McLure, Charles E.Jr. 1990. "Review of the Theory of Taxation for Developing Countries." In D.Newbery and N.Stem, eds., Economic Development and Cultural Change 38 (2).
McLure Jr., Charles E., and George R. Zodrow. 1990. "Tax Reform in Colombia: Process and Results."
Newbery, David and Nicholas H. Stern, eds. 1987. The Theory of Taxation for Developing Countries. New York:
Oxford University Press.
Shalizi, Zmarak, and Wayne Thirsk. 1989. "Tax Reform in Malawi." August.
Slemrod, Joel. 1990. "Optimal Taxation and Optimal Tax Systems." Journal of Economic Perspectives 4 (1):15778.
Thirsk, Wayne. 1989. "Tax Reform in Bolivia." World Bank, Country Economics Department, Washington, D.C.
_______. 1989. "Tax Reform in Morocco." World Bank, Washington, D.C.
_______. 1989. "Tax Reform in Zimbabwe." World Bank, Washington, D.C.
Yitzhaki, S. and W. Thirsk. 1990. "Welfare Dominance and the Design of Excise Taxes in the Côte d'Ivoire."
Journal of Development Economics 33:118.
The Organisation for Economic Co−operation and Development (OECD), the International Monetary Fund (IMF), and the World Bank have recently published important studies on the economic, technical, and
distributional aspects of the VAT.1 None of these studies, however, has systematically evaluated such essential design features of the existing VATS as the most appropriate coverage or the tax base or rate structure. In short, the questions, "who should be taxed, on what, and to what extent?" deserve further exploration. This is
particularly true for developing countries, which, because of limited administrative capability, often find it difficult to implement desired policy objectives.
The chapter has been organized as follows. First is an overview of VATS in the world describing their basic characteristics. Second is an examination of the coverage of VAT. Should the tax extend through the retail stage or should it be confined to the manufacturing or wholesale level? How should an appropriate small−firm exemption be designed and how should the agricultural sector be treated? The chapter then addresses tax−base issues. Should services be taxed comprehensively or should a selective approach be adopted? What is the best treatment of real estate? What about capital goods? What follows is a review of rate issues. Is rate differentiation desired and, if so, should essential commodities be exempted, zero rated or taxed at a lowerthan−standard, but positive, rate? Is there a case for imposing a higher rate on luxury commodities, or should these perhaps be liable to separate excises?
After these structural issues have been discussed, the chapter sums up the lessons from the experience with
the VAT in developing countries. The conclusions of this paper differ from those of the world Bank study mentioned above. Although the latter leaves room for preretail VATS, diverse treatment of services, and
substantial rate differentiation,2 this chapter argues that retailers should always be included in the coverage of the VAT (subject to a small−firm exemption); that services should be taxed comprehensively (subject to selective exemptions); and that the case for extreme forms of rate differentiation—such as a zero rate on food products—is weak.
The Characteristics of Value Added Taxes
This section dwells briefly on some definitions and the major characteristics of various VATs found around the world.
Classification Issues
The ideal VAT is a transactions tax on all goods and services collected on sales at all stages of production and distribution. Tax neutrality can be ensured by confining the tax to the value added at each stage. (Value added is defined as the difference between the value of sales and the value of purchases at that stage.) Tax neutrality is achieved by giving registered firms a credit for the tax paid on all taxable purchases from registered suppliers (including capital goods) against the tax payable on sales. As a result, the same value added is never taxed twice;
that is, there are no cumulative effects, as would be inherent to a gross turnover tax. Similarly, tax neutrality in international trade is achieved by applying a zero rate to exports (which results in a refund of any tax paid in earlier stages) and by taxing imports on a par with domestically produced commodities.
Not all VATs are neat, broadly based, tax−credit, net consumption taxes that extend through the retail stage and that are imposed on the destination principle. Some VATs stop at the manufacturing or wholesale stage, which makes it unlikely that services would be included in the base. Furthermore, these and other VATs may not allow a full or immediate credit for the tax on capital goods. In this chapter all tax−credit types of sales tax, regardless of the stage at which they are imposed, are defined as VATs, provided that the tax is levied on goods (but not necessarily services) comprehensively and that there is a credit for the tax on raw materials and intermediate goods (but not necessarily capital equipment. By this definition, production taxes that permit a deduction of
The Characteristics of Value Added Taxes 125
purchases from sales and tax credit types of excise systems are not considered to be VATs.3 The production taxes are not levied on transactions; administratively, they are more akin to a business income tax.
Table 5−1 lists the fifty−five countries in the world that have some form of VAT. The tax is found on all continents, but it is particularly prevalent in Europe and Latin America. Apart from the incomplete tax−credit manufacturers' tax in Algeria and Côte d'Ivoire, which was inherited from the French, the VAT was first adopted by the Brazilian states and Denmark.4 The table also shows the coverage, base, and rate structure of the tax in each country. Because the interaction between a general and a selective tax on goods and services is important, the nature of each country's excise system is highlighted.5
As table 5−1 shows, the coverage of a VAT may extend through the retail stage (R), the wholesale stage (W), or the manufacturing stage (M). Furthermore, the base may comprise all consumer goods and services, unless specifically exempted (G + S); goods and selected services (G + ST); goods only G; consumer goods and capital goods (G + CG); or consumer goods, selected services, and capital goods (G + ST + CG). The rates for each VAT are tax−exclusive, in accordance with the practice in most countries. A distinction is made between standard rates, lower−than−standard rates (including exemptions, denoted by the letter "x"), and higher−than−standard rates.
The nature of the excise system is defined as limited (it comprises mainly duties on tobacco, alcohol, and petroleum products), intermediate (duties are levied on traditional excise goods as well as luxury products), or extended (all the foregoing are in effect along with duties on various producer goods). CT means that a consumption tax separate from the (traditional) excises is imposed, mainly on luxury products.6
Coverage, Base, and Rate Structure
Most economies extend the VAT through the retail stage (R−VAT), although the small−firm exemption (to be discussed below) may exclude most retailers (but not necessarily most retail sales) from coverage (see table 5−1).
Three countries (Indonesia, Mauritius, and Morocco) have cut the tax off at the wholesale stage (W−VAT), and four countries (Algeria, Côte d'Ivoire, Kenya, and Malawi) restrict it to the manufacturing (and importing) level (M−VAT). Once they gain experience with a pre−retail VAT, countries tend to push the tax through the retail stage, as Peru, Senegal, and Tunisia have done in recent years. Indonesia and Morocco, which started with an M−VAT, recently extended the tax to the wholesale stage.
The VAT is the first sales tax that has successfully integrated the taxation of services with the taxation of goods.
Not surprisingly, thirty−seven countries tax services and goods comprehensively, often defining services as any commodity that is not a good. Five countries, however, confine the tax to goods (G or G +
Table 5−1. Value Added Taxes: Basic Charasteristics, by Economy
Scope Rates (percent) c Excise system
Area and Economy
Year introduced
Coverage
a Tax base b Standard Lower d Higher Nature e
Luxury products f European
Communities
Belgium 1971 R G+S 19 6,17∗ 25,33 Limited —
Denmark 1967 R G+S 22 —∗ — Intermediate∗ —
France 1968 R G+S 18.6 5.5,7 22 Limited∗ —
Germany 1968 R G+S 14 7 — Limited —
Coverage, Base, and Rate Structure 126
Greece 1987 R G+S 18 8∗ 36 Limited —
Ireland 1972 R G+S 23 0,10∗ — Limited —
Italy 1973 R G+S 19 4,9∗ 38 Intermediate —
Luxembourg 1970 R G+S 12 3,6 — Limited —
Netherlands 1969 R G+S 18.5 6 — Limited —
Portugal 1986 R G+S 17 0,8 30 Limited —
Spain 1986 R G+S 12 6 33 Limited —
United Kingdom 1973 R G+S 15 0 — Limited —
Other Western Economies
Austria 1973 R G+S 20 10 32 Limited —
Canada 1991 R G+S 7 0 — Limited —
Finland 1976 R G+ST+CGg 21.2 — — Limited∗ —
Hungary 1988 R G+S 25 0,15 — Intermediate CT∗
Iceland 1989 R G+S 25 — — Limited —
Norway 1970 R G+ST 20 —∗ — Limited∗ h —
Sweden 1969 R G+S 25 —∗ — Limited —
Asia
Indonesia 1985 W G+ST 10 X — Intermediate CT
Israel 1976 R G+S 16 —∗ — Extended CT
Japan 1989 R G+S 3 — —∗ Limited —
Korea 1977 R G+S 10 X — Intermediate CT
New Zealand 1986 R G+S 12.5 — — Limited —
Philippines 1988 R G+S 10 X — Intermediate —
Taiwan 1986 R G+S 5 X — Intermediate CT
Turkey 1985 R G+S 12 8∗ 20 Limited —
South America
Argentinai 1975 R G+ST 13 X — Extended CT∗
Boliviaj 1987 R G+S 11 — — Intermediate CT∗
Brazil (states) 1967 R G+CGk 20.5 —1 — Extendedm CT∗
Chile 1975 R G+S 18 — — Intermediate —
Colombia 1974 R G+ST 10 0∗ 35∗ Limited —
Ecuador 1970 R G+ST 10 X — Limited —
Perun 1982 R G+STo 14 X — Extended CT∗
Uruguay 1973 R G+S 22 X,12 — Limited —
Coverage, Base, and Rate Structure 127
Central America and Caribbean
Costa Rica 1975 R G+ST 10 0 — Extended CT∗
Dominican Republic
1983 R G+ST+CG 6 X — Extended CT
Grenadap 1986 R G+S 20 0,8∗ — Limited —
Guatemala 1983 R G+S 7 0 — Extended CT
Haiti 1982 R G+S+CG 10 X — Limited —
Honduras 1976 R G+ST 7 X —∗ Intermediate CT
Mexico 1980 R G+S 15 0,6 20 Limited —∗
Nicaraguaq 1975 R G+ST 10 X∗ 15∗ Limited —
Panama 1977 R G+S 5 X —∗ Limited —
Africa
Algeria 1960 M G+CGr 25 7.5,11.1 42.9,66.7∗ Limited —
Côte d'Ivoire 1960 M G+CGg 25 11.1∗ 35.1 Limited —
(table continued on next page)
CG). Brazil does so because its constitution relegates the taxation of services to the country's municipalities.
Mauritius, a small island economy, apparently considered it difficult to tax services at the wholesale level or did not want the VAT to interfere with tourism and related services. Malawi may have had similar reasons for excluding services from its M−VAT. Algeria and Côte d'Ivoire retained the old French manufacturers' tax and
(table continued form previous page)
Scope Rates (percent) c Excise system
Area and Economy
Year introduced
Coverage a
Tax base
b Standard Lower d Higher Nature e
Luxury products f
Kenya 1990 M G+ST 18 X 35,50,100 Limited —
Madagascar 1969 R G+S 15 X — Extended CT
Malawi 1989 M G 35 X var. Limited —
Mauritius 1983 W G 5 X — Limited —
Morocco 1986 W G+S 19 X,7,12,14∗30 Limited —
Niger 1986 R G+S 17 X,10 25 Limited —
Senegal 1990 R G+S 20 7 50∗ Limited —
Togo 1984 R G+S 14 3t — Limited —
Tunisia 1988 R G+S 17 X,6 29 Limited —
a. R = value added tax extending through the retail stage; W = value added tax extending through the wholesale
Coverage, Base, and Rate Structure 128
stage; and M = value added tax extending through the manufacturing stage.
b. G = goods; S = services; ST = services taxed selectively; and CG = capital goods.
c. Rates are expressed as a percentage of the tax−exclusive value of taxable commodities, which is the practice in most countries. Algeria, Bolivia, Brazil, Côte d'Ivoire, Finland, Guinea, and Swedan have tax−inclusive rates.
Tax−inclusive rates (ti ) can be converted into tax−exclusive rates (te ) by dividing them by (1−ti ). A asterisk denotes the existence of other special lower or higher rates, often technical in nature, which apply to only one or two commodities.
d. The letter ''X " means that essential products are exempted rather than taxed at a lower or zero rate.
e. Three types of excise system are distinguished: limited, intermediate, and extended excise systems. Limited excise systems tax at least the traditional excise goods: tobacco products, alcoholic beverages, and petroleum products, as well as various forms of road use and entertainment. Some food products (such as sugar, confectionary, and salt), various beverages (such as coffee, tea, and cocoa), and some services (such as insurance) may also be included in the base. In addition to the items covered under a limited system, an intermediate excise system covers a large number of luxury products such as cosmetics, furs, precious stones, audiovisual equipment, and household appliances. Obviously, the taxes on these products serve the same function as a higher VAT rate. An extended excise system would includes in its base the commodities covered by a limited system and an intermediate system, but also a large number of producer goods. An asterisk means that a large number of low−rate special−purpose excises are imposed to earmark their revenues or to achieve various regulatory objectives, for example, pollution abatement. These levels are left out of consideration in defining the nature of the excise system.
f. CT denotes that a separate consumption tax is imposed in addition to the (traditional) excises. CT∗ means that the consumption tax, usually levied at the manufacturing level, has a tax credit feature akin to the VAT.
g. The coverage of services is confined to telecommunications and waiting services in hotels and restaurants. Capital goods are not taxed as such, but using the direct subtraction method, 80 percent of investments in machinery and equipment and 75 percent of investments in factory buildings are deductible from taxable sales.
h. Not including a separate tax on investment goods, which reportedly is used to influence the business cycle.
i. In Argentina, the provinces and the federal district levy gross receipts taxes at rates ranging from 1 to 8 percent, depending on the jurisdiction and the nature of the taxable transaction.
j. Bolivia also has a 2 percent gross receipts tax.
k. Under the Brazilian constitution, the right to tax services is reserved to the municipalities, which tax nearly all services except interjurisdictional transportation and communications (reserved to the federal government) and banking. The taxes on services are turnover type levies without a tax credit for tax paid in previous stages.
l. Lower rates of 7.5 percent and 13.6 percent are imposed on interstate sales between registered taxpayers, whereas sales at retail across state borders are taxed at a rate of at most 20.5 percent.
m. The federal government in Brazil levies a highly rate−differentiated, tax−credit type of industrial products tax.
Unlike the VAT at the state level, the tax credit is available for a wide range of capital goods. A zero rate applies to almost 4,000 items including chemicals, medicines, papers, and common metals. The rates are highly
product−specific.
n. Peru also levies a 2 percent gross receipts tax for municipal development purposes, which is added (without tax credit) to the VAT.
o. The tax credit on capital goods purchases is allowed in two annual installments. If inflation is high as it is in Peru, the real value of the tax credit is eroded and provision would in effect be a tax on capital goods.
p. Grenada also has a 2 percent gross receipts tax.
Coverage, Base, and Rate Structure 129
q. Nicaragua also has a 2 percent gross receipts tax levied by the municipalities ana social welfare boards. Under the VAT, the minister of finance can fully or partly disallow the tax credit attached to the acquisition of capital goods or fixed assets or prescribe that the credit should be taken in annual installments.
r. Algeria has a separate turnover tax on services levied at differentiated rates. Construction is subject to the VAT.
s. Côte d'Ivoire has a separate turnover tax on services levied at differentiated rates. However, building contractors and hire purchase companies are subject to the VAT.
t. In Togo, the lower rate of 3 percent applies to all first sales tht have not been subject to the 14 percent rate. This contrasts with the usual situation in which the lower rate is reserved for essential commodities.
Source: Country legislation and reports. Some information may be incomplete or out of date.
therefore tax services (except construction) separately under a turnover tax.
Twelve countries tax services selectively by enumerating them in the law. At one extreme, Norway lists nearly all services, and the result is almost the same as under the integrated approach. At the other extreme, Finland taxes only telecommunications and waiting services in hotels and restaurants. The number of tax−
able services is also limited in Indonesia, Kenya, Colombia, and the Dominican Republic, but large in most other Latin American countries. The integrated versus the selective approach warrants further examination, as does the practice in six countries (Finland, the Brazilian states, the Dominican Republic, Haiti, Algeria, Côte d'Ivoire) of taxing capital goods, which discriminates against capital−intensive production.
High VAT rates are a typical phenomenon in Europe, where everything and everyone is taxed higher (and receives more benefits) than anywhere else.7 Rate differentiation is found mainly in southern Europe and in Africa, in the French practice of taxing traditions. Interestingly, twenty countries exempt essential commodities in the household basket of lower−income groups. Exemptions are frowned upon in the literature because they cause cascading effects. Nine other countries (notably the United Kingdom, Hungary, and Mexico) zerorate
commodities regarded as essential. Outside Africa and the European Communities, few countries have higher−than−standard VAT rates.
If a country levies a broadly based consumption tax such as the VAT, it may be expected to have a limited excise system confined mainly to the traditional excise goods. By and large, this is the situation in Europe and Africa, but not in Asia and Latin America, where fourteen of the twenty−five countries with a VAT have an intermediate or extended excise system. There are three explanations for this somewhat paradoxical phenomenon. First, most countries with an intermediate or extended excise system use this system, instead of a higher VAT rate, to discriminate against luxury items. Second, many Latin American countries also use their excise system to
discriminate against imports, perhaps because their membership in a free−trade area prevents them from using the import tariff for this purpose. And third, some countries simply did not clean their Augean stable of commodity taxes when they introduced the VAT, but just added another tax.
Tax Coverage
Two important issues related to the coverage of a VAT are what stage of production and distribution should be taxed, and how should small traders and farmers be treated.
Tax Coverage 130
Pre−retail Value Added Taxes
In the literature, pre−retail VATS are often given the benefit of the doubt. At the manufacturing level, it is argued, business units are typically larger (and, hence, taxpayers are fewer) and accounts are better maintained than at subsequent trading levels. In practice, as indicated above, most countries have opted for the R−VAT. Pre−retail VATS, seven in all, are only found in various countries of Africa and in Indonesia.8 The scale on which these taxes have been abandoned in the past fifteen years9 and the well−documented discouraging experience with the M−VAT in Canada10 provide evidence that a VAT short of the retail stage should not be contemplated. Some of the shortcomings are listed below.
An M−VAT may be suitable at the early stages of economic development to succeed the excise taxes imposed previously on products other than alcohol, tobacco, and petroleum. As an economy matures, however, such a tax becomes beset by valuation and trade organization problems, which draw valuable administrative resources away from audit and compliance control. It becomes difficult not only to define "manufacturing," but also to determine how to treat sales at different trade levels, transfers between related parties, sole distributors, and various other issues.
If sales are made by manufacturers to retailers or consumers, the actual sales price causes unintended differences between and within industries, depending on whether wholesale or retail channels are used. As a result, countries are forced to develop elaborate and complex extrajudicial systems of discounts to exclude wholesale and retail margins from the manufacturers' sales price. Such a system complicates administration, is arbitrary, and is subject to abuse and litigation. Furthermore, businesses are likely to want to extend the discount system to all wholesale and retail sales. Such pressure may be especially hard to resist in developing countries with a high degree of interlocking economic interests.
Another problem under an M−VAT concerns sales between registered firms and nonregistered firms that are related. If the sale of a registered firm is not made at arm's length (a fact that is often difficult to determine), the understatement of its value results in a permanent saving of tax. A related problem is that of sole distributors who buy from manufacturers at lower prices than those charged to other wholesalers and retailers. In return, sole distributors take on market promotion costs, which usually are not taxed under an M−VAT if incurred by traders other than manufacturers. In developing countries, sole distributors are particularly prevalent in the import trade.
To the extent that domestic manufacturers do bear marketing costs, they often do, this means that the M−VAT exerts a tax bias against domestically produced goods. Uplifts may correct for the differences, but they are a highly arbitrary device that does not achieve complete equal treatment.
The differences between an M−VAT, and a W−VAT are minimal, although domestic and imported goods are treated more evenly under a W−VAT, in that marketing costs (for example, warranty, advertising, and packaging) included in the value of manufactured goods but not in the value of imports are also taxed11 Otherwise,
the two taxes have many of the same disadvantages. A W−VAT induces large retailers to integrate their operations backward by assuming wholesale functions. The only solution to this problem is to register such retailers, but then a discount should be permitted in respect of the value for tax of their sales. Furthermore, a large number of wholesalers would also sell at retail, that is, to consumers. Some arbitrary line has to be drawn to exclude those whose wholesale sales during the previous year did not exceed, say, 50 percent of their total sales;
perhaps they would not have to register for tax purposes. Whatever is done, the line would be difficult to establish and apply to individual cases.
In conclusion, a VAT extending through the retail stage clearly is the preferred choice. The usual argument against including the retail stage is that it comprises numerous small firms whose records are so poor that it would be wasteful of administrative resources to try to levy the tax on them. But this observation suggests that the
Pre−retail Value Added Taxes 131
coverage of a VAT is not a "stage" problem, but rather a small−firm issue. There is no reason why middle−size and large retailers, which may be assumed to keep adequate accounts, should not be registered. Moreover, the appropriate VAT treatment of small firms is an issue that concerns those at all levels of production and distribution: producers, wholesalers, and retailers. In other words, the small−firm issue is not resolved by
excluding the retail stage. The best VAT covers the whole production−distribution process. The sole criterion for tax coverage should be the size of the firm, regardless of the stage at which it is situated. In other words, attention should be focusing on the design of an appropriate small−firm exemption.
Small Traders and Craftsmen
Almost all VAT employ some method of excluding small traders, craftsmen, and farmers from the coverage of the tax.12 High compliance and administrative costs, in relation to revenue, are the rationale for the smallfirm
exemption. The definition of "small firm" differs from one country to another, depending on such factors as the level of economic development, the organization of the trading sector, and the bookkeeping skills of small traders.
Generally, the exemption implies that the VAT burden of small firms is limited to the tax they pay on their taxable purchases. Usually, small firms are not permitted to state any tax on sales invoices and they do not have to keep records for VAT purposes.
Thirty−nine of the fifty−five countries with a VAT exclude small firms on the basis of turnover. Of this number, at least six countries (Greece, Haiti, Indonesia, Ireland, Niger, and Portugal) have a lower exemption for services, because the value added of establishments rendering services is usually larger, in relation to sales, than that of shops selling goods. A drawback of this refinement is that services have to be defined. Four countries (France, Luxembourg, Japan, and the Netherlands) waive or reduce the VAT liability of small firms in the form of a vanishing rebate. To quality for this concession, firms must compute their net VAT liability; hence, it can be applied only if small firms maintain accounts. Four countries (Belgium, Ecuador, Finland, and Turkey) exclude small firms on the basis of the type of trade they carry on (these include low−margin outlets, stores that sell second−hand goods, peddlers, and hawkers).
More than half of all the countries with a VAT employ various forms of presumptive assessment (forfait system) to collect some tax from firms that are too small to be treated as regular taxpayers, yet too large to be entirely exempted.13 The French forfait system, which is also found in most Francophone countries of Africa, is the most widely known. Under this system, individual assessments are raised for a period of two to three years and
payments are made in monthly or quarterly installments. In other countries, trade−specific percentages (that take the average input tax into account) are applied to the total volume of sales or purchases. A number of countries use presumptive techniques to ascertain the VAT liability of specified traders, such as hotels, restaurants, and truckers. Examples are Bolivia, the Dominican Republic, and the Philippines.
Most countries prefer a straightforward small−firm exemption based on turnover. Additional criteria relating to, say, the type of trader and the number of employees may be useful in establishing a prima facie case for
exempting a particular firm. Apparently, presumptive assessment techniques are helpful in collecting some revenue from firms just above the exemption limit, especially if they are not subject to income tax. The volume of purchases seems the best proxy for estimating the presumptive tax liability. The idea is to approximate the VAT liability as closely as possible without spending too much time on the exercise and without giving the tax office too much discretion.
Farmers
Many of the arguments used to justify the exemption or presumptive taxation of small traders and craftsmen apply equally to small farmers. Records of transactions are often inadequate and compliance is difficult to enforce. In contrast to small traders, however, farmers are situated at the beginning rather than the end of the
production−distribution process. This implies that if the tax credit attached to agricultural inputs cannot be passed
Small Traders and Craftsmen 132