Implementation of Value-Added Tax (VAT)

April 28, 2010

0 6 minutes read

Value-added Tax (VAT), or GST in VAT mode is usually implemented in robust/sustained economies but fortunately (or rather unfortunately ) these days Pakistan has become an economic laboratory of IMF which is in the process of experimenting with the effects of implementing VAT in a country passing through recessionary period. It is about to be experienced in a country which is at the moment riddled with a stalled economy, internal political problems and chaos among its provinces over the distribution even after NFC award.

This is not merely a personal opinion but has also been opined by the international press, such as Washington Post's Lori Montgomery who writes, “The latest sign: the emphatic rejection by both parties in recent days of a value-added tax, a sales tax imposed by nearly every other developed nation.” After a White House economic adviser was reportedly speaking somewhat favorably about VAT, the White House this week vigorously denied that President Obama is looking to include the said tax in his deficit-cutting arsenal. “This is not something the president has proposed, nor is it under consideration,” White House press secretary Robert Gibbs told reporters.

VAT isn't the only potential budget solution drawing fire. Republicans howled about cuts to Medicare in the recent health-care overhaul, and no one in Washington wants to raise taxes on the 98 percent of taxpayers whom the White House has defined as the middle class.

Anyways, VAT/GST has increasingly become steadily more important as source of revenue around the globe. In Mexico and Turkey, it contributes around 50% of Government revenues. This seems to be a trend, but a cautious one, and some commentators have asked why governments dont rely even more heavily on indirect tax revenues and introduction of VAT law in Pakistan may be the answer irrespective of recessionary economy!

But another answer is that higher indirect taxes are politically difficult to introduce as taxpayer often question the benefits of paying taxes. The link between higher indirect taxes and higher prices is obvious to anyone who buys goods and services, but the link between lower corporate tax rates and increased inward investment often results in increased employment and infrastructure development which is less well understood by robust or sustained economies instead of recessionary one! This article is endeavoring to assess the ground realities pertaining to implementation of a comprehensive value added tax.

Table of Contents

VAT and Reduced Direct Tax Rates

Indirect taxes seem to be playing in the revenue-gathering strategies of many countries around the globe and plan to introduce VAT in Pakistan is no exception. It may be correct that this is a worldwide trend but there is a clear tendency in competition to attract and keep inward investment, to reduce their corporate tax rates and seek to make up the shortfall with increases in indirect taxes. This is rather than relying solely on growth brought about by corporate investment to expand the tax base. These tactics suggest that as well as attracting new investment, retaining current investment is a success in itself.

In November 2006, Mr. Lee Hsien, the Prime Minister of Singapore while speaking to the parliament said, “if we have to bring our corporate tax down, every percentage point we bring it down will cost us $400 million a year. It is big money. Therefore, we need to consider raising indirect taxes, in other words, the Goods and Services Tax. It is now five percent; I think we need to push it up to seven percent. Even seven percent will still lower than nearly all other countries which have GST or VAT. But if we raise it from five percent to seven percent, it will give us precious extra resources to implement social programmes.”

This is exactly what the Singapore Government did in its 2007 Budget, announcing a two percent cut in corporate tax rates to 18 percent from next year and an increase in GST to seven percent. There seems to be a clear deviation from this principle in Pakistans VAT introduction fiscal policy.

This nexus of introduction of VAT coupled with reduced tax rate is not based on any myth but on realities. For taxpayers, introduction of VAT has immediate consequences (discussed below). One of the advantages of VAT over direct profits tax is that they supply a steady flow of funds throughout the year, rather than lump sums at widely spaced intervals evidenced in direct taxes.

This present government failed to chalk out any strategy to communicate the benefit of a low direct tax strategy combined with principled VAT regime. It may well be in the long term interests of a country to follow this path, but voters may need persuading of the benefits of paying today for better economy tomorrow.

VAT Collection: Federation or Provinces

Prior to entering into the debate of VAT collection in Pakistan, one must look at the European Union experience. Work is underway to reform the basic structure of the tax in certain areas, such as those determining which EU jurisdiction is entitled to the VAT being collected at present. Much of the legislative debate has been focused on how to alter the system to better reflect taxation where consumption actually occurs, principally for services that can be supplied at a distance like e-commerce, telecommunication etc.

The outcome of any new legislation in this area in EU will see a shift of VAT revenue from one country to another, principally from low rate countries to high rate countries. And no mention of EU VAT moderanization issues would be complete without a reference to the need to tackle the carousel/missing trader fraud issue which is costing EU governments very large sums in lost revenue. This drove urgent legislative change across EU.

The issues faced by EU are not alien to Pakistan but will surface soon! For instance, if a person is registered as service provider in NWFP and delivers the service in Punjab on the instruction of a person registered in Sindh then where will the input and output be paid and claimed. This and other similar peculiar issues will crop up!

Further, one school of thought is of the opinion that if the provinces are finding it difficult to share then wouldnt that also be difficult for federation to allow input of services VAT adjustment against output of goods and federal services! Moreover, if the provincial VAT will be collected by the provinces themselves then this may tantamount to increasing the compliance cost by the businesses which are already overburdened with 47 compliances a year according to the World Bank survey conducted by PwC but actually they are around 58 if labor law compliances are included.

VAT or GST by Provinces

VAT is meant for allowing credit on expenses and purchases but it seems that even after NFC award the provinces are struggling for additional revenue owing to trust deficit. These issues were raised by a local expert in the VAT conference held by the FBR in Islamabad but was not made part of the recommendation of Dr. Hafiz Pashas report.

The ground reality of operation of taxpayers is that some of the companies registered offices are located either in Sindh, Punjab or Islamabad irrespective of the fact that their operations may be carried out in NWFP or Baluchistan. Consequently, the registration domain either at registered address or operational place is the key question when provinces come to know about their actual share.

Further, continuing with the example in previous paragraphs above, if a person is registered as service provider in NWFP and delivers the service in Punjab on the instruction of a person registered in Sindh then where will the input and output be paid and claimed.

In case if it is decided that this situation will avoided by slapping 15% on output of services in the province, as suggested by Mr. Kaiser Bengali in ACCA pre Budget discussion, where the service provider is registered and without allowing any input either in Punjab or Sindh then would such fixed rate cost be acceptable to businesses or could anyone call it VAT!

The Dayton Accord (2001) of Bosnia proved disastrous and they had to revert back to central government. Bird and Abel (2007) study also concluded that transferring the right to the federating unit is preferable when regional units either do not have the capacity or are in a process to build the same.

Rate of VAT

The hottest debate in town is about the rate of VAT on essential and non essential items. As stated above, the link between higher indirect taxes and higher prices is obvious to anyone who buys goods and services. However, the approach of all Pakistan Tax Bar Association Mr. Abdul Qadir at the pre budget proposal meeting called by the chairman KCCI Budget and Tax Committee Mr.Qamar is more rational which require a scientific study. The chairman FBR has also already hinted for a rate ranging between 5 to 7%. The impact can be understood through following comparative chart.

COMPOSITE RATE