A perspective on the Value-Added Tax

This week ‘View point’ puts the spotlight on the Value-Added tax (VAT) which is being introduced in St. Vincent and the Grenadines with effect from May1, 2007. The rapid rise in the VAT is probably the most striking tax development to have taken place in the latter part of the twentieth century. Today it is a key source of revenue in over 120 countries.{{more}} About 4 billion people, 70% of the world’s population now live in countries with a VAT and it raises approximately one quarter of all Governments’ revenues. Much of the spread of VAT has taken place over the last ten years. From being largely the preserve of the more developed countries in Europe and Latin America, it has become an important component of tax systems in developing countries as well, and is increasingly being seen as a key instrument for placing domestic revenue collection on a sound basis.

Despite its name, VAT is not generally intended to be a tax on Value-added as such: rather it is intended as a tax on consumption. The essence being to have it charged on all stages of production, but with the provision of some mechanism enabling firms to offset the tax they have paid on their own purchases of goods and services, against the tax they charge on their sales of goods and services. Hence the definition of VAT as:

“A broadly based tax levied on commodity sales up to and including at least the manufacturing stage, with systematic offsetting of tax charged on commodities purchased as inputs against that due on outputs.”

An example may serve to reduce the apparent complication: Thus while a business-place may be required to charge the tax on the items it sells, it can also claim a credit for taxes it has been charged on its inputs. If today for example, the firm AMPLE Ltd sells its output for $100 to the firm BETA Ltd which in turn sells its output for $400 after adding some value, to final consumers, then that is the end of the transaction. Come May 1st with the introduction of 15% VAT, if AMPLE Ltd sells its output (which has no input cost) to BETA Ltd, the cost to BETA Ltd will be $115, including VAT.

AMPLE Ltd will be obliged to remit $15 to government in tax. Beta Ltd after adding some value to the product will charge its final customers $460, remitting tax of $45, that is output tax of $60, less credit for the $15 of tax charged by AMPLE Ltd on its inputs. The government therefore collects $60 in revenue. In its economic effect, the tax is thus equivalent to 15% on the final sales, but this method of its collection secures the revenue more effectively.

Following the decision of the European Communities to adopt VAT as the common form of sales tax, the member countries have gradually moved towards its introduction. This was in keeping with the drive for greater economic integration among the states comprising the European Communities. The VAT was particularly well suited to avoiding the trade distortions associated with the cascading indirect taxes it replaced. In the OECS it was a decision of the Ministers of Finance who constitute the Monetary Council of the Eastern Caribbean Central Bank that member countries should seek to adopt the VAT as a common tax in the interest of deepening the sub-region’s economic integration. Dominica has so far introduced the tax at 15% and St. Vincent and the Grenadines is now poised to follow their lead.

The standard rate for VAT varies from 3 percent in Singapore to 25% in Denmark and Sweden. In the Caribbean, Barbados, Jamaica and Trinidad and Tobago all have a rates of 15% while Grenada is soon to follow at 15%. Zero rating refers to a situation in which the rate of tax applied to sales is zero although credit is still given for taxes paid on inputs. In a VAT designed to tax domestic consumption only, as is the case of SVG, exports are zero rated, meaning that exports leave the country free of any VAT.

This is consistent with the ‘Destination principle’ which requires that the total tax paid on a good be determined by the rate levied in the country of the final sale. By contrast, the ‘Original principle’ requires that the tax be paid at the rate of, and to the country in which the item is produced rather than consumed.

The ideal VAT is a tax on consumption and a strong case can be made that since an individual’s consumption is one of the best observable indicators of their living standards, so consumption is potentially one of the most equitable of tax bases. The point should be made however that few taxes are very well suited to the pursuit of equity objectives. Expenditure policies, once effectively implemented are often far better targeted to these aims. In that context the first duty of taxation is to raise revenue but it should do so with as little distortions of economic activity as possible.