VAT – Throwing the “Baby with the Bathwater”
File picture of a customer at an electronics shop watching the live broadcast of (an earlier) budget presentation by the then President Mahinda Rajapaksa. TV prices may be affected by the new 2016 tax structure.
A school of thought has gained pre budget momentum that Sri Lanka should abandon VAT and revert to Turnover tax (TT). Prudent analysts would agree that this is an ill-considered measure in the context of the “globalization of VAT” in addition to the reasons for VAT being a far superior form of taxation compared to Turnover tax. This is indeed a case of throwing the “baby with the bathwater”. This article seeks to shed light on “globalisation of VAT” and fading away of TT as a means of collection of indirect tax for state coffers in the global context.
Global trends
Considered the fastest growing form of taxation in the world from its first introduction in France in 1954, VAT/GST has been embraced by over 160 countries in preference to TT as of today other than the US. India is currently on a roadmap to introduce a comprehensive GST system in the very near future in place of the indirect taxes and levies on goods and services.
In 2015, Malaysia replaced the existing sales and service tax by substituting with VAT and Bahamas also introduced VAT at beginning of this year. Egypt, Suriname and Puerto Rico are set to introduce VAT in 2016 replacing their existing turnover tax system (sales taxes/turnover taxes).
It is significant that upon Suriname and Puerto Rico switching to VAT in 2016, only Brunei and the US would remain among the top 100 ranked ( 2015 rankings) countries in World Bank’s “Ease of Doing Business” that use Turnover Tax. Gulf countries are also expected to introduce VAT in the near future. Adoption of VAT is a precondition for a country to enter the European Union (EU) and in 1973 UK replaced its Turnover /sales Tax system with VAT in order to join the EU.
One could opine VAT/GST is the global form of indirect taxation not TT. As per global trend, VAT/ GST is being globalised whilst archaic cascading TT is fading away. In the aforesaid context there is no denial that the school of thought that VAT should be substituted with TT runs counter to global trends. Though there is a need to reform the Sri Lankan VAT system the contention that it should be substituted with TT is simply untenable. In a country that boasts 92 per cent rate literacy, ‘anti – VAT’ critics’ trump card that VAT is too complicated does not hold water.
Alain Tait, in his 1988 publication ‘Value Added Tax International Practice and problems’ refers to VAT as the ‘MATA HARI of the tax world’: “The rise of the Value Added Tax is an unparalleled tax phenomenon. The history of taxation reveals no other tax that has swept the world in some 30 years from theory to practise and has carried along with it academics who were once dismissive and countries that once rejected it. VAT may be thought of as the Mata Hari of the tax world – many are tempted, many succumb, some tremble on the brink, while others leave only to return, eventually the attraction appears irresistible” – (Alain Tait – Value Added Tax International Practice and problems (1988)
Turnover Tax – Tax on Tax
If simplicity of collection of the turnover tax is the greatness of the tax, its inequity caused due to cascading effect is the weakness. The reason cited by fiscal experts the world over for switching from Sales/Turnover Tax to VAT is that it avoids the pernicious implications of “cascading”. The term refers to the ‘tax on tax’ or double taxation as the Turnover Tax is computed by applying the tax rate on the selling price embedded with the tax paid to the suppliers due to the lack of right to set off. As VAT seeks to levy the charge on the ‘value addition’ at each stage of the transactions in the value chain, is devoid of the evil “cascading”. Thus VAT is an equitable form of tax compared to its sibling TT. Fiscal policy makers in more than 160 countries have demonstrated their preference for the more equitable VAT over cascading TT notwithstanding its inherent draw backs including failure to process VAT refunds efficiently in many countries.
Fraud and Audit Trail
Due to the ‘input tax’ credit mechanism utilising ‘tax invoices’ at multiple points, VAT is a self – policing tax. The audit trail created through the different stages of production and trade assists the task of tax enforcement officers. In many countries the system has been shrouded with frauds. Though disturbing this manifests another superior feature over TT. Unlike the latter this system leaves an audit trail, which culminates in frauds occurring in the system being brought to light, unlike in the latter where the frauds remain undetected due to lack of an audit trail. Audit trail acts as a deterrent to the ordinary fraudsters and the bold who insist on engaging in their craft reap the appropriate consequences. Thus the frequent news items on VAT frauds worldwide, is a manifestation of the superiority of VAT over Turnover Tax, but by no means a ‘black mark’ on the system itself.
The importance of the existence of an audit trail and the tricksters being hurled before the law should be appreciated in the context of Asia’s biggest tax fraud which had cost Rs. 3.6 billion to the state being prosecuted in the Sri Lankan courts at present. In a turnover tax regime, tricksters enjoy impunity due to the lack of an audit trail. To further strengthen the self-policing mechanism of the VAT and the curtailing of the use of bogus VAT invoices, tax authorities in the Philippines and China issue serially numbered pre-printed invoices to the tax payers (similar to cheque books issued by banks), a mechanism that is worth evaluating by other VAT jurisdictions, if fraud is the norm rather than an exception in the territory.
Sri Lankan VAT system
The present Sri Lankan VAT system is far from being perfect and it certainly begs reforms. In 1998 the country switched from hitherto prevalent cascading turnover tax regime to the concept of tax on value addition by emulating the New Zealand GST system (Goods and Services Tax Act No.141 of 1985), hailed as the best VAT/GST system in the world. The modifications introduced to the system since then during the last 17 years have resulted in drastic erosion of the VAT base, imposition of heavy compliance burden on the taxpayers and creation of information overload on tax officers due to “plugging” of a “SVAT Scheme” into the statute (to successfully solve the piling up of VAT refunds) in addition to other “ailments.”
Numerous rules laid out in the statutes pertaining deferment of VAT by Commissioner General and the Director General of Customs only contribute to the confusion. Hence one may have sympathy towards ‘anti – VAT’ critics. A neutral observer would certainly opine the Sri Lankan VAT system requires simplification of its complicated web of VAT provisions couched in the statute. The provisions of the Sri Lankan VAT statute are certainly very much complicated in comparison to other VAT / GST jurisdictions
“Exemption Creep” in Sri Lanka
The success of the New Zealand (NZ) GST system is attributed to its broad tax base and the minimal exemptions. Exemptions break the concept of taxing value addition at each point of the supply chain and violate the fundamental principle of VAT. In NZ GST exempt status has been afforded only to three areas, namely financial services, dwelling accommodation and precious stones. Similarly tax policy makers in Singapore, which occupies the number one position in Word Bank’s “Ease of Doing Business Index” also have provided GST exempt status to only three areas i.e. financial services, residential premises and investment in precious metals. On the other hand the Sri Lankan system has been “infected” with “exemption creep” a phrase used in tax literature to denote various goods and services being exempted from VAT due to lobby groups. Year on year, Sri Lankan policy makers have succumbed to lobby groups resulting in over 140 items finding its way to the list of exemptions in the VAT statute including the 11 items that were legislated as new exemptions a couple of weeks back. In Sri Lanka, VAT free business sectors include automobile industry, alcohol and tobacco, pharmaceuticals, petroleum, education and books, telecommunication, power sector, films, certain consumer food products, public passenger transport, local jewelry, local software, locally produced dairy, local handloom, residential accommodation, etc.
OECD findings
In a VAT/GST system, exemptions, zero rate supplies and concessionary rates essentially denote a political compromise. However these VAT exemptions, zero rate or concessionary VAT rate in addition to the standard rate contrary to the popular belief is not the modus to assist socially under privileged,says a recent OECD report. As per the analysis of the OECD the reduced rate in fact benefits more the socially affluent than the under privileged! OECD recommends a broader VAT base with a single rate coupled with social justice and equity to be achieved via tax credits and other specifically targeted reliefs; a lesson for the Sri Lankan policy makers to cut down the number of exemptions and broaden the VAT base to heal the ailing system.
VAT refunds and SVAT
Processing VAT refunds in a timely manner is one of the key challenges facing a VAT administration where there is low level reliance on information technology and Sri Lanka is not the only VAT jurisdiction that has failed the test. As mentioned previously with a unique home grown mechanism under the aegis of ‘Simplified VAT Scheme’ or commonly referred to as the ‘SVAT’Scheme coupled with a legislative amendment to the Act, Sri Lankan tax authorities successfully countered the headache of VAT refunds and provided relief in terms of cash flow managements to the participants of the scheme (specially the exporters). SVAT is a misnomer, for the scheme could hardly be referred to as being simple. Heavy compliance burden inherent to the scheme in terms of documentation has drawn much criticism from many quarters. If the tax authorities could carry out VAT audits efficiently in a timely manner with the ongoing upgrading of information technology for tax administration there would not be a requirement to continue with the SVAT Scheme. “Unplugging of the SVAT Scheme” from the VAT system in the backdrop of an efficient and smoothly operational technology driven VAT administration process would enable the Sri Lankan VAT system to relate to the mechanisms in other VAT jurisdictions whilst substantially reducing the complexity of the present VAT system.
Stakeholder consultation needed
The surgery that is being contemplated to the Sri Lankan tax regime is the most serious in the 83 year-old history of taxation in Sri Lanka. VAT accounted for 44 per cent taxes collected by the Commissioner General of Inland Revenue as per the Inland Revenue Department (IRD) Performance Reports -2013. Thus, such a widespread tax affecting many stakeholders should not be abolished with a stroke of a pen by the policymaker without obtaining proper feedback from all the stakeholders concerned including general public. Perusing and studying the consequences from all the dimensions is a prerequisite for the success of the surgery and to prevent excessive bleeding after the surgery.
Suresh Perera
A transition from VAT to TT also imposes switching costs and inconveniences on the taxpayers as well. It is also relevant to raise the point with regard to the timing of this operation as well. As everyone is aware the IRD is currently undergoing a major transformation with regard to use of information technology pertaining to tax administration with the new Revenue Administration Management Information System (RAMIS) being introduced. It is expected that automation and technology would lead to a new era in tax administration improving the efficiency and effectiveness in revenue management and collection. Hence one could expect the benefits of the widespread use of technology would extend to improved and efficient VAT administration as well. This fact certainly militates against the selection of the timing of the surgery any prudent analyst would opine that the decision warrants a deferment permitting time for a careful study of the pros and cons of the decision to throw the baby with the bath water! Another point to ponder is whether Sri Lanka can sustain the competitiveness of the Sri Lankan products in the global market pursuant to adoption of TT.
Would there be price escalation due to the cascading effect of TT?
(The writer is Principal – Tax and Regulatory, KPMG Ford, Rhodes, Thornton & Co)