The conceptual basis of a VAT

A VAT is a tax on the value that is added to goods and services by enterprises at each stage of the production and distribution process. The principal ingredients of value added are wages and salaries paid and profits earned before income tax; additional elements are taxes other than those on income, rentals, royalties, and interest. Although the tax payable by each enterprise could be measured by the total (net) amount of these separate items, that is, the so-called additive approach, the substractive technique is universally employed. This can operate in either of two ways: (1) by deducting purchases of goods and services from net sales and taxing the balance; or (2) by the tax-credit device. The latter, which is more widely used, sets off the tax paid on purchases against the tax payable on sales.

Unlike a multistage turnover tax, which is applied to the full value of a product every time it changes hands 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. At the end of the chain, the total amount of tax paid on a given commodity is only a function of the rate of tax and of the final price of the commodity, independently of the number of stages through which it has passed. What has been collected in fractional payments is equivalent to a single-stage tax on the value of the final product. There is no incentive to vertical integration, and no discrimination against products that embody value added at an early stage versus commodities that receive the largest part of their value in the later stages of the production and marketing chain.

The treatment of capital goods varies with the type of VAT employed. The gross product variant makes no allowance for investment; its conceptual base is the gross domestic product (GDP). The income variant permits the deduction of annual depreciation to allow for the fact that a firm’s capital equipment gets used up in the production process. Finally, the consumption variant allows a deduction (or tax credit) for the full value of investment goods at the time of purchase. In this form, the VAT reaches only consumption expenditure, and, if it is carried through the retail level, its base is identical with that of a retail sales tax on consumer goods and services.

A VAT that applies only through the manufacturing or the wholesale stage does not offer the advantage of noninterference with market processes to the same extent as one that covers all sectors of the economy, including retailing and services. As long as any stage remains outside the scope of the tax, some distortion may result from the incentives remaining to business firms to integrate forward or backward. For this reason, the VAT systems in Europe all extend the tax to retail sales and cover most services.

According to the system that is most widely used, the tax that is due by a business firm is computed by applying the relevant tax rate to total sales during a given period, and deducting from the resulting figure the amount of tax paid by the firm on its purchases of intermediary products and capital equipment (in the consumption variant). This procedure requires that invoices show the amount of tax paid on value added at earlier stages. A continuous chain of tax credits therefore accumulates as a product moves through the production and distribution process up to the finished product stage and into the hands of the final consumer.

The workings of a VAT may be illustrated by the following simplified example based on the various stages involved in the production and sale of bread produced from, say, 500 bushels of wheat.³ The figures shown are in U. S. dollars.

	Purchases	Sales (including VAT)	10 Per Cent VAT
			Gross	Credit on purchases	Net paid
Farmer	250	1,100	100	_	100
Miller	1,100	1,650	150	100	50
Baker	1,650	2,750	250	150	100
Retailer	2,750	4,400	400	250	150
					400

View Table

	Purchases	Sales (including VAT)	10 Per Cent VAT
			Gross	Credit on purchases	Net paid
Farmer	250	1,100	100	_	100
Miller	1,100	1,650	150	100	50
Baker	1,650	2,750	250	150	100
Retailer	2,750	4,400	400	250	150
					400

It can be seen that a 10 per cent tax is assessed at each stage of the process on the amount of sale, excluding the VAT, but that credit is taken for tax paid on purchases, leaving a net amount of tax chargeable on the value added at each stage. The cumulative tax—$400—is equivalent to a rate of 10 per cent on the final retail sale of the product to consumers.

Apart from adding administrative complications, an exemption at any point along the cycle (except at the very beginning or at the ultimate stage) normally results in a break in the tax-credit chain, which leads to a loss of neutrality and introduces an element of double taxation to the extent that the exempt product re-enters the taxable sector at the next stage.

With regard to exemptions, an important distinction is sometimes made between a so-called zero rate and normal exemption from tax.⁴ When a zero rate applies, sales are exempt from tax and the firm is also entitled to a credit for taxes paid on purchases, so that no element of tax is included in the final cost of goods and services. A tax credit may result in a tax rebate, or it may be offset against tax on taxable sales. On the other hand, a normal exemption does not provide for the remission of taxes paid on purchases. Whether or not the tax is zero rated, European countries usually provide for full rebate of the VAT on goods exported.

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, with minimal exemptions. This is the model that has been generally accepted by European countries. Only with a comprehensive and uniform coverage is it possible to achieve a truly neutral sales tax.

Introduction of the VAT in selected developing countries

Although it has been proposed in many developing countries in recent years, the actual move to a general consumption tax of the value-added type has been made in relatively few of them. The tax structures of seven developing countries are compared to show the different adaptations that have been made to the VAT concept (see Table 1). These countries are Brazil (state levy), Ecuador, Ivory Coast, the Malagasy Republic, Morocco, Senegal, and Uruguay.⁵

Table 1.

Selected Developing Countries: Principal Features of the Value-Added Tax

Table 1.

Selected Developing Countries: Principal Features of the Value-Added Tax

		Brazil (States)	Ecuador	Ivory Coast	Malagasy Republic	Morocco	Senegal	Uruguay
Name of tax			Impôsto sôbre circulação de mercadorias	Impuesto a las transacciones mercantiles	Taxe sur la valeur ajoutée; taxe sur les prestations de services	Taxe unique sur les transactions	Taxe sur les produits; taxe sur les services	Taxe sur le chiffre d’affaires	Impuesto a las ventas y servicios
Date introduced Legislation			January 1967 Federal Law 5.172 of October 25, 1966	July 1970 Decree 469 of May 12, 1970. Revised: Decreto Supremo 124, July 29, 1970	January 1960 Law 59-250 of December 31, 1959	January 1969- Law 68-028 of December 17, 1968	January 1962 Dahir 1.61.444 of December 30, 1961	July 1966 Law 66-34 of May 25, 1966	January 1968 Law 13.637 of December 21, 1967. Revised Budget Law, December 1972
Taxes replaced			State turnover taxes levied on merchandise sales.	Tax on gross receipts from mining, manufacturing, construction, and a number of services.	Manufacturers’ value-added type of sales tax (direct substraction method) ; turnover tax on services.	General turnover tax on goods and services.	General turnover tax.	Manufacturers’ value-added type of sales tax (direct substraction method).	Manufacturers’ single-stage sales tax; wholesalers’ value-added type of sales tax; turnover tax on retail sales and services.
scope of tax Farmers			Exempt in some states. Agricultural producer goods exempt.	Exempt. Agricultural producer goods taxed.	Exempt. Some agricultural producer goods exempt.	Exempt. Agricultural producer goods exempt.	Exempt. Some agricultural producer goods exempt.	Exempt. Agricultural producer goods taxed.	Exempt. Agricultural producer goods exempt.
Merchants		Wholesale Retail	Covered. Covered.	Covered. Covered.	Coverage optional. Not covered.	Covered. Tax on imports only.	Apparently only partial coverage.	Coverage optional. Not covered.	Covered. Covered (not always).
Services in general			Not covered. Separate local tax on gross receipts.	Not covered. Separate tax on gross receipts.	Covered, unless specifically exempt.	Covered, unless specifically exempt (assessed at reduced rate).	Covered, unless exempt (assessed at reduced rate).	Covered, unless specifically exempt (assessed at reduced rate).	Covered, unless specifically exempt.
Financial services			Not covered. Special tax on financial transactions.	Not covered.	Covered, except for (1) insurance policies (special levy) and (2) certain credit transactions (mostly of official institutions).	Covered, except for official financial institutions.	Covered, except for (1) insurance contracts (separate tax assessed instead) and (2) certain credit transactions (mostly of official institutions).	Covered, except for (1) insurance policies (special levy) and (2) certain credit transactions (mostly of official institutions).	Covered.
Construction			Tax on construction materials. Separate service tax on building contractors. No tax credit for business purchases of new buildings.	Tax on construction materials. No tax credit for business purchases of new buildings.	Tax on construction materials and building contractors. Credit for tax paid on industrial buildings.	Reduced rate on construction materials and building contractors. Credit for tax paid on industrial, agricultural, mining, and hotel installations.	Reduced rate on construction materials and building contractors. Credit for tax paid on industrial buildings.	Tax on construction materials. Lower service rate on building contractors. No tax credit for business purchases of new buildings.	Reduced rate.
Real property		Rentals Sales	Not covered.	Not covered.	Sales by registered taxpayers covered. Business rentals covered.	Sales by registered taxpayers covered. Business rentals covered.	Sales by registered taxpayers covered. Business rentals covered.	Sales by registered taxpayers covered. Business rentals covered.	Not covered.
exemptions Exports			Primary products: fully taxed in most states. Manufactures: exempt. State policies on prior-stage tax credit and refunds vary. Scheduled to be fully deductible by 1974.	Exempt. Full credit for prior-stage tax on current inputs only.	Exempt. Full credit for prior-stage tax on current inputs and deductible fixed assets.	Exempt. Full credit for prior-stage tax on current inputs and deductible fixed assets.	Exempt. Also exempt, firms exporting 85 per cent of output under suspension rule for inputs destined for exportable output.	Exempt. Full credit for prior-stage tax on current inputs and deductible fixed assets.	Exempt. Full credit for prior-stage tax on current inputs and fixed assets.
Food and other basic necessities			Exemption of farm sales in some states, plus limited list of unprocessed foodstuffs in all states.	Farm sales exempt.	Exemption for unprocessed agricultural products, bread, flour, cereals, milk and dairy products, and palm oil.	Exemption for unprocessed agricultural products, foods, household necessities, and school supplies.	Exemption for basic foodstuffs (flour, bread, milk, sugar, fish) and presumably for unprocessed agricultural products.	Exemption for unprocessed agricultural products and foodstuffs in general.	Exemption for short list of foodstuffs and other basic necessities. Others at reduced rate.
Other			Newspapers, periodicals, books. Electricity, hydrocarbons, unprocessed minerals (excluded from scope of tax; subject to special excises). Industrial machinery and equipment.	Newspapers, periodicals, books.	Newspapers, periodicals, books. Some public utilities. Passenger transport and freight.	Newspapers, periodicals, books. Public utilities, state monopoly sales of tobacco, and matches. Extensive list of inputs for manufacture of exempt products.	Newspapers, periodicals, books. State monopoly sales of tobacco. Certain mineral products, meat, fish nets and gear, certain wood products, and olive oil.	Newspapers, periodicals, books. Hydrocarbons. Certain public utilities. Passenger transport and freight.	Newspapers, periodicals, books. Tobacco and hydrocarbons (subject to special excises).
investment goods			Industrial equipment exempt; full credit for prior-stage tax on inputs scheduled for 1974.	Tax on fixed assets fully creditable.	Tax on fixed assets fully creditable except for (1) buildings for other than industrial use,(2) transport equipment, and(3) furniture.	Tax on fixed assets fully creditable except for (1) buildings other than for industrial, agricultural, and mining installations, and hotels,(2) transport equipment, and(3) furniture.	Tax on fixed assets fully creditable except for (1) buildings other than for industrial use, (2) transport equipment, and (3) furniture.	Tax on fixed assets fully creditable except for (1) buildings, (2) transport equipment, and (3) furniture.	Tax on fixed assets fully creditable.
tax credits and refunds			No credit for tax paid on inputs used for exempt outputs, except for (1) exports of manufactures and (2) industrial machinery. No cash refunds except on credits for (1) and (2).	No credit for tax paid on inputs for exempt outputs, except exports. Excess export credits, adjusted only after six months. No cash refunds (transfers to suppliers).	No credit for tax paid on inputs for exempt outputs, except exports. No cash refunds except for tax paid on (1) exports and (2) goods assessed at reduced rate.	No credit for tax paid on inputs used for exempt outputs, except exports. No cash refunds (transfers to suppliers).	No credit for tax paid on inputs for exempt outputs, except exports. Excess credit adjustment at the year-end. No cash refunds (credit against future tax liability).	No credit for tax paid on inputs used for exempt outputs, except exports. Excess credit adjustment only at the year-end. No cash refunds except for tax paid on (1) exports and (2) investment goods.	No credit for tax paid on inputs for exempt output, except exports. No cash refunds (transfers to suppliers).
small businesses			Small retailers assessed by forfait. “Substitute taxpayers” used by (1) wholesalers for very small retailers trading in fixed-price products and (2) purchasers of agricultural products, in states where farmers not exempt.	Small firms exempt. Subject instead to turnover tax on actual or estimated gross receipts.	Assessed by forfait. (Retailers not covered by tax.)	Very small businesses exempt. (Retailers not covered except on imports.) Small businesses (including importers/ retailers) assessed by forfait.	Artisans exempt. Others assessed by forfait.	Assessed by forfait. (Retailers not covered by tax.) Forfait taxpayers and unregistered traders may pass on tax credits to business purchasers.	Optional. Instead, smallest taxpayers may elect special regime, partially integrated with VAT.

View Table

Table 1.

Selected Developing Countries: Principal Features of the Value-Added Tax

		Brazil (States)	Ecuador	Ivory Coast	Malagasy Republic	Morocco	Senegal	Uruguay
Name of tax			Impôsto sôbre circulação de mercadorias	Impuesto a las transacciones mercantiles	Taxe sur la valeur ajoutée; taxe sur les prestations de services	Taxe unique sur les transactions	Taxe sur les produits; taxe sur les services	Taxe sur le chiffre d’affaires	Impuesto a las ventas y servicios
Date introduced Legislation			January 1967 Federal Law 5.172 of October 25, 1966	July 1970 Decree 469 of May 12, 1970. Revised: Decreto Supremo 124, July 29, 1970	January 1960 Law 59-250 of December 31, 1959	January 1969- Law 68-028 of December 17, 1968	January 1962 Dahir 1.61.444 of December 30, 1961	July 1966 Law 66-34 of May 25, 1966	January 1968 Law 13.637 of December 21, 1967. Revised Budget Law, December 1972
Taxes replaced			State turnover taxes levied on merchandise sales.	Tax on gross receipts from mining, manufacturing, construction, and a number of services.	Manufacturers’ value-added type of sales tax (direct substraction method) ; turnover tax on services.	General turnover tax on goods and services.	General turnover tax.	Manufacturers’ value-added type of sales tax (direct substraction method).	Manufacturers’ single-stage sales tax; wholesalers’ value-added type of sales tax; turnover tax on retail sales and services.
scope of tax Farmers			Exempt in some states. Agricultural producer goods exempt.	Exempt. Agricultural producer goods taxed.	Exempt. Some agricultural producer goods exempt.	Exempt. Agricultural producer goods exempt.	Exempt. Some agricultural producer goods exempt.	Exempt. Agricultural producer goods taxed.	Exempt. Agricultural producer goods exempt.
Merchants	View Expanded	Wholesale Retail	Covered. Covered.	Covered. Covered.	Coverage optional. Not covered.	Covered. Tax on imports only.	Apparently only partial coverage.	Coverage optional. Not covered.	Covered. Covered (not always).
Services in general			Not covered. Separate local tax on gross receipts.	Not covered. Separate tax on gross receipts.	Covered, unless specifically exempt.	Covered, unless specifically exempt (assessed at reduced rate).	Covered, unless exempt (assessed at reduced rate).	Covered, unless specifically exempt (assessed at reduced rate).	Covered, unless specifically exempt.
Financial services			Not covered. Special tax on financial transactions.	Not covered.	Covered, except for (1) insurance policies (special levy) and (2) certain credit transactions (mostly of official institutions).	Covered, except for official financial institutions.	Covered, except for (1) insurance contracts (separate tax assessed instead) and (2) certain credit transactions (mostly of official institutions).	Covered, except for (1) insurance policies (special levy) and (2) certain credit transactions (mostly of official institutions).	Covered.
Construction			Tax on construction materials. Separate service tax on building contractors. No tax credit for business purchases of new buildings.	Tax on construction materials. No tax credit for business purchases of new buildings.	Tax on construction materials and building contractors. Credit for tax paid on industrial buildings.	Reduced rate on construction materials and building contractors. Credit for tax paid on industrial, agricultural, mining, and hotel installations.	Reduced rate on construction materials and building contractors. Credit for tax paid on industrial buildings.	Tax on construction materials. Lower service rate on building contractors. No tax credit for business purchases of new buildings.	Reduced rate.
Real property	View Expanded	Rentals Sales	Not covered.	Not covered.	Sales by registered taxpayers covered. Business rentals covered.	Sales by registered taxpayers covered. Business rentals covered.	Sales by registered taxpayers covered. Business rentals covered.	Sales by registered taxpayers covered. Business rentals covered.	Not covered.
exemptions Exports			Primary products: fully taxed in most states. Manufactures: exempt. State policies on prior-stage tax credit and refunds vary. Scheduled to be fully deductible by 1974.	Exempt. Full credit for prior-stage tax on current inputs only.	Exempt. Full credit for prior-stage tax on current inputs and deductible fixed assets.	Exempt. Full credit for prior-stage tax on current inputs and deductible fixed assets.	Exempt. Also exempt, firms exporting 85 per cent of output under suspension rule for inputs destined for exportable output.	Exempt. Full credit for prior-stage tax on current inputs and deductible fixed assets.	Exempt. Full credit for prior-stage tax on current inputs and fixed assets.
Food and other basic necessities			Exemption of farm sales in some states, plus limited list of unprocessed foodstuffs in all states.	Farm sales exempt.	Exemption for unprocessed agricultural products, bread, flour, cereals, milk and dairy products, and palm oil.	Exemption for unprocessed agricultural products, foods, household necessities, and school supplies.	Exemption for basic foodstuffs (flour, bread, milk, sugar, fish) and presumably for unprocessed agricultural products.	Exemption for unprocessed agricultural products and foodstuffs in general.	Exemption for short list of foodstuffs and other basic necessities. Others at reduced rate.
Other			Newspapers, periodicals, books. Electricity, hydrocarbons, unprocessed minerals (excluded from scope of tax; subject to special excises). Industrial machinery and equipment.	Newspapers, periodicals, books.	Newspapers, periodicals, books. Some public utilities. Passenger transport and freight.	Newspapers, periodicals, books. Public utilities, state monopoly sales of tobacco, and matches. Extensive list of inputs for manufacture of exempt products.	Newspapers, periodicals, books. State monopoly sales of tobacco. Certain mineral products, meat, fish nets and gear, certain wood products, and olive oil.	Newspapers, periodicals, books. Hydrocarbons. Certain public utilities. Passenger transport and freight.	Newspapers, periodicals, books. Tobacco and hydrocarbons (subject to special excises).
investment goods			Industrial equipment exempt; full credit for prior-stage tax on inputs scheduled for 1974.	Tax on fixed assets fully creditable.	Tax on fixed assets fully creditable except for (1) buildings for other than industrial use,(2) transport equipment, and(3) furniture.	Tax on fixed assets fully creditable except for (1) buildings other than for industrial, agricultural, and mining installations, and hotels,(2) transport equipment, and(3) furniture.	Tax on fixed assets fully creditable except for (1) buildings other than for industrial use, (2) transport equipment, and (3) furniture.	Tax on fixed assets fully creditable except for (1) buildings, (2) transport equipment, and (3) furniture.	Tax on fixed assets fully creditable.
tax credits and refunds			No credit for tax paid on inputs used for exempt outputs, except for (1) exports of manufactures and (2) industrial machinery. No cash refunds except on credits for (1) and (2).	No credit for tax paid on inputs for exempt outputs, except exports. Excess export credits, adjusted only after six months. No cash refunds (transfers to suppliers).	No credit for tax paid on inputs for exempt outputs, except exports. No cash refunds except for tax paid on (1) exports and (2) goods assessed at reduced rate.	No credit for tax paid on inputs used for exempt outputs, except exports. No cash refunds (transfers to suppliers).	No credit for tax paid on inputs for exempt outputs, except exports. Excess credit adjustment at the year-end. No cash refunds (credit against future tax liability).	No credit for tax paid on inputs used for exempt outputs, except exports. Excess credit adjustment only at the year-end. No cash refunds except for tax paid on (1) exports and (2) investment goods.	No credit for tax paid on inputs for exempt output, except exports. No cash refunds (transfers to suppliers).
small businesses			Small retailers assessed by forfait. “Substitute taxpayers” used by (1) wholesalers for very small retailers trading in fixed-price products and (2) purchasers of agricultural products, in states where farmers not exempt.	Small firms exempt. Subject instead to turnover tax on actual or estimated gross receipts.	Assessed by forfait. (Retailers not covered by tax.)	Very small businesses exempt. (Retailers not covered except on imports.) Small businesses (including importers/ retailers) assessed by forfait.	Artisans exempt. Others assessed by forfait.	Assessed by forfait. (Retailers not covered by tax.) Forfait taxpayers and unregistered traders may pass on tax credits to business purchasers.	Optional. Instead, smallest taxpayers may elect special regime, partially integrated with VAT.

The average per capita income of these seven countries covers a wide range of income levels associated with various stages of development, from a little more than US$100 in the Malagasy Republic to approximately US$200 in Eucador, Morocco, Ivory Coast, and Senegal, US$300 in Brazil (the per capita income of the more developed states in Center-South Brazil is twice as high as the national average), and US$600 in Uruguay.

Manufacturing accounts for a low percentage of the total product (10 per cent to 15 per cent) in six of the seven countries, and in all but a few of the Center-South states of Brazil. Except in Brazil, the external sector plays a major part in the economy, with imports reaching 20 per cent to 30 per cent of GDP. The share of taxes in the gross national product (GNP) is relatively high (18 per cent to 20 per cent in most instances and 28 per cent in Brazil).

The VAT was introduced in the seven countries to replace either a general turnover tax, or some form of manufacturers’ sales tax, or a combination of both. In Ivory Coast, Senegal, and Morocco, the VAT replaced production taxes based on the French system (with fractional payments) on manufacturers and importers. The Malagasy Republic had a general turnover tax on goods and services before the introduction of the VAT. In the Brazilian states the VAT also replaced general turnover taxes levied on merchandise sales. Ecuador, until 1970, had a tax on gross receipts from mining, manufacturing, construction, and on certain services; imports were not subject to sales tax. In Uruguay, the sales tax complex that was replaced by a VAT in 1968 included a manufacturers’ sales tax (originally collected by the suspensive method), which was subsequently extended to wholesalers on a value-added basis (indirect substraction method), and was supplemented, after 1963, by a tax on gross receipts of retailers and service enterprises.

General scope of the VAT

The scope of the VAT is usually defined with reference to both taxable transactions and taxable persons. In the developing countries under review, taxable transactions are usually defined broadly as sales by persons engaged in industrial and commercial activity. Except in the Brazilian states, sales by farmers as well as sales of forestry, hunting, and fishing products are excluded at the outset. Taxable transactions are further defined to include both the sale of goods and the rendering of services, except in Brazil and Ecuador, where services are subject to a separate tax. Distinctions are also made between movable goods (such as merchandise) and immovable goods (such as real property), and the latter are subject to value-added taxation only under certain circumstances (in Senegal, the Malagasy Republic, and Ivory Coast), or not at all (in Brazil, Ecuador, and Uruguay).

Taxable persons are defined to include producers (both manufacturers and artisans), importers of taxable goods, sometimes merchants, and service enterprises if services are taxed. Mining, which is not taxed by Brazil, is generally included in industrial production. Construction is usually treated as a service activity and is taxed as such. The treatment of public utilities varies, but they are largely left outside the scope of the tax or are granted specific exemptions.

Sales by farmers

Special problems arise in applying the VAT to sales by farmers. Because farmers normally would be subject to tax on their inputs of machinery, feed, seed, fertilizers, pesticides, etc., it would be necessary for them to maintain adequate records to claim a credit for tax paid on their sales. However, the large number of small-scale farmers in developing countries, many of whom are illiterate, virtually precludes general operation of such a system, with the result that in none of the countries under review, with the exception of some Brazilian states, are off-farm sales subject to a VAT.

The common tax model prescribed by the Federal Government of Brazil does not provide for farm exemption, but it is in fact granted by the more developed states in the Center-South.⁷ The northeastern states, in general, continue to collect tax from the farmer or from his “substitute taxpayer,” that is, processors or traders who purchase the goods. Revenue lost by exempting farm sales is recouped in any event at the processing or marketing stages (except for direct sales to consumers). The problem remains, however, of how to allow for the tax paid by farmers on their inputs. One way to deal with the problem is to exempt farm inputs from the tax. The southern states of Brazil have followed this policy from the beginning, and in 1969 the Brazilian Government made the exemption of farm inputs compulsory in all states.⁸ Ivory Coast, the Malagasy Republic, Senegal, and Uruguay provide similar exemptions. The Malagasy Republic further exempts an extensive list of raw materials and supplies required for the manufacture of agricultural producer goods. Such exemption, in turn, poses a problem for manufacturers of agricultural producer goods of obtaining refunds for taxes paid on their inputs. This can be accomplished through zero rating. Imports of such goods can, of course, be exempted with no great difficulty.

Another way of avoiding the assessment of a VAT on farmers without sacrificing credit to taxable processors or wholesalers of farm products is the “global credit offset” technique employed by EEC countries.⁹ Under this method, farmers may elect to pay tax and claim credit for taxes on purchases on the basis of their accounting records, or they may elect not to pay tax at all. In the latter case, the purchaser of farm produce, however, is fully accountable for tax on his sales (usually at a reduced agricultural rate) and is entitled to a credit for tax presumed to be paid by the farmer on his inputs; to provide for this, a standard global credit offset is allowed, equal to a specified rate on the farmer’s sales that approximates tax paid on farm inputs. For example, if farm sales of 100 are made, the tax payable by the processor on these purchases at a (reduced) rate of 10 per cent is 10, for which he can claim a global credit offset of 5, computed at a standard 5 per cent of the purchases.¹⁰ No comparable device is used in the developing countries.

Sales by merchants

The tax status of merchants varies widely among the countries covered. In the three Latin American countries, as in the Western European countries, merchants are expressly included in the scope of the VAT, at both wholesale and retail stages (with special provisions for assessing the tax on small retailers). In Senegal and Ivory Coast, however, the VAT extends to only a small part of merchandising activities beyond the manufacturing and import stage, and in the Malagasy Republic only sales of imported goods are taxed. The same appears to be true of the Moroccan tax.

In Ivory Coast, only producers, building contractors, and service enterprises are required to register as taxpayers (imports are taxed by the customs office). Merchants may elect to come under the tax, but normally they will take that option only if they sell to taxable producers, or if they wish to claim tax credits on exports. Otherwise, they are entirely outside the ambit of taxation to the extent that they engage only in strictly merchandising activities.

The Senegal statute exempts resale of goods not further processed or altered, provided that the tax has already been paid at the production or import stage.¹¹ Merchants therefore are required to register as taxpayers only if they sell goods that have not yet been subject to tax (for instance, goods bought directly from farmers). As in Ivory Coast, they have the right to opt for the VAT, if they find it advantageous to do so, for passing on to taxable purchasers the credit for tax borne on their merchandise. Those who sell only to retailers generally will not elect to be taxed, because retail sales are exempt. However, even if merchants in Senegal do not register as taxpayers, they are allowed to state on their sales invoices the tax paid on their purchases, for purposes of facilitating claims for tax credit by taxable customers.¹²

Services in general

Services are included within the scope of the VAT by five of the seven countries (Ivory Coast, the Malagasy Republic, Morocco, Senegal, and Uruguay). In Brazil and Ecuador, on the other hand, services are subject to a separate gross receipts tax, which in Brazil is imposed by the municipalities. In the countries where the VAT applies, all services are covered unless specifically exempt. A number of exemptions exist, however, the most common being real property rentals, transport and communications services, and financial services. The liberal professions are universally exempt.

Even though the scope of the VAT on services may be limited by exemptions, a substantial part of the value of services may be taxed indirectly when purchased by taxable businesses. Because there is no tax credit for these costs, the taxable margins of these businesses are increased and the VAT payable, accordingly, is greater. Moreover, when a separate tax is imposed on services, as in Brazil and Ecuador, these service inputs are, in fact, taxed twice.¹³ In the EEC, member countries are obliged to tax at least those services that, as business inputs, are likely to have a significant impact on the price of goods and other services, for example, accounting and engineering services.

Financial services

The tax treatment of financial institutions is not uniform in the seven countries. The three Latin American countries follow the European practice of excluding banking, insurance, and other financial activities from the scope of the tax; they subject them instead to separate levies.¹⁴ In the two West African countries and the Malagasy Republic, on the other hand, it would appear from the statutes that financial services are, in principle, within the scope of the tax, although a number of financial transactions are granted exemption. Insurance premiums, for example, are exempt from the VAT in Morocco, Senegal, and Ivory Coast (where a special levy is assessed), but the exemption does not extend to any related activities, such as insurance brokerage, fees, and commissions. Certain banking transactions are similarly exempt, particularly those relating to the activities of official financial intermediaries.

It is generally agreed that a VAT is not well adapted to financial services, especially banking and insurance.¹⁵ The value added by banks and insurance companies is difficult to calculate under the indirect substractive (tax-credit) method, although it would be feasible to employ the additive method and to apply tax to total payrolls and profits after depreciation allowances. Perhaps the most expedient treatment is the levy of a separate tax on profits of financial institutions, as in France and Denmark and as has been proposed by the Republic of China.

Construction activity and real property transactions

Construction activity is subject to the VAT in Senegal, Ivory Coast, and the Malagasy Republic, but the tax paid on building purchases by business firms is creditable for industrial buildings in Ivory Coast and for industrial as well as agricultural, mining, and tourist installations in the Malagasy Republic. In Latin America, only Uruguay taxes building activity, but at a reduced rate. In Brazil, building contractors are subject to the separate municipal service tax, on the value of services performed, while construction materials are subject to the VAT; tax paid on any building purchases is not creditable. Only the materials used are taxed in Ecuador, and building contractors’ margins appear to be excluded from the scope of both the VAT and the separate gross receipts tax on services.

Transactions in real property, in general, are left outside the scope of the VAT in Brazil, Ecuador, and Uruguay, but are included, in principle, in the other countries. In fact, however, only the sales made in the other countries by registered taxpayers are taxable, while property sales by private individuals and exempt persons are not. Similarly, rentals are not covered by the tax in Latin America and are taxed in the other countries only to the extent that they constitute a receipt from commercial or industrial activity.

Exports

If the VAT is intended as a levy on personal consumption, on the assumption that the tax is shifted forward in higher prices, it is proper to provide for the exemption of exports. This practice follows the so-called destination principle, according to which sales taxes are levied only by the country of final consumption, a principle that is sanctioned by the General Agreement on Tariffs and Trade. By effectively removing all sales taxes that may have accumulated in the production and distribution process, a country can better compete in the world market for its industrial goods. Virtually all countries, in fact, provide for the exemption of industrial exports from their different types of sales tax. One of the advantages claimed for a VAT in this respect is that the amount of tax applicable to the goods can be determined with greater precision, and no residual indirect taxes (taxe occulte) remain, as frequently happens with other types of sales tax.

On the other hand, many primary producing countries that enjoy a comparative advantage in the production of certain commodities do impose export taxes, and the retention of a VAT on semiprocessed or processed agricultural products may sometimes be justified.

When exempt, exports are, in principle, zero rated, that is, they are exempt from further tax and full credit is granted for taxes paid at earlier stages or on deductible inputs. Generally, however, creditable inputs include only the cost of goods purchased and other current inputs, and specified types of capital input (see section, Investment goods). Moreover, the tax credits that exporters accumulate thereby are normally supposed to be applied against VAT liabilities arising from the exporters’ taxable domestic sales. If the VAT liabilities are lacking or are insufficient to absorb the credits, the latter may be made transferable to suppliers or to other taxpayers.

Only as a last resort do most of the developing countries go so far as to provide exporters with cash refunds of the excess tax credits, and then often after the credits have been carried by them for an extended period without possibility of being used up. In Senegal, for instance, the adjustment for exporters’ excess credits can take place only after the close of the year, for either transfer to other taxpayers or as eventual cash refunds. Similarly, in Ecuador, excess tax credits arising from exports may be transferred to suppliers only after a six-month lag. No refunds are contemplated in either Ecuador or the Malagasy Republic. Uruguay appears to favor either offsetting the excess export credits against domestic tax liabilities or transfers to suppliers. In Morocco, there are no refunds, but export production can be exempted from taxes paid at earlier stages if producers are registered with the Customs Department for this purpose or if exports constitute at least 85 per cent of total turnover. Ivory Coast is the only one of the seven countries that clearly places no limitations on cash refunds.

In Brazil, the treatment of exports differs somewhat from that in the other six countries.¹⁷ Exports of primary products generally are not exempt but are taxed at reduced rates in some states and are taxed fully in others. Exports of manufactured goods are exempt, but, until recently, state policies on credit for taxes already paid and on refunds varied widely. State practices are now being standardized, and by 1974 it is expected that tax on manufactured exports paid at earlier stages will be fully creditable throughout the country. The extent to which actual cash refunds will be allowed, however, is still uncertain. Moreover, the export of a whole range of semimanufactured goods still generates prior-stage tax credit only in the states in the Center-South, while in the northeastern states such goods benefit only from a regular exemption at the export stage.

Food and other basic necessities

All seven countries grant some tax relief on food. This is generally provided in two ways: (1) by not taxing direct sales by farmers of unprocessed agricultural products in general; (2) by exempting specific foodstuffs, processed or unprocessed, regardless of the seller.¹⁸

The exemption of off-farm sales is provided in the VAT laws of the seven countries covered, except those of several Brazilian states. The attendant tax relief on basic food items probably goes much further in developing countries than in developed countries toward providing a general exemption of expenditures on food even if foodstuffs are not specifically exempt.

Of the seven countries surveyed, only Ecuador appears to rely solely on the farmers’ exemption to provide tax relief on food consumption. All the others complement this with a specific foodstuff exemption, which varies from country to country. Brazil exempts only a limited number of foodstuffs, mostly in their natural state.¹⁹ Until 1973, Uruguay had an extensive list of exemptions that included a number of processed foods as well as basic necessities, such as medicines, soap, water, gas, electricity, coal, firewood, and kerosene, but many of these items are now subject to a reduced rate. The two West African countries also exempt most foodstuffs, while the Malagasy Republic adds household necessities and some school supplies to the list and expressly exempts a number of raw materials and intermediate products used for manufacturing goods that are exempt as basic necessities. Similarly, in Ivory Coast, the exemption of bread, for instance, is supported by an exemption for flour and cereals. Morocco exempts only basic foodstuffs.

Newspapers, periodicals, and other exemptions

Newspapers and periodicals are exempt everywhere, usually along with newsprint (as in Brazil, Uruguay, Senegal, and the Malagasy Republic), and Uruguay also exempts printing equipment. Occasionally the exemption is extended to books, other educational materials, and records.

Exemptions other than those covered elsewhere apply mostly to certain services (in those countries where the VAT applies to services) and to real property sales and rentals (either totally or partially). In Senegal and Ivory Coast, exemption is also granted on the sales of certain public utility enterprises that operate under state concessions.

Goods subject to special excises

The tax treatment of goods subject to excises presents a special problem. Excises on tobacco products, alcoholic beverages, petroleum products, sugar, etc., are generally levied at high rates and account for a substantial part of government revenues; in some instances these goods are produced and sold through government monopolies. If these excises were replaced with a VAT, it would be necessary to introduce special high rates so as not to sacrifice revenue; also, the advantages of excise tax administration and enforcement might be lost. On the other hand, producers would be subject to a VAT on their purchases, and unless these purchases were made taxable, or were zero rated, the producers would not be able to recoup tax paid. European countries have generally extended the VAT to cover sales of excisable goods; in some countries, such as Denmark and Sweden, it has been superimposed on existing excise tax rates, while in others, such as the Netherlands and Germany, excise rates were reduced so as to maintain approximately the same level of tax as before.

In developing countries, a limited number of goods and services subject to excises or sold by state monopolies are excluded from the VAT, particularly alcoholic beverages, tobacco, petroleum products, and public utilities. On the other hand, luxury excises are often superimposed on the regular VAT, as an alternative to using the luxury rates in the VAT itself (see the third paragraph of the section, Tax rates).

Coverage of GDP

As we have noted in the section, The taxable base, in none of the seven countries covered is the VAT very complete in its sectoral scope. All countries exempt farm sales, exports of manufactured goods, and substantially all financial services; only three tax retail sales but they grant exemptions for certain essential foods and other products; two exempt all services, but the others exempt only specified services.

No estimate is available of the proportion of GDP covered by the VAT, except for Brazil, where it is approximately 60 per cent.²⁶ It should not be inferred, however, that this represents value added only by the taxable sectors of agriculture, manufacturing, and trade; the output of the excluded sectors (for example, services and mining) is taxed indirectly by the purchases of such exempt goods and services because they carry no tax credit. The value of the intermediate production that is outside the direct scope of the VAT in Brazil and that is effectively taxed in the form of noncreditable inputs is estimated to amount to from 15 per cent to 20 per cent of the value added by agriculture, manufacturing, and trade.²⁷

Tax ratios

For the seven countries covered, the VAT tax collections in a recent year ranged between 1.1 per cent of GDP for Ecuador and 8.1 per cent for the Brazilian states (Table 4). While some difference in these extremes could be expected because of the wide disparity in rates—ranging between 4 per cent for Equador and 20 per cent for Brazil—this accounts for only about 70 per cent of the difference.

Table 4.

Selected Developing Countries: General Sales Tax Revenue as a Percentage of Gross Domestic Product (GDP), Recent Years

Sources: Government reports; International Monetary Fund, International Financial Statistics.

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

²With effect from January 1, 1973, replaced with a tax on sales by manufacturers and importers, with a partial tax credit, and separate lower rate taxes on wholesale sales and certain services.

³With effect from June 1, 1971, revised to a single-stage manufacturers’ tax (2).

Table 4.

Selected Developing Countries: General Sales Tax Revenue as a Percentage of Gross Domestic Product (GDP), Recent Years

	Type of Tax1	Fiscal Year	Percentage of GDP
Brazil (states)	4	1970	8.1
Chile	1	1970	7.2
Tunisia	4	1970	6.3
Ivory Coast	4	1970	5.4
Morocco	4	1970	4.5
Senegal	4	1970	4.0
China, Republic of	1 and 3	1969	3.9
Peru	12	1970	3.3
Mali	2	1970	2.9
Malagasy Republic	4	1970	2.7
Korea	1 and 3	1969	2.7
Thailand	2	1969	2.6
Costa Rica	5	1970	2.4
Philippines	2	1971	2.4
Uganda	2	1970	2.3
Chad	2	1969	2.2
Uruguay	4	1970	2.1
Tanzania	2	1970	2.1
Mauritania	2	1970	2.0
Pakistan, West	2	1971	1.6
India (states)	1 and 2	1970	1.6
Ghana	2	1969	1.4
Indonesia	2	1971	1.3
Ecuador	4	1971	1.1
Colombia	2	1971	1.1
Argentina	2	1970	1.1
Nicaragua	5	1971	1.1
Mexico	1	1970	1.0
Honduras	5	1970	0.9
Bolivia	13	1970	0.8

Sources: Government reports; International Monetary Fund, International Financial Statistics.

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

²With effect from January 1, 1973, replaced with a tax on sales by manufacturers and importers, with a partial tax credit, and separate lower rate taxes on wholesale sales and certain services.

³With effect from June 1, 1971, revised to a single-stage manufacturers’ tax (2).

View Table

Table 4.

Selected Developing Countries: General Sales Tax Revenue as a Percentage of Gross Domestic Product (GDP), Recent Years

	Type of Tax1	Fiscal Year	Percentage of GDP
Brazil (states)	4	1970	8.1
Chile	1	1970	7.2
Tunisia	4	1970	6.3
Ivory Coast	4	1970	5.4
Morocco	4	1970	4.5
Senegal	4	1970	4.0
China, Republic of	1 and 3	1969	3.9
Peru	12	1970	3.3
Mali	2	1970	2.9
Malagasy Republic	4	1970	2.7
Korea	1 and 3	1969	2.7
Thailand	2	1969	2.6
Costa Rica	5	1970	2.4
Philippines	2	1971	2.4
Uganda	2	1970	2.3
Chad	2	1969	2.2
Uruguay	4	1970	2.1
Tanzania	2	1970	2.1
Mauritania	2	1970	2.0
Pakistan, West	2	1971	1.6
India (states)	1 and 2	1970	1.6
Ghana	2	1969	1.4
Indonesia	2	1971	1.3
Ecuador	4	1971	1.1
Colombia	2	1971	1.1
Argentina	2	1970	1.1
Nicaragua	5	1971	1.1
Mexico	1	1970	1.0
Honduras	5	1970	0.9
Bolivia	13	1970	0.8

Sources: Government reports; International Monetary Fund, International Financial Statistics.

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

²With effect from January 1, 1973, replaced with a tax on sales by manufacturers and importers, with a partial tax credit, and separate lower rate taxes on wholesale sales and certain services.

³With effect from June 1, 1971, revised to a single-stage manufacturers’ tax (2).

In Ivory Coast, Morocco, and Senegal the VAT is also important in relation to GDP. While their rates are fairly high—ranging between effective normal rates of 10 per cent and 17.65 per cent—their tax ratios are at least twice that of Uruguay, which has a rate of 10 per cent. Moreover, Uruguay taxes retail sales whereas the others do not.

It seems clear that in developing countries, in general, sales tax revenue depends heavily on the value of imported goods.²⁸ Information is not available for all the countries covered that have a VAT, but data for Ivory Coast, the Malagasy Republic, and Senegal show that the VAT revenue collected by the customs administration amounts almost uniformly to about 60 per cent of total revenue.²⁹ In Morocco, the proportion is about one half.³⁰ Imports probably play a less important role in Latin America, especially in Brazil, but rough estimates indicate that Ecuador derives at least 40 per cent of its VAT revenue from imports.

It is rather striking that, of a representative list of 30 countries with sales taxes, 5 of the 6 countries with the highest ratios of sales tax to GDP are those with a VAT (see Table 4). On the other hand, both Uruguay and Ecuador are at the lower end of the range, and the Malagasy Republic falls in midrange.

It is sometimes argued that the VAT is best prescribed for conditions of high sales tax effort because it becomes increasingly difficult to enforce tax collections from turnover taxes as tax rates are increased.³¹ This theory finds support in practice by the decision of 5 of the 6 countries with high ratios of sales tax to GDP to employ this form, and by the fact that others with high tax ratios—including Chile, the Republic of China, Peru, and Korea—have been giving serious consideration to converting to a VAT. On the other hand, countries with low sales tax ratios, such as Argentina, Colombia, and Mexico, have also considered the feasibility of the VAT technique.

Small enterprises

As has been pointed out, large or medium-sized enterprises can absorb the accounting and procedural requirements of a VAT with relative ease. Because there are relatively few such enterprises in developing countries, and an important part of total economic activity is concentrated in their hands, they tend to become a target for audit and control by the tax administration services.

The problem arises with the large numbers of small artisans, traders, and peddlers that exist in developing countries, who may comprise an insignificant proportion of total business activity. Various solutions to problems of administering the tax on these firms have been advanced, mainly the following:

(1) Apply the VAT to all stages of production and distribution, including retailing, but limit it to those firms that have a yearly turnover above a specified level. Since most of the exempt firms would pay tax on their purchases, tax would be sacrificed only on their retail margins. These small firms could choose coverage by the VAT and might do so if the tax paid on their purchases exceeded the tax paid on their sales (or if their buyers insisted on a tax credit). As we have seen, many European countries and some developing countries exempt small businesses.

(2) Establish a limit, generally based on yearly turnover, below which taxpayers may elect either to be incorporated within the VAT system or to pay a low rate of turnover tax on their total sales with no deduction for taxes paid on their purchases.

This system relies heavily on the accuracy of sales reported by small taxpayers. It is precisely this point that causes most difficulties in administering any type of sales tax, as it is practically impossible to determine total sales of a large number of small taxpayers. In such a system most customers of these small taxpayers have no interest in paying the tax or in receiving an invoice, while the taxpayer wishes to minimize his total sales for purposes of both sales tax and income tax.

(3) Use the forfait type of assessment. This system is widely used for small businesses both in the countries that provide no exemption for small businesses and in those with firms that are larger than those in the exempt category.⁴² In Uruguay, a variant of this system is to assess all exempt small firms with a special turnover levy (applied to either actual or estimated gross receipts) that substitutes for both the VAT and several other taxes, including the schedular income taxes on business enterprises. The VAT that is assessed on a forfait basis is in some respects a separate levy, especially to the extent that it does not provide credit for taxes already paid, and since normally it cannot be stated on invoices even if sales are made to taxable taxpayers. One exception to this rule is the Senegal statute specified in footnotes 11 and 12, which allows firms assessed by forfait, and even unregistered traders, to pass on to business purchasers the tax credit on their sales invoices.

The forfait mechanism is a crude way of taxing small enterprises and is subject to arbitrary decisions on the part of the administration and to collusion between taxpayers and tax inspectors. In those developing countries in which political influence or other disruptive factors characterize tax administration, the forfait system might tend to perpetuate such abuses. Moreover, use of this technique does not encourage the use of invoices and improvements in accounting.

(4) Use a variation of the forfait technique in which the taxpayer would be allowed to deduct from his fixed tax the amounts of the VAT that are shown on his purchase invoices. Here, the forfait payment would be fixed at a higher amount than in a normal forfait system to allow for the deduction of taxes paid on purchases. One advantage of this modified forfait is that the taxpayer has a greater interest in obtaining an invoice for his purchases. Moreover, it has been suggested that the relative amount of tax credit taken by the forfait taxpayer would provide a guide to the administration in making periodic changes in the forfait estimates.

(5) Give small enterprises, especially in the retail field, the option of coming within the scope of the VAT or of being subjected to an “equalization” levy that is chargeable at various rates on goods delivered to them, depending on their selling margins. This technique has been adopted in Belgium and has been studied for possible application in the Central American countries that have adopted a hybrid system of sales taxes. Under this system, it is the responsibility of sellers to collect the equalization tax, showing on their invoices both that tax and the VAT. The Belgian system, which is of a transitory nature, has the advantage of incorporating small businesses within the scope of the VAT without the need to audit or control them directly; however, it has been criticized for the multiplicity of the rates required, the burden on the seller, and the reluctance of small businesses to come under the system.⁴³

With respect to the problem of small businesses, the fundamental difficulty, common to all the systems described, is to determine which taxpayers should be considered “small.” Faced with this problem, most countries have fixed a limit on total yearly turnover as an appropriate dividing line.⁴⁴ This criterion is open to several objections. One of the main difficulties of administering any type of sales tax is to obtain an accurate report of total sales from small enterprises. Small taxpayers will try to adjust their total sales to fall within or outside the scope of the VAT, according to their interests, and the authorities are generally unable to control such a situation. The amount of the limit is also arbitrary, and it is difficult to justify why two taxpayers should be in different situations only because one has a turnover that slightly exceeds the fixed limit and the other is barely below this limit. It may therefore be desirable to incorporate in the definition other objective elements, such as value of total assets, value of inventory, or number of employees.

Farmers

The inclusion of farmers presents one of the most serious problems of administering a VAT. As we have seen in the section, Sales by farmers, some European countries have dealt with them by means of a “global credit offset” device, according to which farmers do not have to pay the VAT but simply issue a receipt for goods that enables purchasers to claim a tax credit. The main reason for using such a procedure is to avoid imposing on these taxpayers the obligation of keeping the records that are essential for administering the VAT. If this is the situation in developed countries, it cannot be expected that the VAT can be applied to farmers in developing countries with any degree of success, unless a similar technique were to be devised for them.

In developing countries in which a VAT is in force, one solution has been to exempt direct sales of unprocessed agricultural goods by farmers and to exempt agricultural producer goods that comprise the main cost of their inputs. While this method may not be precise in avoiding cumulation of tax, neither does it sacrifice tax revenue, because the value of the farmer’s output is recouped at the next taxable stage, that of the trader, cooperative, or processor.

On the other hand, in many developing countries there is a great cultural and economic difference between different categories of farmer; frequently, large holdings are concentrated in the hands of a small percentage of landowners, who make an important contribution to total agricultural production and many of whom maintain accounting records required for a VAT. Therefore, although administrative reasons are of considerable weight in favoring the exemption of most farmers in developing countries from the VAT, they do not justify exempting large commercial producers.

Elimination of cascading

Cascading is inherent in the taxation of most manufacturing industries if purchases of raw materials, semifinished goods, and supplies are made taxable. Two different well-established techniques are employed to eliminate the cumulation of tax on manufacturing: (1) the suspensive system, according to which licensed manufacturers are entitled to purchase goods and services tax free,⁵² and (2) the value-added principle, according to which an allowance is made for the tax paid on purchases.

The suspensive principle is illustrated by the law recently adopted in Malaysia, whereby licensed manufacturers, with the authorization of the Customs Department, are entitled to import or purchase materials and components from other manufacturers free of tax; when these goods are purchased from a tax-paid source, such as an importing firm, the seller may apply to the sales tax office for a refund of the tax previously paid. If, as is usually true, sales tax is collected by the Customs Department at the time of import, this system may be cumbersome because of the seller’s need to apply for tax rebates on tax-paid goods. The scope for this treatment is greatly reduced by a long list of goods, including materials and supplies, that are exempt under the law. Although this system, in principle, should substantially avoid the accumulation of taxes on manufacturers’ sales, it may leave a residue of tax that is impracticable to recoup on purchases from taxable sellers; while this is likely to be of little overall significance, it may be important for particular industries.

The value-added principle is applied at the manufacturing level by a large number of developing countries. The French-speaking West African countries ⁵³ as well as Argentina, Colombia, and the Philippines employ the direct deduction technique. With minor differences, the taxes in the West African countries replicate the French production tax as revised in 1948 to provide for fractional payments on the value added by each producer; the French tax follows the physical deduction principle in allowing a deduction from manufacturers’ sales only for taxable purchases of raw materials and components that either are physically included in the product or lose their identity, such as abrasives, lubricants, and chemicals. Unless exempted outright, purchases of capital equipment are also taxable. These countries differ in the extent of the deductions allowed.

The sales taxes in Algeria, Ivory Coast, the Malagasy Republic, Morocco, Senegal, and Tunisia, although differing among themselves in some respects, best approximate the concept of a VAT at the manufacturing/wholesale level. They follow in general the 1954 French model, which came to be known officially as the value-added tax. It differs in two major respects from the reformed production tax of 1948 that was adopted by other French-speaking countries in (1) providing for the elimination of tax on purchases of machinery, equipment, and industrial buildings (the financial deduction) and (2) replacing the direct deduction method with a tax credit. This improved version represents a more desirable model at the manufacturing level than the production taxes of other French-speaking West African countries.

Full application of the VAT principle, whether based on the direct deduction or the tax-credit method, provides a clear-cut elimination of any cascade effect and avoids discrimination among competing manufacturers with different structures of production (that is, integrated versus nonintegrated). When imports of equipment, components, and supplies serve a variety of uses, there may be some advantage in assessing tax uniformly on all goods at customs and allowing manufacturers to claim a deduction or credit for tax on their sales; the risk of evasion is greater if tax is not imposed at this point.⁵⁴ On the other hand, when imports are used in producing for export, it may be more expeditious under a VAT to provide for the exemption of imports of materials by licensed exporters, as in Morocco, so as to avoid the need to finance inventories of goods that include an element of sales tax.⁵⁵ Moreover, such a system minimizes the problem of refunding tax on exported goods. In this respect, there is no essential difference from a single-stage manufacturers’ sales tax, except for the accumulation of tax on goods that are not imported directly by the licensed manufacturer who uses them, but the VAT has an advantage because it completely eliminates double taxation.

Colombia’s experience with the two methods illustrates possible limitations of the suspensive system. With the introduction of the tax in 1965, provision was made for manufacturers to buy materials free of tax by notifying the seller that the purchases were to undergo further processing; in addition, manufacturers were allowed to reduce their tax base by the cost of other materials that were subject to tax (that is, using the direct deduction method). Because of the abuses of this system by manufacturers who overstated their purchases of taxable materials, and the difficulties of checking and controlling such evasion, Colombia amended the law to limit the suspensive principle to those manufacturers who produce goods for export, or other specifically exempt goods, and replaced the direct deduction method used for other purchases with a credit for taxes paid.⁵⁶ Pakistan also recently replaced its suspensive method with the tax-credit device.

Neither Indonesia nor Thailand completely resolves the cascading problem. Rather, they tax raw materials, other intermediate products, and services in general at a reduced rate—in Indonesia at one half the normal rate and in Thailand at a nominal rate of 1.5 per cent. Thus, cascading is mitigated somewhat but not eliminated at the manufacturing level. Its elimination could be accomplished either by sacrificing revenue or by higher tax rates. From an administrative point of view, it is necessary to specify the materials and supplies that are subject to the reduced rate and to enforce payment of the correct tax. It is more difficult, of course, to provide for precise rebate of tax imbedded in the cost of manufactured goods that are exported.

Administration and compliance

From the point of view of administration and compliance, there would appear to be no significant difference between the suspensive and tax-credit approaches at the manufacturing level. Substantially the same number of taxpayers would be covered under both systems, and neither would entirely avoid the need for refunds. However, as noted earlier, uniform application of the tax to purchases, including imports of taxable goods, would limit the possibilities of evasion that are implicit in the suspensive method. Auditing of accounts would, of course, be necessary to check the validity of invoices for which tax credit is claimed and to ensure that all taxable sales are reported.

Exemption of exports would present no problem under either system. No tax refund would be needed under the suspensive method, where no tax is assessed; however, it may not be feasible to eliminate the tax completely when taxable purchases of supplies, etc., are unavoidable. Tax refunds may be necessary under the VAT method unless purchases of licensed exporters are completely exempt. Payment of tax on purchases of materials, of course, would increase the cost of financing inventories under the VAT method.

Allocative effects

The Honduran prototype is well adapted to countries where manufacturing is undeveloped and it is desirable to have a broadly based tax that is distributed roughly according to consumer expenditures. As a single-stage tax, it avoids cascading and does not encourage integration. Rather, it favors small-scale entrepreneurs who are taxable only on their purchases and who escape tax on their value added. This very discrimination, however, may provide an undue advantage to small firms that are not required to add the tax to their sales, thereby attracting business because of their actual, or apparent, tax-free status. This has been the experience in Costa Rica where marked competition developed between registered and nonregistered restaurants, bars, nightclubs, and other service firms that were small enough to escape the tax entirely.⁵⁹ But the same type of discrimination could arise with a VAT that provided similar exemptions.

The degree of disparity between registered and nonregistered firms is suggested by data for Honduras that show that only 27.4 per cent of tax was collected from retailers and 3.1 per cent from restaurants, bars, hotels, etc.⁶⁰ This means that possibly as much as two thirds of the Honduran-type tax is based on wholesale or manufacturing sales to retailers and other sellers who are not taxable on their own value added. While the discrimination inherent in this situation may not be serious at present rate levels (5 per cent in Costa Rica and Nicaragua and 3 per cent in Honduras), it may be necessary at higher rates to close the gap in the effective tax burden between registered and nonregistered firms.

Beginning in 1968 Honduras took measures to assess the sales tax at the end of the year on the difference between taxable purchases and sales by nonregistered firms with annual turnover above a certain minimum, covering about 2,000 firms.⁶¹ Since this is tantamount to applying the VAT principle, it would seem to be a short step to replace this hybrid form of tax with a VAT.⁶² Alternatively, it might be feasible to lower the limits of registration to the level adopted for the annual assessment, and to collect the tax regularly throughout the year. If this were done, the differences between the two techniques would substantially disappear, except for the use of the suspensive principle by the hybrid method in exempting intermediate goods and machinery from tax.

Administration

As has been noted, the difficulty of enforcing a single-stage sales tax at the retail level in developing countries militates against its use and has led to the adoption either of taxes at the manufacturing/wholesale level or of retail sales tax structures based on the Honduran model or the VAT principle. Both types of tax extending to the retail level have been administered successfully in developing countries, although neither has been without problems. Since the main touchstone of their applicability to developing countries is their ease of administration—especially at high rates—it is important to compare the principal characteristics of each from this point of view.

Sales taxes generally run into trouble because of the large numbers of returns that must be processed and taxpayers who must be controlled and audited. The hybrid method has been advanced as a practical means of confining the tax to larger firms without producing undue interfirm discrimination. But, as we have seen, inequities arise even at low tax rates, and these would be intensified with a rise in rates. Attempts to mitigate such discrimination by compensating taxes on the value that is added by nonregistered retailers and other firms increase the administrative burden. At this point of development, the number of taxpayers covered by a retail VAT would not appear to be greater than those covered by a modified hybrid system, especially since it may be most practicable to exempt the very small firm under each system.

The suspensive system employed under the hybrid model facilitates diversion of taxable to nontaxable sales, similar to that already discussed in connection with a manufacturers’ sales tax and which led Colombia and Pakistan to replace it with a tax credit. From the point of view of compliance, it is necessary for sellers to make a distinction between taxable and nontaxable sales of intermediate goods, based on the statement of the purchaser. No such distinction need be made under a VAT; all sales are uniformly subject to tax, and the purchaser simply sets off the tax paid on purchases against tax added on his sales.⁶³ On the other hand, all firms covered have to maintain accurate records of purchases as well as sales.

As discussed in the section, Audit of a VAT, one of the advantages claimed for a VAT is the self-reinforcing nature of the assessment and collection process. Because the tax paid on purchases is set off against tax, every taxable firm should have an interest in seeing that tax is included in the seller’s invoice. This process, however, is subject to abuse through collusion and by the use of fraudulent invoices; moreover, no such discipline is imposed at the final sale to consumers. Experience nevertheless appears to attest the efficiency of the system in minimizing evasion. Danish tax officials, for example, believe that evasion is more easily deterred if it is based on a false statement to tax officials to gain a credit or refund than if it is only necessary to give false information to a seller as to the intended use of the goods in order to obtain an exemption under a single-stage tax.⁶⁴

Some advantage also is claimed in the splitting up of the tax liability in the manufacturing/distribution chain, so that a single firm is not subject to more than a fraction of the cumulative tax at the retail level—the part that is applicable to its value added. The significance of this factor, of course, is related directly to the rate of tax. Under the hybrid system, the tax is paid only at a single stage, and if this is evaded the entire amount of tax is sacrificed; the risk of loss is minimized when more than one seller is involved in the payment of the VAT on a particular good or service. Nevertheless, a problem may remain under either system for personal service businesses with a high labor content. Where taxable purchases of materials are a relatively small part of the total business revenue, the burden of the sales tax may represent a large share of net profits.

Effects on channels of distribution

A tandem system, whether based at the manufacturing or wholesale level, is inherently discriminatory as to distribution channels; markups vary among different types of commodity and also, even for competing goods, the sales tax base varies with the division of the marketing functions between the manufacturer or wholesaler and the retailer. With a tax at either level, large retailers are encouraged to buy directly from manufacturers at preferential prices and assume much of the wholesaling function themselves. They are thereby favored with lower effective tax rates in relationship to the retail value of their sales than those chargeable to small unit retailers who buy from a wholesaler or jobber. This type of discrimination with respect to distribution channels has posed serious problems under both the Canadian manufacturers’ sales tax and the British wholesale (purchase) tax, especially at the higher rates, and has led to the adoption of “uplifts” in the United Kingdom for equalization purposes.⁶⁵ As we have seen, a VAT through the retail level is neutral in its effects on channels of distribution and avoids integrative effects.

Conversion from a multistage turnover tax to a VAT presents special problems for integrated industries that have succeeded in minimizing their turnover tax, as in Chile and Peru. Because a substantially higher VAT rate might be necessary to replace turnover tax revenues, taxes chargeable against integrated manufacturers, for example, would be increased greatly. When the turnover tax rate is already high, as in Chile, much higher rates might be resisted and administrative problems would be intensified. When turnover rates are low, however, as in the business activities taxes in Korea and the Republic of China, and integration has not reached large proportions, similar problems may not exist. Replacement of turnover taxes by separate sales taxes on manufacturing and retailing would somewhat mitigate the sharpness of the increase, especially when integration has not been carried to the retail level.

Flexibility

One reason advanced in favor of a tandem system is that a sales tax at the manufacturing or wholesale level is more adaptable to rate differentiation.⁶⁶ A VAT is also amenable to multiple rates, but it is most easily administered with one or two rates, as in Latin America, Denmark, the Netherlands, Germany, Norway, and Sweden. While higher rates on luxuries are frequently defended on distributional grounds, and may be necessary for political reasons, it is questionable if a sales tax is the best tax instrument for achieving vertical equity. On the other hand, it is usually thought desirable to mitigate the regressivity of a sales tax by exempting such necessities as food, medicines, and rent, and this probably can be done as readily through a zero rate or exemption under the VAT as under a tandem system.

Enforcement considerations also tend to limit the level of rates that may be necessary to expand sales tax revenues, both at the manufacturing or wholesale stage and the retail stage. This is known to be an important factor in the sales tax planning of Ireland, although its entrance into the EEC was the decisive consideration in adopting a VAT. Fractional payment of tax under a VAT and its built-in self-checking features tend to reduce the risk of evasion, and thereby permit higher tax rates than might be tolerable on manufacturers’ or retailers’ sales under a dual regime.

Administration

Administrative considerations do not appear to give any clear net advantage to either sales tax structure. While a tandem system is likely to entail fewer taxpayers, the difference is not likely to be so great as to give it much weight in the choice. On the other hand, as we have already seen, the VAT principle is less conducive to tax evasion: the same arguments made with respect to the comparative advantages of the suspensive method of eliminating cumulation of tax are equally applicable to the VAT system (see the section, Elimination of cascading).

It is also argued that a tandem system permits a low tax rate at the retail level and thereby reduces incentives for evasion in a sector that is especially vulnerable. A greater share of the revenue can then be collected at high rates from a more limited number of manufacturers and importers. There is some force to this argument for personal service businesses with a high labor content, but it should not be overlooked that retailers are subject to the VAT only on their gross profit margins, usually a moderate fraction of their sales.

Because of the administrative problems that are encountered under any sales tax on small retailers and artisans in developing countries, the need for a special regime to cover them is generally recognized. Provision can be made, as in a hybrid tax, to exempt small firms from a VAT, leaving them taxable only on their purchases. Or a forfait system can be adopted, based on presumptive sales (see (3) and (4) in the section, Small enterprises). One alternative that has been proposed in the Republic of China and other developing countries is to tax small businesses at a reduced rate (say, one fourth of the standard rate) on their reported sales, but to give them the option of being taxed under the VAT system and claiming credit at the standard rate. This system would obviate the need for maintaining proper records of purchases, etc., but would reach the value added by retailers and other small firms.

Differences in structure

On the basis of the laws enacted in these seven countries, it is not possible to construct a model of the type of VAT that is likely to emerge in developing countries. These examples, however, suggest some lines along which these countries may be expected to go in their efforts to adapt the tax to their particular circumstances.

The scope of the VAT is narrowest in Ivory Coast, Morocco, and Senegal and is 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, however, in all these countries but Brazil and Ecuador, where they are covered by other taxes.

Developing countries are apt to limit the range of the VAT by excluding the most troublesome sectors (farmers, retailers, etc.) because they pose difficult enforcement problems. Virtually all developing countries exempt farmers as a simple way of providing tax relief to the lowest-income group. Even if no measures are taken to exempt processed foodstuffs and other basic necessities or to tax them at a reduced rate, equity purposes are served. Luxury goods, on the other hand, are mostly imported and may be assessed at a higher rate of tax directly at the customs. Selective excises on luxury goods also increase the tax burden on the higher-income groups without necessarily resorting to multiple rates for the VAT.

The tax is also simpler in structure in the Latin American countries because of the use of a uniform tax rate and relatively few exemptions (as in Brazil and Ecuador). In the Malagasy Republic the value-added technique apparently is not used to the full extent even in the manufacturing sector: the extensive list of intermediate products exempted or taxed at a reduced rate suggests that a substantial proportion of the total tax that is due on industrial goods is collected at the last stage of manufacture rather than being spread over earlier stages.

Developing countries are likely to be less concerned than industrial countries with removing investment expenditures from the tax base. The tax treatment of investment may vary with the objectives of the country’s economic policies, including the relative incentives for using labor and capital.

Another characteristic of the VAT in developing countries is their reliance, in part, on exempting producer goods from the tax, rather than on the tax-credit method, when the former is easier to apply. This results not only in the widespread exemption of agricultural producer goods but also in the exemption of industrial machinery equipment in Brazil and of construction materials in Uruguay. The tax exemption of industrial producer goods in the Malagasy Republic also represents in effect a partial use of the suspensive principle to postpone collection of tax on intermediate products.

One of the major problems that confronts the developing countries under a VAT is the treatment of small businesses. While in industrial countries small firms are concentrated in the agricultural and retail sectors, in the developing countries a significant share of manufacturing and trade may still be carried out on a small scale. Techniques designed to deal with this type of situation include use of the forfait technique and the tax-credit pass-through facility offered by Senegal to its forfait taxpayers and unregistered traders on sales to registered purchasers.

Revenue importance

Revenue data for the countries covered show that the VAT is one of the most productive forms of sales tax, accounting for between 10 per cent and 30 per cent of government tax revenue. VAT revenue in a recent year exceeded 2 per cent of GDP for all countries except Ecuador and ranged as high as 8 per cent in Brazil. As with sales tax revenue generally, VAT revenues in developing countries can be expected to increase at a faster rate than the rate of growth of the economy.

With few exceptions (Brazil, for instance), a substantial part of the revenue is derived from imports (almost uniformly 60 per cent in the African countries). No information is available on the proportion of GDP covered by the VAT in the developing countries except for Brazil, where it is estimated at 60 per cent. Despite substantial exemptions, the VAT effectively taxes a substantial portion of GDP outside its direct scope; this is so because of the nontaxable purchases by businesses for which no tax credit is given on their chargeable sales—amounting to an estimated 15 per cent to 20 per cent of value added by agriculture, manufacture, and trade in Brazil.

Administrative considerations

The possibility of efficiently administering a VAT in developing countries depends on many factors, including characteristics of the VAT 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 developing countries is the problem of coping with small taxpayers, which include a large percentage of retailers, service enterprises, and farmers. If an adequate solution can be found to exclude these taxpayers from the general requirements of the VAT, the problems of administering such a tax will be reduced greatly. 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.

A VAT with multiple rates and many exemptions undoubtedly presents greater difficulties of administration and compliance than does a single-rate tax with few exemptions. The VAT systems in the Latin American countries except Uruguay have uniform rates, while in Africa they are differentiated with the class of consumption expenditure.

The administrative requirements for efficient control and audit of a VAT are closer to those of an income tax than to those of other types of sales tax; therefore, those countries that have a high degree of efficiency in administering income taxes are in a better position to administer a value-added type of sales tax. Even though a VAT contains a built-in system of cross-checking, undue reliance should not be placed either in the ability of administration in developing countries to effectively apply a computerized or manual system of cross-checking of information, or on the incentive that a VAT gives to purchasers to require invoices from sellers. Other audit techniques must complement such cross-checking and self-enforcing features of the tax in order to adequately enforce compliance.

Finally, the transitional aspects of introducing a VAT must be studied in each case, depending on the taxes for which it is intended to substitute. Simple, although perhaps less equitable, transitional provisions seem to be preferable, so as not to overburden tax administrators and taxpayers in the initial stages of its application.

The choice of a sales tax

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 in this respect: (1) a single-stage manufacturers’/ importers’ tax of the suspensive type; (2) a hybrid retail/wholesale tax modeled on that of Honduras; and (3) a tandem system, including a tax on sales by manufacturers or wholesalers and one on retail sales.

Neither a single-stage retail sales tax, because of enforcement problems, nor a multistage turnover tax, because of the discriminatory effects arising from its cascading, appears to be a viable alternative.

Most developing countries have limited their general sales taxes to the manufacturing stage, with a compensatory tax on imports. Two techniques may be employed to eliminate double taxation: (1) the exemption of purchases by licensed manufacturers and importers (the suspensive method); and (2) the value-added technique, which provides either for a deduction from taxable sales of taxable purchases, or a credit against tax chargeable on sales for sales tax paid on purchases.

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 price. On the other hand, it offers greater opportunity for evasion and may require greater administrative effort in its enforcement. The value-added technique permits greater precision in the elimination of cascading, including the remission of taxes on exports, and is less subject to tax evasion. For these reasons, both Colombia and Pakistan recently converted to this form.

A hybrid retail/wholesale tax system has been applied successfully in several developing countries in Latin America. 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, rather than the VAT, principle is applied. Greater possibilities therefore exist for evasion, as under a manufacturers’ sales tax. On the other hand, the number of taxpayers is considerably smaller than would be covered by a VAT. Small retailers, etc., are not taxed on their value added, and they enjoy some tax advantage as against larger retail firms. It is possible, however, to assess these margins by an annual tax, as in Honduras.

Separate taxes at the manufacturing or wholesale level and at the retail level offer another realistic alternative to developing countries. Once a manufacturers’ sales tax has been established, it can be supplemented by a lower tax rate on retail sales of goods and services. Such a tandem system has operated successfully in Ireland and has been suggested for replacement of multistage turnover taxes, as in Chile. One advantage claimed is the greater flexibility of taxation at the manufacturing or wholesale stage, so as to permit variation of rates with classes of consumer goods. A tax at the manufacturing or wholesale level, however, encourages the absorption of wholesaling functions by retailers for the purpose of minimizing tax, and discriminates against the small-scale retailer. Such discrimination is avoided by a VAT at the retail level.

Size of retail units

As we have noted, only sales taxes carried to the retail level can be truly neutral in their effects on the organization of production and distribution and on consumer prices. The European precedent for a VAT at the retail level has, in fact, identified the VAT as a comprehensive tax on household expenditures that is implemented by means of fractional payments on producers and traders through the retail level. 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 countries at an early stage of development is characterized by small traders militates against effective enforcement of a retail tax, and a VAT in itself offers no solution to this problem. Indeed, very small businesses are typically excluded from such a tax. Optional assessment methods, such as forfait, are available, but there are limits to their toleration in a VAT system.

Records and bookkeeping

Another indispensable condition is the adequacy of records maintained by firms. Since a true record of purchases and sales is a minimum requirement for applying 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, their reliability is often open to question.

On the other hand, the introduction of a VAT is bound to enforce better accounting discipline because of the need for invoices to support claims for tax credit. Standard forms issued or approved by the government could be used for this purpose.

Administration and compliance

Closely identified with the adequacy of records is the level of administrative competence in collecting and enforcing a sales tax. Although a VAT imposes a somewhat greater burden on both taxpayers and the administrative service than other forms of sales tax, it nevertheless is less complex than an income tax. Unless the administrative service is strong or can be strengthened, it would not be advisable to take on the additional burden. Computerization of tax returns is an important consideration.

Previous experience with sales tax

It would appear inadvisable for any developing country to adopt a VAT at the retail level without previous experience with a sales tax. All VAT systems now in effect evolved from different forms of preexisting sales taxes, and it was a short step to the introduction of a VAT. The nature and extent of the transitional problems vary with the form of the preceding tax and the stage to which it was carried. There would be some advantage if retail sales were taxed previously.

Level of tax rate

Another important consideration is the level of the tax rate that would justify introduction of a VAT rather than an alternative form of sales tax. If rates are low, the discriminatory effects inherent in a turnover tax or hybrid form may not be sufficiently great to warrant a more complex and comprehensive tax, and the incentives for evasion may be minimal. As tax rates are increased, however, they may reach a critical point at which 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 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.