Rethinking VAT incentives: Zero-rating or exemptions?

On June 14, 2022, the Minister for Finance and Planning, Dr Mwigulu Nchemba, tabled the 2022/23 Budget. Whilst the minister proposed numerous commendable tax reforms, these two proposals captured my attention; zero rating of VAT on double refined edible oil manufactured locally and zero rating of VAT on ex-factory sales of fertiliser manufactured locally.

The minister was categorical that these proposals are short-term, one-year, fiscal measures to curb price hikes of critical products and to provide relief to consumers.

The government has had a tendency of incentivising businesses through VAT exemptions as opposed to zero rating of domestic supplies. Zero-rating has generally been a practice for export supplies only. In fact, there has been various VAT exemptions in each fiscal year and some of them were government’s response to lobbying for zero-rating. For example, during this year’s consultative sessions for fiscal reforms there was a proposal by forestry stakeholders to zero-rate VAT on standing trees. However, the minister’s Budget Speech seems to have responded to this by resorting to the VAT exemption option as opposed to zero-rating of standing trees.

On the other hand, the minister has proposed to abolish the VAT exemption that was introduced in the fiscal year 2021/22 on smart phones, tablets and modems on the basis that the VAT exemptions did not lead to reduction of prices to end consumers. Making a U-turn from the VAT exemptions on smart phones, tablets, and modems within a year of being introduced, might be an indicator of the ineffectiveness of VAT exemptions as an incentive to reduce prices of goods/services. I would be interested in the evidence base. Therefore, the above proposals to zero-rate local supplies for one year would imply that the government is exploring new options to attain the desired effects.

Clearly, there are strong technical grounds to argue that VAT exemptions cannot be a feasible option if at all the key trigger for the policy change is to reduce the price of the specific products/services. This is because if a supply is “exempted from VAT,” the suppliers cannot claim relief for the input VAT they paid to produce that supply. In other words, one can claim a deduction of input tax paid on purchases only if such input VAT is attributable to taxable supplies - definitely, not input VAT attributable to exempt supplies. Therefore, the taxable business that makes exempt supplies, is left with no option other than to absorb the non-recoverable input VAT.

Absorbing the irrecoverable input VAT increases the cost of sales and subsequently reduces income tax payable. VAT being a consumption tax, there is also another potential likelihood of passing the VAT costs to the final consumer in the supply chain. In other words, the supplier can take a business decision to pass the irrecoverable VAT costs to the market by factoring them in the retail price such that the tax burden is ultimately borne by the consumer. Since this is a more practical and sustainable business approach, it leaves the consumer price unchanged despite the VAT exemption incentive.

You would then agree with me that zero-rating is an option if the real motive is to reduce prices. Zero-rating of supplies enables the supplier to claim relief for the input VAT incurred on purchases and therefore no additional costs are passed to the consumer. This results in lower prices for consumers of goods/services unless the laws of supply and demand undermine the spirit of the regulation which would then call for other legal actions.

However, zero-rating of domestic supplies may result in unintended consequence of the administrative burden of VAT refunds, particularly because the output VAT would be NIL but there will be credits for the input VAT. I believe this explains why zero-rating of domestic supplies is generally not preferred. This could also be the reason as to why the minister’s proposal of zero-rating supplies of locally manufactured ex-factory sales of fertilizers and double refined edible oil is limited to just one year.

Besides the impact, I believe it is time to rethink VAT incentives on basic supplies including wheat, Ultra High Temperature (UHT) milk and yoghurt, as well as other products such as pasture grass seeds, which have all been exempted according to the minister’s Budget Speech. The zero rating could be temporary to gauge the desired effect of price reduction. In my opinion, zero-rating of such items would echo better the main theme for the 2022/23 budget i.e., “Accelerating Economic Recovery and Enhancing Productive Sectors for Improved Livelihoods”.

The views expressed here are the author’s and do not necessarily represent the views and opinions of KPMG.