The rapid rise of the value-added tax (VAT) around the globe suggests that it may be a good tax.

However, VAT can be problematic in case the economy has a large informal sector. The basic concept behind this consumption tax was that the legal incidence of VAT would be on sellers, including importers, manufacturers, distributors and eventually retailers while the effective incidence would be on consumers according to their capacity to consume.

However, a considerable number of manufacturers in an informal economy fail to shift the tax burden to consumers: several intermediate distributors/retailers are not registered for VAT. Therefore, the major burden of VAT — both legal and actual incidence — is borne by manufacturers. This aspect adversely affects manufacturing activity and economic productivity.

Value-added tax appears to be problematic in agro-based economies where prices of agricultural products are usually fixed by governments for poverty-related reasons

Moreover, in informal economies, registered taxable people find it difficult to better compete in the market owing to higher prices that are inclusive of VAT: non-registered suppliers commonly offer inputs of similar quality at lower tax-exclusive prices. Therefore, informal economies discourage taxable people to operate under VAT by encouraging them to keep their turnover below the VAT registration threshold. Taxable people do it by under-reporting their turnover in economies where the prescribed turnover is the basis for VAT registration. Or they do it by splitting the utility bills among different taxable people (largely manufacturers) in case a certain value is prescribed as yardstick for VAT registration.

These could be the reasons for extremely narrow VAT bases in informal economies/developing countries. Furthermore, in large informal economies, VAT is susceptible to evasion and fraud. Informality has at least three faces — evaders, avoiders and outsiders. Unsurprisingly, VAT evasion and VAT fraud are more common in informal economies than documented economies.

These occur in different forms whereby taxable people remain out of the VAT net by keeping their turnover below the VAT registration threshold, continue supplying taxable goods and services without charging VAT, establish shell companies and do non-existent/paper transactions, use fake and flying invoices to enhance the input tax in order to reduce their output tax liability, understate the value of supplies or overstate the value of purchases, register dummy units using fake identity just for the purpose of issuing sales tax invoices to enable other registered taxable people to reduce their tax liability or to claim illegal refunds, and/or remit to the government less sales tax amount than they have charged their customers by submitting fraudulent VAT returns.

VAT appears to be problematic in agro-based economies. In developing countries at least, prices of agriculture products are usually fixed by governments for poverty-related reasons. So if VAT is applicable to agricultural produce, it may not be possible to determine the actual output tax, which may lead to the creation of massive VAT refunds. This is the reason that a majority of countries have exempted agricultural produce from the chargeability of VAT. Secondly, charging VAT on the agricultural input may reduce profits to the growers of agricultural produce.

VAT is a regressive tax being charged on goods and services. Hence, VAT is not justified on equity grounds. It may be problematic in tax jurisdictions facing a high level of income inequalities and poverty rates. It is considered harmful for the poor and low-income earners. Moreover, an increase in VAT has a greater negative impact on inequality than an increase in the personal or corporate income tax.

VAT appears to be ineffective and inefficient where its design, instead of being standardised, is riddled with too many rates, excessive exemptions, reduced rates and zero-rated schemes on domestic supplies and exports. Other things being constant, its imperfect design diminishes the merits associated with a good VAT. It encourages taxable people to evade it by misclassifying taxable goods as exempt, applying a reduced rate on goods that are otherwise subject to the standard rate, or manipulating zero-rating schemes. Thus, it increases the cost of VAT collection as tax authorities use additional human and technological resources to counter evasion.

Last but not least, VAT is operated on a self-assessment basis where taxable people declare taxable supplies and purchases and pay the government any amount exceeding the input tax. This system of self-assessment may encourage taxable people to indulge in VAT evasion, which occurs by under-reporting taxable supplies for a tax period, misclassifying taxable supplies as exempt supplies, claiming input tax on exempt supplies, adjusting the input tax on flying invoices and/or paying a less than due amount.

To prevent VAT evasion, tax authorities must be well-equipped with sufficient human resources to trace taxable people liable for VAT registration. They should be professionally competent to conduct investigative audits to create deterrence against VAT evasion by imposing penalties. They should be legally skilful to initiate prosecution proceedings against VAT fraudsters and technologically resourceful to prevent the use of fake and flying invoices.

The writer serves as additional director at the FBR

Published in Dawn, The Business and Finance Weekly, October 7th, 2019