Introduction to Value Added Tax System.ppt
- 1. 1 Taxes on Consumption & Income and Introduction to VAT Hrushikesh Mallick
- 2. Sources of finance – Tax – User charges • Prices charged for the delivery of certain public goods and services • Examples: Toll roads, public swimming pools – Administrative fees • Definition of service/benefit is broad & imprecise • Examples: licences, parking fees – Borrowing – Disinvestment Receipts
- 3. Benefit Principle of Taxation • Unlike ability to pay principle, benefit principle links tax obligation to the value of services received in exchnage. • Adam Smith suggested a proportional income tax , a sort of benefit tax. • Because, the tax payment is “proportional to the revenue enjoyed under the protection of the state”. • State’s social, legal and economic framework makes it possible to earn and keep one’s income and the value of services can be assumed to be proportional to that income. • Example of benefit taxes: taxes on gasoline, property taxes. 3
- 4. Tax base and rates of taxation • Tax bases – Income – Wealth – Consumption • Tax rate – Proportional – Progressive – Regressive.
- 5. Properties of a ‘good tax’ – Adequacy: Generate sufficient revenue to finance budgeted government expenditure. Sensitive to economic growth. At least one tax with a broad base is an essential part of the revenue system for each level of government. – Equitable: Fair distributional impact – Economically efficient: A tax is said to be efficient if it does not change any of economic decisions that firms and households would have made in the absence of tax. – Administratively efficient: Some taxes are complicated or expensive to collect (collection cost). – Flexible: – Stability: Revenue flows should not unduly sensitive to fluctuations in economic activity. Stability has a price. A revenue source that is stable over the business cycle tends to be unresponsive to growth in population, income and price level
- 6. Is visibility desirable? • Visibility: How obvious the amount of tax is top taxpayers and others. • Depends on one’s perspective. Those who think government is too large prefer that taxes be highly visible so that pain of paying taxes will be weighted carefully against the benefits from government services. • Example: retail sales taxes are more visible than Value added taxes. • Property taxes are more visible as they are paid in lump sum and annually. 6
- 7. A good revenue system • Relies on a diversity of sources: A good tax system is one which uses a mix of sources with different desired characteristics. • Taxes that minimize unintended distortions of decisions in the private sector while steering taxpayers toward desired choices involving externalities. • Designing taxes that achieve both equity and revenue objectives is important. • Efficiency and equity remain at the top of the list. 7
- 8. Types of Taxes – Single-stage commodity tax – Multi-stage commodity tax – Excise duties: sometimes called a duty of excise special tax , is an inland tax on the sale, or production for sale, of specific goods or a tax on a good produced for sale, or sold, within a country or licenses for specific activities. – Customs duties: taxes on importation. Excises are inland taxes, whereas customs duties are border taxes. – Sumptuary taxes: Any tax on a socially undesirable class of products. Example: Alcohol and tobacco Indirect taxes: Taxes that are imposed on commodities or market transactions. Indirect taxes: Direct taxes: taxes on wages, profits, interests, rents, royalties, and all other forms of income and taxes on the ownership of real property, company taxes etc. Direct taxes
- 9. Indirect Tax • Excises are typically imposed in addition to another indirect tax such as sales tax or VAT. • In common terminology, an excise is distinguished from a sales tax or VAT in three ways: (i) an excise typically applies to a narrower range of products; (ii) an excise is typically heavier, accounting for a higher fraction of the retail price of the targeted products; and (iii) an excise is typically a per unit tax, costing a specific amount for a volume or unit of the item purchased, whereas a sales tax or VAT is an ad valorem tax and proportional to the price of the good. • Examples of excise duties : taxes on gasoline and other fuels, and taxes on tobacco and alcohol (latter is referred as sin tax). • Value added tax : A multi-stage sales tax levied on the value added at different stages of production. 9
- 10. Specific vs. Ad valorem taxes • Specific tax: Imposed on the basis of some quantity measure – units, volume, or weight. Example- A tax of Rs 5 on a pack of cigarettes, & Rs 12 on gallon of wine, or Rs 50 on imported cashew nuts. • Ad valorem taxes: imposed as a percentage of price or value. Example: State retail taxes like taxes on telephone service and automobile tires etc. 10
- 11. 11 VAT has spread around the world more quickly than any other new tax in the modern history • Tax on consumption usually refers to tax on goods and services acquired by individuals for their personal use or satisfaction. • It is important for a business operating internationally to know the sales tax system and its implication on international trade. • USA does not have a sales tax or VAT except at the state and local levels of government. However, a US business operating or shipping goods or transferring services to developed or developing countries with VATs must consider VAT implications of exports to or imports from those countries.
- 12. 12 Evolution of Consumption Tax • Taxation of goods changed as firms were organised to produce goods and sell them through distributors to retailers. It became common in Europe, to impose taxes on business turnover (gross receipts). Thus, a cascading turnover tax was imposed every time that the goods were transferred in the process of production and distribution to the final consumer. • Cascading taxes can’t be reclaimed by the purchaser, so that tax component of the price of goods becomes larger and larger the more stages are there between producer to consumer – with obivious distortionary effects.
- 13. 13 • Businesses must pay turnover tax on all purchases/inputs. At each subsequent turnover of goods (i.e. sales), the taxes previously paid and the values previously taxed are again subjected to tax in a process often referred to as pyramiding or cascading (or just as tax-on-tax). • This element can be reduced in retail sales if the there can be vertical integration among different input producing operations for manufacturing a commodity. • Adam discussed a value added concept in US in 1921 to reduce the tax on sales by the taxes already paid on business inputs in order to avoid tax-on-tax effect and to remove the incentives to vertical integrate a business along the line of “improved turnover tax” developed in Germany(by Wilhelm Von Siemens).
- 14. 14 • “Improved” turnover tax is imposed and collected at each stage of production and distribution of goods and services whenever there is a transaction but the net tax liability represents only the tax on value added by selling business at that stage. • By granting a reduction in tax liability for the tax imposed on the taxable purchases (input tax credit), the tax base at each stage basically limited to the value added by the employment of labour and capital. • Before widespread use of multistage VATs, countries usually were imposing single stage consumption taxes. • Single stage taxes at the retail level still are in use by almost all states in US and several provinces in Canada. More commonly, a single stage tax is imposed at the manufacturer’s (Canada formerly) or wholesaler’s level (Australia before its GST).
- 15. 15 Direct & Indirect Taxes on an Income or Consumption Base • Both taxes can be imposed on an income or consumption base. But the distinction is that: • A direct tax is one that is assessed upon the property, business or income of the individual who is to pay the tax. • Conversely, indirect tax is levied upon commodities before they reach the consumer who ultimately pays the taxes as part of the market price of the commodity. • This distinction based on incidence of tax is criticized, as modern theory points out income taxes may be shifted.
- 16. 16 JS Mill’s Classical Principles • Distinction between direct and indirect taxes relates to whether the person who actually pays the money over to the tax collecting authority suffers a corresponding reduction in his income. If he does, then – in traditional language - impact and incidence are on the same person and the tax is direct, if not and the burden is shifted and the real income of someone else is affected (i.e. impact and incidence are on different individual) the tax is indirect. • In the field of international trade, WTO defines direct taxes as taxes on wages, profits, interests, rents, royalties, and all other forms of income and taxes on the ownerships of real property and indirect taxes as sales, excise, turnover, value added, franchise, stamp, transfer, inventory and equipment taxes, border taxes and all taxes other than direct taxes and import charges.
- 17. 17 Income and Consumption Base for Tax • An annual tax can be imposed on an income base or on consumption base. • Thomas Hobbes advocated consumption as an appropriate base for taxation. People should pay tax based on what they consume (withdraw from society’s limited resources) rather than on what they earn in income (contribute to resources through labour). Both receive protection from the government. • Income and consumption can be viewed as different aspects of consumption in a broad sense. Income represents potential power to consume and consumption represents the exercise of power by consuming goods and services. • Consumption-based taxes can be imposed on or collected by business, its workers and individuals. • If tax is imposed on business, can be measured by sales or by value added by business firms at ach stage of production and distribution. Tax can be imposed both on business and its workers. Under this tax, the base for business is sales less both tax-paid purchases and tax-paid wages. • Wage portion of value added base is taxed to the wage earners and reported on returns filed by them. If a consumption-based tax is imposed only on individuals, tax base is income less savings.
- 18. 18 •Direct taxes are imposed on an income base include individual and corporate income tax and payroll taxes. A direct tax like income tax can be imposed on a consumption base by removing returns to capital (such as interest, dividends and capital gains) from tax base. •A personal expenditure tax was used briefly in India and Sri Lanka and was proposed in the US in 1995. Many forms of indirect taxes can be levied on a consumption base, including excise taxes, turnover tax, single stage sales tax or a multistage sales tax like VAT. •Unlike individual income taxes imposed on income or hybrid income-consumption base, consumption-based taxes imposed on transactions (like VAT). However, individual income taxes are more flexible to achieve progressivity. •VAT is regressive as tax is imposed on a larger percentage of income of a low- income household than a high income household.
- 19. 19 •To the extent VAT increases prices of goods that poor buy, it is proper for public policy to provide relief through public spending measures tailored to the needs of those targeted for relief. •Advocates of consumption-based taxes claim that income-based taxes discourage savings by double taxing it. Savings itself does not attract tax but gives rise to income tax as savers gain additional economic resources by lending or investing their money. Thus, return on savings is treated exactly like wages or any other accretion to one’s command over economic resources. •Consumption taxes encourage savings which is desirable in developing economies. The net return obtained on saved or invested income is higher than it is under an income tax. With comparable tax rates, postponement of consumption postpones payment of consumption taxes while does not postpone payment of income tax.
- 20. 20 Tax Structure in Developing Economies •Developing economies with an agrarian base have limited scope for personal taxes. It is often limited to public employees and employees of large firms. In many countries, sales tax at retail or manufacturer levels are complicated with numerous exemptions on imports and domestic sales are being replaced by broad based retail sales tax or VAT. •Developing countries import a significant portion of goods sold in domestic market and raw materials and supplies used in domestic production. Taxes on import (custom duties and VAT) may represent a much larger percentage of revenue than taxes on domestic sales. Majority of VAT would be collected by Customs and Excise personnel at the border and remainder of VAT will be collected by the agency (if separate from Customs) responsible for VAT. •Developed countries impose higher taxes as a percentage to GDP and tend to rely more on direct personal income and payroll taxes. USA and Japan impose lowest taxes on goods and services.
- 21. 21 Broadening the Tax Base •Tax revenue of a country can be increased either by adding new taxes or by expanding the base of the existing taxes. •Narrower the base, the higher the rate required to generate a given tax revenue. Higher the rate, the greater the benefits of avoiding or evading tax. Tax evasion erodes the tax base and hence amount of revenue generated. •With single stage sales tax imposed only at the manufacturer or retail level that is riddled with exemptions may expand its sales tax base by extending tax to all levels of production and distribution with a VAT. •Alternatively, it can reduce number of exemptions on particular sales or imports and also impose taxes on new entities/sectors that are excluded from sales tax base.
- 22. Exemptions under VAT 22 •VAT can be designed in a way entities are exempted from taxes to achieve non-revenue economic, social or political goals. •Small business may be exempt for administrative reasons as they may operate without record keeping or have low sales turnover. •Non-profit organisation and units of government may be exempt as they provide services normally provided by government or taxing them merely shifts taxes from one part of government to general revenue. •Food, housing, and medical care may be exempt to reduce burden on necessities for lowest income households. Some services such as financial services may be exempt because of administrative difficulty in taxing intermediation services that are not rendered for explicit fees.
- 23. Goods or service specific taxes: • Cascading: A part of the value added is taxed more than once. – Production decisions and investment decisions are distorted. This adversely affects income generation and growth in the economy. • Shifting of value added to stages of production and distribution that are not taxed – Leakage in the tax base.
- 24. What is VAT? •VAT: According to European Commission VAT is a general consumption tax designed to be imposed on all commercial activates involved in the process of producing goods or rendering services (general tax) and tax to be borne by consumers (consumption tax). •Principle of common system of VAT involves application to goods and services of a general tax on consumption exactly proportional to the price of goods and services, whatever the number of transactions take place in production and distribution process before the stage at which tax is charged. •On each transaction, VAT calculated on the price of goods or services at the rate applicable to such goods or services shall be rechargeable, after deduction of the amount of value added tax borne directly by various cost components.
- 25. 25 Contd… • Each commodity passes through several stages of production and distribution before it reaches a consumer. • Value at the final stage is the sum of values created/added at each of these stages. • If value added at each stage of production and distribution is taxed once and only once the problem of tax on tax should vanish – this is what a Value Added Tax aims for
- 26. 26 Alternatively, VAT is a method of taxing final consumer spending in stages. It is a multistage tax levied on the value added at each stage. Value at the final stage is the sum of values created / added at each of these stages Under VAT, the value added at each stage of production and distribution is to be taxed.
- 27. 27 Difficulties with Sales Tax System? • Levy of taxes at the manufacturer level - the first point sales tax • base of tax tends to be narrower • narrow base forces fixing of higher rate • higher rate induces tax evasion • Exclusion of services from the sales tax • Services are an integral part of the modern economies and the distinction between manufacturing and services are getting blurred • Bias against goods favouring services • Distorts producer and consumer choices • Taxation of inputs and output result in tax on tax • cascading of taxes • High level and multiplicity of rates.
- 28. 28 Effects on Trade, Industry and Revenue • High cost to industry and trade due to cascading. • Impediments to the free flow of trade within the country and development of common market. • Handicap to exports • High cost of compliance. • Loss of revenues
- 29. 29 • Prevailing sales tax system was mainly origin based. • Creates inequitable interregional resource flows by allowing richer producing states to export the tax burden on to the consumers in poorer consuming states. • Predominantly, first point tax making the base narrow. • Multiplicity of rates, surcharge, turnover tax, entry tax, additional sales tax made the system complex and non- transparent. Rationale for VAT?
- 30. 30 • VAT serves as an alternative principally due to: • Neutrality • Simplicity • Equity • However the design of VAT is critical. The key issues are • computation of VAT • Whether origin or destination based • How to treat farmers, small producers/ dealers, • treatment of exports • consignment transfers • treatment of interstate sales - CST VAT as an Alternative
- 31. 31 Computation of Value Added • Gross proceeds from sale of output = cost of inputs purchase + wages and salaries + Rent + Interest + Depreciation + Surplus (Profits) • Value Added = Value of Output - Value of inputs. • How to compute value added? • Subtraction: Gross income from sale of output - cost of input purchased • Addition: Wages and salaries + Rent + Interest + Depreciation + Surplus(Profits)
- 32. Contd… • Since the consumer is finally to pay the tax, the tax collected at each stage has to be passed on to the next stage. – Tax credit method: each dealer collects tax on full value of sales, retains taxes paid on purchases, and remits balance to the treasury. • In the invoice, the dealer would show the tax exclusive price and the tax element separately
- 33. 33 • Addition Method Tax payable= t*(wages and salaries + rent + interest + Depreciation + Surplus (profits)) • Subtraction Method Tax payable = t*(value of output-value of input) • Tax Credit Invoice Method Tax due = t* value of output - t*value of input
- 34. 34 Producer (Steel) Maker Dealer Retailed Tax Sales 100 200 250 300 Purchases 0 100 200 250 Value Added 100 100 50 50 VAT @ 10 % 10 10 5 5 30 VAT due on sales 10 20 25 30 Less: VAT paid on purchase 0 10 20 25 VAT @ 10 % 10 10 5 5 30 A: Subtraction Method B: Tax Credit or Invoice Method
- 35. 35 Relative Significance of these methods • Subtraction Method • Need to calculate value added at each stage of transaction • Less transparent than the tax credit method if the tax rate is not uniform across all commodities • Effective tax rate under subtraction method is the weighted average of rates at different stages of transaction, the weights being the proportion of value added in each transaction. • Tax Credit Method • More flexible (except Japan most other countries follow tax credit invoice method) • Tax credit is more helpful in relieving the burden of tax totally (particularly in case of exports). • Effective tax rate under input tax credit method is equal to the rate at the last transaction point. • Both forms of computing the tax yield identical results under a regime of single tax rate. However, tax rate would differ under both if there are multiple rates at different stages of pdn. and distribution.
- 36. 36 Primary Manufacturer Manufacturer Manufacturer Total Average Producer (Steel) (A) (B) (C) Tax Rate Sales 100 200 250 300 Purchases 0 100 200 250 Value Added 100 100 50 50 VATRate 10 10 10 15 Tax Collection 10 10 5 7.5 32.5 10.83 VAT due on sales 10 20 25 45 Less: VAT paid on purchase 0 10 20 25 Tax Collection 10 10 5 20 45 15.00 (When Manufacturer C is taxed ata differentrate) Multiple Rate Example A: Subtraction Method A: Tax Credit or Invoice Method
- 37. 37 Primary Manufacturer Manufacturer Manufacturer Total Average Producer (Steel) (A) (B) (C) Tax Rate Sales 100 200 250 300 Purchases 0 100 200 250 Value Added 100 100 50 50 VAT Rate 10 15 10 10 Tax Collection 10 15 5 5 35 11.67 VAT due on sales 10 30 25 30 Less: VAT paid on purchase 0 10 30 25 Tax Collection 10 20 -5 5 30 10.00 Multiple Rate Example A: Subtraction Method A: Tax Credit or Invoice Method (When Manufacturer B is taxed ata differentrate)
- 38. 38 Choice of Base for VAT: Key Issues • Theoretically, base of VAT depends on number of factors relating to its design: • Whether origin or destination based • Implemented with credit invoice or subtraction method • Many or few exemptions • Ideally, the base of VAT is final consumption on goods and services. Unless service sectors also brought under VAT, cascading will not be totally eliminated • Thus, suffers from the measurement problem and adjustment for exemptions and zero ratings. • Practically the tax base depends on how one defines sales and purchases • if purchases include capital goods as well as inputs, it is the broadest definition. • if sales include all goods and services, it is again the broadest base of sale.
- 39. contd. • Ideally all goods and all services should be included in VAT. However, there are instances of difficult to tax sectors/dealers. Within VAT there are two ways of dealing: – Zero-rating – Exemption
- 40. 40 Base of VAT Contd…... • Zero Rating: » Under destination VAT principle, goods going out of the country or state are relieved of any domestic trade taxes while imports are taxed at the same way as the domestic products. One of the ways to operate under the destination principle is zero rating: Under zero-rating, no tax is imposed on sales, but full refund/rebate is given on purchase. Thus, under zero rating effective rate of tax is zero. • Exemptions : VAT system usually excludes traders and producers having turnover below a specified level Though no tax on sales, taxes on purchases not refunded Unlike in case of zero rating, exemption does not relieve the complete tax burden.
- 41. 41 • Exemption is given to tax sectors: » Financial Services » Small Business and unorganised sectors » Small farmers etc. • However, exemption at the end of the chain of transaction implies lower tax revenue as the value added at the last stage is lost. • Exemption in the middle of the chain of transaction: between two taxable transactions » Reintroduces cascading, » breaks chain of invoices : which in turn destroys self-policing. » Implies loss of transparency. Exemptions: The Key Issues
- 42. Characteristics of VAT by ITC method • Avoids Cascading in the absence of exemptions – Reduces costs of operation: • increase in costs due to taxes is not there. • markup on such taxes too is not there. • interest costs to finance these higher costs too is lower. – No distortions in the production and investment decisions: market forces and technical considerations determine the nature of business organisation, not the tax structure.
- 43. Characteristics of VAT • Since all stages of production and distribution are taxed, incentive to undervalue at some stages is absent. • Permits better policing through the trail of invoices generated – often called a self-policing tax: purchaser would ask for an invoice in order to get credit for the taxes paid.
- 44. Objectives of a Tax System and VAT • Taxation following a destination principle of taxation – Since VAT permits effectively curbing tax exportation, it provides a means for achieving the destination principle. – In inter-state trade: the exporting dealer need collect no tax on the sale and has to claim complete refund of taxes on purchases
- 45. 45 Countries Implementing VAT •VAT has become a popular source of revenue. France had adopted primitive version of VAT after world war II. Other member countries agreed to share their national revenues (including revenue from VAT) to finance the operation of European Economic Community (now the EU) in Treaty of Rome (1957). Treaty required member states to convert their turnover taxes to a harmonised VAT. •In 1985, New Zealand adopted a European style invoice VAT with a much broader base than had been adopted elsewhere. NZ taxes certain government services and non-life insurance. This is copied in South Africa. •In 1989, Japan introduced its consumption tax, a VAT that differs from European style VAT in its calculation of net VAT liability and use of invoices. •In Jan 1991, Canada has been implementing Gods and services tax. In 2000, Australia followed it. The US among the industrialised countries remains one of the only countries without a VAT. •Over past couple of decades, IMF has assisted developing and emerging countries (member countries) in terms of providing technical assistance to convert their turnover taxes, manufacturing tax, retail sales and other indirect taxes to VATs.
- 46. 46 • There are direct taxes measured by their level of consumption rather than their income referred as a cash-flow or consumption-based income tax. • Most taxes on consumption are indirect taxes. These are collected by the sellers of taxable goods and services and are expected to be borne by final consumers. • This indirect taxes can take the form of a single-stage tax like retail sales tax or multistage tax like VAT. • VAT base can be altered by the legislator by removing some sellers or some goods and services (by providing special treatment to designated services). Forms of Consumption-Based Taxes and Altering the Tax Base
- 47. 47 Consumption-Based Direct Tax • Consumption-based income tax (or direct expenditure tax) was proposed by British economist Nicholas Kaldor (1955). He proposed an annual progressive tax on an expenditure base at graduated rates for an egalitarian society while improving on efficiency of operation and rate of progress of the economy. • Under another approach by Irving Fischer, tax base could be calculated by adding to income monies received from sale of capital assets, depletion of bank balances etc. and deducting sums spent on purchase of capital assets and on non- personal or non-chargeable expenditure. Kaldor criticised this appraoch as it relies on income as the basis of tax. • Kaldor relied on personal expenditure as the legal basis of tax – that satisfies the requirements of equity and efficient administration. Taxpayers would be required to declare their personal expenditure annually and pay tax directly to the government rather than pay to the sellers as part of each sale. • In effect, taxpayer required to report all income and receipts for the year and then deduct all investment, the difference being consumption.
- 48. 48 •Difficulties faced with Kaldor’s approach with regard to distinction between personal consumption and capital wealth, treatment of gifts and bequests and the need to set an annual exemption threshold for lower income taxpayers, etc. Kaldor also recognised significant difficulties in moving from individual income tax measured by annual income to measured by consumption. Therefore, Kaldor recommended for operating this tax alongside individual income tax and to apply only those tax payers in top income groups. If successful, legislature can expand the scope of expenditure tax and reduce the scope for income tax.
- 49. 49 Single and Multistage Sales Taxes •An indirect tax on consumption like sales tax (tax on goods and services) can be imposed at a single or at multiple stages of production and distribution. •Single stage sales tax includes retail sales taxes like imposed by most of the states in US or some of provinces in Canada. •A single stage tax can be imposed at the manufacturing level such as prior Canadian Manufacturer’s tax which is replaced by GST or at wholesale level. •A sales tax also can be imposed at more than one but less than all levels of production or distribution. •Modern sales tax is imposed at all levels of production and distribution.
- 50. 50 Conclusion • It has been most pervasive tax reform throughout the world during second half of 20th century and 21st century and proved major source of revenue for the government. • VAT is widely used across developed and developing economies and by local, sub-national ,national and even supra-national (European Union) levels of government. • The base of VAT is predominantly personal consumption of individual, measured by price paid for goods and services. • In general, the rate of tax is uniform and base is broad. • Non-uniform rates and extensive exemptions destroy neutrality and affect patterns of consumption as well as patterns of production and distribution while greatly increasing administrative and compliance costs.
- 51. Readings • Aian Schenk & Oliver Oldman (2007) “VAT: A Comparative Approach”, Cambridge . • Gurumurthi, S. (1999) “Fiscal Federalism Towards an Appropriate VAT System for a Federal Economy,” Economic and Political Economy, 2875-2888. 51