Value-added Tax (VAT) as an instrument

Around 70 per cent of the world’s population now lives in countries with a value-added tax (VAT) which is essentially an alternative method of collecting what most people would readily understand as a sales tax.

The acceptance of a value-added type of tax as a revenue instrument is largely based on the fact that it has raised more revenue than the sales/turnover tax it replaced. It is also justified on the theoretical grounds that (a) it is a neutral tax, (b) it removes cascading (a tax on tax), and (c) enables a zero-rating of exports.

The VAT is a multi-point sales tax which allows a set-off for tax paid on purchases, since only the value added at each stage of manufacturing or sale is taxed at a percentage of the value added at each stage of production or sale, currently 16 per cent. Under a pure sales tax system, taxation of inputs incentivises vertical integration of firms, militating against ancillary industries and encouraging them to produce more and more of the inputs needed rather than purchase them from ancillary industries.

The tax is collected in instalments on each transaction in the production-distribution process. There is no cascading because of the system of deduction or credit for taxes paid. The tax is levied on consumption and, therefore, the final and total burden of the tax is fully and exclusively borne by domestic consumers. No VAT is charged on exported goods and services. The above in summary represents the arguments in support of VAT.It is generally argued that VAT (GST in our case) provides a better audit trail than a single point/stage sales tax. However, such an argument assumes that someone is going to, or has the capability to, follow the trail. With millions of credits being taken it is rather difficult to follow them.

Fraudulent transactions and fake invoices (‘flying invoices’ are still a common feature in Pakistan) have made tax administration a nightmare. Despite improved automation systems, the revenue authorities will continue to face challenges on several fronts. Key problems include exaggerated refund claims through the use of bogus invoices, non-accounting of cash sales or purchases and under-reporting of sales through multiple books of account. Then there are claims based on purchases from unregistered businesses or those that exist only on paper, input tax credit claims on exempted goods, VAT collected on imported goods with the tax revenue being pocketed, false export claims, barter arrangements (exchange of goods against goods), etc. For revenue collectors the cost of administration and monitoring refunds is high (extensive administrative capabilities are required to operate the tax) and potential for evasion huge.

The Pakistan experience shows that the costs of compliance are also high because of the somewhat cosy relationship between some taxpayers and revenue staff, the frequent audits (commonly more than one per year) of those registered for GST purposes and the endemic, and never likely to be resolved, problem of exporters being unable to get their refunds of GST paid on inputs on a timely basis.

Finally, and not less importantly, the VAT, especially now that we are planning to extend it to the retail level, requires a fairly high level of literacy and understanding among taxpayers. The successful implementation of such a tax needs a long period of upfront taxpayer education and eventual societal acceptance.

It is perhaps for a combination of these reasons, and because it is a federation with highly autonomous units that the US, the biggest and most powerful economy, has not instituted a VAT type tax and relies on a sales/ turnover tax levied by each state with its own rates of sales tax for different goods and services.

However, it is now too late to contemplate a revenue instrument other than the destination-based consumption type retail stage VAT being envisaged. And now that VAT is going to be implemented at the retail level from next year, it is encouraging to note that the federal and provincial governments have decided to extend the base of VAT/GST on services, the fastest growing sector of the economy.

The artificial distinction between goods and services, owing to the constitutional division of taxation powers, has given sustenance to an uncoordinated system for GST, opening up opportunities for avoidance and evasion of taxes. The development of a non-cascading system for taxing consumption and raising revenues significantly will only be possible when all services are taxed.

Moreover, relieving tax on inputs and zero-rating of taxes on exports is also not fully possible unless all services are taxed. Therefore, the government should be commended for recognising that a modern and rational tax system can only be established by immediately abandoning the selective approach to tax some services while exempting others. There was a reluctance to include powerful professional interest groups like lawyers in the GST net because tax collections from them would constitutionally all end up in the coffers of provincial governments.

However, apart from the huge political challenge facing the government in extending the range of goods and services that would be covered under the VAT regime, what is disconcerting is the extremely poor level of preparation and awareness about the VAT system among both tax collectors and taxpayers. Such education needs to be supported by designing appropriate incentives for ensuring compliance. Such incentives could include lotteries of receipts on which VAT was paid and these receipts would provide the audit trail for tax deposited.

So far, the government has done little to ensure that all potential stakeholders are on the same page, which it could have achieved through a much wider consultative process instead of trying to push through VAT hurriedly through parliament simply to meet an IMF conditionality without taking all the steps necessary to facilitate its successful implementation. Maybe the reason, as one friend put it, is that Islamabad is confusing VAT with VAT 69!

The author is a former finance minister of Punjab. This article was originally published in Daily Dawn