Updated: 8 Feb 2012

ECON 635: PUBLIC FINANCELecture 7

Topics to be covered:

a. Value Added Tax

b. Credit or Invoice Method

c. Why adopt a VAT?

d. Types of VAT Tax Bases

e. Calculation of Tax Revenue with Exemptions

f. Zero Rate Issues

g. Zero Rating with Subtraction Method

h. Taxation of Small Traders

i. Treatment of Border Transactions

j. Destination Principle of Taxation

k. Origin Principle of Taxation

l. EU Transitional System

m. Border Adjustments

n. Inflationary Effect of VAT

o. Inflation and Introduction of VAT

p. Is VAT Regressive?

q. Summary on Domestic Indirect Taxes

2

VALUE ADDED TAX (VAT)

• The value added tax (VAT) is an indirect tax

collected at various stages based on the value

added created at each stage.

• It is not really a new tax but is merely a sales tax

administered in a different way.

• A fully implemented, VAT is equivalent to a single

stage tax at retail level.

• More than 120 countries now are using VAT.

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• Value added is the value that an economic agent adds to the raw

materials or intermediate inputs before selling the new or

improved good or service.

• Inputs (raw materials, transport, rent, advertising etc.) are bought

by a firm, labor is paid to work on the inputs along with the

capital used by the business and when the final good or service

is sold to the next producer or consumer, some profits are left.

• The difference in between the value of the final product and the

value of intermediate inputs used in its production (excluding

labor and capital services) is the value added. • Price output– Sum of intermediate input costs =

WL + rK = Value Added

What is Value Added Tax ?

4

Value Added = Wages + Profits = Value of Output – Cost of Inputs

• We can tax $100 at the retailer level, or

• Can tax the value added at every stage ($50 at the manufacturer level, $20 at the wholesaler level, and $30 at the retailer level)

• If the tax rate is the same, both these methods would give the same tax revenue.

Level Sales Value added

Manufacturer $50 $50

Wholesaler $70 $20

Retailer $100 $30

5

Calculation of VAT

Farmer Miller Baker Consumer

FIRM 1 FIRM 2 FIRM 3

PP P1 2 3

Labor Capital

wheat flour bread

• P1 is the value added at the farmer level = WL + rKWhere W = wage rate

L = Labor hours r = cost of capital

K = capital used.• Suppose that the price of flour sold by the miller is P2 and the price of

bread sold by the baker is P3.Value added at the level of the farmer = P1

Value added at the level of the miller = P2 - P1

Value added at the level of the baker = P3 - P2

Total value added = P3

6

Alternative Methods to Compute Value Added Tax

• Addition Method

• Subtraction Method

• Invoice or Credit Method

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Addition Method

• This method taxes wages and the income accruing

to capital (profit plus interest) at each year.

• In this method one has to find out how much was

paid to labor and capital at each stage and then

calculate the tax on that basis.

Farmer Miller Baker

t (WL + rK) t (WL + rK) t (WL + rK)

• This method is difficult to implement.

8

Addition Method (Cont’d)

• Used only by Japan:

• The tax at each stage = tax rate (wages + profits); or

• If the tax rates on profits and wages are different (say

t1 and t2)

• Tax at each stage = t1 x wages + t2 x profits.

9

Disadvantages of Addition Method

• A great deal of information is needed to calculate the

tax liabilities.

• The estimation of profits has the same problems that

we come across in case of corporate income tax.

• The addition VAT turns out to be a combination of a

payroll tax and a corporate income tax.

• Suitable for Japan because Japan has a very well

functioning corporation income tax.

10

Subtraction Method

• This is also called business transfer tax.

• The revenue is calculated as follows:

Revenue = tax rate (Value of output - Cost of inputs)

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• In this method, if "t" is the tax rate, then the sum of

the taxes for all stages is:

tP1 + t(P2 - P1) + t(P3 - P2) = tP3

• If tax rates at the three stages are t1, t2 and t3, total

tax revenue will be:

t1P1 + t2 (P2 - P1) + t3 (P3 - P2).

Subtraction Method (Cont’d)

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• In this method, the output is taxed and a credit is given for the taxes paid on inputs.Farmer pays = tP1

Miller pays = tP2 – tP1

Baker pays = tP3 - tP2

Total tax paid = tP3

• This means that the tax is effective at the last price or last point. The credit or invoice method is superior when different tax rates are used. In the illustration, if t1, t2, and t3

are tax rates used for the farmer, miller and baker,

• The total tax paid is t1P1 + (t2P2 - t1P1) + (t3P3 - t2P2) = t3P3.

Credit or Invoice Method

13

EXAMPLE

Single tax rate

Selling price Single Tax 10% Tax

Stage 1 50 (50)(0.1) 5

Stage 2 70 (70)(0.1)-5 2

Stage 3 100 (100)(0.1)-7 3

Total Tax paid 10

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EXAMPLE (Cont’d)

Multiple tax rate (t1 = 6%, t2 = t3 = 10%)

Selling price Tax 6%, 10% Tax

Stage 1 50 (50) (0.06) 3

Stage 2 70 (70) (0.1)-3 4

Stage 3 100 (100) (0.1)-7 3

Total Tax paid 10

• The tax rate levied at the final stage determines the total tax burden.

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• Although theoretically all the three methods give

the same result, the invoice or credit method has

become more acceptable due to the following

reasons:

– The invoice becomes a crucial evidence for the

transaction occurring as well as the tax payment,

– The tax invoice creates a good basis for audit,

– In the subtraction method, if different tax rates are to

be applied on various products, it is difficult to find out

exactly the amount of inputs which go into the

production of each type of output.

Invoice or Credit Method

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Why adopt a VAT ?

Existing tax laws may be unsatisfactory. For example,

• The turnover tax is problematic due to cascading

effects.

• The manufacturers and wholesalers try to seek

exemption from the tax on inputs if a turnover tax is

used, particularly when producing for export.

• In turnover tax integration between manufacturers,

wholesalers, and retailers may be done for the

purpose of tax evasion.

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• In LDCs, tax revenue is difficult to collect with a single stage sales tax.

• With a VAT, tax revenue is collected at each stage and it is the next business who will obtain a credit for the tax paid on its inputs.

• Revenues can be collected at any given stage with less accuracy than for the case of a single tax and no serious problem is created.

• Custom Unions require that discriminatory border taxes (i.e. import tariffs) be abolished (for example EU, MERCUSUR).

• VAT can be helpful in increasing tax revenue or in reducing other taxes. For example, VAT can replace the corporate tax, or import duties.

• It is becoming internationally increasingly fashionable to use VAT as a revenue instrument.

• It is a sign of modernization, but the EU’s sixth directive on VAT (1971) now needs to be improved.

Why adopt a VAT ? (Cont’d)

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The different types of VAT according to the tax base, are:

GNP Type. In this type of VAT, all final goods and services

produced and sold in a period of time are subject to tax.

• This means that both capital goods and consumer goods are

taxed, input tax credit is not given for the purchase of capital

goods used in a business.

• If the GNP of a country in a year is $5 billion, then the tax at a

5% rate would be $250 million.

• The tax base is simply the gross receipts minus cost of

intermediate goods. No deduction is permitted for depreciation

or for the purchase of capital goods.

Types of VAT Tax Bases

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• NNP Type. In this case, VAT is applied to gross receipts

minus purchase of intermediate goods minus depreciation,

hence the name Net National Product or NNP type VAT (NNP

is equal to Gross National Product minus depreciation or

capital consumption allowances). The NNP type of VAT is an

income tax because the base for NNP type VAT and the

income tax is the same.

• Consumption Type. In this case, the tax base is gross

receipts minus purchases of intermediate goods minus capital

expenditures on plant and equipment. What is left is the

consumer goods. Thus the base of consumption type VAT is

like the base of a retail sales tax.

Types of VAT (Cont’d)

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Calculation of Tax Revenue with Exemptions• If stage two (miller) is exempt from tax, then the tax revenue would be:• by the invoice credit method:

Tax paid by farmer = t1P1

Tax paid by miller = 0Tax paid by baker = t3P3

Total tax paid = t3P3 + t1P1,

which is more than the revenue, t3P3 that would have been collected if

no exemption.• By the subtraction method:

Tax paid by farmer = t1P1

Tax paid by miller = 0Tax paid by baker = t3P3 - t3P2

Total tax paid = t1P1 + t3P3 - t3P2,

which may be less than the taxes paid when there were no exemptions. But it is certain that if the subtraction method is used the total tax paid is less as compared to tax paid under the credit method.

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EXAMPLE

Stage 1 exempted

Selling price Single Tax 10% Tax

Stage 1 50 0 0

Stage 2 70 (70)(0.1) 7

Stage 3 100 (100)(0.1)-7 3

Total Tax paid 10

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Stage 2 exempted

Selling price Single Tax 10% Tax

Stage 1 50 (50)(0.1) 5

Stage 2 70 0 0

Stage 3 100 (100)(0.1) 10

Total Tax paid 15

EXAMPLE (Cont’d)

• As can be seen, an exemption at the intermediate levels leads to an increase in tax revenue.

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EXAMPLE (Cont’d)

Stage 3 exempted

Selling price Single Tax 10% Tax

Stage 1 50 (50)(0.1) 5

Stage 2 70 (70)(0.1)-5 2

Stage 3 100 0 0

Total Tax paid 7

• Exempting the final stage from tax reduces the total tax revenue collected.

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• A major problem with exempting a sector is that the input tax credits earned in the exempt sector might be diverted to a related business activity that was taxable.

• A North Cyprus innovation is to levy a low rate of tax on sectors that would otherwise be exempt.

• In this way the low tax rates extract the input tax credits from the sector while little or no additional tax is paid.

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Zero Rate Issues• Credit method.

i) If the tax rate (t2) on miller is zero, then Tax paid by farmer = t1P1

Tax paid by miller = t2P2 - t1P1 = -t1P1

Tax paid by baker = t3P3 - t2P2 = t3P3

Total tax paid = t3P3 - t1P1 + t1P1 = t3P3

ii) If t1 is zero, thenTax paid by farmer = t1P1 = 0Tax paid by miller = t2P2 - t1P1 = t2P2

Tax paid by baker = t3P3 - t2P2

Total tax paid = t3P3 - t2P2 + t2P2 = t3P3

iii) If t3 is zero, thenTax paid by farmer = t1P1

Tax paid by miller = t2P2 - t1P1 Tax paid by baker = t3P3 - t2P2 = - t2P2

Total tax paid = - t2P2 + t2P2 - t1P1 + t1P1 = 0• Zero rating at the first level or intermediate level does not reduce the total tax

paid but changes the taxes paid at different levels in the chain as the credits at some stages are reduced or increased.

• With zero rating at the last level, however, the total tax is reduced to zero.

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EXAMPLE• Zero Rating

t1 = 10%, t2 = 0%, and t3 = 10%

Selling price Single Tax 10% Tax

Stage 1 50 (50)(0.1) 5

Stage 2 70 (70)(0)-5 -5

Stage 3 100 (100)(0.1)-0 10

Total Tax paid 10

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EXAMPLE (Cont’d)

t1 = 10%, t2 = 10%, and t3 = 0%

Selling price Single Tax 10% Tax

Stage 1 50 (50)(0.1) 5

Stage 2 70 (70)(0.1)-5 2

Stage 3 100 (100)(0)-7 -7

Total Tax paid 0

• So, zero rating in the final stage cleans out all the tax revenue through the credit mechanism.

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Zero Rating with Subtraction Method• Only the value added at particular stage that is zero rated is free from tax.

i) If t1 is zero, then

Tax paid by farmer = t1P1 = 0

Tax paid by miller = t2(P2 - P1)

Tax paid by baker = t3(P3 - P2)

Total tax paid = t3 (P3-P2) + t2 (P2-P1).

ii) If t2 is zero:

Tax paid by farmer = t1P1

Tax paid by miller = t2 (P2-P1) = 0

Tax paid by baker = t3 (P3-P2)

Total tax paid = t3 (P3-P2) + t1 P1.

iii) If t3 is zero:

Tax paid by farmer = t1P1

Tax paid by miller = t2 (P2-P1)

Tax paid by baker = t3 (P3-P2) = 0

Total tax paid = t2 (P2-P1) + t1 P1.

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• To tax small traders, different options are available to suit the

particular situation:

• Most countries have a minimum threshold level of turnover.

Businesses with sales below this threshold amount are exempt

from VAT on sales but receive no credit for inputs.

• Alternatively one could impose a minimum tax based on a set

of criteria such as the size of the establishment or estimated

sales.

• No credit may be given on purchases but a low sales tax rate

can be introduced on gross receipts.

Taxation of Small Traders

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Taxation of Small Traders (Cont’d)

• One could impose a higher tax on purchases made by small

traders but no tax on their sales.

• Some sectors are easy to tax even though their turnover is

small. For example, car sales are easily taxed because cars

need to be registered.

• The level of economic activity in different sectors varies from

country to country. In Indonesia and TRNC, 70% of the

potential value is on imports, petroleum production, and sales

of products by public enterprises. Therefore, it would be easy

to tax these sectors which constitute the bulk of the economy.

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Treatment of Border Transactions

Destination Principal• Imports are taxed, exports zero rated• This has been the traditional type of border

adjustment.

Origin Principal• Imports are exempted, deemed credit given on next

sale of imported items.• Exports are taxed.• The treatment of border tax adjustments can be

considered with the help of the following example.

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Destination Principle of Taxation• The tax is imposed at the point of consumption. Thus imports are

taxed and exports are exempted.• Consider three stages, S1 (imports), S2 (domestic manufacture), and S3

(export sales) and three rates of taxes, t1, t2, and t3 respectively imposed on

them.

Transaction Selling price Single Tax 10% Tax

S1 (imports) 50 50 x 0.1 5

S2 (manufacturing) 70 (70 x 0.1)-5 2

S3 (exports) 100 (100 x 0)-7 -7

Total Tax paid 0

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Destination Principle

COUNTRY A

EXPORTING IMPORTING

zero tax

refund tax on intermediate goods

COUNTRY B

EXPORTING

zero tax

refund tax on intermediate goods

tax imports

IMPORTING

COUNTRY C

tax imports

refund tax paid on

intermediate inputs

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Origin Principle of Taxation• The tax is imposed at the point of origin. Imports are

exempted and exports are taxed.

* A deemed credit is given on first sale of imported goods to account for the fact that tax was paid to the exporting country when item purchased.

Transaction Selling price Single Tax 10% Tax

S1 (imports) 50 50 x 0 0

S2 (manufacturing)

70 70 x 0.1 – 5* 2

S3 (exports) 100 (100 x 0.1) – 7 3

Total Tax paid 5

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Origin Principle

Imported exemptDeemed credit

given on next

sale of imported

goods

COUNTRY A

EXPORTING IMPORTING

taxed

COUNTRY B

EXPORTING

intermediate good.

for tax paid to A when

IMPORTING

COUNTRY C

importstaxed

imports used asexempt

credit given

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Origin Principle of Taxation (Cont’d)

• Russia, which did not have customs union with the CIS

continued to use the original principle.

• It has failed, and they have moved to destination principle.

• The EU is trying to introduce a system of origin principle

taxation for VAT in countries of EU. It has not been very

successful.

• The origin and destination principles of taxation can also be

explained with an example in which three countries A, B,

and C are involved.

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EU Transitional System

• The Single European Market was intended that sales

between businesses in different member states

would be treated exactly like a domestic transaction,

with VAT being charged by the supplier.

• The European Commission therefore adopted an

interim arrangement, which was destination-based,

whereby the supplier usually zero-rated their invoice

and the buyer paid VAT, at the local rate, to the tax

authority at destination.

38

EU Transitional System• Under the present transitional system, the supplier can zero-

rate their invoice on a VAT registered trader in another member state subject to three conditions.1. The buyer's VAT registration number, prefixed with the appropriate

country code, is shown on the supplier's invoice.

2. The goods are dispatched to a destination outside the Country.

3. The supplier holds documentary evidence, for example a CMR note or certificate of shipment, showing that the goods were removed from the Country.

• The sale can only be zero-rated if all these conditions are met.

• Where sales are made to a non-VAT registered person, the supplier must charge VAT at the Country rate.

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• Distance selling is defined as the dispatch of goods by a supplier, who is not registered in the country of destination, to a non-VAT registered customer.

• In these cases suppliers are able to charge Country VAT until their sales in any member state reach a certain value threshold.

• Once that threshold is reached, the supplier must register for VAT in the country of destination and charge VAT at the local rate.

• The thresholds are 35,000 euro per annum in some member states and 100,000 euro in others. The level of sales is calculated from the beginning of a calendar year.

• If a supplier does not have a place of business in a particular member state, a tax representative can be appointed to account for VAT to the local tax authority.

• Sales of new vehicles, trucks, airplanes are not covered by distance selling rules as the customer usually accounts for VAT at the place where the new vehicle, boat or aircraft is first put into use.

EU Transitional System

40

• Some revenue sharing agreements have to be worked out

among governments, if the origin principle is used.

• This could be difficult to accomplish (has not been possible in

EU).

• Production of goods varies greatly across countries.

• Some countries export services that are difficult to tax on

export.

• Countries that receive remittances would suffer.

• Consumption is a more uniform base when destination principle

is used.

Border Adjustments (Cont’d)

41

Inflationary Effect of VAT

• Sometimes it is argued that the VAT has strong inflationary

effects.

• To analyze the effect of VAT on prices, it is necessary to

realize that many countries tend to finance government budget

deficits by increasing the money supply through printing of

currency. If:

M = money supply

V = velocity of money supply

T = number of transactions in a year

P = price level,

• Then, MV = TP

42

Inflationary Effect of VAT

MV = TP

• Whenever M increases due to printing of money, even if V

remains constant, the price level P increases.

• Consider that VAT is introduced in order to increase

government revenue instead of printing of more currency or

increasing the money supply. The inflation may actually fall.

This is explained in the following figure.

43

Inflation and Introduction of VAT

t* is time when VAT introduced

t*+1 one year after VAT introduced

• In this case, a 6% increase in prices takes place between periods t*-1 and t* due to an increase in the money supply.

• VAT at a rate of 5% is introduced at time t* when prices are at level A.• This will push up the prices at time t* to level B.• It will, however, also increase the government revenue and may ultimately

lower the inflation rate over time.

(Time of Measuring Effect)

t*-1 t* t*+1

A

BC

DE

F

5% VAT

+6%

(due to money supply increase)

44

Inflation and Introduction of VAT (Cont’d)

t* is time when VAT introduced

t*+1 one year after VAT introduced

• By original expectation, the price level measured in period t*+1 should have been at F. But this does not happen.

• This is because the government revenue increases following the introduction of VAT, budget deficit is cut down, and there is a contraction in money supply.

• The price level comes to point D or even to a lower level depending on the effect of revenue raised by the VAT and its resultant effect on the money supply.

• Here, DE represents the price effect as a result of increased revenue and reduction in the money supply growth.

• The VAT can lower the rate of inflation.

(Time of Measuring Effect)

t*-1 t* t*+1

A

BC

DE

F

5% VAT

+6%

(due to money supply increase)

45

Is VAT Regressive ?

• It is sometimes alleged that VAT is regressive. This

argument is given since VAT is usually levied on

consumption while full credit is given on capital goods.

• The two arguments why VAT need not be regressive

are outlined below.

46

Is VAT Regressive ? (Cont’d)i) Consider the following example in which the effect of VAT on two persons,

one poor and the other rich, is analyzed.

YP = Income of poor Yr = Income of rich CP = consumption of poorCr = consumption of richSp = savings of poor Sr = savings of rich

as the rich save more as percentage of their income. That is,

and if "t" is the tax rate on consumption, then

• Generally, the regressivity of VAT is attributed to this relationship. But we need to consider the fact that the rich people save to consume in future.

• It is also the case that rich people live longer in retirement than do poor people, hence, they consume more after they stop earning income.

S p

RICH

POOR

Y r

C r S r

p Y

C p

C

Y

C

Yp

p

r

r

t C

Y

t C

Yp

p

r

r

S

C

S

Cr

r

p

p

47

Is VAT Regressive ? (Cont’d)

• If Y'u is the unearned income of a rich person consumed later

on, and Y'r is the later year's income, then in that year the

consumption of the rich person (=C'r) is equal to Y'r + Y'u.

• Since these savings are consumed later on, the rich pay more

taxes in present value terms.

• Poor people tend to retire and live off government pensions or

family members income.

C r

r Y ' u Y

48

Is VAT Regressive ? (Cont’d)• In LDCs, a large part of the consumption of poor people is

purchased from the informal sector where there is no tax.

• Due to this fact, the actual tax base that covers the poor population is smaller as compared to the rich people.

• If these are the tax bases for the rich and the poor, then their relative magnitudes would be as shown in the following diagram:

• Then,

S p

RICH

POOR

Y r C r S r

p Y C p

T r B

T p B

T

Y

T

YBp

p

Br

r

49

• The share of consumption subjected to tax as a percentage of income for a high income person is more than that for a poor person.

• Therefore, due to the existence of a large informal sector that caters to consumption by the poor, the VAT in developing countries is progressive.

• Empirical analysis of Bolivian case shows that VAT is progressive.

Is VAT Regressive ? (Cont’d)

50

The various issues that are generally considered while designing a tax system are as follows:

• There is a wide range of options available for levying indirect taxes.

• There is a tradeoff among these different taxes in terms of the tax base, the number of taxpayers and the cost of administration.

• The level of economic activity at different levels is another factor which could influence the choice of an indirect tax.

• In some countries, producers are easier to tax than in other countries. For example, in a country that produces manufactured goods, it will be easier to run a producers level sales tax than in a country that produces business and tourism services.

• This will determine which level of sales tax will generate sufficient revenues.

Summary on Domestic Indirect Taxes