I. VAT Policy Issues: Structure, Regressivity, Inflation, and Exports

Alan Tait
Published Date:
June 1991
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Alan A. Tait

This chapter discusses the major policy issues involved when considering a VAT. It briefly reviews the reasons why the VAT is chosen as the main sales tax and why particular forms of VAT are adopted and not some alternatives such as the retail sales tax. As soon as a VAT is considered, politicians become concerned about the possible regressive effects of VAT and its impact on domestic prices and on exports. Since these debates are often crucial as to whether or not the VAT is selected and what rates and exemptions are chosen, the central part of this chapter attempts to anticipate the arguments for and against and evaluate their worth. Finally, the principal issues in the treatment of food, capital goods, financial services, and small traders are outlined, as these are important considerations in all countries.

Why a VAT?

There are three main groups of reasons to adopt a VAT: revenue, neutrality, and efficiency.


Traditional income and sales taxes have been meeting public resistance and the VAT provides a new, buoyant revenue base, typically yielding more than initial estimates, as the cases of Indonesia, Korea, New Zealand, Portugal, and Tunisia show. However, this is by no means an automatic result. For instance, Kenya and the Philippines experienced an initial revenue shortfall after introducing the VAT, but this was partly because insufficient lead time was taken over the introduction and the tax administration could not be fully prepared. Broadly speaking, the VAT contributes from 12 percent to 30 percent of revenue in most countries, representing about 5-10 percent of gross national product. This reliable revenue creates a valuable alternative tax source, especially in countries that have a limited income tax base or that must rely on revenues from primary commodities that may be volatile, such as oil, minerals, coffee, sugar, and cocoa.


The VAT is nondistortionary—provided there are few exemptions and little zero rating. VAT on investment should be fully credited and this frequently is an improvement over the taxes replaced that often taxed capital goods. Similarly, the way the VAT on an export can be fully identified and rebated should ensure that exports compete on an equal footing (arguments that VAT makes exports more competitive are probably exaggerated—see below).


The VAT has often replaced inefficient, distortionary, and badly administered taxes. Examples include taxes that cascade liabilities, use many rates (sometimes mounting into the hundreds), tax capital goods and exports, favor imported goods, reduce the base, and frequently involve an antiquated (and sometimes corrupt) administration. The introduction of the VAT provides an opportunity to sweep away the cobwebs and revamp a substantial part of the tax administration. Finally, the VAT has proven popular, as Table 1 shows. The more examples there are of well-functioning VATs, the more familiar it becomes. Moreover, the revolution in computerization has transformed VAT administration, especially for smaller administrations, making the management of the tax less formidable than it had been earlier. Over 50 countries now use the VAT and at least a further 10 are seriously considering its adoption. Of course, because something is popular—especially a tax—does not mean it should be part of everyone’s wardrobe, but there are good reasons for the VAT’s popularity which deserve careful consideration.

Table 1.Percentage VAT Rates Throughout the World
VAT Rates1
Date VAT Introduced or ProposedAt introductionOn July 1, 1991
Algeria2Jan. 1992
ArgentinaJan. 19751616,25
AustriaJan. 19738,1610,20,32
BelgiumJan. 19716,14,181,6,17,19,25,33
BeninApr. 19911818
BoliviaOct. 19735,10,1511,13
Brazil4Jan. 1967159,11
Brazil5Jan. 19671517
Burkina Faso2
CanadaJan. 199177
ChileMar. 19758,2018
ColombiaJan. 19754,6,104,6,10,15,20,35
Costa RicaJan. 1975108
Cote d’lvoireJan. I960811.11,25,35.13
DenmarkJuly 19671022
Dominican Rep.Jan. 198366
EcuadorJuly 19704,106
El Salvador2
FinlandOct. 19901717
FranceJan. 19686.4,13.6,20,252.1,4,5.5,18.6,22
GermanyJan. 19685,107,14
GreeceJan. 19876,18,363,8,18,36
GuatemalaAug. 198377
HaitiNov. 1982710
HondurasJan. 197636,7
HungaryJan. 198815,2515,25
Iceland5Jan. 199014,24.514,24.5
IndonesiaApr. 19851010
IrelandNov. 19725.26,16.37,30.262.2,3.3,12.5,21
IsraelJuly 197686.5,16
ItalyJan. 19736,12,184,9,19,38
JapanApr. 19893,63,6
KenyaJan. 199017,20,40,50,27017,20,40,50,270
KoreaJuly 1977102,3.5,10
LuxembourgJan. 19702,4,83,6,12
MadagascarJan. 19696,1215
MalawiMay 198910,35,55,8510,35,55,85
MaliJan. 199110,1710,17
MexicoJan. 1980106,15,20 4.5
MoroccoApr. 19867,12,14,19,307,12,14,19,30
NetherlandsJan. 19694,126,18.5
New ZealandMay 19861012.5
NicaraguaJan. 197566,10,25
NigerJan. 19868,12,1815,25,35
NorwayJan. 19702011.11,20
PakistanJuly 199012.512.5
ParaguayJan. 19911212
PeruJuly 19763,20,4018
PhilippinesJan. 19881010
PortugalJan. 19868,16,308,17,30
SenegalMar. 1961-8067,20,34,50
South Africa2Sept. 199110
SpainJan. 19866,12,336,12,337
Sweden3Jan. 19692.04,6.38,11.125
Taiwan Province of ChinaApr. 198655,15,25
Thailand2Jan. 19927
Trinidad and TobagoJan. 19901515
TunisiaJuly 19886,17,296,17,29
TurkeyJan. 1985101,6,8,12,20
United States2
United KingdomApr. 19731017.5
UruguayJan. 19685,1412,22
Sources: Various reports.

Rates shown in bold type are the so-called standard rates applied to goods and services not covered by other especially high or low rates. Most countries use a zero rate for a few goods, and Ireland, Portugal, and the United Kingdom use it extensively to ensure that substantial amounts of goods and services are free of VAT.


Effective rates.

On interstate transactions depending on region.

On intrastate transactions.

Senegal’s VAT evolved from a limited manufacturers turnover tax with credits, and no precise date of introduction is given.

The standard rate to increase to 15 percent in 1991-92.

Sources: Various reports.

Rates shown in bold type are the so-called standard rates applied to goods and services not covered by other especially high or low rates. Most countries use a zero rate for a few goods, and Ireland, Portugal, and the United Kingdom use it extensively to ensure that substantial amounts of goods and services are free of VAT.


Effective rates.

On interstate transactions depending on region.

On intrastate transactions.

Senegal’s VAT evolved from a limited manufacturers turnover tax with credits, and no precise date of introduction is given.

The standard rate to increase to 15 percent in 1991-92.

Not everything is in favor of VAT. It is not an immediately easy concept for the public to understand and this is why some countries prefer a more familiar name that seems less threatening. For example, Canada and New Zealand call their VATs the goods and services tax (GST). The VAT also appears more complicated to administer than other sales taxes and substantial refunds can be involved; collecting VAT and paying refunds simply means spinning wheels for no revenue and this is clearly inefficient. The solution is to eliminate the need for refunds, that is, to use the zero rate only for exports.

The Retail Sales Tax Alternative

The most usually quoted alternative to a VAT is a retail sales tax (RST). However, a RST has its own problems and a quick review makes the following points about both taxes.

(1) A retail sales tax is usually identified with the sale of goods and not services. For example, transport, telecommunications, professional services, and construction are not usually taxed under the RST. In practice, the VAT has been applied to a larger tax base including most goods and services and, hence, has required a lower tax rate to collect the same revenue as an RST.

(2) It might seem that fewer traders have to be registered under an RST than under a VAT, which requires all traders—other than those below some minimum thresholds—to be registered. However, under an RST, businesses that sell goods that become the inputs of other businesses have to register themselves so that due allowance can be made to avoid cascading. This trader registration system to ensure that businesses get exemptions on inputs liable to the RST results in nearly as many businesses being registered under an RST as for a VAT. It has been estimated that 75-85 percent of the businesses to be registered for a VAT in the United Kingdom and the United States would have to be registered for an RST. Under the VAT, no distinctions need be made between the sales to different purchasers; all are taxable. The need to make distinctions under the RST and to keep records distinguishing business input sales and final consumption sales makes the RST more complicated than it appears on the surface.

(3) This means that the VAT is more efficient in ensuring that producer inputs are freed from tax than is the RST system. It does not mean, however, that all business inputs are free of tax under a VAT. Undoubtedly, some business inputs will be taxed—for example, inputs into financial services—but if the VAT is kept simple, with few exemptions, then the amount of cascading will be trivial.

(4) It is sometimes claimed that the VAT requires more working capital for traders than an RST. Most calculations show that this is not so. Indeed, as businesses collect VAT and hold the proceeds for, say, two months (if the taxable period is two-monthly) then they are getting some free working capital. Often RST returns are more frequent (e.g., monthly) than VAT returns. Of course, it is crucial under VAT that refunds should be paid promptly and traders not be out-of-pocket on the tax content of their capital purchases or their exports.

(5) It is claimed that the legislation and administration to run an RST is simpler than for a VAT. This means that an RST can be introduced much more quickly than a VAT. For countries that have short parliamentary terms (e.g., Australia, Canada, and the United States), this can be an important factor. However, the VAT has become such a well-known and widely adopted tax that the lead time to introduce it has shortened considerably and 18 months is a reasonable figure to aim for.

(6) The most important distinction between the RST and the VAT may be the question of evasion. There is no doubt that the RST at low rates is an extremely simple tax to understand and administer. However, the experience of countries that have raised RSTs to levels that are similar to VAT (e.g., Iceland, Norway, and Sweden) is that as the tax rate mounts, problems of evasion increase. The RST is collected from the weakest link in the distribution chain. Many retail sales require no invoice and the only evidence may be, for example, till rolls. Cash sales are common. On the other hand, the VAT provides a better audit trail than an RST. The use of invoices throughout the system gives auditors an opportunity to create a better series of checks. It is important not to exaggerate this property of the VAT, since, with the exception of Korea, no country has conducted comprehensive cross-checking. In general, neither the RST nor the VAT can tax the unofficial or black economy, and both are open to evasion by underrecording sales; however, underreporting of sales with a VAT will show up in reduced value added unless connivance with those who provide inputs is also arranged; this greatly increases the risks of detection under the VAT.

Form of VAT

Invoice-Based or Accounts-Based?

Nearly all countries use the invoice or credit method of levying VAT (Benin and Mauritania use the “subtractive direct” method, sometimes called the business transfer tax). The reasons for using the invoice method are (1) the tax liability is attached to the transaction and the invoice becomes the crucial documentary evidence; (2) a good audit trail is created; (3) multiple rates can be used (accounts-based VATs can use only a single rate); and (4) any tax period (a month, two months, or quarterly) can be used, whereas accounts-based VATs must focus on annual profit and loss accounts.

On April 1, 1989 Japan introduced an unusual accounts-based VAT at a very low rate of 3 percent and with extremely high thresholds (a simplified low-rate scheme applies to turnovers under US$3.5 million).1 The great advantage of an accounts-based VAT is that the income tax department can levy the tax on the basis of the existing accounts for corporate tax liability (although adjustments must be made to expense all capital purchases). This should be administratively much cheaper.

The problems of such an accounts-based VAT are (1) the VAT will be seen by business as simply a supplementary corporate profits tax and by labor as another payroll tax; (2) accounts are closed only once a year so any VAT payments other than the annual payment would have to be provisional; (3) the invoice audit trail is sacrificed; (4) the potential cross-check to validate corporate profits is sacrificed; (5) only a single rate can be used; and (6) at present the General Agreement on Tariffs and Trade recognizes only VAT as a sales tax to be rebated on exports (although the Japanese version appears to have been accepted).

Basically, the original European invoice-type VAT is the worldwide model and it is the one assumed for the other chapters of this book.

Manufacturing, Wholesale, and Retail Steps

Another decision is whether the VAT should cover all stages of production from imports to retail sales or whether it should be restricted initially to manufacturing only. A further intermediate decision is whether to extend a manufacturing stage VAT to the wholesale level. Finally, the VAT can cover all goods and services or only goods and no services or some in-between combination as shown below.


A VAT on imports and manufactured goods alone is one way to initiate a VAT, as was done in Indonesia. The advantages are fewer registered traders, clearly identifiable taxable commodities, and a less complex administration. The disadvantages are that the revenue base is much smaller and vertically integrated firms will shift profit centers downstream, hence eroding VAT revenue.

Although superficially attractive, the idea of extending VAT from manufacturing to include the wholesale stage (but still exclude the retail stage) is inherently unsatisfactory. “Wholesale” is not a clear concept. Problems of defining wholesale values are immense. Solutions that depend on “markups” or “markdowns” are unfair and discriminatory and give the administration far too much discretion, opening the door to corruption. For these reasons, it is preferable that the VAT should cover all stages of production to the retail level.

Taxable services for VAT should be retail. Where services are used as an input (e.g., advertising, financial, and architectural services), the VAT element must be allowed as a credit. It may be thought services are difficult to define; however, since in a broad-based VAT anything that is not a good is by definition a service, any further definition is unnecessary. Even services provided by the government (e.g., electricity, telecommunications, and transport) should be taxed so as to generate a continuous monthly or yearly stream of revenue.

A proposal to introduce a VAT will immediately trigger two political responses—first, that the VAT is regressive and, second, that its introduction will be inflationary.

Regressivity, Equity, and the VAT

A straightforward single rate VAT with no zero rates (except for exports) and few exemptions must mean that the VAT payment by low-income households will be a higher proportion of their incomes (and expenditures) than payments by higher-income households. That is, the VAT will be regressive.

It will be even more regressive if the items consumed as household incomes rise are untaxed. This is typically the case where countries introduce a VAT on manufacturing but do not tax electricity, telephones, professional services, financial services, hotels, and restaurants.

However, although many will undoubtedly try to make political capital out of the regressivity of VAT, the issue is by no means simple. Indeed, in discussing VAT and regressivity, the first question should be “Is VAT more regressive than the alternative?”

Is VAT More Regressive Than the Alternative?

The answer to this question is different for each country. It is interesting how infrequently we hear it asked. After all, governments adopt the VAT usually because of their extreme dissatisfaction with existing taxes.

The VAT may be an equal-yield replacement but the tax it replaces is presumably less desirable. Many taxes replaced are often highly distortionary with many multiple rates, often taxing capital and exports. Of course, what the public may see are rates reduced on “luxury” items and yet increased on necessities. Clearly, the government should offset this criticism by pointing to the extension of VAT to “luxury” items that were previously untaxed, such as professional services and telecommunications.

Moreover, if the government needs new revenue the question has to be put as to what taxes would be raised if VAT were not introduced. Would excises be increased? Taxes on tobacco, soft drinks, and alcohol are likely to be even more regressive than the VAT. Would the income tax be able to provide the revenue without hitting lower-income households? A payroll tax increase, such as social security, would probably be more regressive than VAT.

If the VAT is a new, additional source of revenue, the effect on households of the government expenditures must also be estimated, emphasizing the services that the new tax will allow the government to provide. In addition, at least some identifiable new services should be seen to accrue principally to the poor, preferably in such areas as housing, medical care, and education—see below. One way to present this discussion is that if the new revenue from the VAT is not obtained then the services will not be provided, or even more worrying, existing services may get worse. So the first point about VAT regressivity is to think what will happen if there is no VAT.

The VAT in Combination with Other Taxes

Next, we should consider the VAT not by itself but as part of the entire tax system. The VAT, as we have seen, is intended to be a neutral, efficient, buoyant, revenue-raising tax. It is not designed to correct for income or wealth inequalities; other parts of the tax system are supposed to do that, most obviously, the progressive personal income tax. So, the impact of VAT should be considered in the context of the overall tax system and not just the introduction of this one tax. (In the United Kingdom, for example, the VAT is progressive—the average rate of tax increases with income—and the overall tax structure also is progressive, but the contribution of VAT to that overall progressivity is small relative to income tax.)

Perhaps, combined with the introduction of VAT, income tax collections should be strengthened to ensure that the progressive rates legislated are actually collected. Excises on items represented in higher-income household budgets could be targeted for increases, for example, gasoline, cars, and wine. Again, it is the impact of the overall tax system that is important.

Consider the VAT with Expenditures

In discussions of regressivity, not only the overall tax system but the overall budget, taxes, and expenditures should also be considered. The government’s impact on the poor and rich is probably made even more effective through the ways the government spends its revenue. So the question is not whether the VAT is regressive but whether the overall mix of government taxes and expenditures has the desired effect on low- versus high-income households. It is a great pity to sacrifice the good qualities of the VAT (uniformity, simplicity, and revenue potential) to try and make it do what it is not intended to do (be progressive). Instead, transfers should be used to target house-holds (low-income, single parent, elderly, unemployed) or special benefits (sickness, first-time housing) to get help to the really poor.

Let us now look at what politicians try to do with the VAT to deal with its regressivity and, on the other hand, what they might be advised to do.

Typical Political Reactions About VAT Regressivity

Initially, people are often confused about the distinction in VAT between exemptions and zero rating. This sometimes leads lobbyists and politicians to seek exemptions for goods and services. Although this reduces the VAT base, such exempted goods and services do not escape VAT entirely as they cannot claim credit for the VAT paid on their purchases. Much worse, however, is that such exemptions introduce cascading and unpredictable rate variations into a tax that is designed to avoid cascading. Thus, in trying to soften the regressivity of VAT major distortions can be introduced.

To make sure that goods and services are really untaxed by VAT they must be zero rated. This ensures that all VAT paid can be claimed as a credit. Not only does this punch a major hole in the revenue, it also enormously increases the cost of administration. Zero rating food can knock out up to 40 percent of the tax base. Clothing can represent 10 percent, and housing 10-15 percent of household spending. A VAT with major zero rating becomes an inefficient machine, collecting huge sums of tax and then in a whirl of paper and administrative costs returning a large proportion of the revenue collected to the traders in zero-rated goods.

If persuaded that neither exemptions nor zero rating is desirable, politicians may turn to other devices. For instance, the Turkish authorities have instituted an ingenuous, extensive, and expensive structure of VAT rebates to households. This scheme has at least two purposes: to reduce the impact of the tax on lower-income households and to ensure that receipts are demanded and issued for retail sales, thus helping VAT enforcement. Consumers must present receipts showing purchases of “eligible” items (food—excluding alcohol and tobacco, clothing, consumer durables, residential fuel, education, and transport) on a monthly basis. They then get VAT rebates on the sales purchase price on a scale: for purchases under LT 30 a month, 20 percent is rebated and then a sliding scale applies until eventually on purchases above LT 100 and below LT 1,000, only 5 percent is rebated. For some consumers the rebate may exceed the VAT payment.

This complex system seems to encourage compliance and should help lower-income households, but at what cost? The total VAT revenue represents some 24 percent of Turkish tax revenue; the consumer rebates repay about 12 percent. So half the revenue is returned through a cumbersome mechanism that requires monthly presentation of receipts (which should be subject to random verification) differentiated according to total monthly purchases. Again, a vast amount of paper is generated and bureaucracy thrives. The cost to the exchequer is huge.

Such a structure creates implicit multiple rates of VAT. Politicians may be tempted instead to use explicit multiple rates to soften VAT’s regressivity. Studies show that a combination of zero and two positive rates can create progressivity with respect to expenditures but not necessarily with respect to incomes. Eleven reasons against multiple rates can be itemized:

  • (1) They distort consumer and producer choices.
  • (2) Traders may mark up low-taxed items to cross-subsidize higher taxed goods.
  • (3) It is an inefficient way to protect the poor as it also benefits the rich.
  • (4) “Administered” prices should pay full VAT.
  • (5) Borderline disputes are created, and huge potential is opened up for lobbying.
  • (6) High-quality staff time is wasted in dealing with demarcation disputes.
  • (7) The tax base is eroded.
  • (8) The high rates yield little revenue yet involve administrative costs.
  • (9) Differential rates rarely reflect genuine consumer choices and weights.
  • (10) Welfare gains are sacrificed.
  • (11) The strength of VAT uniformity is undermined.

What Reference Should Be Made to the Regressivity Arguments?

First, the validity of the straightforward case made above should be recognized. Second, emphasis should be put on the need to maintain the good qualities of VAT (uniformity, a broad base, no cascading, buoyant revenue) by having very few exemptions (see below), zero rating only for exports, and only one (or, at most, two) rates. Third, other ways to deal with regressivity should be examined: such as whether “luxury” excises could be increased; whether income tax administration (sometimes with information from VAT records) could be tightened up; and whether expenditure “safety nets” could be considered.

Directing government expenditure to help the poor creates “safety nets” for those who might be hurt by a broad-based VAT. This is a separate subject in itself (apart from VAT), but some ideas can be sketched.

(1) Expenditures should be targeted to help the poor and not be given as “blanket” rights to be enjoyed by everyone—for example, general bread or rice subsidies. There are five main forms of targeting: (a) geographical, rural, or urban, according to indexes such as regional income, infant mortality, and malnutrition; (b) by family (Canada is a classic example where zero rating of food and housing was combined with income supplements for housing to help low-income families); (c) individual, usually young children or mothers (e.g., the nutrition program in Tamil Nadu, India, and similar programs in Bolivia, Chile, and Colombia); (d) means test, as incomes rise, benefits decline (but there are well-known difficulties of work disincentives, fraud, and abuse); (e) self-targeting, subsidizing “inferior goods,” such as brown bread or dried cassava; (f) special outlets; and (g) food stamp programs, as in Mexico and Sri Lanka.

(2) Credit schemes and loans for small businesses, as in Bangladesh, Ghana, Guinea, India, Indonesia, Mauritania, and Senegal.

(3) Public works (often combined with food aid), such as the Bangladesh food for work programs and similar programs in Bolivia, Chile, and Ghana.

(4) Retraining, as has been carried out in Bangladesh, Ghana, Madagascar, and Mexico.

All such schemes have their disadvantages but public discussion of choices might help focus political attention on programs that actually help the poor rather than rhetoric that often substitutes for action in debates on the VAT.

The question of VAT regressivity and inequity is not simple. It deserves a more thoughtful treatment than simplistic use of exemptions and zero rating. Basically, instead of trying to amend and distort the VAT, its strengths should be used to generate revenue that will enable the government to help the poor in more effective ways. This is probably a more positive way to tackle the issue of regressivity than throwing out the VAT or manipulating the new tax until its merits are eroded.

Is VAT Inflationary?

The second political preoccupation is likely to be with the possible inflationary consequences of introducing the VAT. Why should a VAT be inflationary? If it replaces an existing, equal-yield tax, there may be changes in relative prices, but no overall price increase. Indeed, even if the VAT generates a net rise in revenue, a tax increase should be deflationary rather than inflationary. It is only if other actions are taken—for example, through indexation and increased money supply-that a general price increase could occur. In other words, it is not the VAT itself that can be inflationary but other accompanying policies that might make it so.

The timing of the introduction can influence the price effects. In Portugal, for instance, the impact of the VAT on prices was minimal partly because it coincided with a period of disinflation. In addition, care had been taken to inform businesses of the extent to which the new tax should be reflected in prices. Much the same was true in Taiwan Province of China where, in addition, the authorities took action to sell bonds, mop up liquidity, and reduce the money supply.

A typical once-and-for-all price adjustment for Denmark is shown in Chart 1 and for Japan in Chart 2.

Chart 1.Denmark: Price Effects of VAT Introduction, First Quarter 1966–First Quarter 19691

Source: International Monetary Fund, International Financial Statistics.

1 VAT introduced July 1989.

Chart 2.Japan: Price Effects of VAT Introduction, January 1988–March I9901

Source: International Monetary Fund, International Financial Statistics.

1 VAT introduced April 1989.

A survey2 of the price effects of introducing VAT in 35 countries suggested the following:

(1) In 22 cases, no major impact on the consumer price index (CPI) could be identified. That is, in 63 percent of the countries the introduction of the VAT can be said to have had little or no effect on the CPI.

(2) In a further 8 cases (23 percent of the total), the introduction of the VAT is associated with a highly defined once-and-for-all shift in the CPI, but in only 1 of these cases could this be said to contribute to an acceleration in the rate of increase of the CPI. In the other 7 cases, although the shift was permanent there was no acceleration of the rate of change in prices attributable to the VAT.

(3) Therefore, in 29 cases (22 and 7)—83 percent—the introduction of the VAT did not alter the rate of price change.

(4) In 6 countries, the VAT could have contributed to an acceleration in the rate of inflation, although this was associated in each case with expansionary wage and credit policies.

(5) Clearly, it is possible to introduce a VAT (sometimes even to increase the yield) and not to shift, or to increase the rate of change of, the CPI. There is no necessary corollary between introducing a VAT and increasing inflation; if anything, the assumption should be that an equal-yield VAT substitution will have little or no effect on the rate of change of the CPI and that even if an increased yield is desired and the CPI is shifted it will not necessarily have a continuing effect on the rate of inflation.

(6) Price controls can be used effectively to dampen the potential price-wage acceleration of inflation after the introduction of VAT, as the examples of Austria, France, Korea, the Netherlands, and Norway show.

(7) Of the 6 examples of rate changes in existing VAT systems, only 1 was associated with an acceleration of inflation and 1 with a shift in the CPI. In the other 4 cases, the rate changes had little or no effect on prices.

(8) Perhaps the most important conclusion of the survey is that there seems to be nothing inherently inflationary about the use of the VAT. In 33 out of 41 cases reviewed—over 80 percent—(the “shift” cases and the “little or no effect” cases), the VAT was not a contributory factor to inflation. Government policies to inform the public and traders about the expected effect of the VAT on prices, the use of price controls, offsetting adjustments in other taxes, the correct timing of the tax changeover, and generous provisions to ensure full credit for previously paid taxes on business assets and inventories are a few of the more important government decisions that help to contain any potential inflationary effect the introduction of the VAT may have.

It should be noted that these commitments by governments must be taken seriously. If they are not, then the introduction of VAT can become the trigger for inflation. To cite one commentator,

  • A lot of people both in and outside Australia are going to need to be convinced that the inflationary burst caused by a GST [i.e., a VAT] is going to be a once and for all shift in the price level and not the start of a new much higher rate of inflation.
  • That is very tricky—inflation expectations here [in Australia] are high and remain high despite stringent monetary policy. Throw in a year in which inflation goes from current levels around 8 [percent] or prospective levels of 6 percent to the low 20’s [because of introducing a VAT] and you will create in the mind of the public an expectation of savings erosion which will have a fairly long-standing impact on their behaviour.3

Does VAT Help Exports?

As VAT is fully rebated on exports, but some other sales taxes and direct taxes are not, it is often suggested that substituting VAT for such taxes could improve the balance of payments on current account. The substitution for sales taxes is discussed first and then the case of direct taxes.

A VAT Substituted for Other Sales Taxes

Retail sales taxes and most wholesale and manufacturing single-stage taxes do not apply to exports except insofar as cascading increases export prices (e.g., Canada); therefore, their substitution by a VAT would not alter the tax position of exports. A minor point for most countries, but important in some is that a VAT can be rebated on purchases by tourists, but most other sales taxes cannot; using a VAT might be expected to encourage tourism compared to, say, a wholesale or a retail sales tax.

Where the existing sales tax is cascaded, the tax content of any good depends on the number of cumulative tax liabilities. In this way, the tax content can be different for identical goods or the same for different goods. The point is that the sales tax content cannot be determined exactly. This led to the various tax rebates on exports that characterized, for instance, the Italian system before VAT, and that could be considered as subsidies if they more than compensated for the tax content or, less frequently, as a tax on exports if they did not fully compensate. The substitution of the VAT replaces an uncertain tax content by a transparent and known tax liability. Depending on the previous sales tax, tax rebate, and subsidy regimes, exports could improve or worsen under the VAT. Equally, imports that are liable to the same VAT as domestic goods, could be less favorably treated (if previously the cascade had discriminated against domestic goods).

The exact determination of the relative impact on the trade balance derived from introducing VAT needs an estimate of the existing tax content by products or principal trade sectors and usually this can be obtained (for cascaded sales taxes or direct taxes) only where an input-output table exists. In addition to the usual disadvantages of using input-output tables (infrequent updatings, inconvenient sectoral breakdown), tax incidence faces the additional difficulty that a transformation has to be made from the input-output sectors to the trade categories used for normal statistical and tax purposes or to typical household consumption categories. This usually demands some heroic assumptions. When this transformation is made and potential price changes are assigned to goods (and services), the foreign trade assessment needs to use elasticities of supply for exports and elasticities of demand for imports. Of course, even more heroic assumptions are needed if a general equilibrium analysis is to be used.

The magnitude of the trade benefit from the changeover to VAT depends on (1) the positive response of producers to the shift in the ratio of producer prices (inclusive of any previous export rebates or subsidies and the VAT rebate) of exports to producer prices of domestic sales; (2) the response of consumers of the exports to the price change; and (3) the negative response of domestic consumers to market prices of imports relative to market prices of domestically produced goods. The outcome of all this depends on each country’s individual circumstances and may vary considerably in one sector compared with another, but overall the net change is unlikely to be large.

A truly general VAT on all consumption might, in the short run, help exports but quite quickly we would expect exchange rates and domestic prices to adjust “to offset the effect of the tax on the relative prices of domestic and foreign goods. When prices or exchange rates have adjusted, a general value added tax will have no effect on imports and exports.”4

However, many VATs exempt and zero rate important sectors of the economy, especially food, housing, and many personal services. Therefore, this type of VAT raises the price of tradables relative to nontradables and encourages the substitution of food, housing, and services for tradable goods. This implies that both imports and exports would be reduced. “The most likely effect of the introduction of a VAT would thus be a decline of exports.”5

A VAT Substituted for Direct Taxes

It can be argued that since VAT is rebated on exports and corporate income taxes are not, replacing the profits tax by the VAT must help exporters. This depends on at least six assumptions.

The first is that corporate income taxes are reflected in higher export prices that are reduced if the profits tax is reduced. This is not necessarily so; some evidence suggests a “myopic” attitude to taxes by businesses; when taxes rise they are passed on, when they fall they are not. Second, even if corporate taxes are passed on they may not be passed on to export prices; cross-subsidization may occur.

Third, it is the position of the country relative to others that matters. If all countries acted in a similar fashion by substituting VAT for direct taxes in the same way, there is no net advantage to anyone.

Fourth, the elasticities of supply and demand have to be such as to yield a worthwhile advantage. Fifth, unless exchange rates were fixed, an expansion of exports and containment of imports might be expected to cause a currency appreciation.

Finally, and possibly most important, if there is a budget constraint then the government revenue foregone, substituting VAT for nonrebated direct taxes, must be replaced by raising other taxes. Such increases will reduce, one way or another, real household income and are likely to spark claims for wage increases that, eventually, will increase manufacturing costs and erode the competitive advantage gained for exports through the original tax substitution. The advantage of the VAT substituted for the direct taxes would be temporary depending on the speed with which other taxes fed through into final prices, the lags in response in the labor market, and the extent to which traders passed forward the increased domestic costs in export prices. However, as the advantage from the tax substitution was predicated on full forward shifting, it would be capricious to assume anything different for the general equilibrium outcome.

It should be mentioned that, quite apart from these assumptions about shifting, there are two other possible positive influences. First, the substitution of the VAT for profits tax could unleash hitherto contained productivity in industry that could improve the balance of payments. Second, there is the response of savers as the cost of savings falls relative to the cost of consumption. The substitution of a VAT for income taxes would reduce the “excess cost of capital inputs relative to labor inputs resulting from the income tax. With border tax adjustments, the cost of both labor and capital inputs used in production for exports would fall compared with their cost under the income tax and compared with their cost when used in production of goods for domestic markets.”6 Thus the profitability of a given volume of exports should increase and improve the balance of trade.

When all this is taken into account it is usual to estimate the immediate short-run effects of the foreign trade balance while emphasizing the temporary nature of any such gain. Moreover, one suspects that the larger the short-run gain (and some have been estimated as quite large), the more brief the short-term advantage.

Company Liquidity

VAT does affect international trade adversely in one way. As importers are liable for the VAT on imports to be used to manufacture exports, the government can end up with a once-and-for-all, interest-free loan for the length of time it takes to produce the export. However, most countries get around this by some system of suspension of tax payment through a postponed accounting system.


Overall, the VAT is not thought to have contributed significantly to improved export performance in the European Community (EC); the VAT makes the customs union possible but is not the agent that creates international trade. However, in some other countries (e.g., the Philippines, where zero rating of exports is reckoned to have improved the profitability of exporters and where export earnings increased by 20 percent in the first year of the VAT), the rebated VAT may have increased profits from exports compared to the previous tax regime and is thought to have, at least, encouraged exporting (e.g., Korea).

Treatment of Food

Although many EC countries tax food under the VAT, most other countries exempt food, especially cheaper foods likely to be important in low-income household budgets. Evidence indicates that zero rating such foods is an effective way of making the VAT proportional or even mildly progressive. However, such exemptions or zero rating create problems of definition. Many countries wish to exempt “essential foods” but whatever definition is adopted to isolate foods that are “essential” is bound to be controversial and the definition will be contested.

Some countries have tried to simplify their approach by exempting “unprocessed foods.” In fact, remarkably few foods are wholly unprocessed. Even rice is usually polished; wheat is turned into flour; and meat is butchered and frequently semiprocessed. The producers of canned, dried, packaged, and frozen foods will lobby that they are essential (and more hygienic and, hence, to be encouraged). Authorities try to establish lists of exempt products but demarcation between, for instance, bread, buns, pastries, biscuits, and confectionery creates opportunities for endless debate, confusion, and deliberate misclassification and evasion.7

Some countries (e.g., Morocco) have tried to exempt foods that are important inputs into the food industry, such as sugar, salt, and flour. As manufacturers of the products already pay VAT on their inputs, the actual final rate of VAT is more or less unknown and, in the particular case of Morocco, very odd as sugar was already liable to a separate excise and was subsidized. In many countries agriculture depends on so few inputs and output is sold (if sold at all) directly to local markets that any taxation is impractical. Straightforward exemption is probably best.

Of course, even if farmers are outside the VAT they will still have paid tax on their inputs of seeds, fertilizers, insecticides, etc., and this may, as in Latin America, lead to a demand for a further erosion of the VAT base by zero rating those industries.

If essential food is to be exempted then the way to make the best of a bad job is to create a limited list of products. Although no recommendation is perfect, probably one of the best is to exempt only unprocessed food and to define that in as restrictive a way as possible, to make tax free those foods consumed by the poorest households.

Treatment of Capital Goods

In what might be called the “pure” VAT, the tax paid on all capital purchases should be allowed as a credit at once and, if a net repayment is established, the tax should be refunded immediately. This ensures that the tax is on consumption and should encourage investment. Some countries, however, before introducing the VAT got a substantial amount of revenue from taxing capital goods, and removing all tax liability on capital purchases can be too draconian a change. Spain, for instance, requires that the VAT paid on movable fixed assets (e.g., plant and equipment) is written off over four years and on immovables over nine years. South Africa had a lengthy debate before it was agreed that capital goods should be freed of tax.

In Hungary the authorities felt they could not make an immediate transition to the full expensing of capital and opted to allow only a 20 percent credit in the initial year, increased each year there-after until by 1992 all the VAT on capital goods is reimbursed.8 In Argentina credits from the purchase of fixed assets used to be spread over three years and claimed once a year (and not deducted from the monthly payments). However, this has now been repealed.

Brazil has a complex position on the treatment of capital, which ends up distorting investment decisions. The state VAT, ICM, allows no deduction for tax paid on capital goods. The federal VAT, IPI, although allowing credit for capital goods, keeps large categories exempt from the VAT (agricultural inputs, transport, and other services), including many specific industrial exemptions granted over a number of years. Such exemptions create an uncertain tax content and are further skewed by separate taxes on the exempted activities (e.g., transport).

Basically, a great advantage of the VAT is that it does not discriminate against investment and it is a mistake to erode this desirable aspect of the tax. Therefore, if at all possible, the VAT should be used to ensure that capital expenditure is free of tax.

Treatment of Financial Services

A minister of finance once put the issue clearly, “I feel uneasy proposing a VAT on all goods and services, including food, but exempting banks and insurance companies. Why should the poor pay VAT on food and the rich not pay VAT on their use of financial institutions?” A good question. Yet, we know that all European VATs exempt financial services. They do so, first, because it is extremely difficult to identify on conventional invoice credit lines, the value added on each service provided by financial institutions. The value of services supplied by financial services is a spread that may be only a few base points in the total charge to a consumer. There is not necessarily a market price for these services that can be used for VAT. “If the nominal interest rate was taxed, you would be taxing capital in the inflation compensation component and the return on saving in the real component (thereby converting the tax from a consumption tax to a partial indirect income tax).”9

Second, the VAT actually payable on financial services would only be on the “retail” sale to households. All use of financial services by businesses, which is by far the greater part, would be deductible as a credit. Therefore, extending the VAT to include financial services does not, actually, greatly increase the tax base. It improves equity but does not necessarily yield large amounts of extra revenue. This is particularly so when it is appreciated that even when financial institutions are exempt from VAT they continue to pay tax on all their inputs (buildings, computers, office equipment, stationery) and this tax is not creditable. If these institutions were pulled fully into the system, they would be able to claim these credits and as they did so the net yield from the VAT on that sector’s final sales would fall. Also, there are political implications of increasing the cost of borrowing to the private sector that may need delicate handling. Finally, both capital and financial services are internationally extremely mobile. Significant taxation, even of retail financial services, can persuade residents to move their transactions offshore and this creates more problems for monitoring and policing. It can well be imagined that this could be the most important argument against levying VAT on financial services in many countries.

The Israeli authorities experimented with a VAT on financial institutions. Ingeniously, they sidestepped the problem of computing value added through sales by levying the tax instead on the additive principle. A proportional tax, at the VAT rate, was levied on wages and profits of financial institutions; this was administered through the income tax system (the normal Israeli VAT is administered by Customs and Excise). Demands that other traders should be allowed to credit the implicit VAT in their purchases of financial services (interest payments, insurance premiums, etc.) led the authorities to “abolish” the VAT on financial services and recreate it, phoenix-like, immediately, as a separate income tax on wages and profits; that is, identical but not a VAT and hence not creditable.

The White Paper on the proposed VAT in Canada suggested applying the tax to the domestic financial margins. For a bank or other lender, the taxable sale is represented by interest income against which a deduction for interest expense should be allowed. For insurers, a further twist is needed as premiums and interest income are taxable sales against which policyholder benefits should be allowed. There has been substantial debate on these proposals but the 1989 budget statement introducing the VAT stated “Given the magnitude of the remaining difficulties and the plain fact that no country in the world has successfully applied sales tax to financial intermediation services, the Government does not intend to apply tax under the GST to these services.”10

New Zealand decided to tax financial services on the basis of what is done rather than who does it and levies a VAT limited to fire and general insurance. Notional drawback is allowed and rules have been worked out to separate performance and advisory activities, that is, whether the financial institution is working as a principal or an agent. However, for most countries, this artificial distinction hardly seems worth the bother.

In the EC, insurance premiums are often subject to a separate tax: for example, the tax is 5 percent in Germany; 3, 8, or 18 percent in Greece depending on the kind of insurance; 1-5 percent in Italy; and 2.4-30.0 percent in France. In Taiwan Province of China financial institutions are charged 5 percent of gross receipts with no credit for VAT on inputs.

The attraction of taxing financial services under a VAT remains. One way might be to levy a “financial services tax” separate from the VAT but on the value added of the agencies, that is, on profits and wages. This tax would be seen as a direct tax and would not involve any creation of input VAT credits for businesses “purchasing” financial services. To avoid large distortions through cascading, the rate would probably have to be substantially lower than the standard rate of VAT; for example, if the usual VAT rate was 10 percent, the financial services tax might be 4 percent. Although this could not be part of the VAT, it could be seen as a rough and ready way of redressing the inequity mentioned at the beginning of this section.

Treatment of Small Traders

Probably the most crucial question for simplifying the administration of the VAT—apart from the number of rates—is the choice of threshold for liability to the tax. The differences in practice are huge. In Denmark complete exemption is granted only to those with an annual turnover below approximately US$1,500, whereas, as Table 2 indicates, Japan has adopted a figure of over US$200,000. Moreover, as Japan really only applies the VAT proper to traders with a turnover above US$3.5 million (those below use a simplified scheme based on turnover), only the largest traders are fully part of the tax. An advantage of a higher threshold is that it automatically cuts out many difficult-to-tax groups, such as farmers. Those farmers who are large enough to be above a (generous) threshold will also be running the farm more as a business with books of account, etc. Of course, many large farms are like businesses in any case (chicken, fish, shellfish, turkey, market garden).

Table 2.Treatment of Small Firms Under VAT, 1990
Complete ExemptionSimplified SchemesForfait
Hungary(I) Ft I million (US$15,900) (retailers); and (2) Ft 250,000 (US$3,975) (others).
IndonesiaRp 60 million (US$33,408).
Japan¥30 million (US$210,000).¥ 30-60 million (US$210,000-220,000). ¥500 million (US$3,500,000) or less, rate is 0.6 percent of sales, except for wholesalers the rate is 0.3 percent. Also, if interim tax liability is under ¥300,000, tax payment can be delayed until year-end.
KoreaW 24 million (US$35,346). W 6 million (US$8,834) (agents, contractors, proxies).2 percent of turnover tax (and allowed to deduct 5 percent of reported input tax).
Mexico(I) Income must not exceed 32 times the minimum wage; (2) no more than three employees; and (3) business space no more than 50 square meters.Applied on a presumptive basis if (I) to (3) are met.
NigerTurnover below: CFAF 30 million (US$88,950) (goods); and CFAF 10 million (US$29,650) (services).
Philippinesp200,000 (US$9,250).2 percent turnover tax.
Portugal(I) Esc 7.5 million (US$27,300) (retailers); (2) Esc 800,000 (US$4,850) (entrepreneurs); and (3) Esc 500,000 (US$3,030) (professionals).Small retailers pay quarterly 25 percent of tax on purchases.
SpainIndividual retailers not required to register.Withholding "markup" VAT applied by suppliers to retailers.
Taiwan Province of ChinaNT$2.4 million (US$91,954).I percent of turnover tax (and allowed to deduct 10 percent of reported input tax).
Trinidad and TobagoTT$75,000 (US$17,650).
European CommunityECU 150,000-300,000 (US$144,000-287,000) (suggested).
Source: Various reports.
Source: Various reports.

Tables 3 and 4 give some idea of the potential scale of such economies. As the number of registered traders is reduced, moving from no threshold to one of US$50,000, the number of registered traders is cut to a quarter of the previous number. If the threshold is lifted to over US$1 million, the number of traders drops to one fortieth of the total. The Japanese threshold of US$3.5 million suggests that relatively few traders will have to pay the VAT calculated on the full accounts basis. This, in turn, implies large economies in staffing. For instance, in Korea, “special” (small) taxpayers file about 76 percent of all VAT returns yet account for only 5-6 percent of revenue.

Table 3.Accounts-Based VAT: Estimates of Changes in Taxpayer Numbers and Returns Processed as Exemption Limit Changes
Gross Receipts Over US$ (Exemption Limit)Number of Taxpayers (Thousands)Returns (Millions)Processing costs (US$ millions)Returns (Millions)Processing costs (US$ millions)
Source: Various estimates.
Source: Various estimates.
Table 4.Accounts-Based and Invoice-Based VAT: Estimates of Number of Staff Needed According to Frequency of Returns and Exemption Limits1
Gross Receipts Over US$ (Exemption Limit)Accounts-Based VATTotal Staff for European Invoice-Based VAT
Processing and Accounting
Source: Various estimates.

Figures in parentheses are approximate equivalents for a U.S. invoice-based VAT.

Source: Various estimates.

Figures in parentheses are approximate equivalents for a U.S. invoice-based VAT.

Table 4 indicates the sharp fall in staff needed as the threshold is lifted. Note the much larger number of staff needed for an invoice-based VAT and how, as the exemption threshold rises, the staff needed for either the accounts-based or invoice-based VAT start to equal each other. This is because the number of field audits for an invoice/credit method VAT is much higher than one where the audit for VAT takes place at the same time as the income tax; but since the number of traders to be visited drops sharply as the exemption limit increases, the staff needed for audit starts to be similar under both accounts-based and invoice-based VATs.

A high threshold does create some problems. Small businesses whose value added is untaxed are given an advantage. Traders are, therefore, tempted to misrepresent sales to remain below the threshold. Indeed, there is an incentive to split businesses to keep each below the threshold when the single entity would have been taxable. Against these arguments it is also found that small traders will volunteer for the VAT if they are supplying to larger VAT-registered traders who want the VAT shown on their purchase invoice so that they can claim the credit.

There may be a case for distinguishing between service traders (smaller and, hence, lower thresholds) from others when setting tax thresholds, but many businesses both provide service and sell goods and introducing such a distinction is yet another administrative burden.

Some countries levy a separate fee or gross turnover tax on small traders; such taxes may encourage smaller traders to opt into the VAT under which they can claim credit for VAT paid on inputs. Overall, it is sensible to adopt a higher rather than a lower tax threshold. The administrative resources needed to monitor numerous small taxpayers can be put to much more effective use concentrating on medium-sized and larger traders. Also, resistance to a new VAT is likely to be lower if many small businesses are omitted; for example, in Korea, much of the initial opposition to the VAT, that spilled over into the first few years of the tax, came from small traders.


All the issues discussed above affect the ultimate administration of the VAT. Whether all retail sales are included, should services be taxed, how many rates are to be used, the treatment of capital goods, financial services, food, small traders, all will affect administration. The rest of this publication turns to the administrative details of introducing and running a VAT.


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It was described as the “deeply-unloved sales tax” in the Japanese press.


See Tait (1988), Chapter 10, and Gillis, Shoup, and Sicat (1990), Chapter 2.


Dickson (1990), pp. 28-29.


Krugman and Feldstein (1989), abstract, p. iii.


Krugman and Feldstein (1989), abstract, p. iii.


As an example of the complexity involved in a simple definition consider one example for bread. “Bread means food for human consumption manufactured by baking dough composed exclusively of a mixture of cereal flour and any one or more of the following ingredients in quantities not exceeding the limitation, if any, specified for each ingredient: (a) yeast, or any leavening or aerating agent, salt, malt, extract, milk, water, gluten; (b) fat, sugar and bread improver not exceeding for each ingredient 2 percent of the weight of the flour included in the dough; and (c) dried fruit, subject to its not exceeding 10 percent of the flour in the dough.”


This was also used as a way to favor certain areas and investments; 100 percent credit is given for investment in “disadvantaged areas” and investment in “environmental protection.” It is not recommended that the VAT should be used for such regional policies; as emphasized earlier, the VAT should be kept simple, broad-based, and unbiased; if regional subsidies are needed, they should be given directly (and debated by parliament) and not hidden in the VAT legislation.

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