisdiction in which a taxable good is produced) with greater facility since it is by construction precisely a tax on value added at source. The difference, however, should not be overstated. The origin principle can be implemented under the invoice method: all that is needed is to tax exports and give credit in respect of imports for the notional tax that would be payable at the domestic rate in the importing country (rather than for the tax actually paid in the exporting country); Box 17.1 in Chapter 17 provides a numerical example.
Further differences arise in the treatment of exempt goods. Achieving exemption is easy in both cases: under the invoice credit system, tax is neither payable on output nor recoverable on inputs; under the subtraction method, a rate of zero is applied to the difference between revenue and costs. The issue concerns the purchases of exempt goods by registered traders. Under the invoice credit system, the purchaser enjoys no credit in respect of purchases of such goods. On the other hand, under what McLure (1987) calls a “naive” subtraction system (one that gives a deduction in respect of all purchases, taxed or not), such purchases would be deductible and the tax paid to the exempt trader consequently recovered by the purchaser. Which treatment is superior? This depends on the reason for the exemption. One important form of exemption is that of small traders, on grounds of administrative convenience. Here, the treatment under the subtraction method would seem appropriate, in that it places purchases from exempt small traders on the same footing as purchasers from registered traders.29 It may also be an attraction of the subtraction method that it relieves exports of the tax implicit in the price of exempt inputs, and eliminates the incentive to self-supply by registered traders (discussed in Chapter 7).
Where there exists an effective income tax (which is not the case in most developing countries), there may be some advantage to the subtraction method in terms of compliance costs, since the information and records that it requires are essentially already required for income tax.
The Comparison Between VAT and Retail Sales Taxation
The VAT is of course not the only possible form of consumption tax. It is natural to compare it, in particular, with the retail sales tax (RST).30 As a single stage tax levied in principle at the point of sale of the final product, the RST may appear to be a simpler way of achieving the same key effects—preserving production efficiency and avoiding cascading—as a VAT. The comparison between RST and VAT need not be pursued here in any detail: see, for instance, Cnossen (1987), Gale and Holtzblatt (2000), and Zodrow (1999). Among the key points, however, are the following:
In practice, it is hard to ensure that RST does not fall on business inputs. Ring (1989) estimates (for 1989) that in the U.S. states that have a RST about 40 percent of the revenue collected was from business purchases.
On the other hand, the alleged “self-enforcing” feature of the invoice-credit VAT—the notion that the purchasers will help enforce the VAT as a consequence of their interest in obtaining a proper invoice from their suppliers—is not as important in practice as has sometimes been argued: purchasers do not care, for instance, whether tax has actually been paid by their suppliers, only about the acceptability to the authorities of the invoices they hold. There is evidently a potential problem in the claiming of credits on the basis of fraudulent invoices.31
What does appear important in securing revenues, however, is the collection of revenue at many points under the VAT rather than simply at the final stage under the RST. This renders the RST much more vulnerable to evasion.
These features are reflected in something of a conventional wisdom among tax practitioners: while the RST may work well at relatively low rates, below say 5-10 percent, at higher rates it proves too vulnerable. This has certainly been widely argued by FAD: Tanzi (1995, pp. 50-51), for instance, believes that “10 percent may well be the maximum rate feasible under an RST.” There are of course those who argue for the superiority of the RST over the invoice-credit VAT, including those who currently advocate it for the United States. On balance, however, the judgment appears to be that expressed by Zodrow (1999): “… although… some of the advantages of the VAT have been exaggerated by its proponents, it seems difficult to argue that the VAT is not on balance superior to the standard RST.” In any event, it is indeed notable that very few RSTs are set at rates above 10 percent32 while few VATs are set at rates below.