Thursday, May 17, 2018

MANAGING TAX RISKS: Are VAT exemptions a necessary evil?

Shabu Maurus ,

Shabu Maurus ,  

By Shabu Maurus

Last week we discussed some of the reasons the VAT exemptions seems to be necessary. Countries with good VAT performance tends to have fewer VAT exemptions. Despite the possible positives of VAT exemptions, there are also a number of negatives. I use the production chain of a bread to illustrate some of the possible drawbacks. For simplicity, the chain has only three stages. The farmer sells wheat to a miller. Then the miller makes flour and sells to a baker. Then, lastly, the baker makes bread and sells it to a final consumer.

Inefficient subsidy mechanisms

One reason some commodities are made exempt is to reduce their prices to the final consumer to achieve social or distributional objectives. The impact of VAT exemptions on prices will be shaped by a number of economic aspects such as price elasticities of demand and supply, competitive conditions, the length of the production-distribution chain, production efficiencies and the stage at which exemptions are offered. Therefore, it is very difficult to predict the impact of exemptions on prices and identify the actual beneficiaries especially if there are no price-caps set by the state. In our example, exempting wheat and flour may end up increasing the margins of the miller and the baker rather than the price of bread.

Tax base erosion

This is perhaps the most obvious immediate implication of VAT exemptions. If in our bread example, the three main products (wheat, flour, and bread) are all made VAT exempt then no VAT will be collected from the chain.

Cascading effect

VAT is by design a consumption tax. VAT is a tax burden to the final consumer and not the VAT-registered business. In our bread example, if the farmer is unable to recover the VAT it pays on inputs explicitly from the miller (its customer) because wheat is exempt, then it will tend to recover such VAT implicitly. The farmer will indirectly recover VAT cost from the miller. Now, the miller (though not a final consumer) will not be able to recover that hidden VAT. This is the cascading effect.

Vertical integration

VAT exemptions may also be distortive by favoring vertical integration (or self-supply) as opposed to outsourcing. In our bread example, if the wheat and flour are both exempt but the bread is taxable, then the baker will be more inclined to also farm and mill. That is self-supply the flour. By integrating vertically, the baker is able to reduce the impact of cascading on its profitability.

Local Competitiveness

The cascading effect tends to make local manufacturers of exempt products less competitive in the domestic market. If, for example, flour is exempt but wheat is taxable, the price of flour from the local miller is likely to have hidden cost of VAT (from wheat). In the absence of tariff barriers, the imported flour would be cheaper than the local flour. The local baker would be inclined to import the flour. The local miller’s natural reflex would seek VAT exemption on its major input. The wheat.

Exemption creep

Once A is exempt, B will also seek an exemption. If wheat and flour are exempt, it also “makes sense” to exempt the bread. And the pollical cost of removing some of the exemptions may be too high. Once it is accepted that VAT exemptions amount to tax expenditures (government expenditure), then the exemptions should be subject to the same cost‐benefit analysis as other direct government expenditure programs. What are the real policy objectives of the VAT exemptions? Are there alternative spending or subsidy programs that might achieve the intended economic, social or distributional goals more efficiently?

Mr. Maurus is a Partner with Auditax International