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VAT by another name

December 04, 2010

THE debate over the Reformed General Sales Tax (RGST) is resonating loudly in Pakistan these days. It appears as a VAT mode of consumption tax. The government has been downplaying the fears of critics by claiming that the new system is merely an improved form of the existing sales tax system.

Perhaps in coining the name, the cue has come from Shakespeare who wrote that a rose by any other name would smell as sweet. This analysis addresses the need for a dispassionate appraisal of the issue, and an understanding of VAT, in less technical jargon.

Introduced in 1954 by the French Tax Authority, VAT soon gained EU-wide recognition and became one of the conditions for EU membership. Various surveys suggest it is now a major source of revenue in more than 120 countries. Unlike an ordinary sales tax VAT is a multi-stage tax.

The system requires all business sellers/buyers to be registered with the tax authority, keep proper VAT records and file regular tax returns. Those who fail to do so get penalised and lose the opportunity of claiming back VAT paid on their purchases. Therefore, self-policing and documentation of the economy are cited as the major benefits of the VAT system by the latter’s advocates.

Despite being adopted across the world, VAT has always been regarded as a gatecrasher and is greeted with protests by the business lobby everywhere. This opposition has been more vociferous in developing countries where businesses view VAT’s record-keeping requirements with great suspicion and other opinion-makers raise alarms over imminent inflationary tidal waves.

For a dispassionate appraisal of the VAT system Adam Smith’s famous canons of taxation are useful. On the ‘efficiency’ yardstick VAT measures well as large amounts of tax revenue can be collected after spending very little. No wonder world bodies like the IMF and World Bank prescribe it as a panacea for under-performing tax systems in developing countries.

On the ‘certainty’ principle, VAT again measures well as tax authorities can have reliable forecasts and taxpayers are certain of their liability. On the ‘convenience’ principle, VAT is a very convenient system for raising tax revenue but businesses are forced to act as unpaid tax collectors. The seminal research of Prof Sandford has established that compliance costs are borne regressively higher by smaller businesses.

Finally, on the ‘equity’ principle, VAT does not fare very well as it is regressive in nature. This means that a clerk earning Rs10,000 will pay the same amount of tax when he buys a bottle of milk for his infant as would be paid by a business tycoon for the same purchase. The equity-related concern can have greater socio-political consequences as it is now commonly known that hardly anyone in the ruling elite pays income tax.

The strongest argument against VAT’s introduction is its perceived inflationary effect. The IMF-based researchers conclude that there is little evidence that VAT resulted in an inflationary spiral in the countries where it was introduced. They opine, however, that if other monetary measures are weak then VAT can cause inflationary trends.

Given the recent price hike in essential commodities and the fragile post-flood economic situation in Pakistan, the fears expressed by the RGST opponents are not entirely misplaced.

Fiscal federalism is another problematic area for VAT as it was primarily designed for unitary states like France and Britain. In federations, a federal authority can only collect VAT on provincial subjects if it is authorised by the sub-national governments. The GST bill has tried to resolve the issue by having a scheme of federal sales tax and provincial sales tax after accommodating the concerns of the provinces, especially Sindh.

An old tax is a good tax, goes the saying. However, if countries like Sri Lanka and Bangladesh can have the VAT system to plug the revenue gap, and when even oil-rich countries like the UAE and Saudi Arabia are planning to introduce it soon, there is little justification for Pakistan not to follow suit.

Instead of opposing this VAT-style tax, political parties and pressure groups should target those fiscal policy areas where meaningful opposition is conspicuous by its absence.

According to Allan Tait, VAT is a flexible, buoyant and non-distortionary source of tax revenue and is not designed to achieve equity in a tax system. Equity demands should be addressed by other progressive direct taxes like the capital gains tax, income tax and wealth tax.

The proposals of the MQM and ANP in widening the tax net to bring in affluent classes like feudal lords and stock exchange investors are very genuine. Similarly, it is important that all services should be brought under the scope of the VAT-style general tax. There should be no room for the ‘all are equal, but some are more equal’ policy.

The most important issue of fiscal policy that our public opinion-makers do not raise is how the taxpayers’ money is actually spent. For instance, in the UK, public services account for 75 per cent of the total public expenditure, and health, education and social welfare top the list.

The UK military is one of the most respected and active institutions but still defence expenditure is only five per cent and the government has been making cost-saving efforts to ensure that military expenditure is in line with Value For Money (VFM) spending. If we impose the VAT system, which is a regressive form of taxation, it becomes all the more important to ask where the taxpayers’ money will go.

We should frown on a non-developmental use of taxpayers’ money. Using taxpayers’ money to finance the elitist dreams of civil or military bureaucrats is condemnable. As said Tiberius Caesar: “It is the duty of a good shepherd to shear his sheep, not to skin them.”

The writer has a doctorate in public policy management and teaches in the UK.