Value Added Taxation: Mechanism, Design, and Policy Issues Tuan Minh Le




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Value Added Taxation: Mechanism, Design, and Policy Issues

Tuan Minh Le

Paper prepared for the World Bank course on Practical Issues of Tax Policy in Developing Countries

(Washington D.C., April 28-May 1, 2003)

            1. Introduction

The idea of the value added taxation (VAT) traces back to the writing by von Siemens, a German businessman, in the 1920s. Not until 1948, however, was the tax first applied in France. At the beginning, France applied the GNP-based VAT covering up to the manufacturing level and subsequently replaced it with a consumption VAT in 1954. Theory and practice indicate that to be efficient, the VAT must be consumption-typed, broad-based, and applied through to the retail stage.

Empirical studies have shown the interlinks between the VAT performance of a country and its level of development. The revenue gains from VAT are likely to be higher in an economy with higher level of per capita income, lower share of agriculture, and higher level of literacy (Ebrill et al. 2001).1 VAT proves to be an efficient tool for revenue collection; its performance, therefore, has direct impact on fiscal mobilization, macroeconomic stability, and development.

Compared with alternatives in indirect taxation, the VAT has more revenue potential: it is generally more broad-based and entails a trail of invoices that helps improve tax compliance and enforcement. Note also that the VAT may eliminate the cascading problem, which is typical for the turnover tax. Heady (2002) observes a clear, consistent trend for greater use of the VAT to collect sales tax revenues among OECD countries: “[The VAT becomes] the sales tax of choice in OECD countries” (p.4). While these countries continue to rely heavily on income tax collection, the VAT revenues have risen steadily in both absolute and relative terms: the general consumption taxes (mainly VAT—in recent years) increased sharply from 12 percent of the total tax revenues in 1965 to 18 percent in 2000 (Heady, 2002. p.16). A similar trend is applied to developing countries, which typically rely more on sales tax than OECD countries. The IMF assesses the growing importance and worldwide expansion of the VAT as follows:

“[The VAT has become] a key source of government revenue in over 120 countries. About 4 billion people, 70 percent of the world’s population, now live in countries with a VAT, and it raises about $18 trillion in tax revenue—roughly one-quarter of all government revenue. Much of the spread of the VAT, moreover, has taken place over the last ten years. From having been largely the preserve of more developed countries in Europe and Latin America, it has become a pivotal component of the tax systems of both developing and transition economies.” (Ebrill et al., 2001. p. xi.)

This paper covers the mechanism of the VAT and presents critical issues in the tax design, implementation, and policy implications. The paper consists of six sections. Section II reviews the rationales for the VAT in comparison with other types of indirect taxes. Section III discusses the nature of VAT, alternative methods of VAT calculation, and three major types of VAT base. Section IV presents the mechanics of calculating VAT liability and introduces VAT performance measurement indexes. Section V analyzes critical issues in the VAT design, implementation, and policy implications. Section VI concludes.


In a nutshell, VAT is a form of indirect tax collected at various stages of production-distribution chains. If properly designed and implemented, the tax, at any stage, is effectively collected on the pure value added generated at that stage; as such, the VAT can be viewed as equivalent to the single retail sales stage tax but implemented in a different fashion. We will discuss further the mechanism of the VAT in sections III and IV.

There are some good rationales for a VAT.



  1. The VAT replaces other unsatisfactory indirect taxes (e.g., turnover and single-stage taxes)

Many developing countries have introduced the VAT to replace turnover tax or some type of single-stage sales tax. The replaced taxes are inherently troublesome in terms of either revenue leakage or economic inefficiency or both. To illustrate the relative advantages of the VAT, in what follows I will briefly review the problems with the turnover and single-stage taxation.

    1. Turnover taxation

The tax is imposed on every stage of the production-distribution chain. The tax base at any single stage includes the sales value of the goods plus the tax charged accumulatively in previous stages. A serious problem with this tax is the “cascading effect,” literally understood as the tax-on-tax effect. The tax generates a trail of accumulated distortions carried from the first stage of production on to the last stage of the retail sales distribution. To gauge how bad the cascading effect is, one may simply imagine a situation, in which a smart entrepreneur “negotiates” with his partners to vertically integrate, and by colluding, they can avoid a large part of the tax burden.

    1. Single-stage taxation

The tax can be imposed at any single stage of the production-distribution chain—there may be manufacturing, wholesale, or retail sales taxation. The tax, at the first glance, is ideal, because its design is expected to eliminate the cascading effect and does not require huge administration costs (the base is significantly smaller than the one with the turnover tax). It has many potential problems, however.

For example, the tax at manufacturing level needs “ring fencing” the production of capital goods in order to avoid any bias against capital and escalation of production costs. But it would require efficient monitoring to detect any potential reselling problem—ring-fenced firms may obtain their tax-free inputs, resell them to the market, and thereby erode the base. Likewise, the tax on wholesales stage is not easy to administer: the problem derives mainly from the obscure definition of the wholesale stage. For both manufacturing and wholesale stage taxation, the base is narrow, and hence the rates need to be high to collect sufficient revenues. However, higher rates provide stronger incentives for evasion and avoidance; taxpayers can easily avoid the taxes by artificially lowering price at the taxed level (manufacturing or wholesale level respectively) and raising price at the subsequent, untaxed, level.

On the other hand, the retail sales tax (which is currently applied, for example, at the state level in the U.S.) requires, inter alia, massive registration. Mikesell, in his brief on the topic entitled “Retail Sales Tax,”2 indicates that to ensure the economic efficiency of a retail sales tax regime, two major principles must be followed. First, the tax must be applied to all sales for final consumption at a uniform rate. Second, there must be no tax on savings or production consumption. Both conditions are, however, practically hard to be met. It is not uncommon that tax regimes—applied in practice—feature multiple rates and exemptions. On the other hand, it is costly, administratively, to distinguish consumption (to be taxed) from production purchases (to be exempted)—there are many items used for both production and final consumption.

The administration of the retail sales tax is not simple for at least two reasons: (1) the tax requires that all retailers be registered to collect taxes from their customers; and (2) multiple exemptions and rates, and limited coverage (the tax is typically extended only to goods and very few services) tend to erode the base and give rise to the need for setting high standard rate for sufficient revenue collection. The high rate, however, would become an attractive invitation to evasion and avoidance. An interesting vicious circle can be seen: narrow base—high standard rate—evasion and avoidance—narrower base etc. In addition, retailers in developing countries are largely small, informal, and mobile (no fixed business location); these typical taxpayer characteristics combined with the complex tax regime pose real challenge to tax administration.

In general, single-stage sales taxation is prone to serious revenue leakage. Especially, the tax collection is restricted to only one stage of the chain: if some businesses succeed in slipping out of the tax net (i.e., at the tax point), revenues will immediately drop. The VAT is relatively more advantageous than the alternatives, be it turnover tax or single-stage tax. First, the VAT is generally more broad-based (it is extended to cover both goods and services). Second, it is less risky in terms of revenue leakage (the invoice-based credit mechanism in administering the VAT facilitates collection and enforcement; even if revenues are missed in one stage, they are still collected in other stages). The VAT has, therefore, greater revenue potential than its alternatives.

Opponents to the VAT usually argue that the VAT is more complex to administer than other types of consumption taxation, and the complexity naturally leads to higher collection costs (defined as the combined compliance costs from the taxpayer side, and administration costs from the tax authority side). However, as described, the taxes replaced by the VAT in developing countries are generally far from being simple in their design and riddled with narrow base, multiple rates, and numerous exemptions. For example, the VAT, introduced in 1988 in the Philippines, replaced a web of indirect taxes including manufacturer’s sales tax, turnover tax, advance sales tax on imports, miller’s tax, forest charges, and other sorts of ad valorem taxes on services. McMoran (1995) indicates that the administration and compliance costs under a single-stage tax and a VAT extended to the same level in the production-distribution chain do not differ significantly.



  1. Invoice-based credit VAT, the most common form of VAT, is, in principle, self-enforcing and hence a buoyant tax3

The VAT is, in principle, described as “self-enforcing.” The description stems from the nature of the invoice-based credit VAT: a taxable business can claim for the refund of the input VAT only if the claim is supported by purchase invoices—the mechanism provides strong incentives for firms to keep invoices of their transactions and is an efficient means for tax authorities to check and cross-check for enforcement enhancement. In reality, the tax is, however, not at all self-enforcing—“ghost” invoices and false refund claims are common.4

Despite certain inherent problems in administration, the VAT is empirically found to be a buoyant tax (Tait, 1991). Most countries started the VAT with an initial idea of reforming the existing sales tax system on a revenue-neutral basis but then realized that the VAT is revenue-enhancing, largely due to the improved compliance. A recent survey by the IMF (Ebrill et al., 2001) shows that this is true for all regions, except for Central Europe, Russia, and some other countries of the former Soviet Union. Note another advantage of the VAT: being a buoyant tax, the VAT may allow for some relief in income taxes; and if the VAT introduction accompanies a reduction in income taxes, the whole tax system tends to be more politically acceptable and hence more stable.



  1. Unlike income taxes, consumption-based VAT does not distort consumption-savings/investment decision

Being a consumption tax, the VAT does not have discriminating effect on savings/investment because savings are essentially excluded from the consumption VAT base. The following example helps illustrate.

In a simplified world, a typical individual lives over two years. He earns income in year 0 and uses up his income over his two-year lifetime, years 0-1. Suppose his income in year 0 is $100. For simplicity, assume he could exercise two extreme options: consume all his income in year 0, or save all income to consume in year 1. Also, assume the discount rate, a measurement of his patience, is 10 percent, the same as the interest rate.



Case 1: No tax world.

If he saves all his money in year 0, then in year 1, he will consume $110 or $100 in present value (i.e., 100*(1+10%)/1.1), the same as the amount earned in year 0. There would be no distortion: the individual would be indifferent between the two options.



Case 2: Income tax of 30% (uniform rate applied to income from different sources).

If he consumes now, he can consume $70 (i.e., 100*(1-30%)). But if he saves the money for the next year, then he can consume less, at just $68 in present value (i.e., {[100*(1-30%)]*[(1+10%*(1-30%)]}/1.1). Obviously, he is more likely to consume all his earning income in year 0! Put it differently, the income tax does discourage savings and investment.



Case 3: Consumption tax of 30%.

He can consume now at $70, net of tax. If he saves all his earned income to consume in the next year, then in year 1, he expects to earn a present value of the same amount, $70 (or {100*(1+10%)*(1-30%)}/1.1=$70). The consumption tax does not distort consumption-savings decision—the outcome is similar to the one in the no-tax world (case 1).




  1. A VAT on destination principle may relieve exports from indirect tax burden on inputs if the tax is properly applied

Under destination principle, conventionally, the VAT zero rates exports. If properly applied, zero rating removes exports from all VAT burden: exporters do not collect the VAT when exporting but are still eligible to claim for refunds of all the VAT paid on their input purchase. (Section IV details and illustrates the mechanism of the zero rating.) This is true, however, only in the case where refunds of the input VAT are made in a timely manner.

In practice, it is not uncommon that the VAT refunds are delayed by as long as six months in developing countries. Without any interests earned on the portion of the eligible but delayed refunds, export-manufacturing firms lose in terms of time value of money. Desai and Hines (2002) argue further that empirically, the VAT is associated with less trade (fewer exports and imports). They explain that in addition to the delayed and incomplete refunds, exporters suffer from exchange rate appreciation, which is likely resulted from the VAT introduction. One may, however, question the data and methodology applied in their paper.


            1. The VAT Mechanism

        1. The value added: how to measure it

The VAT, by definition, is the tax on the value added at each stage of a production-distribution chain. The value added, in turn, can be defined in two alternative ways. First, value added is equivalent to the sum of wages to labor and profits to owners of the production factors including land and capital. Second, value added is simply measured as the difference between the value of output and the cost of inputs. The two ways of definition of value added give rise to three major alternatives for computing the VAT liability as described below.

  1. Three alternatives in VAT computation

    1. The addition method

The tax liability is equal to the tax rate multiplied by the value added defined as the sum of wages and profits. If t1 and t2 are the rates on wages and profits respectively, then the tax liability will be the sum of (t1*wages) and (t2*profits). The addition method, in practice, would be politically hard to sell to the public, as taxpayers would simply view the VAT as an additional layer of tax burden on top of corporate and personal income taxes. On the other hand, the structure of the tax implies that the VAT, theoretically, can be used to replace both personal income tax and corporate income tax.5

    1. The subtraction method

The tax liability at any stage is equal to the tax rate multiplied by the tax base or value added measured as the difference between the values of outputs and inputs.

    1. The invoice-based credit method

This is the most common method of the VAT computation. Under the invoice-based credit method, a firm at any stage of the production-distribution chain charges its customers the VAT on its output, submits the tax to the treasury, and then claims for the VAT already paid on its input purchase. Let t1 and t2 be the tax rates on output and inputs respectively, then the tax liability is the difference between (t1*output) and (t2*inputs).

    1. Which VAT computation is the best practicable

The invoice-based credit VAT apparently has advantages over both addition and subtraction methods. The addition method relies on accurate information on wages and profits which are hard to obtain in developing countries, and thereby runs into the same problems faced in income taxation. The subtraction method, on the other hand, requires an explicit estimation of the tax base—this would be fine for a VAT with a single rate structure but would result in serious problems for a multiple-rate VAT regime. For the purpose of illustration, let us look at a simple case: assume a firm purchases a single type of input (I) subject to a tax rate of ti and produces two types of output subject to different rates of t1 and t2, respectively. To properly refund the tax on inputs to the firm, the tax administration needs to know how to apportion the input (I) into the two types of outputs. Misaligned information, and the resulted monitoring problem inherently make the subtraction method practically hard to apply.

On the other hand, under the invoice-based credit method, the VAT on outputs and inputs is, essentially, assessed and collected separately, and the refunds are credited on the basis of the invoice on input purchases. As the tax base does not need to be directly calculated, the system handles a multiple rate structure more efficiently than does the subtraction method.6 An extra benefit of the invoice-based credit mechanism is that it requires firms to retain invoices and hence self improves the general record keeping practice. “Self-policing,” a desired character of the VAT, is specifically related to the invoice-based credit VAT.



  1. Three types of VAT base

    1. GNP type (Product-typed)

A GNP-typed VAT taxes all final goods and services except for intermediate goods. Investment costs also enter the tax base—no capital expensing or depreciation is allowed. The advantage of this type of the VAT is that the base is relatively large. The big disadvantage is, however, that the investment items will bear the full tax burden.

    1. Net national product type (Income-typed)

This type of the VAT excludes from the base the value of intermediate inputs and depreciation. The base is, therefore, similar to the one in income taxation.

    1. Consumption type

The base excludes the value of both intermediate inputs and investment items from the gross value of goods and services. The base—as defined—is close to the one in retail sales taxation.

Most countries apply the consumption type VAT but introduce various ways of giving credit for capital goods. Rarely do countries allow for immediate and full credit of the tax charged on capital goods. They generally limit the credit in a certain period to the level of the VAT chargeable on output and allow the remaining credit to be carried forward to offset the tax in later periods (for example, this is a common practice in Latin America). On the other hand, some countries selectively grant immediate exemption of the VAT on the purchase of capital goods as part of an overall package of fiscal incentives to priority industries.

There are two important notes. First, both product and income-typed VATs entail cascading effect as they more or less charge the tax on investment items. Thus, they are not production-efficient. The income-typed VAT allows for partial and delayed refunds of tax: investment items are not immediately expensed but gradually deducted from the tax base over a specified period in the project’s life—the investment items, therefore, bear partial tax burden in present value terms. However, the GNP or income tax base is relatively larger than the one of the pure consumption-typed VAT and is not commonly applied in practice—China and Brazil are among a few exceptional cases, which apply the GNP-typed VAT (China apply the GNP-based VAT at state level). On the other hand, the pure consumption base would relieve production from tax burden and hence makes the VAT more production-efficient. In addition, as a general consumption tax, the consumption-typed VAT does not distort the investment and saving behavior (discussed in section II).


  1. Some further basic concepts in VAT: exemption v. zero rating

An exempt stage is completely eliminated from the production-distribution chain: an exempt firm is not required to collect the tax on output sold to its consumers, but it is not entitled to claim for the credit of the tax the firm has already paid on its input purchase.

A zero rated firm charges no VAT on its consumers—equivalently put, the firm charges the rate of zero percent on its sales—and then, it claims for refunds of the VAT previously paid on its input purchase. In essence, zero rating does not break the link between the zero-rated stage with others in the whole production-distribution chain—zero rating can be thought of as an extreme case of reduced rate on output of eligible products.



  1. How the VAT is calculated: some illustration

The following examples are set up to illustrate the mechanism of the VAT calculation and to make contrast between the invoice-based credit method and subtraction method.

Let us look at the case of, say, producing bread. At the first stage, a farmer sells wheat to a miller. In stage 2, the miller makes flour and sells to the baker. At the final stage, the baker makes bread and sells it to final consumers. For simplicity, let us assume that the value added at the first stage makes up the total value of the output sold (i.e., wheat).

Let P1, P2, and P3 be the price of wheat, flour, and bread respectively. Likewise, t1, t2, and t3 are the VAT rates on wheat, flour, and bread respectively.

2.1. No exemption, no zero rating

Under subtraction method, the VAT in the whole chain would be calculated as follows:

Tax liability = t1*P1+t2*(P2-P1)+t3*(P3-P2) (1)

Under credit method:

Tax liability = t1*P1+[t2*P2-t1*P1]+[t3*P3-t2*P2] = t3*P3 (2)

In a single rate system, the tax liabilities in (1) and (2) are the same, and the effective tax revenues are equivalent to the ones received under a retails sales tax system.



2.2. Exemption

We now introduce exemption in the tax structure and analyze its revenue implications.



      1. Exemption of the first stage

Under subtraction method: Tax liability = t2*P2+t3*(P3-P2) (3)

Under credit invoice method: Tax liability = t2*P2+[t3*P3-t2*P2] = t3*P3 (4)

Note, under the invoice-based credit method, the tax revenues are the same in both non-exemption and first-stage exemption cases. On the other hand, under the subtraction method, the revenues may be lower or higher in the first-stage exemption case than in the non-exemption case, depending on the relative magnitudes of t1 and t2.


      1. Exemption of the second (middle) stage

Under subtraction method: Tax liability = t1*P1+t3*(P3-P2) (5)

Under invoice-based credit method: Tax liability = t1*P1+t3*P3 (6)

With the middle-stage exemption, the tax revenues under invoice-based credit method are higher than the ones without exemption. This is the case, because the exemption of the middle stage effectively eliminates this stage from the whole chain: the second firm (the miller) cannot claim for refund of its input tax (the tax paid by the firm on its purchase of wheat)—the tax burden hence carries on. This generates “cascading effect,” which is typical in turnover taxation. The subtraction method, on the other hand, collects less revenue when the middle stage is removed from the VAT chain (the value added generated in the second stage is effectively removed from the tax).


      1. Exemption of the third (last) stage

Under subtraction method: Tax liability = t1*P1+t2*(P2-P1) (7)

Under credit invoice method: Tax liability = t1*P1+[t2*P2-t1*P1] = t2*P2 (8)

Under both methods, the tax revenues are less than the ones collected in the non-exemption case. As the last stage is out of the tax net, the value added in this stage escapes the tax. This indicates that the overall tax burden could be reduced by exempting the last stage.


    1. Zero rating

      1. Zero rating of the first stage

Under subtraction method: Tax liability = t2*P2+t3*(P3-P2) (9)

Under credit invoice method: Tax liability = t2*P2+[t3*P3-t2*P2] = t3*P3 (10)

Zero rating of the first stage does not change the effective tax revenues under invoice-based credit method. However, the tax revenues would be lower under subtraction method: the value added generated in the exempt stage (first stage) is not taxed.


      1. Zero rating of the second (middle) stage

Under subtraction method: Tax liability = t1*P1+0*(P2-P1)+t3*(P3-P2) (11)

Under credit invoice method:

Tax liability = t1*P1+[0*P2-t1*P1]+[t3*P3-0*P2]=t3*P3 (12)

Under invoice-based credit method, zero rating of the second (middle) stage does not change the VAT revenues. Under subtraction method, the value added generated in the second stage is free of tax.



      1. Zero rating of the third (last) stage

Under subtraction method: Tax liability = t1*P1+t2*(P2-P1)+0*(P3-P2) (13)

Under credit invoice method: Tax liability = t1*P1+[t2*P2-t1*P1]+[0*P3-t2*P2]=0 (14)

Under invoice-based credit method, the tax revenues for the whole chain become zero if the last stage is zero rated. This implies that to completely relieve exports from the VAT burden, zero rating, but not export exemption, must be applied. A destination VAT regime (to be discussed later) zero-rates exports, but taxes imports.

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