Global Trends and Issues in Value Added Taxation

International Tax and Public Finance, 5, 399–428 (1998)c© 1998 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.

Global Trends and Issues in Value Added Taxation

SIJBREN CNOSSENEconomics Faculty, Erasmus University, P.O. Box 1738, 3000 DR Rotterdam, The Netherlands

Abstract

Since the late 1960s, the VAT has become one of the mainstays of the tax systems in over one hundred countries.Apparently, its revenue raising and neutrality properties make it an attractive tax in a rapidly integrating, high-taxworld. Following an overview of VATs throughout the world, this article examines various VAT structure andpolicy issues under the following headings: tax coverage features, tax base aspects, hard-to-tax sectors, ratestructure issues, and interjurisdictional coordination problems. It is shown that the normative requirements of a‘good’ VAT are often met only in the breach.

JEL Classification: H25, H71, H77

Keywords: value-added tax, consumption tax, survey of VATs, tax neutrality, tax burden distribution, destinationprinciple, tax harmonization

1. Introduction

The nearly universal introduction of the value-added tax (VAT) should be considered themost important event in the evolution of tax structure in the last half of the 20th century.Since the late 1960s, the VAT has become the main consumption tax in 105 industrial anddeveloping countries. Although the specific reasons for adopting the VAT differ from onecountry to another, the main argument has been that a properly designed VAT raises morerevenue with lower administrative and economic costs than other broadly based consumptiontaxes. A VAT, with few exemptions, can generate revenues of on average some 0.4 percent ofgross domestic product (GDP) for every one percentage point of the rate. A well-designedand administered VAT does so in a highly neutral fashion. Unlike the income taxes, itdoes not influence the forms or methods of doing business. The tax bill is the same fora product made in the corporate or noncorporate sector, with capital-intensive or labor-intensive technology, or for one made by integrated or specialized firms. The VAT alsoensures neutrality in international trade by freeing exports of tax and by treating imports ona par with domestically produced goods (destination principle).1 Clearly, these tax attributesare important in an interdependent, competitive world.

This article surveys and evaluates global trends and issues in value added taxation. Section2 reviews the introduction of the VAT throughout the world on the basis of the informationprovided in the Appendix, which identifies each VAT by reference to its coverage, basecharacteristics, rate structure, and contribution to revenue. The nature of the excise system,and hence its interaction with the VAT, is also indicated. Subsequently, sections 3 through7 examine important VAT structure and policy issues. It is widely agreed that a good’ VATextends through the retail stage, is as broadly based as possible, permits registered firms a

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full and immediate deduction (tax credit) of the VAT on inputs (including capital goods)from the VAT on output, limits the extent of rate differentiation, and is imposed on thedestination principle. However, as concluded in section 8, these normative requirementsare often met only in the breach. Continuing review and reform seem desirable.

2. Survey of VATs Throughout the World

Pioneered in France, the VAT was first embraced by the original member states (France,Germany, Italy, and the Benelux countries) of the European Union (EU) which, subse-quently, made it a condition for membership.2 The Brazilian States and Uruguay were alsoearly converts to the VAT. In the 1970s and 1980s, the VAT was adopted by most other SouthAmerican countries, as well as various Central American, Caribbean and Asian countries.This was followed, in the 1990s, by a wave of new VATs in Central and Eastern Europeancountries, as well as the newly independent states—formerly part of the Soviet Union—thatadopted market-oriented economic policies and attendant forms of taxation.3

As shown in the Appendix, most countries extend the coverage of their VATs throughthe retail stage (R), but ten countries stop at the manufacturers (M) or wholesale (W) stagewhich, as discussed below, causes economic distortions and administrative complications.Furthermore, as the table indicates, most countries tax services comprehensively along withgoods (G+S). In fact, the VAT is the first consumption tax that has successfully integratedthe taxation of services with the taxation of goods. Nonetheless, eighteen countries taxservices selectively (ST), thus favoring services that are not taxed. Seven countries, more-over, do not permit a full and immediate deduction for the VAT on capital goods (CG),thereby discriminating against capital-intensive production processes. In considering thesetax coverage and tax base aspects, it should be noted that administrative shortcomingsmay constrain the effective reach and workings of a well-designed VAT. Consequently, inpractice, various VATs may not be as broadly based and neutral as implied by the overview.

VATs can be levied at fairly high rates. As indicated in the Appendix, many standardrates lie in the range of fifteen percent to twenty-five percent. Eighteen countries havea single, uniform rate; all other countries impose one or more reduced rates on items ofconsumption, mainly food products, that are disproportionately consumed by the poor.Some 50, mainly developing, countries simply exempt (X) basic foodstuffs from the VAT.This eases administrative problems, but leaves an indeterminate amount of VAT paid ontaxable inputs in output prices. This effect can be eliminated by zero rating foodstuffs(done in eleven countries) which, however, requires registration and refund of prior-stagetax. Interestingly, only nine countries levy higher-than-standard rates on luxury products.

To the extent figures are available, the Appendix indicates that most VATs make a ma-jor contribution to total tax revenue (defined to include social security contributions). Inindustrial countries, represented by the Organisation for Economic Cooperation and De-velopment (1997), VAT revenues generally range from 15 percent to 20 percent of total taxrevenues or 5 percent to 8 percent of GDP. In developing countries, the VAT ratio generallyis lower, but the share of VATs in total tax revenues is often larger. This indicates a higherpreference for the VAT over other taxes—presumably on feasibility grounds.

The effects of the VAT should be evaluated in conjunction with the excise system.4 The

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interaction should be limited if the coverage of the excise system is confined to taxes onsmoking, drinking and driving—levied either on externality grounds (tobacco, alcohol, CO2

emissions) or to charge for benefits received (road user charges). Sixty six countries havesuch a limited excise system. Although, as noted, few countries impose higher VAT rates onincome-elastic items of consumption, some progressivity in tax burden distribution can alsobe achieved by imposing excises on luxury products under what are here called intermediateexcise systems (which are found in 34 countries). Furthermore, the neutrality advantagesof the VAT may be undone through the taxation of producers goods under extended excisesystems, found in five countries.

Approximately 80 countries have not (yet) adopted the VAT. Half of these countries aresmall island economies in Oceania and the Carribbean. These countries are better off withselected excises, gross receipts taxes, license type levies, and revenues from tourism andtax haven concessions. The VAT is also not found in most Middle Eastern countries, whichcan rely on oil revenues to finance their public expenditures. Beyond that, a large numberof African countries still work with old French type of production taxes (under whichdomestically produced raw materials and intermediate goods are exempted) or old Britishsuspension-type of manufacturers sales taxes (under which registered traders are permittedto purchase their goods tax-free from other registered traders).

The most notable country without a VAT is the United States, where the pros and cons ofthe VAT and other types of consumption taxes have been the subject on an ongoing debatesince the early 1980s.5 Opponents fear that the VAT would become a money machine forthe Federal Government and that it would encroach upon the base of the retail sales tax,which is levied by almost all the states. Another noteworthy example is India, whoseconstitution assigns the levy of general consumption taxes to the states.6 Most states levysuspension-types of manufacturers and retail sales taxes. Maharashstra is the only statethat has introduced a full-fledged VAT. Australia, another federal country, still clings to itsantiquated wholesale sales tax, which was introduced in 1930.7

3. Tax Coverage Features

There is general agreement that a ‘good’ VAT should make all entities liable to tax thatproduce goods and services which are used by or benefit other entities or individuals. Inother words, manufacturers, wholesalers and retailers should all be registered, subject to anappropriate small-business exemption. There is less agreement, however, on how far theVAT should go in taxing public sector bodies.

3.1. Extension Through the Retail Stage

Many countries that started with a VAT at the manufacturers stage (M-VAT) have extendedtheir VATs through the retail stage (R-VAT). These countries include Argentina, Indonesia,Peru, and various francophone African countries (which began with French-type of produc-tion taxes).8 These countries found that M-VATs are highly distortionary (luxury products,services and imports tend to be favored); that M-VATs cause the VAT burden to be distributed

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unevenly, accentuating the regressive impact of the VAT with respect to consumption ex-penditures; and that M-VATs involve numerous valuation problems (when manufacturerssell directly to retailers and consumers, or establish their own distribution outlets) anddefinitional issues (arising from attempts to delineate manufacturers from distributors).9

Indonesia and Peru also found that the marginal improvements produced by shifting theimpact of the VAT to the wholesale stage (W-VAT) were not worth the effort.

In contrast, a well-designed R-VAT has none of the problems of an M-VAT. Neutrality isensured because the tax is imposed as close to the consumer as possible. Discount mech-anisms (required if manufacturers or wholesalers sell directly to retailers or consumers) oruplift mechanisms (desirable if large retailers integrate backwards by assuming marketingfunctions usually performed by wholesalers and manufacturers) are not necessary. Manu-facturing or distribution does not have to be defined, and taxable values are nearly alwaysidentical to actual prices. The usual argument in favor of pre-retail VATs—the number oftaxpayers is smaller than under an R-VAT and accounts are better maintained—is irrelevant,because an appropriate exemption would remove most small retailers from tax coverage,yet include department stores and super markets. In other words, it is not the stage at whichthe VAT is imposed which determines the number of taxpayers, but the size of the small-business exemption. Moreover, the exemption is not costly in terms of revenue foregone,because exempt small businesses (whose value added usually is small relative to consumerprice) would still pay VAT on purchases.10

It is somewhat surprising, therefore, that ten countries still stop their VATs at the man-ufacturing or wholesale stage. As indicated in the Appendix, these countries are mainlyfound on the Indian subcontinent and in Africa. Bangladesh, Pakistan and Sri Lanka con-verted their suspension-type of manufacturers sales tax, which was rooted in British taxingtraditions, into tax credit VATs but maintained the same point of impact. Recently, however,Bangladesh announced plans to extend its M-VAT to selected goods traded by distributors.Similarly, Pakistan started to apply a 3 percent turnover tax to distributors who, however,can opt for the VAT. In Sri Lanka, there are constitutional difficulties in extending the VATbeyond the manufacturing stage. Apparently, previous taxing traditions also slow down theextension of various African M/W-VATs through the retail stage.

3.2. Wider Taxation of Public Sector Bodies

While there is general agreement that all business entities should be registered for VATpurposes (subject to an appropriate small-business exemption), there is less agreement onthe extent to which public sector bodies should be taxed. Generally, most countries do nottax activities that are performed by governments in the exercise of their public authority.The philosophy is that it does not make much sense to require government departments tocharge VAT on the “sale” of their services (in effect, their budgetary allocations) and, at thesame time, to increase their funding. Beyond that, in Europe and elsewhere, public sectorbodies generally are exempt if treatment as a nontaxable person does not lead to significantdistortions of competition with the private sector.11

This treatment of public sector bodies contrasts with the stance taken under the NewZealand VAT, which taxes nearly all public sector bodies, except if, exceptionally, they


make exempt supplies. In New Zealand, public sector bodies pay VAT on their “sales”,i.e. the revenue that they receive in the form of fees, charges, grants, subsidies and, in thecase of local governments, in the form of proceeds from the local taxes. Furthermore, allVAT-liable public sector bodies receive a tax credit for the VAT they pay on purchases.12

The authorities believe that the registration and payment of VAT by public sector bodiesincreases the accountability and transparency of government operations.

Increasingly, other countries are also coming around to this view. Thus, at least in Europe,various countries are now taxing public postal services which, after all, compete with privateletter or parcel carriers, newspapers and periodicals. Similarly, public transit competeswith private cars, taxis, and other forms of transportation and, hence, should be taxedas well. Competitive conditions are distorted if the government’s transportation servicesbear a lower tax or no tax, while private-sector services are taxed in full. Admittedly,prices of government services may be regulated or subsidized (which may be justifiedon the grounds, of, say externalities) which makes the levy of the VAT little more thana bookkeeping exercise, because the effect of the VAT can be exactly replicated by theexemption. Nonetheless, application of the VAT (in conjunction with an increase in thesubsidy) has the advantage of confronting policymakers more directly with the full cost ofpublic intervention.

4. Tax Base Aspects

A ‘good’ VAT should tax the broadest possible range of goods and services which areultimately used by or benefit consumers. Various countries, however, do not apply thisphilosophy to services. The application of the VAT to and only to consumer goods andservices means, moreover, that no VAT should remain on intermediate inputs (unless boughtby exempt entities), in particular capital goods. This rule also is not followed by somecountries.

4.1. Comprehensive Inclusion of Services

The move through the retail stage permits the inclusion of services, often rendered by retail-type of establishments, in the tax base. The efficiency case for taxing services rests on threearguments.13 First, given the amount of revenue that has to be raised, omitting servicesfrom the VAT base means that the rate has to be higher on goods.14 This would increasethe excess burden of the VAT exponentially, since that burden is measured as the squareof the rate. Second, as economic development proceeds, productivity gains are likely tobe larger in the industrial sector than in the services sector. It would certainly not be goodpolicy, therefore, to tax the gains in the industrial sector higher than is necessary. Third,most services—such as transportation, storage, professional services, communications—are used for personal as well as business purposes. Businesses providing these services willpurchase taxable inputs. Taxing intermediate services means that the tax on these inputscan be passed on to the ultimate consumer and does not become a distortionary elementin the tax system. Furthermore, the equity case for taxing services rests on the argument

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that the income elasticity of demand for most services exceeds unity—which implies thata uniform-rate VAT on services would have a progressive impact on the distribution of thetax burden.

In this light it is rather surprising that 18 countries still tax services on a selective ratherthan a comprehensive basis. In these countries, taxable services are individually enu-merated in the law, the implication being that those not mentioned are exempt. Servicesthat are taxed selectively include laundry, dry cleaning, hairdressers, beauty shops, hotels,restaurants, night clubs, discotheques, electricity, gas, telecommunications, leasing, repair,maintenance, publicity, and advertising. Some countries, for example Norway, tax so manyservices selectively that there is little difference with the comprehensive approach. In mostother countries, however, the number of services that are included in the tax base is morelimited. This violates equal treatment notions, distorts producer and consumer choices, andoften requires fine legal distinctions that add to administrative complexity.

Clearly, the comprehensive approach under which all services are taxed, except thoseenumerated as being exempt, is to be preferred. The comprehensive approach, however, isnot without problems, either. Thus, the exemption, on social grounds, of health, education,social and cultural services, violates the neutrality criterion to the extent that the institutionsrendering these services are induced to perform laundry, cleaning, food and administrativeservices themselves in order to save the payment of VAT on the labor element of the valueof the service that would have been acquired from outside establishments but for the ex-emption. Furthermore, it is increasingly being recognized that exempt cultural services,such as admissions to theatres, concerts, museums and the like compete with taxable formsof entertainment such as travel and reading. If the latter are taxed, why not the former?Moreover, while exemption lowers the cost of services to consumers, it raises the cost forbusiness because the tax on inputs to the exempt service cannot be passed on. Hospitals, forinstance, may undertake research for pharmaceutical companies which would be interestedin the application of the VAT to the research services that are billed to them, because theywould then be able to take credit for that tax (and implicitly for the tax on the hospitals’ in-puts) against their VAT on sales.15 A similar reasoning applies to universities that undertakeresearch or provide training courses for the private sector.

4.2. Full and Immediate Credit for Tax on Capital Goods

In the past, a number of countries, particularly in Latin America, have tried to use the VATto slow down the development of capital-intensive production processes. To this end, theydisallowed the credit for the VAT on fixed assets (defined as all assets which are subjectto depreciation) and nonmaterial assets, such as know-how, etc. In recent years, however,most of these countries have introduced a full and immediate credit for the VAT on capitalgoods applied for the purposes of registered businesses.

These countries realized that disallowing the tax credit on capital goods (which, inciden-tally, are produced by labor) violates the neutrality of the VAT. First, the VAT on fixed assetsenters into price, causing uneven effects on consumer prices (depending on the capital in-tensity of the production process). Second, the noncreditable VAT on fixed assets, unless itcan be fully shifted forward to consumers, deters investment, which hampers technological


change. (Forward shifting is unlikely, however, if competing imports can be sold withoutthe element of tax on capital goods.) Third, the noncreditable VAT acts as a disincentiveto exports, because exporters facing world prices will have to absorb the tax. Last but notleast, capital goods must be defined.

As indicated in the Appendix, seven countries still tax capital goods under their VATs. Itshould be noted, moreover, that capital goods are also implicitly taxed if the tax credit is notpromptly granted. This occurs if excess credits are not refunded but must be applied againstVAT on future sales. In the face of inflation, moreover, the real value of the tax credits carriedforward declines rapidly, becoming equivalent in effect to a tax on fixed assets. Apart frombeing distortionary, this procedure is inequitable if businesses are nonetheless obliged topay the VAT on capital (and other) goods to their suppliers.

5. Hard-to-Tax Sectors

While VATs should have the broadest possible coverage and bases, some sectors are nonethe-less difficult to include on administrative grounds. Thus, it does not seem feasible to taxresidential housing services, financial services, and agricultural activities. As shown by theexperience of various countries, however, some approaches to excluding these potentiallytaxable goods and services from the base or, better, of taxing them indirectly, are preferableto other approaches.

5.1. Re-examination of the Taxation of Immovable Property

In theory, housing services should be included in the VAT base. For tax purposes, these ser-vices do not differ from food products, clothing and other goods or services that are taxable.The problem, however, is that it would be difficult—administratively and politically—tolevy the VAT on the imputed rental value of owner-occupied property. But if rental valuescannot be taxed, equal treatment seems to indicate that rents should also be excluded fromthe base. As a second-best approach, therefore, all countries with a VAT exempt rentalvalues, and nearly all countries exempt rental charges as well. Instead, these countries taxnew residential construction. Since the purchase price of a house may be taken to representthe capitalized value of its future services, the tax on the purchase price may be considereda proxy for the capitalized value of the tax that should have been levied on the flow ofhousing services.16

Two approaches are used to effect this philosophy: the exemption method and the taxmethod. Under the exemption method, prescribed in the EU’s Sixth Directive, the sale andrental of immovable property is, in principle, exempt, but newly constructed buildings, aswell as alterations and maintenance of the existing building stock, are taxable. Under thetax method, found in Canada, Hungary and New Zealand, for instance, the sale and rentalof immovable property is, in principle, taxable, but residential rents (and rental values)are exempt, as is the sale of previously occupied residential property. This implies thatthe construction, alteration, and maintenance of all buildings is taxable, as is the rentaland sale of commercial accommodation. The exemption method needs a definition of

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specified nonresidential use (hotel accommodation, boarding houses, camping facilities,parking space) that is taxable; it must also have the opportunity for optional registration andpayment of tax on the commercial use and sale of immovable property to avoid potentialdiscrimination and cumulation of tax. The tax method requires a definition of residentialuse, but optional registration and payment of VAT is not an issue.

Clearly, the tax method, under which all leases and sales of commercial immovableproperty are subject to VAT, is to be preferred to the exemption approach. Under thetax method, increases in the value of commercial immovable property (and hence in thevalue of the services that the property renders) are always included in the tax base; hence,distortions are fewer (and change-of-use rules easier to apply). This has induced somecountries to review the exemption method for immovable property. Changing to the taxmethod, however, involves some difficult transitional problems regarding the treatment ofcommercial property previously exempted.

Furthermore, countries are becoming increasingly aware that the consistent and neutralapplication of the VAT to immovable property requires that all building activities, formsof leasing, and sales should be taxed at the standard rate. The VATs in the Czech andSlovak Republics are examples of taxes that do not heed this rule: building materials aretaxed at the standard rate, but the lower rate is applied to repair and maintenance services,as well as newly created buildings. This requires that for any repair or maintenance ofthe existing building stock, the VAT on materials must be calculated separately from theVAT on the labor component of the total price. Obviously, construction companies will betempted to undervalue the input of standard-rated buiding materials and overvalue the inputof lower-rated repair services to immovable property. The same applies to the taxation ofnewly created buildings.17

5.2. Reconsideration of the Treatment of Financial Services

Conventional wisdom holds that financial services (banking and insurance) cannot be in-cluded in the VAT base calculated on the tax credit method, because the intermediationcharge that should be taxed cannot be separated from the pure interest rate, premium, orrate of return that should not be taxed.18 The exemption of financial services means thatfinancial institutions incur input VAT on their purchases, but cannot charge VAT on theirsales of financial services. As a result, consumers of such services face effective tax ratesthat are lower than statutory rates, thus distorting their choice in favor of financial services.What is probably worse, the input VAT incurred by financial institutions cannot be passedon to business users of financial services in a way that does not distort producer choices.

Nonetheless, it has, thus far, been considered unavoidable that financial services shouldbe exempted from VAT. In practice, most countries find it difficult to define the scope of theexemption. Often, the supply of financial servicesper sebrings in its train various comple-mentary or component services, such as legal, accounting and tax advice which, if suppliedseparately, are taxable. Segregating these taxable elements from pure financial transactionsis difficult. If the complementary services are also exempted, financial institutions would beinduced to provide them “in-house” rather than purchasing them from specialized traders.Another complication is the inherently arbitrary apportionment of the input tax between


taxable supplies (including zero-rated exports and supplies related to exports) and exemptsupplies.19

Alternatives that have been or are being considered include the zero rating of financialservices, the optional approach, the addition method, the subtraction method, and, mostrecently, the cash flow method.20 While zero rating would solve the cascading problem,it would also favor consumer use of financial services over other products. The optionalmethod (used in France and Germany) is probably a more promising alternative. Germany,for instance, permits banks to opt for the VAT on a transaction-by-transaction basis forservices rendered to businesses. The drawback of the German approach is that servicesrelated to consumer loans and checking accounts are still not taxed in full. Under the additionmethod, value added is calculated as the sum of labor income and above-normal profits.Israel taxes banks in this way. The addition method, however, does not solve the cascadingproblem, because the VAT cannot be passed on to business users on a transaction-by-transaction basis. The subtraction method (at one time proposed by Canada’s Departmentof Finance), under which value added is calculated as the difference between lendingrevenues and borrowing costs, suffers from much the same defects.

Under the cash flow approach, cash inflows from financial transactions (deposits, interestreceipts) are treated as taxable sales, and cash outflows (loans, interest payments) are treatedas purchases of taxable inputs.21 The VAT on these inputs along with the VAT on inputs ofnonfinancial goods and services would be creditable against the VAT on outputs. The VATon outputs, in turn, would constitute input tax credits for other taxable persons involved inindustry and trade (or, for that matter, banking). (At the same time, of course, these taxablepersons would pay VAT on their inflows, i.e. loans extended by banks.) As a result, taxcascading, inherent to the exemption approach, would be avoided, while consumers wouldbe taxed in full.

The pure cash-flow method, however, is not directly equipped to deal with tax rate changes.Also borrowing requirements would increase, because taxable persons taking out loanswould have to finance the VAT on the loans. Beyond that, compliance costs, especiallyof small- and medium-sized businesses would increase, because nonfinancial businesseswould be required to carry out various calculations in order to obtain input tax creditsfor financial services purchased. To resolve these problems, a tax calculation account(TCA) would have to be introduced, to be administered by financial institutions (and not bynonfinancial businesses). The TCA would permit the tax on cash outflows from financialinstitutions charged by nonfinancial businesses to be carried forward to the time that theloan would be repaid. Thus, there would be no increase in borrowing requirements. Thetax on cash inflows from financial institutions would be similarly postponed until depositsare withdrawn. To account for differences in VAT liabilities due to differences in timing,the net balance in the TCA would be subject to an indexing adjustment at the short-termgovernment borrowing rate (as a proxy for the pure rate of interest). The grossed-up balancewould be payable or refundable (if negative) periodically, subject to a deduction of a notionalamount equal to the tax rate times the amount of the loan outstanding at the end of the taxperiod. Tax rate changes, including the introduction of the VAT on financial transactions,would be handled by grossing up (down) the TCA balances when the VAT rate would beincreased (decreased).

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Further conceptual and administrative review of the cash-flow method is required. Thechoice of the appropriate indexing rate, single or composite (reflecting different maturitiesof loans and deposits), and the frequency of the indexing adjustments require further study.Administrative issues that need to be addressed concern the valuation of financial assetsand liabilities required at the time of commencement of the cash-flow method and at thetime of VAT rate changes, as well as the proper definition of financial institutions permittedto keep TCA accounts. Currently, the EU is involved in various pilot projects to test thecash-flow method.

Although the final verdict is not in yet, at this juncture none of the alternatives seem tooffer a viable way of including financial services in the VAT base, because they either donot permit the tax on inputs to be passed on to taxable users, continue to exempt consumeruse, or are too complicated. As Alan Tait (1988, p. 100) puts it succinctly: “Trying toget to grips with banking. . . is akin to trying to get your hands around a piece of jelly.”Most economists and lawyers, therefore, probably still share his conclusion that “whileunsatisfactory, the exemption of financial services from VAT, and the subsequent cascadeeffect, look to be the best solution for the time being.” This would seem to be particularlyapplicable to developing countries. The problems of prudential and regulatory control ofthe financial sector in these countries are such that no more weight should be put on thisfragile sector.

5.3. Difficulties in Taxing Farmers

Agriculture is another troublesome field for the VAT. In most countries, agriculture accountsfor a sizable portion of GDP and employment.22 Since substantial value is often addedbeyond the farm gate, consumer expenditures on farm products tend to be a multiple ofthe farm value of food. Beyond that, the agricultural sector may be a large exporter. Onthe basis of these considerations, the appropriate VAT treatment of the agricultural sectoris obviously important, yet the sector is usually difficult to tax properly on political andadministrative grounds.

Most developing countries keep farmers out of the ambit of the VAT by exempting farmproduce (see Appendix). Exceptionally, to relieve farmers of the VAT on purchases, coun-tries zero rate the following: seed, feed, fertilizer, pesticides, and sometimes machineryand equipment. The zero rating of farm inputs may be feasible for feed, seed, fertilizer andpesticides (which are rarely used outside the agricultural sector), but it is difficult to monitorthe zero rating of farm machinery and equipment. A tractor can indeed be used on the farm,but it can also be employed in a factory or for private purposes. The exemption of farmproduce, moreover, discriminates against imports of agricultural products that are usuallytaxed at positive VAT rates. This issue is of importance in free trade areas and commonmarkets.

A better alternative to keep farmers out of the ambit of the VAT, used in some Europeancountries, is to provide purchasers of agricultural products with a presumptive tax creditapproximately equal to the tax borne by farmers on their inputs. The purchaser is expectedto pass that benefit on to the farmer. Alternatively but equivalently, farmers are permitted toinvoice the VAT on their sales at a presumptively determined rate approximately equal to the


average VAT on inputs expressed as a percentage of output. In either case, farmers do notbecome liable to VAT. However, only rough equal treatment is provided under these “flat-rate” schemes. While some farmers using few taxable inputs may be overcompensated,other farmers making extensive use of taxable inputs may receive too little compensation(although optional registration and payment of VAT might provide relief for them). Finally,if on the aggregate, the flat rate is set higher than the average tax on inputs, farm producemay be subsidized through the VAT system.

The best approach to the taxation of the agricultural sector, found in some industrialcountries, is to treat farmers like any other VAT-liable business. This approach is preferredif agricultural products are a major export, if taxable inputs are an important share of farmcosts and if input/output ratios vary widely. In the event, small farmers would have to look tothe small-business exemption for relief, just like other small businesses. Little cumulationof tax would occur if there are few small farms, if small farms use few taxable inputs, or ifthey sell their products directly to consumers. This approach may not be feasible, however,in most developing countries.

6. Rate Structure Issues

In high-income countries, it is increasingly being realized that VAT-rate differentiationmakes little sense on equity and administrative grounds. In low-income countries, how-ever, which face major constraints on administrative capacity, VAT-rate differentiation con-tinues to be defensible, particularly in the form of lower-than-standard rates (includingexemptions).

6.1. High-Income Countries: Uniform VAT Rate Desirable

In recent years, the member states of the EU that applied higher-than-standard VAT ratesto items of luxury consumption have all abolished these rates. To the extent that theserates covered expenditures on drinking, smoking and motoring, increases in the relatedexcises or user charges were indicated. What remained of the VAT base susceptible to theapplication of increased rates was extremely small—at most a few percent of consumptionexpenditures. Also, higher rates were difficult to enforce with respect to small high-valueitems, such as jewelry, toilet goods and cameras, which could easily be smuggled in fromabroad. Policymakers realized that it was more cost-effective to tax high-income groups bymeans of adjustments to the personal income tax.

There is also a growing consensus in high-income countries—albeit more on paper thanin practice—that lower-than-standard rates are not really an effective way of alleviating thetax on the poor. Because the consumption patterns of low and high income groups haveconverged, rate differentiation changes the impact of the VAT less than might be expectedwhen necessities are zero rated (as, for example, in the United Kingdom), taxed at a lowerrate (as in the Netherlands), or taxed at the standard rate (as in Denmark and Sweden).23

As another example, it was found in Ireland that although the poor spend relatively moreof their income on food, the rich spend twice as much in absolute amounts as the poor,

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because they buy more expensive varieties, eat out more often, and tend to throw food awaymore easily.24 Consequently, Ireland’s zero rating of food gives twice as much tax reliefto high-income groups than to low-income groups, an odd way of alleviating the plightof the poor. In the same vein, and perhaps more telling, a study in Sweden showed thatabolition of that country’s standard rate on groceries would mainly benefit single people withhigher incomes.25 Other instruments, such as the income tax and income-support systems,are clearly much more effective in financially assisting the poor. Differentiated VAT ratestructures, moreover, greatly increase administrative and compliance costs, particularly ofsmall businesses.26

Despite these findings, the Appendix suggests that most high-income countries, par-ticularly in Europe, seem to have settled for a dual rate structure under which a lower-than-standard rate is applied to food products, medicines, books, newspapers, and publictransportation.27 Some countries, e.g. the Netherlands and Spain, have improved on theirdual rate structures by moving seafood, confectionary, soft drinks, and cat and dog food(previously subject to the standard or higher-than-standard rate) into the lower rate category.The same has been done with on-premise consumption. As a result, administration andcompliance problems have been eased. Furthermore, Hungary and Portugal are examplesof countries that have come to realize that a lower-than-standard rate on food productsis superior to a zero rate. After all, zero rating involves the tax office in an expensivecollection-and-refund process that does not yield any revenue. As the Appendix shows, 10other countries, following the example set earlier by the United Kingdom, still like to carrycoal to Newcastle.

6.2. Low-Income Countries: Dual VAT Rate Indicated

The arguments in favor of a single VAT-rate in high-income countries do not apply to low-income countries that face major constraints on administrative capacity in taxing personalincome and in operating income support programs. Low-income countries, moreover,often have dualistic economies with class-differentiated consumption patterns that lendthemselves more easily and effectively to the alleviation of the regressive impact of con-sumption taxes. In these countries, poor families purchase most of their goods from localsmall-scale producers whose output must either be exempted or escapes taxation, whilerich families are likely to buy more factory-made or imported goods that can be taxed moreeffectively. Thus, there are good grounds in these countries for exempting (no VAT on sales,no tax credit for VAT on inputs) a (limited) number of unprocessed foodstuffs that are soldin their “original” or “natural” state. In fact, as the Appendix indicates, this is what some50 low-income countries do.

Like high-income countries, low-income countries, though for quite different reasons, arerealizing that there is no place for higher-than-standard rates under their VATs. Whereashigh-income countries have a well-administered personal income tax at their disposal toeffect changes in the after-tax burden distribution, in low-income countries the excisesare a more appropriate instrument to impart some progressivity to the overall tax burdendistribution. Excises are inherently selective, their mode of imposition can be attuned tothe peculiarities of specific production processes, and they are more easily recognized as


taxes on the rich. As shown in the Appendix, 34 countries complement their VATs with anintermediate excise system that includes luxury products in the base.28

7. Interjurisdictional Coordination Problems

One of the main reasons why the VAT is the most favored form of taxing consumptionis its advantage in implementing the destination principle under which exports are freedfrom tax and a domestic-equivalent tax is imposed on imports. Generally, these border taxadjustments can conveniently be effected through border controls administered by customsauthorities. With the abolition of border controls in the EU in 1992, the destination prin-ciple as well as alternatives to the system of border controls have become the subject ofconsiderable debate.

7.1. Destination or Origin Principle?

In the professional literature, it has long been argued that the substitution of the originprinciple (tax on exports, no tax on imports) for the destination principle would obviate theneed for border tax adjustments and hence border controls, yet would not affect real trade.After all, since exports are exchanged for imports, a tax on exports is equivalent to a tax onimports and compensating exchange rate and wage adjustments would simply restore theoriginal position. Generally, the conditions for this equivalence theorem to hold (including,among others, a comprehensive uniform-rate VAT and full price flexibility) are assumed tobe attainable.29

Serious questions have been raised, however, about the feasibility of the origin principle.If exports are to be taxed, export values must be verified to ensure that all domestic valueadded is included in the base (even equal VAT rates between EU member states would notobviate the need for this). In other words, arm’s length pricing rules (whose contentiousnature is well-known from the application of the separate accounting principle under thecorporation income tax) would have to be adopted. Notional tax credits, moreover, wouldhave to be attached to imports (at amounts equal to the product of the domestic VAT rateand arm’s length import values) to ensure that they would not be taxed in domestic stages ofproduction or distribution. In contrast to the assumptions made in the literature, therefore,the proper treatment of exports and imports under the origin principle might well requirethe maintenance or re-establishment of border controls.30

The real world experience with the use of origin-based VATs, exemplified by the BrazilianStates, moreover, is not encouraging.31 The distortions and administrative problems of theorigin principle in Brazil have had to be alleviated by imposing lower rates on interstate trade(resulting in carousel types of evasion) and by introducing some border control betweenstates. The basic neutrality and tax entitlement issues, however, remain to be resolved. Inan attempt to make some progress, the Federal Government recently proposed a uniformfederal VAT (in lieu of the present tax credit type of extended excise system) complementedby an equally uniform state retail sales tax.

412 CNOSSEN

7.2. Border Tax Adjustments Without Border Controls

Although the destination principle is clearly the preferred choice for treating goods andservices entering interjurisdictional trade, the question remains how border tax adjustmentsshould be effected without border controls. The answer to this question is important notonly for the EU, but also for those newly independent states—formerly part of the SovietUnion—that wish to trade with each other without being hampered by border controls.

Upon the abolition, in 1992, of border controls between its member states, the EU agreed totax cross-border trade between registered businesses within the EU on a deferred paymentbasis. Under this method, the mechanism of the VAT is relied upon to pick up the tax,previously imposed at the border, at the first inland production or distribution stage.32

Under the deferred payment system—whose workings are identical to the reverse chargemechanism that many countries apply to services supplied from abroad—the recipient ofgoods is required to apply the VAT to his purchases from abroad and, at the same time, totake credit for that VAT, all in the same return.33 The system is backed up by special rulesfor cross-border mail order sales (subject to VAT in the country of destination), cross-borderpurchases by exempt entities (obliged to file returns and pay VAT), and cross-border carpurchases (subject to VAT in the country of destination). Last but not least, cross-borderpurchases by consumers are taxed on an origin basis.

The deferred payment system breaks the fractional VAT collection process, however,because exports continue to be zero rated. The fear is that goods may be diverted to theuntaxed underground economy. For this reason, the European Commission seeks to replacethe ‘transitional regime’ by a ‘definitive regime’ under which exports by registered traderswould be subject to the VAT of the country of production, but a tax credit for an equivalentamount would be granted to the registered importer by the country of destination.34 Theworkings of the destination principle regarding transactions between registered traderswould then remain intact if, subsequently, the country of exportation would transfer theVAT collected on its exports to the country of importation. The drawback of this systemis that importing countries have little incentive to check the accuracy of the tax creditsclaimed by their importers and that exporting countries might be slow in transferring theVAT remitted by their exporters to the importing countries.35 In any case, it would not bepossible to settle VAT payments on a transaction-by-transaction basis. Instead, some EU-wide form of clearing mechanism would be required for settling VAT balances of memberstates that are net importers. This means that member states would have to cede someoperational independence to the European Commission.

Interestingly, a definitive regime of some sorts is being administered by the Common-wealth of Independent States (see Appendix).36 All states levy VAT at a mutually agreedrate of 20 percent. Furthermore, most states permit a credit for the out-of-state VAT onimports that is levied by exporting states. There is no clearing mechanism, however, forsettling balances of net importing states. As a result, the system seems unstable. First,states whose imports exceed their exports may feel short-changed and might be temptedto refuse credit for VAT on imports from other states. Second, net exporting states canincrease their VAT revenues by overvaluing the prices of exports in which they dominatethe market. Third, states exporting goods imported from other states to third countries have


to refund VAT collected by those states, while states importing from third countries cancollect VAT on imports destined for other states. Both situations are difficult to rationalize.The Ukraine has drawn its own conclusions and has installed border controls on its frontierswith the other commonwealth countries.

This review indicates that the choices in common markets seem fairly clear. The clearingmechanism requires some overarching authority to verify cross-border VAT complianceand to settle VAT balances. The deferred payment system requires effective internal auditsand a high degree of compliance by VAT-liable traders.37 In the meantime, the EuropeanCommission is arguing for a modified clearing regime under which goods and servicesentering intra-EU trade would be taxed on the basis of the place of business establishmentinstead of the location of the transaction. VAT revenues collected under the regime wouldbe allocated between member states on the basis of statistics of aggregate consumption.Apart from the merits of the proposal, however, it is unlikely that member states will permitthis intrusion of their taxing powers.38

8. Concluding Comments

The VAT has come of age, and with it an increased awareness of its potential and limitations.Basically, the VAT is a revenue workhorse. Properly designed and administered, it canraise more revenue with lower operational and economic costs than can other broadly basedconsumption taxes. The danger is, of course, that the VAT becomes over-used in the sensethat it contributes to the maintenance of an oversized, inefficient public sector. If poorlyadministered, moreover, the VAT may degenerate into a highly distortionary, multistagecumulative turnover tax that hampers specialization and hence economic growth.

This article has reviewed existing VATs against the requirements of a ‘good’ VAT. It hasbeen shown that not all VATs extend through the retail stage or adequately cover public sectorbodies. Postal services, telecommunications and public transit, to name a few sectors, couldbe more widely taxed. Also, services should be taxed comprehensively. Arguments can beadvanced, moreover, to tax cultural services and perhaps to include health and education inthe base. All countries with a VAT have difficulties in taxing immovable property, financialservices, and agricultural activities. Clearly, the tax method is preferable to the exemptionapproach in the treatment of immovable property. No solution is yet in sight for the propertreatment of financial services, and various ad hoc approaches continue to be applied intaxing farmers.

In high-income countries, lower-than-standard VAT rates on essential products are noteffective in financially assisting the poor, because consumption patterns have converged. Asingle, uniform rate is best. In low-income countries, on the other hand, which face majorconstraints on administrative capacity, lower-than-standard rates or exemptions for selectedunprocessed foodstuffs make sense in alleviating the regressivity of the VAT. Nonetheless,differentiated rate structures complicate the administration and compliance with the VAT.39

Border tax adjustments in common markets without border controls can be shifted tobooks of account under what is called the deferred payment system. This system appears towork well in the EU. Cross-border audit is made possible under an information exchangesystem. Dual VATs, as in Canada, are probably even more effective in the cross-border

414 CNOSSEN

enforcement of VATs, but this would require an overarching VAT in the EU, which wouldimpinge on member state tax subsidiarity. In the Commonwealth of Independent States,exports are taxed and a tax credit is given for the out-of-state VAT on imports. This systemseems unstable, however, without a mutually agreed-upon tax clearing mechanism.

To summarize, the worldwide introduction of the VAT should be considered the mostimportant event in the development of tax structure in the last half of this century. Manycountries, however, have departed from the requirements of a ‘good’ VAT, often withoutheeding the costs in terms of economic distortions and administrative complications. Crite-ria relating to simplicity in structure and operation have not always been taken as seriouslyas they should be. This applies also to the EU, whose Sixth Directive appears to representaverage practices rather than, as should be the case, best practices based on widely agreednotions relating to neutrality and administrative feasibility. In the EU, as well as elsewhere,further review and reform seem desirable.


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+S

18X

-..

..Li

mite

dB

urki

naF

aso

1993

RG

+S

T18

X-

....

Lim

ited

Cam

eroo

n19

95R

G+

S18

.7X

/8.8

-28

.62.

7Li

mite

dC

ongo

,Rep

.of

1997

RG

+S

18X

/0∗-

....

Lim

ited

Cot

ed’

Ivoi

re19

92R

G+

S20

11.1

-..

..Li

mite

dG

abon

1995

RG

+S

18X

/7.2∗

-..

..Li

mite

dG

uine

a19

96M

G+

ST

18X

-..

..Li

mite

dK

enya

1990

MG

+S

T15

X/0

/10

-34

.2∗7.

1∗Li

mite

dM

adag

asca

r19

90R

G+

S15

X-

12.1

1.0

Ext

ende

dM

ali38

1991

RG

17X

/10

-..

..Li

mite

dM

aurit

ania39

1994

RG

+S

14X

/5-

....

Lim

ited

Mor

occo

1986

RG

+S

20X

/7/1

0∗ /14∗

-24

.0∗

6.1∗

Lim

ited

Nig

er19

86R

G+

S17

X-

....

Lim

ited

Nig

eria

1993

WG

+S

T5

X-

....

Ext

ende

dS

eneg

al19

90R

G+

S20

10-

....

Lim

ited

Sou

thA

fric

a19

91R

G+

S14

0-

24.5

6.8

Lim

ited

Togo

4019

95R

G+

S18

X-

....

Lim

ited

Tun

esia

1988

RG

+S

17X

/6/1

029

10.3

2.6

Lim

ited

Uga

nda

1996

RG

+S

17X

-..

..Li

mite

dZ

ambi

a19

95R

G+

S17

.5X

-29

.04.

8Li

mite

d

Sou

rces

:In

tern

atio

nalB

urea

uof

Fis

calD

ocum

enta

tion,

Afr

ican

Tax

Sys

tem

s,Ta

xatio

nin

Latin

Am

eric

a,Ta

xes

and

Inve

stm

enti

nA

sia

and

the

Pac

ific,

Taxe

san

dIn

vest

men

tin

the

Car

ibbe

an,T

axes

and

Inve

stm

enti

nC

entr

alan

dE

astE

urop

ean

Cou

ntrie

s,Ta

xes

and

Inve

stm

enti

nth

eM

iddl

eE

ast,

and

Valu

eA

dded

Taxa

tion

inE

urop

e(A

mst

erda

m:

loos

e-le

af),

asw

ella

sIn

tern

atio

nalM

onet

ary

Fun

d,Ye

arbo

okof

Gov

ernm

entF

inan

ceS

tatis

tics

1997

and

Inte

rnat

iona

lFin

ance

Sta

tistic

s,Ja

nuar

y19

98(W

ashi

ngto

nD

C).

Inso

me

case

s,th

ein

form

atio

nis

inco

mpl

ete

orou

tofd

ate.


Ap

pe

nd

ix.C

ontin

ued.

1.T

hele

tters

have

the

follo

win

gm

eani

ng:

R=

Valu

e-ad

ded

tax

exte

ndin

gth

roug

hth

ere

tail

stag

eW

=Va

lue-

adde

dta

xex

tend

ing

thro

ugh

the

who

lesa

lest

age

M=

Valu

e-ad

ded

tax

exte

ndin

gth

roug

hth

em

anuf

actu

ring

stag

e2.

The

lette

rsde

note

the

follo

win

g:G

=G

oods

S=

Ser

vice

sS

T=

Ser

vice

sta

xed

sele

ctiv

ely

CG

=C

apita

lgoo

ds3.

Rat

esar

eex

pres

sed

asa

perc

enta

geof

the

tax-

excl

usiv

eva

lue

ofta

xabl

ego

ods

and

serv

ices

whi

chis

the

prac

tice

inm

ostc

ount

ries.

Bol

ivia

,B

razi

land

Cot

ed’

Ivoi

reha

veta

x-in

clus

ive

rate

s.Ta

x-in

clus

ive

rate

s(t

i)ha

vebe

enco

nver

ted

into

tax-

excl

usiv

era

tes

(te)

bydi

vidi

ngth

emby(1−

t i).

4.A

nas

teris

k(∗ )

deno

tes

spec

iall

ower

orhi

gher

rate

sw

hich

appl

yto

only

one

ortw

opr

oduc

ts.

5.T

hele

tter

“X”

mea

nsth

ates

sent

ialp

rodu

cts

are

exem

pted

rath

erth

anta

xed

ata

low

eror

zero

rate

.6.

Gen

eral

ly,

reve

nue

figur

espe

rtai

nto

1995

or19

96an

dar

efo

ral

llev

els

ofgo

vern

men

t.A

nas

teris

k(∗)

indi

cate

sth

at19

94is

the

late

stye

arfo

rw

hich

figur

esar

eav

aila

ble.

7.T

hree

type

sof

exci

sesy

stem

s(in

som

eco

untr

ies

calle

dco

nsum

ptio

nor

busi

ness

taxe

s)ar

edi

stin

guis

hed:

limite

d,in

term

edia

tean

dex

tend

edex

cise

syst

ems.

Lim

ited

exci

sesy

stem

sco

mpr

ise

atle

astt

hetr

aditi

onal

exci

sego

ods:

toba

cco

prod

ucts

,alc

ohol

icbe

vera

ges

and

petr

oleu

mpr

oduc

ts,a

sw

ella

sva

rious

form

sof

road

use

and

ente

rtai

nmen

t.S

ome

food

prod

ucts

such

assu

gar,

conf

ectio

nary

and

salt,

vario

usbe

vera

ges

such

asco

ffee,

tea

and

coco

a,as

wel

las

som

ese

rvic

essu

chas

insu

ranc

em

ayal

sobe

incl

uded

inth

eba

se.

Inad

ditio

nto

the

item

sco

vere

dun

der

alim

ited

syst

em,a

nin

term

ed

iate

exci

sesy

stem

cove

rsa

larg

enu

mbe

rof

luxu

rypr

oduc

tssu

chas

cosm

etic

s,fu

rs,p

reci

ous

ston

es,a

udio

-vis

uale

quip

men

tand

hous

ehol

dap

plia

nces

.O

bvio

usly

,th

eta

xes

onth

ese

prod

ucts

serv

eth

esa

me

func

tion

asa

high

erVA

T-ra

te.

An

exte

nd

ede

xcis

esy

stem

wou

ldin

clud

ein

itsba

seth

eco

mm

oditi

esco

vere

dby

alim

ited

syst

eman

dan

inte

rmed

iate

syst

em,b

utal

soa

larg

enu

mbe

rofp

rodu

cers

good

s.In

defin

ing

the

natu

reof

the

exci

sesy

stem

s,va

rious

low

-rat

e,sp

ecia

l-pur

pose

exci

ses

impo

sed

toea

rmar

kth

eirr

even

ues

orto

achi

eve

vario

usre

gula

tory

obje

ctiv

es,e

.g.p

ollu

tion

abat

emen

t,ar

ele

ftou

tofc

onsi

dera

tion.

422 CNOSSEN

Ap

pe

nd

ix.C

ontin

ued.

8.A

nas

teris

k(∗ )

mea

nsth

atth

eex

cise

syst

em,u

sual

lyle

vied

atth

em

anuf

actu

ring

leve

l,ha

sa

tax

cred

itfe

atur

eak

into

VAT.

9.T

heG

over

nmen

tofM

alta

has

anno

unce

dth

atit

will

abol

ish

the

VAT

infa

vor

ofa

sing

le-s

tage

exci

seta

xon

prod

ucts

and

sele

cted

serv

ices

.10

.Ve

nezu

ela

intr

oduc

edth

eVA

Tin

1993

buta

bolis

hed

itag

ain

in19

94in

favo

rof

a16

.5pe

rcen

twho

lesa

lean

dlu

xury

tax.

11.

InA

rgen

tina,

the

prov

ince

san

dth

efe

dera

ldis

tric

tal

sole

vygr

oss

rece

ipts

taxe

sat

rate

sra

ngin

gfr

om1-

6pe

rcen

tde

pend

ing

onth

eju

risdi

ctio

nan

dth

ena

ture

ofth

eta

xabl

etr

ansa

ctio

n.12

.B

oliv

iaal

soim

poses

a3

perc

entg

ross

rece

ipts

tax.

13.

Und

erth

eB

razi

lian

cons

titut

ion,

the

right

tota

xse

rvic

esis

rese

rved

tom

unic

ipal

ities

whi

chta

xne

arly

alls

ervi

ces,

atra

tes

rang

ing

from

0.5

perc

entt

o10

perc

ent,

exce

ptin

ters

tate

and

inte

rmun

icip

altr

ansp

orta

tion

and

com

mun

icat

ion

serv

ices

(res

erve

dto

the

fede

ralg

over

nmen

t)an

dba

nkin

g.T

heta

xes

onse

rvic

esar

etu

rnov

erty

pele

vies

with

outa

cred

itfo

rta

xle

vied

inpr

evio

usst

ages

.14

.In

Bra

zil,

low

erra

tes

of7.

5pe

rcen

tand

13.6

perc

enta

reim

pose

don

inte

rsta

tesa

les

betw

een

regi

ster

edta

xpay

ers,

whi

lesa

les

atre

tail

acro

ssst

ate

bord

ers

and

impo

rts

are

taxe

dat

ara

teof

atm

ost2

2pe

rcen

t.15

.T

heF

eder

alG

over

nmen

tin

Bra

zill

evie

sa

high

lyra

te-d

iffer

entia

ted,

tax

cred

itty

pein

dust

rialp

rodu

cts

tax.

Unl

ike

the

VAT

atth

est

ate

leve

l,th

eta

xcr

edit

isav

aila

ble

fora

wid

era

nge

ofca

pita

lgoo

ds.

Aze

rora

teis

appl

icab

leto

esse

ntia

lpro

duct

s.T

hera

tes

are

high

lypr

oduc

t-sp

ecifi

can

dra

nge

from

0pe

rcen

tto

330

perc

ent.

16.

InC

olom

bia,

mun

icip

aliti

esal

sole

vygr

oss

rece

ipts

taxe

sat

rate

sra

ngin

gfr

om0.

2pe

rcen

tto

3pe

rcen

t,de

pend

ing

onth

em

unic

ipal

ityan

dth

ety

peof

activ

ity.

The

rate

onad

vert

isem

ents

and

billb

oard

sis

15pe

rcen

t.17

.P

eru

also

levi

esa

2pe

rcen

tgro

ssre

ceip

tsta

xfo

rm

unic

ipal

deve

lopm

entp

urpo

ses

whi

chis

adde

d(w

ithou

ttax

cred

it)to

the

VAT.

18.

Gre

nada

also

levi

esa

2pe

rcen

tgro

ssre

ceip

tsta

x.19

.In

Mex

ico,

the

10pe

rcen

trat

eap

plie

sin

bord

erre

gion

s.20

.In

Nic

arag

ua,m

unic

ipal

ities

levya

2pe

rcen

tgro

ssre

ceip

tsta

x.21

.In

Nic

arag

ua,t

heM

inis

ter

ofF

inan

ceca

nfu

llyor

part

ially

disa

llow

the

tax

cred

itat

tach

edto

the

acqu

isiti

onof

capi

talg

oods

orfix

edas

sets

,or

pres

crib

eth

atth

ecr

edit

shou

ldbe

take

nin

annu

alin

stal

men

ts.

22.

InIn

dia,

the

stat

eof

Mah

aras

hstr

ain

trod

uced

aVA

Tin

1995

.F

urth

erm

ore,

the

Cen

tral

Gov

ernm

ent’s

exte

nded

exci

sesy

stem

has

ata

xcr

edit

feat

ure

akin

toVA

T(c

alle

dM

OD

VAT

).F

urth

erm

ore,

Cam

bodi

a,P

apua

New

Gui

nea

and

Vie

tnam

plan

toin

trod

uce

aVA

Tin

1998

.23

.C

hina

levi

esa

sepa

rate

busi

ness

(tur

nove

r)ta

xon

serv

ices

atra

tes

of3

perc

ent(

tran

spor

tatio

n,co

nstr

uctio

n,co

mm

unic

atio

ns,c

ultu

rala

ndat

hlet

icac

tiviti

es),

5pe

rcen

t(ba

nkin

g,in

sura

nce,

imm

ovab

lepr

oper

ty)

and

5–20

%(e

nter

tain

men

t).

24.

Incl

udes

sepa

rate

tax

onlu

xury

prod

ucts

levi

edin

conj

unct

ion

with

the

Indo

nesi

anVA

T.25

.T

heJa

pane

seVA

Tin

clud

esth

esp

ecia

l1pe

rcen

tloc

alco

nsum

ptio

nta

x.


Ap

pe

nd

ix.C

ontin

ued.

26.

InP

akis

tan,

who

lesa

lers

and

reta

ilers

are

subj

ectt

oa

3pe

rcen

ttur

nove

rta

x,bu

thav

eth

eop

tion

tobe

taxe

dun

der

the

VAT.

27.

Incl

udes

the

Taiw

anes

ebu

sine

sstu

rnov

erta

xle

vied

atva

ryin

gra

tes

onba

nkin

g,in

sura

nce,

nigh

tclu

bs,b

ars

and

coffe

esh

ops.

28.

Incl

udes

the

Tha

ispe

cific

busi

ness

tax

levi

edat

vary

ing

rate

son

bank

ing,

insu

ranc

e,pa

wn

shop

s,tr

ansf

erof

imm

ovab

lepr

oper

ty,a

ndth

esa

leof

secu

ritie

s.29

.U

zbek

ista

nis

noti

nclu

ded

sinc

eits

18(1

0)pe

rcen

tVAT

appe

ars

toha

veth

ech

arac

teris

tics

ofa

cum

ulat

ive

turn

over

tax.

30.

InA

rmen

ia,w

hole

sale

rsan

dre

taile

rsar

eta

xed

onm

argi

ns(d

irect

subt

ract

ion

tech

niqu

e).

31.

InA

rmen

ia,t

heta

xcr

edit

for

purc

hase

sof

capi

talg

oods

has

tobe

spre

adov

era

6-m

onth

spe

riod.

Par

ticul

arly

unde

rin

flatio

nary

cond

ition

s,th

isam

ount

sto

aVA

Ton

capi

talg

oods

.32

.In

Aze

rbai

jan,

the

rate

onen

terp

rises

subj

ectt

ota

xon

inco

me

from

capi

tali

sre

duce

dto

16.6

7pe

rcen

t.33

.In

Bel

arus

,the

VAT

isle

vied

ongr

oss

mar

gins

(dire

ctsu

btra

ctio

nte

chni

que)

.34

.K

yrgy

hsta

nan

dTa

jikis

tan

also

lev

ya

3pe

rcen

ttur

nove

rta

x.35

.In

Kyr

ghys

tan

and

Tajik

ista

n,re

taile

rsar

eta

xabl

eon

mar

gins

(dire

ctsu

btra

ctio

nte

chni

que)

.36

.T

urkm

enis

tan

does

notp

erm

ita

cred

itfo

rth

eVA

Ton

impo

rts.

37.

Gha

nain

trod

uced

and

abol

ishe

dth

eVA

Tin

1995

,but

plan

sto

rein

trod

uce

the

tax

in19

98.

Fur

ther

mor

e,Ta

nzan

iapl

ans

toco

nver

tits

susp

ensi

onty

peof

man

ufac

ture

rssa

les

tax

into

aVA

T.Z

imba

bwe

has

also

anno

unce

dpl

ans

toad

optt

heVA

T.38

.M

alil

evie

sa

sepa

rate

turn

over

tax

onse

rvic

esat

ast

anda

rdra

teof

15pe

rcen

tand

are

duce

dra

teof

7pe

rcen

t.39

.M

aurit

ania

appl

ies

a16

perc

entt

urno

ver

tax

tota

xpay

ers

subj

ectt

oth

epr

esum

ptiv

eVA

Tre

gim

e.T

his

tax

isal

soim

pose

don

finan

cial

activ

ities

.40

.To

goal

sole

vies

atu

rnov

erty

peof

busi

ness

tax

atra

tes

rang

ing

from

0.5–

3.0

perc

ent.

424 CNOSSEN

Acknowledgments

This article is based on a paper presented at the 53rd Congress of the International Institute ofPublic Finance, held at Kyoto, August 25-28, 1997. I should like to thank the participantsin the Working Group on Tax Reform, as well as John Brondolo, Carlos Silvani, EmilySunley, two anonymous referees, and especially Peter Sørensen, for stimulating commentsand suggestions. The responsibility for whatever faults that remain rests, of course, withme.

Notes

1. See McLure (1987; 1993) and Shoup (1990) for concise reviews of the workings and neutrality propertiesof the VAT, as well as the reasons why the (tax credit) VAT should be preferred over other broadly basedconsumption taxes.

2. As indicated in the Appendix, Denmark introduced the VAT a year earlier than France, but initially its versiondid not tax services in a comprehensive manner. For a review of developments in the EU, see Cnossen andShoup (1987) and Aujean (1995); for developments in the OECD, see Messere (1993).

3. For a comprehensive survey and evaluation of VATs in Central and Eastern European countries, see Cnossen(1998).

4. For the definition and role of excise systems in taxation, see Cnossen (1977).

5. For contributions to the debate, see McLure (1987), Walker and Bloomfield (1987), and Boskin (1996).

6. It should be noted that the federal extended excise system has a tax credit feature akin to VAT (hence, its nameMODVAT), similar to the Brazilian excise system. For a critical review of India’s sales and excise tax systemsand arguments in favor of moving to the VAT, see Bagchi Report (1994), Burgess, Howes, and Stern (1995),and Shome (1997).

7. For a scathing attack on the Australian wholesale tax, see Williams and Guthleben (1990). For arguments infavor of moving to the VAT, see Chisholm and Freebairn (1997).

8. Compare Table 2.1 in Cnossen (1977) with the Appendix to this article.

9. It should be noted that the problems of delineating producers from distributors also arises under the VATsadministered in a number of countries that belong to the Commonwealth of Independent States (see Appendix).These countries impose a tax credit type of VAT through producers stages, but tax distributors on their margins(see Summers and Sunley, 1995). Exceptionally, Belarus taxes all stages of production and distribution onmargins (direct subtraction technique). For a critique of this unusual form of VAT, see Bird (1996). Of course,the problems of M-VATs also arise under suspension-types of manufacturers sales taxes. For a telling accountof the distortions and complexities of the Canadian manufacturers sales tax before the country moved to aVAT, see Gillis (1985).

10. Careful calculations for the United States (which does not have a VAT) show that a small-business exemptionof $100,000 would reduce the number of registrants from 24.4 million to 9.0 million (after taking account ofoptional registrations). The exempt registrants would account for 2.6 percent of aggregate gross receipts. Inother words, if their value added would be one-third of gross receipts and the VAT rate would be 10 percent,then the revenue foregone would be 0.17 percent of gross receipts. See GAO Report (1993) which made thecalculations for 1995.

11. This provision has little meaning, of course, if legal restrictions, pricing-cum-subsidy schemes, or the statusof public monopoly in effect preclude competition by the private sector. In Europe, therefore, a number ofactivities are always taxable, regardless of the legal form of the entity undertaking them or the absence of anyinfringement of competitive conditions. These activities include telecommunications, the supply of water, gasand electricity, transportation, warehousing, and any other activity that can also be performed by the privatesector. See Annex D of the Sixth Directive in European Commission (1996).

12. In contrast, but largely with the same result, France, Luxembourg and the United Kingdom permit localgovernments to claim refunds of VAT paid on purchases of goods and services used for non-business activities.In effect, these bodies are zero-rated. See OECD (1988), p. 173.


13. The arguments in this paragraph draw on Kay and Davis (1990).

14. This effect is important, because even in developing countries, consumer spending on potentially taxableservices probably constitutes 25–30 percent of GDP. This figure excludes the services provided by wholesaleand retail trade (which would be included in the base for goods), public administration and defense, andintermediate services provided to business (for which a tax credit would be available if they were taxed). Onthe other hand, the figure includes the portion of electricity, gas and water purchased by consumers.

15. In a curious anomaly, Austria, upon joining the EU, had to rescind the application of its VAT to hospital bills(and rents), although the taxation of hospital services should be preferred to their exemption.

16. For a detailed treatment of housing and commercial property under the VAT, see Cnossen (1995).

17. To ensure that the standard rate continues to apply to builders’ hardware, annex 3 of the Czech VAT lawstipulates that the value of (and the tax on) a large number of items must be shown separately on the bill whensupplied along with a new building. These items include all kinds of household appliances, upholstery, andvarious fittings. No doubt, it must be difficult to verify whether the provision has been properly complied with.

18. For a useful exposition, see Henderson (1988).

19. The turnover basis is the most widely used apportionment basis. It divides the tax on inputs into deductibleand nondeductible amounts in the same proportion as taxable (including zero rated) and exempt supplies bearto total turnover. Interestingly, in the EU, the exemption of financial services causes few complaints by thefinancial community. One reason may be that some member states permit financial institutions to use the grossmargin, i.e. the difference between lending revenues and borrowing costs, instead of total lending revenues,as the denominator in the apportionment formula. This “bankers’ method” significantly increases the amountof deductible input tax. Another way in which banks might be able to maximize their input tax recovery usingthe turnover method is to artificially increase the level of taxable supplies by transacting a small number ofhigh value zero-rated transactions (such as gold).

20. For a summary treatment of these alternatives, see Merrill (1995), and for a survey of the actual treatment offinancial services in OECD countries, see KPMG (1996).

21. Satya Poddar is theauctor intellectualisof this highly imaginative solution. See Poddar and English (1997) onwhich the following paragraphs draw. It should be noted that the cash-flow method can be made compatiblewith the destination principle, simply by ignoring the provision of financial services to or from non-residents.

22. The following applies also to animal husbandry, horticulture, viticulture, forestry, and fishing.

23. See OECD (1988), pp. 127 ff. Appendix 1 to chapter 8 of this study provides an overview of a large numberof impact studies, generally based on household budget surveys. Generally, they show that the impact of theVAT is proportional when measured on the consumption base and slightly regressive when measured on theincome base. Some caution should be exercised, however, in interpreting the results of these studies. Themathematics of impact analysis may seem simple, but there are conceptual and empirical difficulties in definingand measuring both the numerator and the denominator for various levels of consumption or income. Thesedifficulties have been discussed at length in the literature. For a good example, see McLure (1990).

24. See Ireland, Commission on Taxation (1984), appendix 9. A good example of a well-intentioned but misdi-rected form of rate differentiation is the application of a lower rate to children’s clothing, shoes, cosmetics,school stationery, skis and bicycles in Poland. First, many of these items would also fit or could also be usedby small adults. Second, rich parents also benefit from the concession. Third, the really poor do not buy thesegoods new in shops, but instead mend or refashion worn out clothing of adults into children’s clothing, orrepair second-hand skis and bicycles which are not subject to VAT. Not surprisingly, research in other countrieshas established that these kinds of concessions make the VAT more instead of less regressive. For an example,again see Ireland, Commission on Taxation (1984), table 9.2.

25. SeeSkall Matmomsen Slopas? (1983).

26. The arguments in favor of a uniform VAT rate are at odds, of course, with the famous “Ramsey-rule” oftaxation, which holds that the efficiency costs of taxation can be minimized by applying higher rates to thosegoods that are poor substitutes for the products that are left out of the tax base (including leisure) and lowerrates to those that are good substitutes for the left-out goods. As Harberger (1990) has argued persuasively,however, uniform taxation can be defended on pragmatic policy grounds. Unlike the Ramsey-rule solution,it does not require knowledge of demand and supply relations (generally not available anyway) and is morerobust to changes in tastes and technology.

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27. In the EU, the choice in favor of a dual rate structure is supported by Directive 91/680/EEC of the EuropeanCommission. Also, as Sørensen (1997) has pointed out, a case can be made for applying lower-than-standardrates to those parts of the services sector that compete most directly with home production and undergroundproduction of services; this will act to prevent a shift of resources from the more productive official marketeconomy to the less productive informal economy.

28. For arguments in favor of excise taxation in developing countries to achieve progressivity goals, see Cnossen(1978).

29. For recent expositions of the argument, see Genser, Haufler, and Sørensen (1995), as well as Lockwood, deMeza, and Myles (1995).

30. See Cnossen (1983) and Cnossen and Shoup (1987).

31. For a review of the Brazilian experience, on which this brief discussion draws, see Bird (1997). See alsoPurohit (1997).

32. The deferred payment system has been in use in the Benelux countries ever since these countries introducedthe VAT in the late 1960s and early 1970s. It had also been incorporated in Article 23 of the EU’s SixthDirective on Value Added Tax.

33. Other countries simply rely on the tax credit mechanism of the VAT to pick up the tax that would have beenpayable at the border by registered businesses but for the abolition of border controls. This approach, nor thereverse charge mechanism, does not work, of course, for goods or services supplied from abroad to consumers.In the event, special rules must be devised to tax either the sellers (who have to remit the VAT collected to thecountry of destination) or the recipients (in the form of use taxes). The issues have become more acute withthe advance of electronic commerce. For an interesting treatment, see McLure (1997).

34. See Commission of the European Communities (1985). Note that the European Commission refers to thedefinitive regime as the origin system, because goods and services are initially taxed in the country of produc-tion. This destination-based (sic!) origin system (under which the tax on exports is effectively rebated in thecountry of importation) should not be confused with the origin principle (under which the VAT on exports isnot rebated).

35. See especially Lee, Pearson, and Smith (1988) for a coherent critique of the Commission proposal.

36. See Summers and Sunley (1995), as well as Baer, Summers, and Sunley (1997).

37. This is achievedin tandemunder the dual VAT system in Canada, where the federal VAT is levied along withthe provincial VAT in Quebec. For a good exposition, see Bird (1997).

38. See Commission of the European Communities (1996). For a not-so-favorable critique, see Smith (1997). Foran alternative strategy, combining a harmonized rate of VAT on transactions between registered businesses(both between and within member states) with national discretion over rates applied to final sales, see Keenand Smith (1996).

39. Administrative and compliance costs are not as low as is often believed. For a review, see Cnossen (1994).

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Global Trends and Issues in Value Added Taxation