Appendix: Impact of Exemptions
As discussed in section II, the exemption of certain goods and services or sellers of such items from the tax base has an effect on the average statutory rate, which is difficult to measure without detailed information on the tax rates levied at earlier stages of production, and on the share of consumption purchased from exempt sellers. This appendix presents an example of the adjustments that must be made to the average statutory tax rates calculated in the text, in the presence of exemptions.
Let Xi denote the quantity of good i purchased by an individual at the retail level. This good faces a VAT rate of ti if sold by registered taxpaying retailers, and zero if sold by exempt retailers. The share of purchases of good i made from registered taxpayers is γi, with a share of (1-γi) being purchased from exempt sellers. Assume for simplicity that, apart from labor and capital, all inputs are subject to their statutory VAT rates—that is, no intermediary inputs are exempt. If ϵij is the input of good j used in the production of a unit of good i, then the total tax revenue from sales of good i to final consumers is
Total expenditures by the individual on good i amount to
so the average statutory tax rate on good i is
When γi = 0, all purchases of the good are exempt, and the average statutory tax rate is
Exemption of certain retailers—most usually those with small turnovers—is reflected in values of γi between zero and one. For example, the value of γi for services provided mostly by small businesses (e.g., home gardening) will be close to zero, but that for goods which are mainly sold by large establishments will be close to one. As is clear from (A.3), as γi → 1, the average statutory tax rate on good i is as included in equation (1) in the main text. Under the assumption that
Aguirre, Carlos A. and Parthasarathi Shome, “The Mexican Value-Added Tax (VAT): Methodology for Calculating the Base,” National Tax Journal, Vol. XLI, No. 4 (1988).
International Bureau of Fiscal Documentation, Taxation and Investment in Central and East European Countries, edited by M. Véghelyi (Amsterdam: IBFD, 1994).
Lindholm, R.W., The Economics of VAT: Preserving Efficiency Capitalism and Social Progress (Lexington, Massachusetts: D.C. Heath and Company, 1980).
Comments from Biswajit Banerjee, Gérard Bélanger, John Crotty, Neven Mates, Alan Tait, Ranjit Teja, Marijn Verhoeven, and Emmanuel Zervoudakis are gratefully acknowledged. Thanks also to Dale Chua, Daniel Hewitt, Sepideh Khazai, Huyen Le, Reza Moghadam, Gerd Schwartz, Beatrice Weder, and David Maxwell for helpfully providing data, and K.C. Craig for preparing the manuscript.
See, for example, Lindholm (1980). Note, however, that this claim is often overstated for two reasons. First, in a static setting, it is unlikely that uniform taxation of all consumption goods is optimal. Second, it is generally not the case that preserving the inter-temporal marginal rate of substitution between consumption at different dates at its tax-free rate (by exempting capital income from the tax base) is optimal. (See Atkinson and Stiglitz (1980).) However, the calculation of optimal tax rates is sufficiently complicated and open to argument that uniformity may be an nth-best approach.
Kay and King (1986) report that, when the VAT replaced the single-stage wholesale tax in the United Kingdom, the number of tax payers rose from 74,000 to 1.4 million, and the number of collectors rose from 2,000 to 12,500.
VATs are often thought to be by definition consumption taxes. However, income-based VATs are also possible. The main difference is in the treatment of capital investment purchases for purposes of calculating the tax base. Under a pure consumption-based VAT, the total amount of tax paid on any capital purchases is immediately creditable, while under an income-based VAT, the input tax is creditable on an accrual basis over the useful life of the investment. Thus, the income-based VAT retains some of the administrative problems of the income tax system.
A credit-invoice VAT is implemented by basing VAT liabilities on total sales less VAT already paid on creditable inputs. This method accommodates multi-rate systems more easily than two other alternatives (known as the addition and subtraction methods). Japan, which has a single VAT rate, is the only industrial country with a VAT that does not use the credit-invoice method. It uses the addition method.
The difference between zero-rating and exemption is that VAT paid at an earlier stage is creditable on zero-rated sales, but not on exempt sales.
There is, in principle, no net revenue impact of exempting government purchases from tax. However, administration is generally easier, and the scope for fraud narrower, if suppliers must remit tax on all sales independent of the identity of the purchaser.
That is, if Cp is private consumption, Cg government consumption, Tp VAT revenues collected on private purchases, and Tg that collected on government purchases, then the “ideal” measure of the ETR is (Tp+Tg)/(Cp+Cg), and the ETR on private consumption only is Tp/Cp. Another reason for calculating the ETR exclusive of government consumption is that this approach could sharpen the ability of the study to detect inefficiency. In general, one expects a smaller incentive for government purchasers of VAT-able goods and services to evade the tax, so including them would reduce the power of any efficiency measure to detect evasion in general.
Taxes on goods and services are nearly always on a net basis—that is, if the tax rate is t and the pretax price is p, then the after-tax price is P(1+t). This is different to the income tax, which is typically levied on a gross basis—that is, if the tax rate is τ and the pretax wage is W, then the after-tax wage is W(1-τ).
A credit is refundable if, when the credit is larger than the gross tax liability, the taxpayer receives a net payment from the Government. If the credit is non-refundable, the taxpayer would pay zero net tax, but would also receive zero net refund, in this situation.
If there is a single VAT rate, the tax on purchases from registered sellers will be higher than the implicit tax on purchases from exempt sellers, as long as there is some value added at the retail stage. However, if there are multiple rates and the rate applied to the final consumption good is less than that applied to some of its inputs, purchases from registered sellers may be subject to a lower tax rate than the implicit rate on purchases from exempt sellers.
In the two-good case, if pretax prices are 1, and if X1 and X2 face tax rates t1 and t2, respectively, then σi = (1+ti)Xi/E, where E is total expenditure. The average tax rate is τs = (t1X1+t2X2)/E which reduces to the expression in the text.
For example, the household survey data suggest that the share of consumption that is exempt from VAT in Poland is not very different to that which is exempt in Hungary, contrary to the impression given in Table 1.
The (simple) average efficiency level of Hungary and Romania is two thirds that of the Czech Republic, Poland and the Slovak Republic, suggesting that the proportion of VAT paid on private consumption in the first pair would have to be 1.5 times that in the second group for the ordering to be reversed. Such a divergence seems unlikely.