VAT relies on fractional collection on the value added that is generated at every stage of production. Due to credits provided for inputs in all B2B transactions, VAT only sticks on B2C transactions. Therefore, VAT is ultimately a consumption tax in the broad sense and its potential tax base consists of all consumption expenditures by households. In practice, the size of the effective tax base depends on the definition of a taxpayer (or taxable person), the definition of a taxable supply and the types of supplies included and excluded in the calculation of the base and, ultimately, the tax.

Several types of exclusions reduce the size of the effective VAT base: non-supplies or supplies other than in the course of taxable activity; exempt supplies; zero rated supplies other than exports; and activities of persons that fall short of the VAT registration threshold.

It is common practice to exclude small businesses from the VAT regime through the application of a registration threshold (a few countries though, e.g., Chile or Spain, do not have any). The threshold is expressed as a monetary value in local currency units. The most relevant concept of the VAT registration threshold is measured in terms of taxable supplies. Persons are required to register if, for example, their taxable sales in one year exceed the threshold. This makes sense because taxable supplies provide a clear indication of tax collection potential. For some businesses, turnover will be an inappropriate measure because it may include exempt supplies and the proceeds of transactions that may not be taxable.

This exemption results in small traders paying unrecoverable VAT on their taxable purchases and not being required (nor allowed) to charge VAT on their sales, such that their value-added is effectively taken out of the VAT base. At the same time, those small traders are relieved of all the compliance obligations attached to VAT.

Although adopting a registration threshold reduces the tax base and introduces economic distortions, those problems are typically small relative to the savings in terms of administrative and compliance (collectively: collection) costs associated with the exclusion of small businesses which, while large in number, tend to generate low aggregate levels of value added and hence small collections.

The standard recommendation is for a single threshold applied across all industries (e.g., without differentiating between goods and services). Multiple thresholds, with the exception of a voluntary registration threshold (see below) are difficult to administer and open up classification disputes and tax planning opportunities. To safeguard against the potential avoidance of the VAT threshold through the artificial segregation of activities across multiple related businesses, related firms should be grouped, whenever possible, for the purposes of determining whether they fall under or above the threshold. Modern VAT laws include rules for the registration of branches, groups of companies, and private firms set up by families to mitigate this type of avoidance.

A best practice system also allows for voluntary VAT registration of businesses falling under the threshold, provided these businesses are able to maintain reliable books of account substantiating their transactions. Voluntary registration provides a practical tool to mitigate competitive distortions and avoid inequities between taxable and non-taxable entities. Small businesses that sell zero-rated goods (e.g., exporters) and wish to claim refunds for excess VAT input credits and those that supply inputs to VAT-registered businesses (which prefer buying from other registered businesses as it allows them to claim VAT input credits) would generally be expected to derive financial benefits from VAT registration, and thus to voluntarily register. VAT laws in some countries also specify a minimum threshold under which voluntary registration is not allowed.

In practice, there is considerable variation in the level at which VAT thresholds are set. Amongst OECD countries, the UK has the highest threshold level (£85,000 annual turnover), whilst other countries, e.g., Chile or Spain, do not apply any threshold. The table below shows VAT thresholds in percent of GDP per capita for different income levels, aggregated based on average values. The question of the appropriate threshold level is explored separately under the Optimal VAT Threshold.

It should be noted, however, that the prevailing view on the threshold level (a trade-off between revenue and collection burden) has been challenged recently with the emergence of new digital business models that rely on self-employed/workers, such as Uber. Since these businesses can be de facto broken-up into smaller businesses, one per individual, so as to avoid crossing that threshold, some countries opt to reduce their VAT threshold. Similarly, new digital business models also facilitate cross-border purchases of goods by consumers. Often these transactions are exempt from import duties, VAT, and other taxes and many countries have reduced or removed de-minimis thresholds to ensure that revenue is collected, and domestic suppliers are not disadvantaged compared to foreign competitors. This question is further explored under the Taxation of the Value-Added of E-commerce.

The choice of VAT registration threshold should also be evaluated in the context of its impact on the overall progressivity of a VAT.

Source: IMF staff

Data. For an up-to-date information on VAT threshold of most countries in the world click here.

The setting of a VAT registration threshold involves a tradeoff between narrowing the VAT base by exempting small taxpayers—whose compliance would be disproportionately costly to enforce by the tax administration—compared to the expected revenue loss from those exemptions. Indeed, if it were not for the costs of administering a VAT (incurred by the authorities) and of complying with it (incurred by taxpayers), the best threshold would be zero: this would maximize revenue (at any given tax rate) while also minimizing distortions of competition between firms of different size. Thus, the need for some threshold arises from the existence of collection costs.

Intuitively, the optimal VAT threshold arises when the marginal loss to the government of increasing the VAT threshold is equal to the marginal private sector gain from reduced costs. Suppose that the objective of the government is to maximize revenue net of administration costs, weighted by the marginal cost of public funds less the loss that the private sector suffers as a direct consequence of paying tax and incurring compliance costs. Then, Keen and Mintz show that the optimal threshold (Z) equals:

\[Z = \frac{δA+C}{(δ-1)τv}\]

Where:

The optimal threshold thus increases with administration (A) and compliance costs (C), but decreases with the government’s need for funds (δ). In addition, the optimal threshold is higher the lower the ratio of value added to output (or sales). Turning this last idea around implies that a purely theoretical case can be made for setting a lower threshold for more profitable and/or labor-intensive activities. In practice, this would be hard to monitor and enforce, especially for labor-intensive activities such as personal services.

This relatively simple rule, however, faces several limitations. First, it neglects the social costs of the production inefficiency associated with the differential treatment of those above and below the VAT threshold. As noted above, a voluntary registration threshold can reduce those social costs. An alternative tax imposed on businesses whose turnover falls below the threshold, such as a turnover tax on non-registered firms, can also mitigate those social costs. Second, the formula relies on parameters that many tax administrations with limited analytical resources may not know. However, tax administrations that cannot estimate some of the parameters in the optimal threshold formula can instead approximate the optimal threshold using VAT return data. The calculations require segmenting businesses by size (measured by taxable supplies or turnover) and evaluating the impact of increasing the threshold on VAT collections using the distribution thus constructed.

References and further reading:

For further discussion of the optimal threshold, see Michael Keen and Jack Mintz (2004), “The Optimal Threshold for a Value-Added Tax,” Journal of Public Economics, Vol. 85, No. 3-4, pp. 559-576.

The optimal VAT threshold formula relies on data that many tax administrations with limited analytical resources may not have. In such cases, the optimal VAT threshold can be approximated using VAT return data. The table below shows the taxpayer size distribution data that would typically be compiled to make an indirect estimate of the optimal threshold. For convenience, currency units are expressed in millions of national currency. This distribution is constructed by segmenting the sample of registered taxpayers in ranges of taxable supplies based on VAT returns. The range cutoffs and sizes are left at the discretion of the analyst but should be fine enough to allow a tracking of the trade-off between the number of registrants (left section of the table), taxable supplies (central section), and VAT paid or to be paid (right section).

A Country: Size Distribution of Businesses with VAT Returns, 2016

Source: IMF staff

Some interpretations of the data can be made. For example, with a threshold set at 25 currency units (see under Taxable Supplies Range heading), 15.7 percent of all business establishments account for 93.2 percent of total taxable supplies and for 85.9 percent of VAT to be paid. Alternatively, with a threshold set at 5 currency units, 33.4 percent of all business establishments account for 98.4 percent of total taxable supplies and for 96.0 percent of VAT payable. An increase of about 10 percentage points (from 85.9 percent to 96.0 percent) in collections require that the tax administration move from handling 15.7 percent of the registrants to 33.4 percent of the registrants, more than a doubling of the number of firms. Summing the number of businesses from the top down to 50 currency units and then from the top to 5 currency units yields 6,394 and 13,588 firms respectively. The next step illustrates the trade-off even more sharply: reducing the threshold from 5 to 2 currency units adds a further 5,414 registrants but VAT to be paid increases to 98.5 percent of the total. Increasing collection by 1.5 percentage points (from 96.0 to 98.5) requires an almost 40 percent increase in the number of covered firms.

It is advisable for administrations to study the behavior of businesses with taxable supplies that are close (slightly below and slightly above) to the threshold to uncover any bunching effects and other incentives presented by the threshold.

References and further reading:

For further discussion of the approximation method and an illustration using real data, see Pierre-Pascal Gendron (2017), “Real VATs vs the Good VAT: Reflections from a Decade of Technical Assistance,” Australian Tax Forum, Vol. 32, No. 2, pp. 257-282.

Deeming rules are used to determine whether an import or export of goods or services has taken place in cases that may not be clear-cut. Such rules may involve tests.

VAT laws usually include barter in the definition of the supply of goods and services and include language to define consideration in that case.

The marginal cost of public funds measures the loss incurred by society in raising additional revenues to finance government spending. Taxes affect the allocation of resources in the economy by changing taxpayers’ consumption, labor supply, investment and risk-taking decisions, resulting in a less efficient allocation of resources. The marginal cost of public funds serves as a summary measure of the additional distortion in the allocation of resources when a government raises additional revenue.

A best practice VAT would have a comprehensive base capturing as much of national consumption as possible in terms of both goods and services. A supply is said to be exempt when it is not subject to VAT. An exemption usually benefits the buyer, unless the buyer is a VAT business using the supply as an input to production. The downside of the exemption for the seller is that VAT paid on business inputs to produce the exempt supply cannot be credited because there is no output VAT to offset. Input VAT paid to make exempt supplies is said to be unrecoverable.

Exemptions violate the logic of a pure broad-based VAT since they result in cascading and excessive taxation (tax on tax) if they apply to pre-retail (intermediate) stages. They also create a bias against outsourcing since the tax burden can be reduced by producing inputs in-house rather than purchasing taxable inputs from third parties. Exemptions, once granted, tend to proliferate as exempt sectors want their suppliers to be exempt too, and other sectors lobby for equal treatment. A limited number of well-defined exemptions are also quite common for policy and practical reasons. In most situations, the case for exemptions is weak as other fiscal policies can be more effective and better targeted.

References and further reading:

For a thorough discussion of exemptions, see Institute for Fiscal Studies and James Mirrlees (eds.) (2010), Tax by Design: The Mirrlees Review (Oxford: Oxford University Press), chapter 7.

A best practice VAT would have a comprehensive base capturing as much of national consumption as possible in terms of both goods and services. A supply is said to be exempt when it is not subject to VAT. An exemption usually benefits the buyer, unless the buyer is a VAT business using the supply as an input to production. The downside of the exemption for the seller is that VAT paid on business inputs to produce the exempt supply cannot be credited because there is no output VAT to offset. Input VAT paid to make exempt supplies is said to be unrecoverable.

Exemptions violate the logic of a pure broad-based VAT since they result in cascading and excessive taxation (tax on tax) if they apply to pre-retail (intermediate) stages. They also create a bias against outsourcing since the tax burden can be reduced by producing inputs in-house rather than purchasing taxable inputs from third parties. Exemptions, once granted, tend to proliferate as exempt sectors want their suppliers to be exempt too, and other sectors lobby for equal treatment. A limited number of well-defined exemptions are also quite common for policy and practical reasons. In most situations, the case for exemptions is weak as other fiscal policies can be more effective and better targeted.

References and further reading:

For a thorough discussion of exemptions, see Institute for Fiscal Studies and James Mirrlees (eds.) (2010), Tax by Design: The Mirrlees Review (Oxford: Oxford University Press), chapter 7.

In many developing countries, collection difficulties (numerous small operators), distributional concerns, and political considerations have resulted in a broad VAT exemption of agriculture (understood to include fishing, forestry, and animal-husbandry). In some cases, agricultural inputs—such as fertilizer, pesticides, seeds, and machinery—are also exempted from the VAT.

The proper treatment of the agricultural sector should be considered in the context of country-specific circumstances. There is nothing inherent in agriculture that implies that the sector—in terms of its outputs and inputs—should benefit from any preferential VAT treatment. For example, there is no compelling reason to treat small-scale farmers with turnover below the VAT registration threshold any differently from other small suppliers. In fact, there are very compelling administrative and revenue reasons to leave them as exempt traders: it simplifies administration considerably, reduces administration and compliance costs, and generates VAT on inputs if inputs are subject to VAT at the standard rate. Full taxation subject to the threshold ensures that larger producers of the value chain such as large processors, wholesalers, and retailers are not taken out of the VAT net. Taxing agriculture is also justified by neutrality arguments: all economic sectors should contribute to the collection of VAT.

The preferential treatment of agriculture is not limited to developing countries. In Europe, a number of countries operate flat-rate schemes in addition to other relief measures such as broad exemption and numerous reduced rates. Under a flat-rate scheme, farmers impute a presumptive rate (less than the VAT rate) on their sales to taxable agricultural processing firms, without remitting this to the government. This is designed to compensate exempt farmers for irrecoverable VAT on inputs. Purchasers can deduct the flat-rate payments from their own VAT on supplies. There are no compelling reasons to subject farmers to flat-rate schemes that often end up overcompensating them for VAT paid on inputs, thereby providing unjustifiable subsidies. Compensation for costs breeds inefficiency and deters establishment growth, a fact borne out by the large number of very small farms in Europe. Full taxation of the sector subject to the threshold appears to be the best policy. If possible, full taxation is best supported by the avoidance of other tax preferences (input exemptions or zero-rating, zero or reduced rates on outputs).

References and further reading:

For a thorough discussion of VAT and agriculture, see Sijbren Cnossen (2018), 'VAT and Agriculture: Lessons from Europe,' International Tax and Public Finance, Vol. 25, No. 2, pp. 519-551.

Financial institutions typically offer two broad types of services: margin-based financial intermediation services and fee-based financial services. For margin-based services, no explicit fee is charged, but the financial institution generates profit from the spread between borrowing and lending or buying and selling costs. Examples of margin-based service, which account for the bulk of some institutions’ income, include services such as lending, bid/ask stock or bond trading, life insurance and annuities. Fee-based services are services for which an explicit fee is charged, such as transaction fees, stock and bond trading commissions, fees for account services, asset management services of mutual fund managers.

Financial services are often exempt. The economic impacts of exempting financial services include: over-taxation of businesses (through input taxation) and under-taxation of final consumers; a bias in favor of self-supply by businesses; and a bias in favor of importing financial services, assuming zero-rated exports from country of origin.

Margin-based financial services pose a special challenge and are thus often exempt from the scope of the VAT. The issue arises from the impracticability or impossibility of identifying value added on a transaction-by-transaction basis, which is required to calculate the correct amount of VAT under the invoice-credit method. For example, in the case of loans, the fee would be the interest charged by the bank in excess of the reference market interest rate. The spread between borrowing and lending rates, which one could hope to make a reasonable attempt at estimating, could be taken as measuring the total value added by the intermediary. For other products such as high-risk loans or life insurance, the implicit spread would include a customer-specific risk premium. But in order for the crediting mechanism to work properly, it would be necessary to go further and allocate this value added to borrower and lender (with an input credit due only to registered VAT taxpayers)—which raises the problem of identifying a reference market interest rate.

Fee-based services do not present the same observability and measurability issues and should thus be included as part of a broad-based VAT, with VAT applied on the fees being charged on a particular transaction; the VAT incurred on purchases directly related to the rendering of such services is fully deductible. Many countries have moved to extend the VAT to fee-based financial services.

Where financial institutions offer both taxed (e.g., fee-based) and exempt (e.g., margin-based) services, an allocation method should be used to apportion VAT credits between these services. A direct method relying on separate accounting would produce a more accurate apportionment of VAT credits but generally involves high compliance costs. Alternatively, indirect allocation methods—such as one based on the pro rata of taxable supplies to total turnover—tend to be much simpler but may produce allocations which are somewhat arbitrary in nature. If margin-based services are fully zero-rated rather than exempt, there is no need to apportion VAT credits as all VAT on inputs will be creditable and therefore refundable.

References and further reading:

For background and further discussion of the issues presented but not fully developed above, see:

Institute for Fiscal Studies and James Mirrlees, eds. (2010), Tax by Design: The Mirrlees Review (Oxford: Oxford University Press), chapter 8.

Pierre-Pascal Gendron (2016), “Policy Forum: Canada’s GST and Financial Services: Where Are We Now and where should We Be?” Canadian Tax Journal, Vol. 64, No. 2, pp. 401-416.

Insurance products are typically categorized into two broad segments. These are:

• Property and casualty insurance (sometimes called general or pure insurance); and
• Life insurance, including term insurance, credit insurance, annuities, and two types of health insurance—long term care and disability income insurance.

The particular challenges posed by insurance are due to the following three characteristics:

• a single transaction typically bundles multiple components that each require different tax treatment;
• risk is pooled; and
• transactions typically unfold over multiple taxable years.

Under modern VAT systems, implicit fees such as those charged by property and casualty insurance providers are easily taxed. Taxation is imposed on the value added (premiums minus claim payouts). Premiums and payouts are expressed on a cash flow basis: premiums are a cash inflow (taxed), and claim payouts are a cash outflow (credited).

The VAT-registered insurer is allowed to claim a credit for the VAT paid on the claim payout. The insurer’s VAT due equals VAT calculated on premiums minus VAT on payouts. The VAT credit enables the insurer to send a check to the insured equal to the claim gross of VAT (net value of the claim multiplied by one plus the VAT rate). The credit element in the gross amount paid exactly covers the VAT on replacement goods purchased. If the insured is a consumer, then the government collects revenue equal to value-added (i.e. value of having insurance) times the VAT rate. If the insured is a business registered for VAT, all transactions offset one another and the government collects nothing.

The ease of handling property and casualty insurance comes from the fact premiums and claims pertain to a single year. In contrast, life insurance contacts extend over multiple years. Since life insurance and related products cover longer periods of time and often include bundling of savings with insurance, the determination of value added on a specific transaction is impractical. The cash flow VAT has been shown to work to calculate the correct amount of VAT on those products.

References and further reading:

For a discussion of the application of VAT to general insurance, see Liam Ebrill, Michael Keen, Jean-Paul Bodin, and Victoria Summers (2001), The Modern VAT (Washington, D.C.: International Monetary Fund), chapter 8.

For a proposal to reform the tax treatment of insurance, see Sijbren Cnossen (2013), ‘A Proposal to Apply the Kiwi-VAT to the European Union,’ International Tax and Public Finance, Vol. 20, No. 5, pp. 867-883.

From a VAT perspective, real property is akin to any other durable good or service. As such, all real estate transactions—whether sales or leases—by VAT-registered taxpayers should attract tax, while purchasers or users of real property should be entitled to a corresponding input tax credit when they use it for making taxable supplies. Net VAT revenue is then only collected if the purchaser or user of the property is not a business or uses the property for making exempt supplies.

In practice, however, many countries effectively exempt residential rents and rental values as well as the sale of previously occupied residential property (unless sold by a VAT-registered property developer).

The most practical treatment, typical of modern VATs, is the prepayment model: VAT is paid once on the fair market value of the property at the time of the first sale. The buyer in effect prepays the VAT on the future stream of services the property will yield over time. Three features ensure the internal consistency of this system. First, all commercial transactions are subject to VAT in the usual way. Second, sales of new or substantially renovated housing to households are subject to VAT with no possibility of credit since households are final consumers. Third, resales of used housing and long-term rentals of housing are exempt from VAT given that VAT has been prepaid. Finally, construction inputs and services are subject to VAT in the usual way to ensure that the VAT liability reaches the final consumer.

The prepayment system does not tax housing in a comprehensive way but offers a reasonable compromise solution given that it is difficult to charge VAT as housing services are consumed over time; dealing with price changes over time is difficult; and requiring homeowners to register for VAT is highly impractical.

Land, just like the structures erected on it, is real property that provides a flow of services over time. It should therefore form part of the VAT base. In modern VAT systems, land is subject to VAT but the modalities of application differ from country to country.

References and further reading:

For a discussion of real property VAT with an emphasis on housing, see Satya Poddar (2010), “Taxation of Housing under a VAT,” Tax Law Review, Vol. 63, No. 2, pp. 443-470.

In most countries with good tax administrations, the extractive sector (natural resources) does not present special concerns. In countries with resource-constrained administrations, however, the extractive sector does present several challenges. First, the long-term nature of many resource projects implies long time lags between the development of projects, the beginning of operations, and the appearance of sales revenue. Second, the resource sector is largely an export sector in many developing countries. For those reasons, any input VAT will be incurred long before any output VAT gets collected, if there is a domestic market for the output. If there is none, then no output VAT will be collected. In many cases, firms engaged in resource extraction will therefore claim VAT refunds. Those claims will tend to be large due to the capital-intensity of the operations.

In many developing countries, refund systems do not work well or work only very slowly. For those reasons, several mechanisms have been devised to avoid having to pay refunds. One such mechanism is to zero rate purchases by resource operators, whether they come from imports or domestic sources. In the case of imports, it should be noted that an exemption achieves the same result as zero rating. Another tool is the deferral of VAT on import until the first domestic VAT payments are due. This second mechanism is usually restricted to imports of large machinery that is not manufactured domestically.

Opportunities for abuse exist in both systems. First, all those schemes are complex to administer. Second, resource operators are essentially taken out of the VAT net (especially under tax incentive regimes). Third, risk exists that some equipment and supplies imported or purchased tax free in the domestic economy could be resold tax free. Finally, if refunds are allowed, claims must be audited properly and there could be cash flow consequences for the government due to the size of refunds.

References and further reading:

For additional discussion, see Philip Daniel, Michael Keen, and Charles McPherson (2010), The Taxation of Petroleum and Minerals: Principles, Problems, and Practice (New York: Routledge), chapters 2, 5, and 11-13.

It is helpful at the outset to separate government services into two broad categories: first, services offered in exchange for nil or nominal consideration (effectively subsidized supplies) consistent with social objectives; and second, services that are offered for a fee and compete with the private sector. Hospitals, primary care clinics, schools, colleges, universities are good examples in the first category. Utilities, postal services, refuse collection, sports and entertainment facilities are good examples in the second category. In the second case, there is a very strong argument to subject services to VAT irrespective of whether provision is public or private. This ensures that private sector providers are not placed at a disadvantage relative to public sector providers.

Healthcare and education are the most important government services in the first category. Consistent with a number of social objectives, governments exempt most supplies of government-provided educational and healthcare services as well as some of the related supplies such as textbooks, course materials, prescription drugs, and so on. This exemption is an inelegant but practical solution which leaves the problem of unrecoverable input VAT unanswered. In some countries, governments provide partial relief for input VAT incurred by service providers. This is a half-way point between exemption and zero-rating.

Assuming that government provides all funding for those organization, then input VAT is a wash transaction since the government ultimately collects the revenues. Despite this appearance of a wash, it is important that governments and their organizations pay VAT on their purchases to ensure the integrity of the system by avoiding the need to treat suppliers to government differently from suppliers to the private sector, and preventing abuse. On the expenditure side, this requires VAT-inclusive budgeting of government purchases. Services (including healthcare and education) that compete with those provided by the public sector or complement public sector services via outsourcing should be subject to VAT in the usual way. To ensure that there is no distortion of competition, all government services with private sector competition should attract VAT.

References and further reading:

For a discussion of VAT on governments and similar entities, see Pierre-Pascal Gendron (2010), “How Should the United States Treat Government Entities, Nonprofit Organizations, and Other Government Entities under a VAT?” Tax Law Review, Vol. 63, No. 2, pp. 477-508.

In principle, all transportation services are subject to VAT. It is very helpful to distinguish between transportation services supplied domestically from international transportation, or transportation services whose supply is performed across borders.

In the case of the domestic supply of transportation services, it is helpful to note that much of the activity consists of commercial (B2B) services where the invoice-credit VAT applies in a straightforward way. Business-to-consumer (B2C) services pose no challenges although certain services such as municipal public transit and tolls are often VAT exempt. There is no good rationale for such VAT exemptions so such services should be subject to VAT at the standard rate.

In some VAT regimes, specific domestic activities may be subject to special treatment or restrictions. The taxi business provides a good example of such an activity. Some VAT regimes exempt taxi services. Some regimes deem all operators to be large businesses so they must be registered no matter their turnover. Finally, some regimes place restriction on input VAT credits on fuel. Presumably, those policies intend to raise revenue from a sector where compliance is expected to be low due to the multiplicity of small operators that rely a lot on cash transactions and with opportunities to divert fuel to personal use.

The case of international transportation services is more complex and raises jurisdictional issues. In the case of goods involved in international trade, for example, services linked to the import of goods are taxed at the same time and place: freight is therefore included in the cost, insurance, freight (CIF) value of taxable imported goods. In the case of true international transportation, the country of origin usually zero-rates transportation services as export as long as the goods or passengers exit the country as part of their journey. Conceptually as well as in practice, this is the proper treatment given that apportionment of distance travelled across countries is difficult to do. Some countries exempt international transportation services, a practice that forces them to bear input VAT.

Advanced VAT regimes specify place of supply rules with articles on transportation services, sometimes with separate rules on passenger and freight transportation. The destination principle seems easy to enforce with freight transportation (see discussion of imports of goods above), but more difficult in the case of passenger transportation where elements of origin taxation may persist. Problematic areas targeted by place of supply rules include, for example, short-term B2C leases of passenger vehicles that are likely to be driven across borders.

References and further reading:

Alan Schenk, Victor Thuronyi, and Wei Cui (2015), Value Added Tax: A Comparative Approach, 2nd ed. (New York, NY: Cambridge University Press), chapter 7.

The VAT treatment of non-profit organizations and charities shares many features with government services provided for social welfare reasons. For those reasons, services provided by such organizations are usually exempt, sometimes with some form of relief for input VAT, and sometimes with the treatment of grants related to supplies as consideration received for the supplies. Input VAT relief sometimes takes the form of VAT refunds, a practice that is open to abuse given the nature of the sector. In principle, supplies that compete with the private sector (e.g., selling tickets to sporting events, clothing, and so on) should be subject to VAT in the usual way. Those supplies would then entitle the organization to input VAT credits.

It is quite common for countries to provide VAT and customs duty exemptions for imports and supplies related to diplomats and embassies, international organizations, non-governmental organizations, aid agencies, donor-funded projects, and so on. These practices can result from purely national policies, but also from international agreements or other contractual obligations.

From a tax policy perspective, these non-standard exemptions make little sense: in a donor-funded project, for example, the exemption means that any domestic final consumption by project members is untaxed anywhere (country of project and country of residence). These exemptions can prove costly in terms of revenue foregone by the host country, impose a significant administrative burden, and undermine the overall efficiency of a VAT by distorting the pattern of economic activities. They are also difficult to control and easy to abuse and fraud. VAT-inclusive budgeting of donor-funded projects would be a far preferable solution.

References and further reading:

Gérard Chambas (2005), Foreign Financed Projects in Developing Countries and VAT Exemptions, paper presented at the International Tax Dialogue conference, Italy.

Victor Thuronyi (2005), Tax Aspects of Donor-Financed Projects, paper presented to the Committee of Experts on International Cooperation in Tax Matters, Economic and Social Council (Geneva: United Nations).

The standard VAT rate is the positive rate that applies to the majority of goods and services that are subject to VAT. The standard rate should be distinguished from reduced rates (rates below the standard rate), increased rates (rates above the standard rate), and the zero rate. While VAT rates can vary considerably across countries, the use of a rate between 10 and 20 percent is most common. Modern VATs tend to have lower standard rates than older VATs.

Source: IMF staff

Noteworthy regional clustering effects are observed. Countries in Asia have the lowest average rates and include relatively new VATs. Middle East and North Africa and Latin America and the Caribbean have rates slightly lower than the world average. Advanced economies and countries in Europe have the highest standard rates and their averages exceed the world average. Newer VATs in Europe have been influenced by the EU experience with relatively high rates.

Data. Data on standard VAT rates for most countries in the world can be accessed here. For live VAT/GST rate data, see Avalara website. Data on historic VAT rates for most countries in the world can be accessed here.

Zero-rating means subjecting supplies to VAT at a rate of zero percent. This effectively relieves the purchaser of the burden of the VAT. While the purchaser pays no VAT, the business supplier is entitled to claim credit for all the VAT paid on inputs purchased to produce those supplies. The ability to claim input credits distinguishes zero-rating from exemption; in the latter, the seller does not charge VAT on its supplies but it cannot claim credit for VAT paid on inputs used to make exempt supplies. Some countries’ VAT laws refer to the zero-rating as described as exemption with credit. In fact, zero-rated goods are taxable albeit at a rate of zero percent. The exemption with credit terminology is inaccurate and is avoided in TPAF discussions.

Under a pure destination-based VAT, only exports should be zero-rated. In fact, zero-rating of exports by the country of origin is necessary to ensure the neutral treatment of international trade between countries that have a VAT.

The zero-rating of certain goods and services that are not exported (domestic supplies)—change the relative prices of goods and services, thus distorting consumers’ choices. This, in turn, affects the structure of production and the allocation of resources, reducing economic efficiency.

Data. Data on standard, increased and reduced VAT rates for most countries in the world can be accessed here. To access IBFD-compiled database of VAT rates, click here. The four large accounting firms (so called, Big-4) maintain datasets of indirect tax rates. For EY’s dataset of VAT, GST and Sales Tax rates over the period 2005-2016 click here. For KPMG’s indirect tax rates click here. For a dataset maintained by Deloitte click here. Data on VAT rates compiled by PwC can be accessed here.

VAT rates that deviate from the standard rate include reduced rates and increased rates. Those are sometimes collectively referred to as non-standard rates. Reduced rates are lower than the standard rate and are sometimes applied to goods and services consumed by low-income households. Increased rates are higher than the standard rate and are sometimes applied to goods and services consumed by high-income households, sometimes in lieu of a luxury excise tax.

The VAT—and consumption taxes more generally—are perceived as being regressive, in that lower-income households are subject to a higher effective tax rate (VAT payments divided by income) given that they consume a larger proportion of their income than higher income households. This sometimes motivates countries to use VAT rate differentiation as an instrument to address the regressive nature of the tax or to achieve broader distributional objectives. Rate differentiation can take several forms but in general it involves setting additional rates (including the zero rate) beyond the standard rate. Differentiation is implemented by offering reduced VAT rates on commodities for which lower-income households spend a larger portion of their income—most typically, basic foodstuffs—but also by applying higher VAT rates on so-called luxury goods.

Rate differentiation suffers from a fundamental flaw. Although lower income households may spend a greater proportion of their income on basic necessities (e.g., basic foodstuffs), higher-income households will usually spend more on such goods and services in absolute terms, even if they spend less in relative terms (relative to total expenditures). Hence, the use of reduced rates to address the regressive nature of the VAT may not offset regressivity in any meaningful way since it unintentionally confers large absolute benefits (effectively, subsidies) to higher income households. Reduced rates are therefore a poorly targeted instrument to achieve distributional objectives.

In addition to resulting in potentially large revenue leakage, rate differentiation within a VAT regime can significantly increase both administration and compliance costs. It forces taxpayers to separate records for purchases and sales based on the VAT rate that is applied. It also invites disputes over the classification of goods, creates tax planning opportunities, and can complicate audits and increase the number and value of VAT refund claims, depending on the difference between the standard rate and the reduced rate. Rate differentiation may also increase the political vulnerability of the VAT by increasing pressure for other goods and services to also benefit from these lower rates. This phenomenon can be called reduced rate creep.

Tourism is one sector that is often characterized by the use of reduced VAT rates to provide an incentive for consumption.

Data. Data on standard, increased and reduced VAT rates for most countries in the world can be accessed here. To access IBFD-compiled database of VAT rates, click here. The four large accounting firms (so called, Big-4) maintain datasets of indirect tax rates. For EY’s dataset of VAT, GST and Sales Tax rates over the period 2005-2016 click here. For KPMG’s indirect tax rates click here. For a dataset maintained by Deloitte click here. Data on VAT rates compiled by PwC can be accessed here.

Most countries in the world determine VAT liability based on the invoice-credit method applied on a transactional basis. Two other methods to achieve the same economic results are theoretically possible: the subtraction method and the addition method. Both are accounts-based and are rarely used.

The invoice-credit method is a transaction-based approach that requires sellers along the value chain to provide invoices to their buyers showing the amount of VAT that was paid on a given transaction. Buyers are then able to credit tax paid as shown on such invoices against VAT that is collected on their own sales. The possibility of matching invoices substantially reduces opportunity for tax fraud, such as undeclared VAT receipts on sales or inflated VAT credits on purchases. Furthermore, the invoice-credit system can easily accommodate different VAT rates, as well as the destination principle for dealing with international transactions.

The subtraction method uses an accounts and entity-based approach to determining VAT liability at each stage of the value chain, with tax owing being calculated based on the difference between a firm’s taxable sales and its allowable purchases in the aggregate. The subtraction method’s attractiveness relies in part on its simplicity, since revenue and expense figures are already to be reported for accounting and/or tax purposes. However, the application of differential rate structures will typically mitigate any such benefits by necessitating some disaggregation of sales and expenses. The subtraction method is also a more natural complement to an origin—as opposed to the widely-accepted destination—approach to dealing with tax liability in cross-border context. In practice, the subtraction method is hardly ever used, except in Japan.

Under the addition method, VAT is levied on an estimate of value added, calculated as the sum of factor payments—such as wages and net interest payments—and profits, converted to a cash flow basis by performing some adjustments to income statement line items. This method does not offer the same safeguards against tax evasion as the invoice-credit method, and does not easily accommodate differential VAT rates. In practice, the addition method has been used only to tax value-added in the financial services sector.

References and further reading:

For a more thorough discussion of the different consumption tax forms, see Alan Schenk, Victor Thuronyi, and Wei Cui (2015), Value Added Tax: A Comparative Approach, 2nd ed. (New York, NY: Cambridge University Press), chapter 3.

A person conducting business and making taxable supplies is subject to registration and is responsible for collecting and remitting the VAT. Such a person is defined as a taxable person. It can be an incorporated business, individual entrepreneur, or unincorporated business such as a partnership, a cooperative, foundation, etc. This ensures the neutrality of the tax vis-à-vis different legal forms under which a business may operate. The terminology can confuse because a taxable person according to this definition would actually not bear any VAT itself if all supplies were taxable. Instead, the role of the taxable person is to act as the government’s agent and collect VAT on its behalf.

A supplier who has made supplies exceeding the VAT threshold becomes a taxable person. A supplier under the threshold in most VAT systems may also become a taxable person by registering voluntarily if either it makes taxable supplies or is carrying on a business and intends to make taxable supplies. Typically, an entity that makes a significant amount of zero-rated supplies would register to claim credits on VAT paid on purchases. Registration rules for entities that make exempt (or almost exclusively exempt, subject to a de minimis rule) supplies sometimes limit the scope of registered entities. Such entities are often not allowed to register, even voluntarily, because they have little or no taxable supplies. Being registered with exempt supplies or unregistered (and hence effectively exempt) makes no difference. This restriction on registration is sometimes observed for non-profit and similar organizations that render mostly exempt supplies.

References and further reading:

For a more thorough discussion of the different consumption tax forms, see Alan Schenk, Victor Thuronyi, and Wei Cui (2015), Value Added Tax: A Comparative Approach, 2nd ed. (New York, NY: Cambridge University Press), chapters 4-5.

The concept of supply is broader than the concept of sale, even though both are often used interchangeably. A supply has a broader scope as it includes sale, lease, rental, and other forms of disposal. Supply is therefore the preferred legal concept. Supplies occur in the context of commercial or taxable activity. VAT laws include special rules that exclude certain transactions from the definition of supply. Examples of such transactions include transfers of assets or an entire business to a legal representative, and asset transfers to creditors. Best practice requires that such exclusions be kept to a minimum.

Even though goods and services are economically equivalent from the perspective of the operation of a VAT and the determination of VAT liability, certain rules are required for the proper functioning of the tax. Goods and real property do not pose any special challenges. Most VAT laws define the supply of a service as any supply that is not a supply of goods. Services and intangible property are more difficult to deal with because of the difficulty of tracking and tracing source and use, and distinguishing business use from self-supply (personal use). Those complications are particularly acute in the case of imported services and intangible property. Both import and export of goods and services require different deeming rules in practice.

Most VAT laws define the registration threshold in terms of taxable supplies during a calendar period of one year. Exempt supplies, although they would form part of the turnover of a business, would be excluded from that amount.

References and further reading:

For a more thorough discussion of the different consumption tax forms, see Alan Schenk, Victor Thuronyi, and Wei Cui (2015), Value Added Tax: A Comparative Approach, 2nd ed. (New York, NY: Cambridge University Press).

VAT refunds should arise from the normal operation of the VAT whenever the VAT paid on inputs in a particular tax period exceeds the VAT collected on supplies (outputs). In some countries, refunds can approach 50 percent of gross VAT collections. The payment of refunds is an essential part of a well-functioning VAT. In practice, the extent to which refunds arise varies from one country to the next and depends on the structure of economic activity, VAT design, and administrative capacity.

Under a standard single rate VAT, the level of VAT refunds should be corrected with the structure of the economy. The higher the share of exports in gross output and the higher the share of gross capital formation (investment) in gross output, the higher the share of gross VAT collections that should be refunded. In the case of exports, refunds arise because exporters zero rate export sales but they can claim credit for VAT paid on inputs to produce exported supplies. In the case of capital formation, including inventory build-up, refunds arise because investment results in up-front expenses that will produce supplies in subsequent periods.

On the other hand, some refunds will arise due to VAT policy decisions, including:

• Use of zero VAT rate on domestic supplies;
• Use of reduced VAT rates;
• Use of VAT withholding and reverse charge mechanisms.
• Refunds made to a variety of unregistered entities that do not act as taxpayers because they make no taxable supplies.

Given the structure of the economy, any or all of the above policies will increase the amount of refunds. This can reinforce problems because administering a refund system well requires adequate administrative capacity. Practices vary by country but they tend to range from the extremes of immediate refund system to indefinite carry forward of refunds to offset against future VAT liabilities.

The denial or delay of refunds involves an opportunity cost in terms of time value of money and may cause serious cash flow problems. The fact that administrations rarely pay interest on carry forwards exacerbates the problem. In the extreme case of exporters, denial or delay of refunds makes the VAT look like a production tax through its unrelieved burden on inputs.

In practice, and for a variety of reasons including budget, some countries worsen the refund accumulation by devising rules to delay or deny refunds or not pay them in cash. Another avenue is to limit the demand for refunds by limiting the amount of input VAT that can be recovered. Policies to achieve those include exemption of imports, zero rates on domestic supplies (including inputs). The end result of this proliferation of schemes often ends up worse than the original problem by converting a small number of large claims (exporters, gross capital formation) to a large number of small claims that are much more burdensome on the tax administration.

Those policy measures or any administrative mitigation measures fail to provide a solution to growing refunds problems because they do not attack the root causes of bad refunds such as domestic zero rating, reduced VAT rates, and VAT withholding.

On the administrative side, the most important best practice consists of having a robust refund management system backed by a vigorous audit program based on risk assessment. On the policy side, it is critical that refunds be considered an integral part of the VAT system. Consequently, self-assessment must extend to refunds, a practice that many countries disregard.

References and further reading:

For a thorough discussion of refunds, including bad and best practices and refund management, see Mario Pessoa et al. (2020), Managing VAT Refunds, How-to Note, International Monetary Fund.

For a discussion of refunds and mitigation tools, see Graham Harrison (2008), VAT Refunds, in Richard Krever (ed.), VAT in Africa (Pretoria: Pretoria University Law Press), pp. 143-158.

VAT is generally imposed on domestic supplies and imports of goods and services. The person either supplying or importing taxable goods or services is liable for tax. Imported services present a special challenge in that border controls are not possible; unlike goods, the imported services cannot be seen, assessed and recorded at the border.

The recipient of a taxable imported service is the person liable for the tax on that service. The mechanism known as a reverse charge refers to the process by which the registered importer of a service self-assesses the VAT on the imported service, and takes it as an input VAT credit to be deducted from output VAT when calculating VAT remitted. The reverse charge terminology is not used universally so it may be more general and accurate to describe it as self-assessment by a registered business. The registered business should be indifferent about the declaration since it will recover the VAT paid on inputs as a credit. An alternative to the reverse charge used in some countries (e.g. Canada) is to suspend the requirement to pay VAT on imported services if a very high proportion of the imported services will be used in commercial activities.

Other importers of services such as non-registered businesses and final consumers are usually legally required to self-assess VAT on import but in practice almost never do so as it is very difficult and costly for the administration to attempt to track such transactions. Due to regulatory reporting requirements, importers of services that make exempt supplies domestically (e.g., government agencies, hospitals, universities, non-profit organizations) may not have as strong an incentive to skirt the self-assessment of VAT on imported services as final consumers do. Nevertheless, the import of services that are zero-rated by the exporting country presents tax planning opportunities if the entities must bear the unrecoverable input VAT as an own cost. The root cause of those planning opportunities resides in the exempt nature of their supplies. Making their domestic supplies taxable restores the ability of the reverse charge system to work effectively in rolling the VAT liability forward from import to the final domestic consumer.

Some countries have devised a variety of solutions to recover VAT on imports of services by non-registered persons. One way to achieve this result is to require the VAT registration of foreign suppliers with a sufficient quantum of supplies in the domestic economy. Under those arrangements, non-resident suppliers have the obligation to register, collect and remit VAT to the domestic tax administration. Another way is to require non-resident suppliers with a sufficient level of activity in the domestic economy to set up a domestic sales corporation which becomes the deemed domestic supplier. E-commerce and electronically supplied services create situations that require creative methods to impose tax in a proper way.

The generalized reverse charge system with an extension to domestic trade in goods and services has been proposed by some academics as a solution to VAT fraud. Several EU Member States have either considered it or implemented it on a limited basis (e.g., transactions involving mobile phones, computer chips). By requiring buyers rather than suppliers to account for VAT on a supply, a reverse charge rule can help address situations where a purchase is made by a “missing trader” (or “bogus trader”), who collects VAT on its own sale and disappears before remitting it to the state. While generalized reverse charging reduces the possibility of fraud by preventing the purchaser to claim input VAT that has not actually been paid, it undermines the fractional nature of VAT. It essentially converts the VAT into what would resemble a retail sales tax in that the whole amount of VAT is collected and remitted to tax authorities only at the retail stage, the most fragile one in the production-distribution chain. Yet, this system does not address the root causes of the most high-profile instances of VAT fraud: extensive domestic zero-rating and exemptions which create risk and forego revenue. As a consequence of those base-eroding policies, the high VAT rates (e.g. in EU Member States) increase the payoff from fraud and evasion. Solutions that do not address those policy flaws head-on will be ineffective.

References and further reading:

For a European perspective on generalized reverse charging, see Kaspar Lind (2013), “Reverse Charging: The Best Solution for Preventing VAT Fraud,” World Journal of VAT/GST Law, Vol. 2, Iss. 2, pp. 97-115.

OECD (2017), Mechanisms for the Effective Collection of VAT/GST When the Supplier Is Not Located in the Jurisdiction of Taxation (Paris: Organization for Economic Co-operation and Development).

OECD (2017), VAT/GST Guidelines (Paris: Organization for Economic Co-operation and Development).

Tax administrations are sometimes (rightly) concerned that small registrants that make supplies to large registrants may not remit the correct amount of VAT collected to the revenue authority. They also may be concerned that audits of many small suppliers are too demanding and difficult. Compliance risks are not limited to small businesses, however. A shortcut is to assign the responsibility of withholding the VAT to the purchaser of the supply. Purchasers will tend to be large registrants that file monthly returns while sellers will tend to be small businesses that file quarterly returns. For those reasons, withholding may also improve accrued collections in the short run.

Take the example of a large telecommunications company that buys office supplies from a small registered supplier. Under normal VAT rules, the small supplier charges and collects VAT on the supplies. With its next return, it must remit to the revenue authority the difference between VAT collected on supplies and VAT paid on its own inputs. Under withholding, the mechanics are turned upside down. The supplier shows the VAT due on its invoice but the purchaser of the supply does not actually pay the VAT portion of the supply to the seller. Instead, the purchaser keeps (withholds) the VAT portion of the transaction and is responsible for accounting for this tax as output VAT collected and remitting it to the authorities with its next return. In this case, the purchaser is the large telecommunications company and it is legally assigned the role of withholding agent. The presumption is that the large business will be more compliant than the large group of small suppliers.

Withholding produces two particularly perverse results. First, it makes auditing of withholding agents harder because it breaks the relationship between VAT collected (output VAT) and VAT paid on purchases (input VAT). VAT collected now consists of two pools: VAT collected on the agent’s own supplies and VAT withheld. The relationship between output VAT and input VAT therefore no longer relates to the nature of the operation and its value-addition potential. For instance, typical industry ratios of output VAT to input VAT are no longer usable. This data contamination renders quantitative information from past audits and industry benchmarks irrelevant, unless return data show the pools of VAT (genuine output VAT versus withheld VAT) separately.

The second perverse consequence of withholding is the generation of excess credit positions for suppliers since they no longer collect VAT on important supplies to withholding agents. Those suppliers still pay VAT on inputs but do not have a sufficient amount of output VAT to produce positive remittances. This means that those suppliers should be entitled to refunds. Those suppliers happen to be much more numerous, smaller, and harder to audit than large registrants tasked with the responsibility of withholding. The policy also breaks the link between output VAT and input VAT and renders benchmarks useless. The practice exacerbates refunds, one of the most difficult issues facing tax administrations in developing countries.

References and further reading:

For a fuller discussion of withholding and refunds, see Pierre-Pascal Gendron (2017), “Real VATs vs the Good VAT: Reflections from a Decade of Technical Assistance,” Australian Tax Forum, Vol. 32, Iss. 2, pp. 257-282.

A supply is the taxable event in VAT and understood to be for consideration. A supply can include the sale, lease, or transfer of rights. In addition, some transactions or transfers may be deemed supplies for VAT purposes. The value of a supply or taxable amount is subject to valuation rules that usually state that the value equals the market price or fair market value of a transaction.

Most countries in the world have adopted the VAT that follows the destination principle. A standard destination-based VAT aims to tax domestic consumption, with VAT being charged in the jurisdiction where the consumer is located. A system relying on the destination principle thus subjects imports—but not exports—to VAT. Subjecting imports to VAT ensures that all goods and services in the domestic market face the same tax. In that situation, consumers have no incentive to favor imported or domestically produced purchases. At the same time, allowing exports to leave the country free of VAT allows them to compete on an equal basis with goods and services produced in foreign countries. It simplifies this discussion if we assume that foreign countries also follow the destination principle.

In contrast, an origin-based VAT would aim to tax domestic production, with VAT being levied in the jurisdiction where the item is produced (rather than where it is consumed). A system relying on the origin principle would thus subject exports—but not imports—to VAT.

For services, it may be harder in practice to determine where the service is provided, or where it is consumed. An origin-based tax will concentrate on the state of origin of the person supplying the service, while a destination-based tax will charge tax in the state where supplies are consumed.

In a situation where two states operate under different approaches, issues of double-taxation or non-taxation would likely arise. Preventing those outcomes would require adjustment mechanisms. In practice, almost all VATs across the world follow the destination principle.

A subnational VAT exists when a lower level of government operates a VAT in parallel to a national (or federal) VAT, or when a subnational jurisdiction imposes a VAT on its own without an overarching national or federal VAT. Key design considerations include:

• Tax base;
• Tax rate;
• Administrative procedures and rules; and
• Administrative structure.

Fundamental questions arise with respect to the above considerations. Do national and subnational VATs:

• Share the same base or do they apply to different bases?
• Share a common rate or do they have autonomy in setting rates?
• Rely on common administrative procedures and rules or rely on separate sets of procedures and rules?
• Operate under a single tax administration or under separate national and subnational administrations? If under a single administration, is it national or subnational?

Answers to those questions provide an indication of the extent of harmonization between national and subnational VATs. Dual (national plus subnational) VAT systems should be evaluated according to the following principles. First, harmonization should lead to simplification of the sales tax system to minimize collection costs and related efficiency losses. Second, harmonization should respect subnational autonomy by allowing each subnational unit to choose its own tax rate. Finally, there should be one agency to administer and collect the sales tax.

In the case of a subnational jurisdiction imposing VAT on its own, the above design considerations remain important but additional ones arise:

• The type of tax are other subnational units imposing;
• Coordination between taxes imposed by different subnational units; and
• The absence of border controls between subnational units in the host country.

The discussion of Interjurisdictional Trade continues the discussion of situations without an overarching federal or national VAT by considering a context without fiscal borders between countries.

References and further reading:

For a discussion of those principles in the context of an actual set of institutional arrangements, see Richard M. Bird and Pierre-Pascal Gendron (1998), ‘Dual VAT and Cross-Border Trade: Two Problems, One Solution?’ International Tax and Public Finance, Vol. 5, Iss. 3, pp. 429-442.

A VAT implements the destination principle in practice through the use of tax and deeming rules that govern the definitions of imports and exports of goods and services to ensure that imports are subject to VAT and exports are zero-rated.

Imports and exports of goods pose no particular challenges when border controls exist. When no border controls exist, as in the case of the EU’s deferred payment system or the Quebec Sales Tax, some vulnerabilities arise since exports to other EU Member States (in the case of the EU) or to other Canadian provinces (in the case of the Quebec Sales Tax) are effectively zero-rated. In the EU, for example, cross-border transactions in goods are handled through the deferred payment system. This practice places the charge of VAT on the acquisition of imported goods via a self-declaration (reverse charge) by the importer. VAT becomes payable when the importer sells the imported goods to the next stage of the production distribution chain. In Canada, the Quebec Sales Tax operates that way with respect to its exports to other provinces with a VAT.

Border controls cannot, however, be used to monitor the flow of services except with minor exceptions (services tied to goods and included in the price of goods, either tangible or real property). Imports of services are particularly important since they constitute a taxable event. Place of supply rules naturally extend the deeming rules required to determine whether an import or export takes place. Place of supply rules are required to determine where the supply is made. Traditionally, this was enough to determine the place of taxation. Over the last decade however, attention has shifted from the place of supply to the place of enjoyment (effectively, consumption) in an effort to get closer to the destination principle when applying VAT. The two are not interchangeable.

Even though applying the VAT does not require the seller to distinguish between business and final (consumer) purchaser like a retail sales tax, in effect place of supply rules for services use that distinction. In the EU, for example, most business-to-business (B2B) services are deemed to be provided where the customer carries on business. Since January 1, 2015, supplies of telecommunications, broadcasting and electronically supplied services by EU-based suppliers to final consumers and not-taxable customers have been taxable in the Member State where the recipient is established, has a permanent address, or normally resides. Before 2015, sellers accounted for the VAT based on their place of establishment. The new rules therefore aim for the place of consumption, a result consistent with the destination principle. In Canada, the place of supply rules to determine whether a supply is made in a province are more complex due to the sub-national element but aim to achieve the same result: impose the tax at the place of consumption.

Given the weakness introduced by intra-community (EU) zero-rating, several methods have been devised to avoid breaks in the VAT chain.

The most important weakness of the deferred payment system is due to the break in the VAT chain at export due to zero-rating of export without guarantee that the importer will self-assess and eventually remit the VAT based on transactions down the chain. This presents attractive opportunities for fraud, with the much-discussed missing trader intracommunity fraud in the EU.

Conceptual responses to the break in the VAT chain at export have taken three general forms. First, under a pure origin system, the liability chain would be reversed between exporter and importer: exporters would remit VAT on their sales at the exporting country’s VAT rate while importers would claim credit from the importing country’s administration at the VAT rate of the country of destination. Second, the exporter rating system would tax exports at the rate of their country of origin and this origin country VAT rate would serve as the basis for input VAT credit in the country of destination. Revenue losses could be avoided by using a clearing house to reallocate revenues. Finally, a system of uniform rating would alleviate the break in the VAT chain by setting and using a single EU-wide VAT rate (an intermediate rate) that does not exceed any existing rate under the existing system. That rate would apply on B2B transactions or on all cross-border supplies in the EU. Member States would retain some rate-setting autonomy to set their rate for domestic sales to final consumers as long as it exceeds the intermediate rate. In one variant of uniform rating, the intermediate rate could apply to exports only (the Compensating VAT or CVAT) or to all transactions between registered traders (the Viable Integrated VAT or VIVAT). The discussion focuses on the EU as such schemes have generated most policy and academic interest in that context. In principle, the schemes have wider applicability in situations with subnational features (Brazil, India, etc.). None of the above-noted mechanisms is currently in use.

References and further reading:

For a clear discussion of the international context facing the EU, see Institute for Fiscal Studies and James Mirrlees (eds.) (2010), Tax by Design: The Mirrlees Review (Oxford: Oxford University Press), chapter 7.

For a fascinating symposium that contrast the different conceptions of uniform rating see: Charles E. McLure, Jr. (2000), ‘Implementing Subnational Value Added Taxes on Internal Trade: The Compensating VAT (CVAT)’, International Tax and Public Finance, Vol. 7, No. 6, pp. 723-740; Michael Keen, and Stephen Smith (2000) ‘Viva VIVAT!,’ International Tax and Public Finance, Vol 7, No. 6, pp. 741-751; and Richard M. Bird and Pierre-Pascal Gendron (2000), ‘CVAT, VIVAT, and Dual VAT: Vertical “Sharing” and Interstate Trade,’ International Tax and Public Finance, Vol 7, No. 6, pp. 753-761.

The VAT is widely seen as an effective revenue raiser. Empirical evidence, for instance, supports that governments with a VAT raise more revenue as a percent of GDP, all else equal, than those without.

The effectiveness of the VAT (the instrument) in raising revenue depends critically on its policy design and the success of its enforcement. Policy design relates to the number of economic and social objectives pursued through the VAT systems. Many countries around the world use the VAT system to pursue non-revenue objectives such as income redistribution; formalization; investment promotion; price control or management; promotion of competitiveness; and protection. The various concessions and deviations from an ideal VAT undermine the VAT’s revenue potential as well as its efficiency and neutrality. Weak enforcement of the VAT – which can correlate with weak policy design – often affects revenue performance by reducing VAT compliance.

In assessing VAT effectiveness, it is natural to wonder whether there are limits to the VAT’s capacity to collect revenue. If we denote VAT revenue by R, the VAT rate by τ and the VAT base by C, then a change in the VAT rate will have the following revenue effect.

\[∆R = ΔτC + τΔC\]

Where the first term shows the revenue effect of a tax change for a given VAT base, and the second term shows the revenue effect of a change in the VAT base. Rearranging gives:

\[∆R = ΔτC(1 + τε)\]

Where $ ε ≡{ {ΔC} \over C} { 1 \over {Δτ}} <0 $ is the semi-elasticity of taxable consumption with respect to the VAT rate. It captures the entire spectrum of behavioral response to changes in VAT rates, such as substitution to untaxed consumption, an increase in non-compliance or cross-border shopping. The second equation can be used to see if there are any Laffer effects in the VAT, or whether there can be reductions in VAT revenues as the rate increases? This would happen if $ τ>{ 1 \over ε} $. For instance, if ε were equal to –5 then a VAT rate of 20 percent would maximize VAT revenue.

VAT rate changes are infrequent and usually small, a data pattern that makes statistical estimation of the elasticity of taxable consumption difficult. The same applies to estimation of revenue-maximizing VAT rate. Nonetheless, recent literature using EU data does suggest that the efficiency of the VAT declines as rates increase due a combination of base erosion and evasion and avoidance.

References and further reading:

Francisca Guedes de Oliveira and Leonardo Costa (2015), ‘The VAT Laffer Curve and the Business Cycle in the EU27: An Empirical Approach,’ Economic Issues, Vol. 20, Part 2, pp. 29-44.

Michael Keen and Ben Lockwood (2006), ‘Is the VAT a Money Machine?’ National Tax Journal, Vol. 59, No. 4, pp. 905-928.

Dongwon Lee, Dongil Kim, and Thomas Borcherding (2013), ‘Tax Structure and Government Spending: Does the Value-Added Tax Increase the Size of Government?’ National Tax Journal, Vol. 66, No. 3, pp. 541-569.

Kent Matthews (2003), ‘VAT Evasion and VAT Avoidance: Is there a European Laffer Curve for VAT?’ International Review of Applied Economics, Vol. 17, No. 1, pp. 105-114.

Alex Ufier (2017), ‘The Effect of VAT on Government Balance Sheets,’ International Tax and Public Finance, Vol. 24, No. 6, pp. 1141-1173.

VAT as percent of GDP provides a crude but useful glimpse of the revenue contribution of VAT relative to the overall size of the economy of the country. Most analyses rely on the ratio of nominal revenues to nominal GDP. Although rarely used, multi-year comparisons can be made more precise by dividing real revenues by real GDP (as the price indices for consumption and GDP deflators may differ). Historical data can be used to analyze trends in the VAT revenue to GDP ratio. Comparative analysis enables benchmarking of the country’s performance to a set of carefully selected comparator countries (e.g., regional peers or countries with a similar level of GDP). While VAT as a percentage of GDP is a good starting point, one should be cautious in drawing firm conclusions based exclusively on this. For example, VAT revenue data will typically increase where accrued collections exceed cash collection and/or refund mechanisms are deficient.

The next table shows the evolution of VAT-to-GDP ratios since 2000 for different groupings of countries as well as the world average. European countries, advanced economies, and Latin American and Caribbean Countries exceed the world average. All the other groups lie below the average. The ratio has increased noticeably over time in Emerging and Developing European countries only. The other groupings have fluctuating ratios but do not exhibit a clear trend over the entire period. On average the ratio has trended up slightly over the period.

VAT as percent of total consumption. Another VAT performance indicator is the ratio of VAT revenue to total consumption. This ratio resembles the effective tax burden on consumption since the VAT base can be proxied by consumption. There are two variants of this indicator. The first and most used is based on private consumption by households obtained from the national accounts. The second is total consumption, which equals the sum of private and public consumption. The latter acknowledges that much public consumption should be brought into the VAT base.

VAT as percent of total tax revenue. This ratio is often used to appreciate the relative importance of the VAT as part of a given country’s tax revenue mix. Again, both trends over time and comparisons with other countries can help assess the relative performance of the VAT.

Data. VAT revenue-to-GDP ratios are available from the IMF’s World Revenue Longitudinal Data (WoRLD), or could be downloaded by clicking here. Based on the WoRLD data the VAT revenue to total revenue ratios can be obtained by dividing the VAT revenue to GDP ratio by the total tax revenue to GDP ratio. Alternatively, the ratios could be downloaded by clicking here.

VAT productivity is measured as the ratio of VAT revenue to the product of GDP and the standard VAT rate:

VAT productivity thus measures how much each percentage point of the standard VAT rate collects in terms of GDP. Comparing this ratio over time or between countries can be used to gauge relative revenue performance of the VAT. A low ratio is typically taken as evidence of weak design (exemption and/or reduced rates) and/or weak enforcement. The measure does not, however, give insight into the relative contribution of these factors.

The VAT productivity ratio has a number of imitations, such that one should generally be cautious in drawing firm conclusions based exclusively from its analysis. First, ratios do not only capture differences between VATs, but also between the share of final consumption in GDP—the base upon which the VAT is ultimately imposed. Second, even if the share of final consumption in GDP was identical across countries, the composition of consumption will generally differ and impact the VAT productivity ratio (e.g., greater consumption by exempt sectors will, all else equal, lead to a lower productivity ratio). Finally, the standard VAT rate is not well-defined in the presence of multiple rates. In those situations, it would be preferable to use a weighted average rate using the relative bases as weights although the required data would be hard to obtain. If most supplies are taxed at the standard rate, the latter will provide an acceptable approximation of the correct rate.

Source: IMF staff

Data. Data on VAT revenue to GDP ratios is available on the IMF’s World Revenue Longitudinal Data (WoRLD), they can be downloaded in Excel format by clicking here. Data on standard VAT rates for most countries in the world could be accessed here.

C-efficiency is defined as:

The main appeal of this indicator is that it is normalized by the benchmark of a uniform tax on all consumption. Under an ‘idealized’ broad-based VAT that is being perfectly enforced and complied with, the C-efficiency measure would be 100 percent; any other value—higher or lower—indicates deviation from a single tax rate on all consumption.

For instance, subtracting certain final products or services from the tax base through exemptions or zero-rating will drive the C-efficiency below 100 percent. On the other hand, increased VAT revenues may result from the taxation of intermediary capital goods, exemptions at intermediate stages of production, or inefficient refunding of excess credits. Those situations could increase the C-efficiency above 100 percent. These effects may, of course, balance each other such that a non-exemplary VAT could have a C-efficiency that is close to 100 percent. However, it remains generally true that the VAT system will be less productive the further away its C-efficiency ratio is from 100 percent.

For the purposes of calculating C-efficiency, final consumption should consist of private and public consumption when government spending on goods and services is not exempt from the VAT base. Where government spending is exempt, only private consumption should be included.

Source: IMF staff

C-efficiency ratios result in a different ordering of country groupings than VAT productivity given that the weight of consumption in GDP varies amongst the groupings. Four regional groupings have ratios above the world average; those in the Middle East and North Africa and Sub-Saharan Africa are below.

C-efficiency could be further decomposed into a ‘policy gap’ (in turn divided into effects of rate differentiation and exemption) and a ‘compliance’ gap (reflecting imperfect implementation).

Data. IMF maintains a database of C-efficiency ratios for many world economies.

References and further reading:

Liam Ebrill, Michael Keen, Jean-Paul Bodin, and Victoria Summers (2001), The Modern VAT, (Washington, D.C.: International Monetary Fund), chapter 4.

VAT revenue collected on imports (as mandated under a destination-based VAT) commonly accounts for a significant proportion of total VAT revenues. For instance, based on a sample of 18 Sub-Saharan African countries, more than half of all VAT revenue was collected on imports in 2015, with several countries (Democratic Republic of Congo, Madagascar, Mozambique) collecting over 60 percent of their total VAT revenues from imports.

To the extent that imports relate to intermediate goods purchased by VAT-registered businesses, import VAT will typically be credited against VAT collected on taxable sales in the domestic economy. In this sense, imports of intermediate goods by registered trade produces transitory revenue to the government. In more extreme circumstances, for instance, imports by VAT-registered businesses feeding into zero-rated chains—such as exports—will typically give rise to credits making the initial revenue collection purely transitory in nature. This does not, however, lessen the importance of securing the collection of VAT on imports, as it has proven to be a crucial part of ensuring effective collection of the tax throughout the chain of production and of securing the overall success of the VAT. Customs is the safest point to collect all VAT on imports by ensuring that all goods that are released in the domestic economy have incurred VAT, to preserve the VAT chain, and to avoid leakage on imports by non-registered traders and final consumers.

To the extent that imports relate to intermediate goods purchased by VAT-registered businesses, import VAT will typically be credited against VAT collected on taxable sales in the domestic economy. In this sense, imports of intermediate goods by registered trade produces transitory revenue to the government. In more extreme circumstances, for instance, imports by VAT-registered businesses feeding into zero-rated chains—such as exports—will typically give rise to credits making the initial revenue collection purely transitory in nature. This does not, however, lessen the importance of securing the collection of VAT on imports, as it has proven to be a crucial part of ensuring effective collection of the tax throughout the chain of production and of securing the overall success of the VAT. Customs is the safest point to collect all VAT on imports by ensuring that all goods that are released in the domestic economy have incurred VAT, to preserve the VAT chain, and to avoid leakage on imports by non-registered traders and final consumers.

VAT buoyancy measures the percentage change in VAT revenue in response to percentage change in GDP:

The ratio can track the total response of VAT revenue to changes in national income and to discretionary changes in tax policies over time. A VAT is described as buoyant and counter-cyclical if the ratio exceeds one, and not buoyant or pro cyclical if the ratio is less than one. A ratio of one means that VAT revenue tracks GDP growth so that the VAT ratio as a share of GDP is constant over time.

References and further reading:

Paolo Dudines and Joao Tovar Jalles (2017), How Buoyant Is the Tax System? New Evidence from a Large Heterogeneous Panel, IMF Working Paper 17/4, International Monetary Fund.

The distribution of VAT revenues across economic sectors provides insight into the relative importance of these sectors in the VAT tax base. It can assist with understanding the impact of the country’s economic structure on VAT revenues, as well as the impact of sector-specific concessions on revenues.

At a more disaggregated level, it makes more sense to speak of VAT collections. Several distinctions can be then made. First, gross collections measure the VAT remitted and equals output VAT minus input VAT, before any adjustment for refunds. Net collections are equal to gross collections minus refunds paid out. A comparison between the distribution of gross VAT revenues and that of net VAT revenues can provide insight into the actual contribution of these sectors in terms of VAT revenues and illustrate the effects of certain design features of the VAT regime, such as the zero-rating of exports and the importance of refunds. Output VAT represents the VAT calculated on taxable supplies, while input VAT represents the VAT calculated on taxable purchases.

Comparisons of output and input VAT for different sectors provide an indication of the margins and hence gross collection potential of different sectors. Those comparisons can highlight special situations in certain sectors such as zero-rated inputs and outputs

Annual VAT refund claims represent the total value of refunds claimed by registered businesses during a tax year. Refund payouts represent the total value of refunds paid out to claimants during a tax year. The values of those two indicators will usually differ because there are always lags between claims and refunds. In addition, there may be restrictions on refunds, e.g., de minimis amounts before claims can be made, time lags before claims can be made, carryforwards of refunds to next tax period, and so on. Timing aspects are further complicated by the existence, in some countries, of stocks of old refund claims that remain unpaid. It can also be useful to calculate the ratio of VAT refund payouts to VAT refund claims as an indicator of how well the refund mechanism operates in a country.

The next chart shows VAT refund payouts as a percent of gross VAT collections for countries grouped by income, pointing to a strong correlation of VAT refunds with country income level. In 2015, high income countries paid VAT refunds at around 35 percent of gross VAT gross collections, whereas the ratio of low income countries averaged only 11 percent.

Source: A. Okello, M. Pessoa, A. Swistak, Managing VAT Refunds; IMF Guidance Note

VAT tax expenditures can be defined as reductions in tax liabilities in comparison with a benchmark VAT system. Those typically include: VAT exempting provisions; VAT zero-rating provisions beyond exports; reduced VAT rates; and any other VAT rebate or concession. VAT tax expenditures are engaged by governments to deliver socio-economic benefits through the VAT systems.

VAT tax expenditures are estimated as part of the overall tax expenditure evaluation framework of a country if it has such a framework. VAT tax expenditures have been quantitatively quite important in a number of countries. For example, the next table shows projected tax expenditures for Canada’s GST in 2010 and 2011, by category or line item of tax expenditure. The distribution of tax expenditures is typical of that in a modern VAT: relatively significant tax expenditures on households, housing, charities and non-profit organizations, health care and education, and smaller line items for the rest.

The general idea of tax expenditure estimation is to estimate the revenue impact of a concession by comparing revenues from the reference VAT system (without concession) to revenue with the concession, holding constant all other tax expenditures.

VAT tax expenditures result in foregone revenues so they will affect several VAT performance measures that incorporate revenues. Importantly, they will affect the C-efficiency ratio and hence the size of the VAT gap. Tax expenditures enter the VAT gap as the policy gap so an increase in tax expenditures will increase the policy gap and alter the mix between the latter and the compliance gap.

References and further reading:

For a detailed discussion of the methodology, data and estimates of tax expenditures, including VAT, see Department of Finance Canada (2017), ‘Report on Federal Tax Expenditures: Concepts, Estimates, and Evaluations’ (Ottawa, ON: Government of Canada).

As a broad-based consumption tax, VAT can be designed as a relatively efficient revenue-raising instrument, one that generates a relatively small welfare loss.

Production-efficiency is a central feature of a broad-based VAT when compared to turnover taxes, which are imposed at every level of production, and therefore cascade through the supply chain. Turnover taxes incentivize vertical integration by firms, opting for self-supplies over outsourcing activities, to reduce the overall tax burden. A broad-based VAT should not distort production decisions. This helps ensure allocation of resources to where they are most productive.

However, VAT remains a distortionary tax. For instance, by raising the relative price of consumption over leisure (or, untaxed home production), the VAT will cause a similar effect on the incentives to supply labor as a tax on wages. This will cause welfare loss.

Public finance/Public economics textbooks provide important guidance for efficient VAT design and, its effect on the distribution of welfare, and the measurement of welfare effects and deadweight loss. In its simplest form, tax theory suggests that the government should tax at a higher rate those goods whose demand is less responsive to price changes. If people do not tend to change their purchasing behavior, efficiency costs are minimized. However, the simplicity of this rule ignores critical cross-price effects. A more general rule is, therefore, that the government should tax at a higher rate those goods that are complementary with leisure. Intuitively, such taxes form an indirect way to mitigate the distortionary effect of the VAT on labor supply incentives. Empirical studies have tried to establish which goods should thus face higher or lower taxes. Unfortunately, the results are far from robust, except for a few types of expenditures such as childcare which appear to be close substitutes for untaxed home production (and which should consequently be subsidized on efficiency grounds). Based on these findings, generally, a broad-based consumption tax without exemptions and a uniform tax rate is viewed as a close approximation to an optimal VAT from an efficiency perspective.

References and further reading:

For a more complete but accessible discussion of efficiency and equity considerations of commodity taxes, see Institute for Fiscal Studies and James Mirrlees, eds. (2010), Tax by Design: The Mirrlees Review (Oxford: Oxford University Press), chapter 6.

The ‘deadweight loss’ or ‘excess burden’ refers to the loss in welfare resulting from changes in consumption and production decisions as a result of the introduction of a tax or other government interventions. It is a measure of economic (in)efficiency and commonly calculated and illustrated using the “Harberger triangle”. The total welfare loss resulting from a tax is the combined loss in consumer and producer surplus less the tax collected by the government. In the illustration below, a tax is introduced, shifting the supply curve and the market equilibrium from the initial intersection of supply and demand in point A. At the new equilibrium, firms produce a lower quantity corresponding to Q2, which is purchased by consumers at the new market price of P2. The government collects taxes, capturing some of the prior consumer and producer surplus, but the reduction in production and consumption results in a welfare loss corresponding to the green “Harberger triangle”.

The design and implementation of the VAT impact on its efficiency. An ideal broad-based VAT with a single rate and no exemptions is efficient because firms’ production decisions are not distorted. Indeed, such a VAT does not affect incentives regarding the stage of the production-distribution chain at which value is added, the form of business organization, and the capital to labor ratio of economic sectors. If the administrative and compliance costs of operating a tax system are considered parts of its efficiency costs, the case for a broad-based uniform VAT becomes even stronger. A uniform system has much lower collection costs and is much less vulnerable to fraud and Laffer effects. Simplicity comes from uniformity, which most likely comes along with good compliance and high revenue collected per dollar of administrative effort.

Real VATs are often non-uniform due to public policy preferences, impacting efficiency gains from introducing and operating a VAT. Inefficiencies arise from:

• Exemptions: render the VAT system less efficient due to cascading effects and distortions in production decisions on both input and output sides;
• VAT threshold: creates similar distortions as firms under the threshold are exempt from VAT and cannot claim refunds on input VAT. Thus, production decisions are distorted, though this can be mitigated by allowing for voluntary registration for business below the threshold;
• Rate differentiation: distorts consumer choices and increases compliance costs.
• Excessive limitation to input tax deduction brings about a similar form of distortion where businesses cannot recover VAT paid on their genuine business inputs. While certain anti-avoidance rules are necessary to prevent the deduction of input tax on items purchased for or used as private consumption (e.g., entertainment), excessive limitations to the right to deduct leads to tax cascading and the related inefficiencies.

Exemptions and reduced rates (including zero rates on domestic consumption) are usually motivated by socio-economic objectives, including concerns about income distribution. However, VAT is a poorly targeted mechanism to provide relief to low-income households, especially when compared to direct spending instruments.

Furthermore, complexities arising from non-uniform treatment complicate administration and create opportunities for tax evasion and avoidance. Extra collection costs incurred to implement inefficient policies compound the resource misallocation and hence efficiency loss. Firms that self-select in the informal economy gain an unfair advantage over firms that honestly assume their VAT obligations, distorting the allocation of resources. In addition, administrative challenges can reduce efficiency. Where, for instance, VAT refunds are not made in a timely manner, the unrelieved burden on inputs potentially distorts production decisions.

Estimates of the total efficiency gains or losses stemming from a VAT’s design features and implementation are rarely reported although they can be calculated if sufficient data are available. For EU member states potential efficiency gains associated with a move to full taxation of postal services, waste disposal, education, cultural and health services and broadcasting have been estimated to amount to 0.34% of GDP (Jarvelund et al, 2013). These estimates are derived from a general equilibrium model, drawing on data of economic activities in member states and capturing linkages across sectors and markets in the EU. In developing countries, required data for similar analysis is often unavailable.

References and further reading:

For a more complete but accessible discussion of efficiency and equity considerations of commodity taxes, see:

Neil E. Bass and Pierre-Pascal Gendron (2012), ‘Sales Taxation’, in H. Kerr, K. McKenzie, and J. Mintz (Eds.) Tax Policy in Canada (Toronto, ON: Canadian Tax Foundation), pp. 8:1-8:41.

Adhikari, Bibek (2020), Does a Value Added Tax Increase Economic Efficiency, Economic Inquiry, Vol. 58, No. 1, January 2020, 496–517.

Jarvelund, Christian et al (2013) VAT in the Public Sector and Exemptions in the Public Interest, Final Report for TAXUD/2011/DE/334, Copenhagen Economics, Copenhagen.

The simplest analysis of the tax incidence of a sales tax relies on the analysis of supply and demand curves in a market for a particular commodity subject to tax. This analysis is referred to as partial equilibrium analysis since it considers the impact of the tax only on that particular market and not on prices and quantities of goods and factors of production in other markets. In a partial equilibrium analysis, the tax can be shifted forward to consumers by charging higher product prices or shifted backward to factors of production by reducing compensation or return. Unless special conditions exist, both producers and consumers will share the burden of taxation. Consumers bear more tax than producers if their demands are less price sensitive or if producers cannot accept lower prices since their per unit costs of production are inflexible (perhaps as a result of inflexible input prices). On the other hand, producers bear more tax than consumers if they provide a product in which costs are flexible or consumers resist price increases by shifting to other products. The side of the market that responds less to the price change induced by the tax bears more of the burden than the side of the market that responds more to this price change. Different market conditions allow for different tax shifting patterns (forward versus backward) regardless of the way in which the tax is levied. Imperfect competition extends the range of possibilities in terms of shifting impacts.

Partial equilibrium analysis provides a useful starting point but ignores interactions between markets. For example, if consumers shift from one good to another in response to a tax increase, the consumption and prices in the other market change as well. To assess these effects, one requires general equilibrium analysis, which accounts for all interactions between markets. In general equilibrium, all prices may change in response to a VAT change and the ultimate incidence of the tax change depends on the complex interactions between markets. General equilibrium models study the effect of tax burdens—allowing all taxes to interact with each other—on other variables within a structural model of the economy, taking into account elasticities of demand and supply. In the case of the VAT, its effect on factor prices, as well as the second-round effects on prices can be incorporated.

It is not uncommon that VAT exemptions are relied upon as an instrument for incentivizing investment in specific sectors. However, there is no reason to do so in a well-functioning VAT system, because VAT charged on inputs should be fully recovered as a credit against VAT charged on sales. Exemptions for specific sectors are nevertheless often introduced to address problems with the credit mechanism arising from imperfect VAT refund procedures. In these circumstances, the administrative process should be improved, rather than exemptions be introduced. Incentives for industry sectors can be provided more efficiently through the profit tax, where cost-based investment incentives can be considered.

Other common opportunities for efficiency gains from broadening the VAT base include full taxation of donor-funded projects and government services that compete with private suppliers, as well as the proper treatment of agriculture and financial services. Exemptions, which are commonly applied to these sectors, incentivize self-supply by businesses and often encourage the importation of supplies to the detriment of local producers. Similarly, in the context of the EU, removal of mandatory exemptions and exclusions under the EU’s Common VAT directive (Article 13, 132 and 133) could generate important welfare benefits.

Few countries have in practice implemented an ideal VAT, which minimizes inefficiencies. The countries that have come close provide some indication on possible approaches to reform. New Zealand, for instance, where the standard VAT rate is applied to almost all goods and services, combined the introduction of its VAT in 1986 with other reforms, including payments and targeted support to low-income households. This helped build public acceptance for the tax. Slovakia replaced its dual VAT rate system with a single rate in 2004 as part of a broader reform package, which improved resource allocation and helped reduce collection costs.

References and further reading:

For a more complete but accessible discussion of efficiency and equity considerations of commodity taxes, see:

Benge et al (2013), Possible Lessons for the United States from New Zealand’s GST, National Tax Journal, 66 (2), 479-498.

Moore, David (2005), Slovakia’s 2004 Tax and Welfare Reforms, IMF Working Paper WP05/133.

Cnossen, Sijbren (2020), Modernizing the European VAT, CESifo Working Paper No. 8279.

Incidence analysis attempts to determine who in the economy bears the burden of taxation. To be more precise, the analysis seeks to determine who in the private sector sacrifices the resources transferred to the public sector. The initial hypothesis of this analysis is that statutory incidence (who remits the tax) differs from economic incidence (who bears the burden of tax). This is because prices may adjust in response to the tax. It is often assumed that changes in VAT rates will be fully passed through to the final consumer, but this might not be generally true, especially if there are multiple VAT rates.

Incidence studies often assume that producers will fully increase their prices with the tax and hence fully shift the burden forward to consumers. This assumption is natural if one considers a uniform VAT on all consumption. In that case, the price of all consumption increases simultaneously so that consumers have no incentives to substitute from one type of consumption to another. However, in the presence of differential VAT rates or exemptions, VAT changes will affect relative prices and will induce substitution effects. This can have important implications for VAT incidence between the supplier and the consumer.

In order to achieve social and distributional objectives, VAT rate reductions or exemptions should be reflected in lower prices, i.e. should be passed on to the consumer. Empirical studies clearly indicate that this is generally not the case. One of the most (in)famous cases—the so-called “labor intensive services experiment”, carried out in the early 2000s, across all European countries. VAT was decreased in labor-intensive industries, in some cases by over 15 percent. The European Commission monitored the prices, over a 3 years period. The results were clear: in most situations prices had not decreased, and where they had, they were back up to previous levels within one year.

Empirical studies looking at the effect of VAT rate changes on average price levels commonly suggest that taxes are largely or fully shifted. However, analysis also suggest lower pass through associated with changes in reduced rates and reclassifications. Analysis of VAT decreases for specific products (e.g. restaurant services in France, Sweden and Finland), for instance, suggest very limited pass-through to consumers. The question is then whether these measures can be justified if they are primarily intended to benefit lower income households. Another question to ask is: if/where prices do come down, who benefits from the reduction? Often the most important reason given to exclude items from the tax base is the protection of low-income households. Analysis of consumption patterns, and distribution of VAT payments by deciles/quantiles of total income or expenditures, indicates that the richest households benefit the most from VAT decreases in absolute terms. As such, the exclusions from the VAT base effectively subsidizes the consumption of the richest households.

References and further reading:

On VAT pass-through, see Dora Benedek, Ruud de Mooij, Michael Keen, and Philippe Wingender (2020), Varieties of VAT pass through, International Tax and Public Finance, Springer, vol. 27(4), pages 890-930.

For a detailed discussion of empirical literature see IHS (2011), 'The effect of VAT on price-setting behaviour' in IFS et al., A retrospective evaluation of elements of the EU VAT system, Report prepared for the European Commission.

For a discussion of VAT rate reduction on employment levels in labor-intensive industries see, for example, Copenhagen Economics (2007), Study on reduced VAT applied to goods and services in the Member States of the European Union, Report prepared for the European Commission.

One of the key results from tax theory is that consumption taxes are inefficient instruments to redistribute income from rich to poor households. The simple reason is that governments cannot observe individual expenditures on commodities on which to base its redistributive policies. For example, it cannot tax the first hundred breads that a person buys each year at a low tax rate and the remaining number at a higher tax rate. Since the tax is collected at a transaction level, regardless of who the buyer is, it is difficult to adjust the tax based on their income level, earning capacity, age, gender or any other personal characteristic. A redistributive consumption tax would therefore rely on aggregate data, such as the average consumption per income group. Such information is generally very crude and blunts consumption taxes as instruments for redistribution. Personal income taxes are superior because they can account for individual income levels as a measure of ‘ability to pay’. Income taxes (in conjunction with targeted social benefits) can thus be better targeted by using a progressive rate structure on personal income and means-tested benefits for example. VAT can still be useful for the governments’ social policy objectives, but largely as a means to finance the budget than as a direct instrument to pursue equity objectives.

Many developing countries cannot operate effective income tax systems nor effectively targeted transfer systems, for a host of reasons, such as weak institutions, concentration of power, corruption, and politics. For them, it might be convenient to employ VAT design to pursue equity objectives. At least two conditions need to be met, however, to ensure that VAT exemptions and/or reduced VAT rates effectively support lower income households—and these are rarely the case:

• Goods/services need to be consumed primarily, if not exclusively, by low-income households. It can be quite challenging—if not outright impossible—to successfully target VAT exemptions and/or reduced rates to goods or services which are only consumed by the poor. Although lower income-households may spend a greater proportion of their revenues on a given set of basic necessities, higher income individuals will often spend more on such goods and services in absolute terms. Hence, the use of reduced rates or exemptions to address the regressive nature of the VAT can result in unintendedly large subsidies to higher income individuals. Those subsidies hardly improve VAT’s distribution and in some cases may be even regressive.
• VAT exemptions and/or reduced rates need to impact consumption prices in order to benefit lower income households. In practice, however, it is far from automatic that VAT exemptions will lower prices as retailers or intermediaries may simply increase their profit margins. Economic theory suggests that the extent to which a reduction in taxes is passed on to consumers through lower prices will depend on the supply and demand elasticities, and that reduced taxation will most likely, at least partly, be captured through higher margins.

In practice, many countries (advanced and developing) pursue social objectives through their VAT system, even though it is undesirable if better instruments are available. The reason is that VAT is perceived to be regressive, with the burden of the tax falling relatively, if not absolutely more heavily on low-income households than on high-income households. This perception is a source of vigorous political opposition to sales taxes and sales tax reform. Whether the perception is true or not requires an analysis of the incidence of the VAT.

In low-income countries where a significant share of the population lives in rural areas, VAT tends to be less regressive because most small traders – where households are likely to make their purchases – tend to be outside of the VAT net. In those situations, the VAT burden tends to fall mostly on final consumers who live in urban areas and tend to buy from larger, VAT-registered, establishments. Since, on average, urban consumers tend to be better off than rural ones, the VAT threshold (VAT registration exemption for small traders) improves VAT progressivity (see Bachas, Gadenne and Jensen, 2020).

References and further reading:

For an illuminating discussion of the proliferation of exemptions and multiple rates, see Sijbren Cnossen (2015), ‘Mobilizing VAT Revenues in Africa,’ International Tax and Public Finance, Vol. 22, No. 6, pp. 1077-1108.

For a discussion on the impact of informality (and VAT registration threshold) on VAT progressivity, see Pierre Bachas, Lucie Gadenne and Anders Jensen (2020), Informality, Consumption Taxes, and Redistribution, Policy Research Working Paper No. 9267. World Bank, Washington, DC.

The distributional impact of the VAT may be assessed by exploring the distribution of VAT payments by decile/quantile. The latter can be measured by either income decile/quantile or expenditure decile/quantile—the difference being net savings. The ability to determine the distributional effects of VAT in quantitative terms depends on the availability of data on incomes and expenditures. Both rely on household surveys, which are available in most countries. Income statistics are not always readily available (and reliable), so that expenditure-based distributional analysis is more common for developing countries. The different approaches will generally yield different conclusions regarding the progressivity/regressivity of the VAT. For instance, since households with low annual incomes save less than households with high annual incomes, VAT is generally found to be regressive when assessed based on incomes. This partly reflects the difference in saving levels, however, not a difference in expenditure levels or lifetime incomes. As households generally smooth consumption over their lifetime (they save in periods of high income and dissave in periods of low earnings), VAT might not be equally regressive or can even be progressive when assessed on the basis of expenditures. Conclusions regarding the regressive nature of the VAT should therefore be interpreted with caution and the specific type of analysis should be kept in mind.

This approach aims to produce estimates of the VAT burden in absolute terms and relative to household income. The approach requires annual data on:

• Household income partitioned by decile or quantile;
• Household expenditures by category of expenditures (e.g., food, transportation, entertainment, etc.) partitioned by decile or quantile (and, ideally, source of purchase), from a household expenditure survey;
• Supply-use tables (or equivalent national accounts data) indicating average value added by sector of economic activity/commodity; and
• VAT act and schedules of rates, exemptions and zero-rated final consumption.

The next chart shows the type of underlying data that serve as a starting point in calculating VAT payments. In this particular case, the consumption data are partitioned in deciles.

Source: IMF staff, based on Namibian National Household Income and Expenditure Survey 2009-2010,

First, the absolute burden is calculated. VAT payments are estimated by applying the VAT code (rates and exemptions) to each category of expenditures. In the case of exemptions, assumptions might be required with respect to the proportion of VAT on inputs that should be passed on to higher consumer prices. VAT payments must then be computed for each income decile or quantile. In the next step the relative burden is derived, i.e. the VAT payments estimated in the first step are divided by the household income in each VAT payment-income partition. The second step can be used to assess the behavior of VAT payments as household income rises and therefore assess whether the VAT is regressive, proportional or regressive in each category of good and services and overall.

Another simple way to express the VAT impact on income distribution is to calculate the relative change in the Gini coefficient (pre-VAT and post-VAT), use the Kakwani progressivity index, or the Reynolds-Smolensky index. While the latter two are less widely used in the VAT incidence analysis, the Gini coefficient is a fairly common and easy to calculate measure.

The data and approach are identical to that for the Distribution of VAT payments by income decile/quantile save for one detail: in the second step, VAT payments are divided by household consumption expenditures rather than income. Since expenditures provide a better indication of utility than income, and saving, dissaving and thus consumption smoothing take place over time, they provide a better indicator of changes in the relative burden of VAT for different households.

The analysis can serve as a starting point to simulate the impact of changes in VAT rates. The baseline scenario would be given by relative VAT burden calculations for the existing VAT system. Then, a similar calculation can be made for the changed VAT burdens. The third step would show the absolute change in burden [(VAT payments post-policy)—(VAT payments pre-policy)] for each consumption expenditures decile/quantile. The fourth and final step of the analysis would show the VAT relief divided by consumption expenditures for each consumption expenditures decile/quantile. The chart below shows the distributional impact of exemptions, with data partitioned in quintiles. While the chart uses data from an African country, consumption patterns tend to be similar globally. As the chart clearly demonstrates, even though the poor may spend a large proportion of their income on, for example, food, the rich spend more on food in absolute terms—so most of the revenue foregone (due to exemptions or zero-rating) accrues to the rich, not the poor. Indeed, a policy of exempting basic foods would not be well targeted on the poor. Despite the fact that the removal of VAT from basic foods gives the largest proportional reduction in tax as a share of expenditure to the poorest 20 percent of households, they would receive only 6 percent of the total cost of the tax exemption. The remaining 80 percent of the population would receive the remaining 94 percent of the cost, with 45 percent of tax expenditures accruing to the richest 20 percent.

References and further reading:

For a detailed discussion of common methodological approaches of distributional studies, including some of the limitations and potential biases when relying on microdata from household budget surveys, see: Thomas, Alastair (2020), Reassessing the regressivity of the VAT, OECD Taxation Working Papers No. 49.

Annual incidence analysis views saving, which is concentrated in upper income groups, as exempt under a sales tax regime. However, lifetime incidence analysis generally views saving as deferred consumption (unless bequeathed to heirs) and therefore subject to sales tax.

Using Canadian data in a life-cycle micro-simulation model, researchers have compared annual and lifetime incidence of various taxes. The results support the hypothesis that sales and excise taxes treated as borne by consumers should appear less regressive in lifetime calculations compared to annual incomes. In addition, lifetime incidence results are much more robust to alternative incidence assumptions than are annual results. Although the data used in this work are old and the Canadian sales tax system has changed, the central insight of the paper is still relevant: sales and excise taxes are less regressive on a lifetime basis, especially for the lowest deciles of the income distribution.

Two lessons emerge: First, lifetime incidence can yield markedly different results from annual incidence, which should be kept in mind when interpreting results. Second, the overall incidence of the VAT will also depend on how revenue is spent.

References and further reading:

On lifetime vs. annual approaches to assessing tax incidence, see Don Fullerton, Diane Lim Rogers (1991), Lifetime vs. Annual Perspectives on Tax Incidence, NBER Working Paper No. 3750, June 1991.

Tax systems have a gender bias if they explicitly or implicitly treat men and women differently. For example, income tax systems based on joint filing by married couples may imply that women (often secondary earners) pay a higher marginal income tax rate than if they filed separately. This can discourage their participation in the labor market and reflect an implicit gender bias. The question is: does the VAT impose a gender bias in the sense that the burden of VAT might fall disproportionately on women?

It is sometimes argued that women are primarily responsible for household purchases and, for that reason, are disproportionately affected by VAT. However, the VAT burden measured by who in the household purchases joint goods and services tells us little about who actually consumes them. Moreover, gender aspects might also depend on how VAT design affects formal employment of women, their informal care and home production, and decisions about savings. Whether VAT is biased for or against women thus depends on various aspects, including the different consumption patterns of men and women as well as the choice of goods and services covered by the VAT. Assessing this can be complicated and, even conceptually, not straightforward. For instance, it is not a priori clear how joint consumption of goods (such as a house, a joint car or consumer durables) should be allocated to each individual in a household. Another difficulty is that consumption data is primarily collected at the household level and not segregated by gender. One study for eight countries explores VAT incidence for male versus female dominated households and female versus male-headed households. The results suggest that both VAT and excises tend to bear more heavily on the male-type households. However, female-type households generally have lower incomes and benefit relatively more from reduced VAT rates on e.g. food, as a percentage of their total consumption.

The simplest analysis of the tax incidence of a sales tax relies on the analysis of supply and demand curves in a market for a particular commodity subject to tax. This analysis is referred to as partial equilibrium analysis since it considers the impact of the tax only on that particular market and not on prices and quantities of goods and factors of production in other markets. In a partial equilibrium analysis, the tax can be shifted forward to consumers by charging higher product prices, or shifted backward to factors of production by reducing compensation or return. Unless special conditions exist, both producers and consumers will share the burden of taxation. Consumers bear more tax than producers if their demands are less price sensitive or if producers cannot accept lower prices since their per unit costs of production are inflexible (perhaps as a result of inflexible input prices). On the other hand, producers bear more tax than consumers if they provide a product in which costs are flexible or consumers resist price increases by shifting to other products. The side of the market that responds less to the price change induced by the tax bears more of the burden than the side of the market that responds more to this price change. Different market conditions allow for different tax shifting patterns (forward versus backward) regardless of the way in which the tax is levied. Imperfect competition extends the range of possibilities in terms of shifting impacts.

In assessing the gender impact of VAT design, it is also important to consider broader aspects. For example, alternative taxes to raise revenue may have their own gender impact, e.g. excises generally have a bias against men. Moreover, the revenue raised by VAT might be used for government spending in support of female labor participation—which highlights the importance of gender budgeting to make transparent the impact of government policies on gender. Another relevant aspect is how the informal economy affects man and women differently, e.g. to what extend does each of them consume goods bought from small traders that fall under the VAT registration threshold? Overall, it is generally hard to obtain general conclusions on the impact of VAT on gender and data are often unavailable to undertake a systematic analysis.

References and further reading:

For a brief and accessible review of issues, see Anuradha Joshi, Tax and Gender in Developing Countries: What are the Issues?, International Centre for Tax and Development, Summary Brief Number 6, 2017.

Administrative and compliance costs are often considered together under the heading of collection costs. It is very useful to distinguish the two, however. Administrative costs include all direct and indirect costs attached to the administration of the VAT by the domestic tax administration and the customs administration. Administrative functions include registration, filing, payment collection, audit, and enforcement. Those activities are typically supported by taxpayer education programs and a host of shared administrative functions such as accounting, finance, human resources management, information technology, legal, media relations, and so on. Compliance costs include all resources (time and materials) registered businesses engage to fulfill their obligations with respect to VAT. Activities include registration, VAT bookkeeping, record-keeping and reporting, filing returns, remitting VAT, claiming refunds, filing objections, and so on.

Compliance costs can be a major expense to registered businesses considering that their role is to act as an uncompensated VAT collection agent on behalf of the government. All empirical evidence available shows that compliance costs are largely fixed so that the compliance cost burden relative to turnover is larger for small businesses.

VAT policy design is important for administrative and compliance costs. A VAT registration threshold that is too low increases administrative and compliance costs since many very small businesses are required to register for VAT despite collecting little. In addition to economic distortions and revenue leakage, the use of multiple non-zero VAT rates and zero rates on domestic consumption can significantly increase both administration and compliance costs through a variety of channels. The same can be said for the use of numerous exemptions, as exempt supplies requires separate record-keeping and the use of allocation methods to apportion input VAT to taxable and exempt supplies.

A comprehensive tax policy assessment of the performance of the VAT should consequently explore whether authorities have conducted analysis of the additional costs of using multiple VAT rates in terms of both administration (e.g., increase in audit time and resources and in the number and value of refund claims) and compliance (e.g., more complicated record-keeping). These costs should be included as part of the discussion on the relative merit of adopting a multi-rate system. Where such studies have not been undertaken, authorities should pursue them in order to gain an appreciation of the impact that this policy decision has on the revenue administration and on VAT-registered taxpayers.

To assess the performance of VAT administration, one can look at indicators of compliance. Recently, methodologies have been developed to estimate the VAT compliance gap.

VAT non-compliance can have a variety of causes, such as VAT fraud and evasion. An assessment of VAT non-compliance and its causes may begin with an assessment of the tax administration itself. For that purpose, the IMF has developed the Tax Administration Diagnostic Assessment Tool (TADAT) to assist governments in making their tax administrations efficient and fair. TADAT provides an independent, standardized, evidence-based, quality-assured, all around assessment of the performance of a tax administration system. This is entirely separate from the Tax Policy Assessment Framework (TPAF).

Some of the VAT that is collected and remitted to the revenue authority is merely transitory. It can be useful for the revenue administration to quantify the “reasonable” level of refunds expected to be paid out each year. The level of refunds (R) as a proportion of (net) VAT revenues under a fully functioning, single-rate, invoice-credit VAT would be given by R:

Where:

Intuitively, the proportion of VAT revenues that will need to be refunded will generally be higher in economies with large export sectors and many zero-rated goods or services (in terms of their relative importance to the economy) and as the share of investment in GDP (generating excess credits) increases.

A numerical example illustrates the use of this formula. Suppose that a country’s investment ratio is 20 percent, and exports account for 30 percent of GDP (there is no domestic zero-rating). Assuming that 5 percent of investment generates excess credits and that the value added is 40 percent of sales in the export sector, a country with an efficiency ratio of 35 percent could expect paying refunds equal to about 54 percent of net collections. Substituting the appropriate values in the formula yields the expression (0.01 + 0.18) / 0.35 = 0.543.

Data. Information on the share of investment in GDP is available through the IMF’s World Economic Outlook (WEO) Database. The share of exports in GDP is available through the World Bank here. Data on VAT revenue to GDP ratios is available on the IMF’s World Revenue Longitudinal Data (WoRLD), country-level data on standard VAT rates is available here.

References and further reading:

Graham Harrison and Russell Krelove (2005), VAT Refunds: A Review of Country Experience, WP/05/218, Washington, D.C.: International Monetary Fund.

The formula for reasonable level of refunds is presented in Liam Ebrill, Michael Keen, Jean-Paul Bodin, and Victoria Summers (2001), The Modern VAT (Washington, D.C.: International Monetary Fund), chapter 15.

The VAT gap is difference between potential VAT revenues and actual VAT revenues. This is closely related to the C-efficiency ratio, which measures ratio between the two, instead of the difference. The VAT gap can be decomposed into two components: the policy gap and the compliance gap.

Policy gap. Consists of a normalized measure of VAT tax expenditures measured relative to a single VAT rate applied to only final consumption and calculated under the assumption of full compliance. The policy gap is in turn decomposed into a rate gap that captures the impact of differentiation in statutory VAT rates, and an exemption gap that captures the impact of exemptions (and the threshold). Data sources used to calculate the gap are diverse as several modelling approaches are available. Essentially, they include a blend of national accounts data and micro data from VAT returns and the operations (e.g., assessment, collection, audit, enforcement, etc.) of the tax administration.

Compliance gap. Consists of the difference between the amount of VAT that is payable in principle under current policy and the amount actually collected by the government, expressed as a proportion of the former. It is the residual of the total VAT gap and the VAT policy gap. The IMF has developed a Gap Analysis Program using a standardized methodology to compute the VAT compliance gap and the VAT policy gap.

References and further reading:

For a thorough explanation of the VAT gap and methods to calculate it, see Michael Keen (2013), The Anatomy of the VAT, WP/13/111, Washington, D.C.: International Monetary Fund, 2013.

For a description of the revenue administration gap program, see Eric Hutton (2017), 'The Revenue Administration – Gap Analysis Program: Model and Methodology for Value-Added Tax Gap Estimation,’ Technical Notes and Manuals TNM/17/04, Fiscal Affairs Department (Washington, DC: International Monetary Fund).

The VAT gap is difference between potential VAT revenues and actual VAT revenues. This is closely related to the C-efficiency ratio, which measures ratio between the two, instead of the difference. The VAT gap can be decomposed into two components: the policy gap and the compliance gap.

Policy gap. Consists of a normalized measure of VAT tax expenditures measured relative to a single VAT rate applied to only final consumption and calculated under the assumption of full compliance. The policy gap is in turn decomposed into a rate gap that captures the impact of differentiation in statutory VAT rates, and an exemption gap that captures the impact of exemptions (and the threshold). Data sources used to calculate the gap are diverse as several modelling approaches are available. Essentially, they include a blend of national accounts data and micro data from VAT returns and the operations (e.g., assessment, collection, audit, enforcement, etc.) of the tax administration.

Compliance gap. Consists of the difference between the amount of VAT that is payable in principle under current policy and the amount actually collected by the government, expressed as a proportion of the former. It is the residual of the total VAT gap and the VAT policy gap. The IMF has developed a Gap Analysis Program using a standardized methodology to compute the VAT compliance gap.

References and further reading:

For a thorough explanation of the VAT gap and methods to calculate it, see Michael Keen (2013), The Anatomy of the VAT, WP/13/111, Washington, D.C.: International Monetary Fund, 2013.

For a description of the revenue administration gap program, see Eric Hutton (2017), 'The Revenue Administration – Gap Analysis Program: Model and Methodology for Value-Added Tax Gap Estimation,’ Technical Notes and Manuals TNM/17/04, Fiscal Affairs Department (Washington, DC: International Monetary Fund).

A VAT model can help policy-makers assess the revenue impact of changes in reduced VAT rates and VAT exemptions. It also allows one to estimate the sectoral impacts of alternative VAT policies.

One of the most common models to the impact of VAT policy changes is based on an input-output table that enables simulation of the actual operation of the VAT in a country. In particular, input-output tables are used to determine: (1) the level of final consumption by households, governments, and non-profits organizations that cannot get VAT refunds on their purchases, and (2) the level of intermediate consumption by businesses whose products and/or services are exempted from VAT and, as such, cannot get refunds for the VAT they pay on their purchases. Of particular importance is the model’s ability to explicitly capture the interactions among sectors arising from the crediting of the VAT charged on outputs of one sector that are used as inputs into another sector, throughout the entire economy.

In addition to input-output tables, detailed VAT taxpayer data—micro data of the entire VAT taxpayer population—can be used to determine the effective VAT rate by industry/economic activity. Multiplying this with the value of household, government and non-profit organizations consumptions gives the VAT paid by each, reflecting both VAT on domestically produced goods and services and imports.

A user-friendly VAT model could use a Dashboard that combines model-simulated results for easy viewing. The sample Dashboard presented below reflects VAT revenue yield under alternative policy scenarios as well as the difference in VAT revenue between them.

Further, an interactive menu system—Control Panel—could be included to facilitate changes the tax policy parameters for simulated Scenarios. A sample Control Panel is presented below.

References and further reading:

For more on techniques to analyze the revenue (and distributional implications) from VAT using input-output models and micro-simulation, consider the IMF’s 'Revenue Forecasting and Analysis (RFAx) online course.

VAT non-compliance results from a combination of mistakes by taxpayers, evasion and organized fraud. Mistakes will always occur, and their incidence can be reduced through communication and by educating taxpayers. There is also avoidance, which is not strictly non-compliance but which can be mitigated by drafting laws and regulations more tightly. This leaves evasion as the central issue of interest. Evasion (or fraud) usually falls in three broad categories:

• Businesses that should register for VAT do not register;
• Registered businesses understate taxable supplies (output) and/or overstate creditable purchases (inputs); and
• Registered businesses disappear without paying VAT assessed and due to the authorities.

Discussions of VAT non-compliance and especially fraud often return to the discussion of the relative merits of the VAT versus the retail sales tax. It is helpful to categorize types of evasion as follows: common to VAT and RST, and specific to VAT. The table below presents a taxonomy of evasion organized this way.

RST and VAT share many types of evasion. Of the three types of evasion that are specific to VAT, the first two can be handled well under a vigorous audit (pre- and post-) program backed up by coordination with the customs administration and an effective regime of penalties, interest, and fines that is enforced by the administration and the courts. Missing traders (or “bogus traders”) is the most challenging type of fraud because it is a natural consequence of zero-rating under VAT.

Zero-rating comes from two sources: the first is structural and relates to exports. In that case, fraudsters exploit the fact that exports are zero-rated and exporters can claim a refund of VAT paid on purchases even though output VAT has not yet been collected in the other jurisdiction. In the EU—where it is often referred to as carousel fraud—this describes the situation under deferred payment system. The second source of zero-rating is optional and results from policies that zero-rate final consumption goods and/or input purchases. In general, traders that face the strongest incentive to evade are those with large VAT liabilities relative to turnover.

Features of VAT design exert a strong influence on the opportunity and payoff from fraud. Those risk factors include: rate differentiation; level of VAT rates; exemptions; registration thresholds; simplified and flat-rate schemes for small traders; withholding schemes; and timing of payments and refunds.

VAT evasion can consume very significant administrative resources but the deployment of those resources deals with symptoms and not root causes. A far preferable alternative is to enact VAT policy reform to address the above risk factors. Dealing with risk factors head on reduces the payoff from fraud and the attendant misallocation of resources engaged for the sole purpose of obtaining tax benefits.

References and further reading:

Michael Keen and Stephen Smith (2007), VAT Fraud and Evasion: What Do We Know and What Can Be Done?, WP/07/31, Washington, D.C.: International Monetary Fund.

For a discussion of VAT evasion in the EU, see Sijbren Cnossen (2010), ‘VAT Coordination in Common Markets and Federations: Lessons from the European Experience,’ Tax Law Review, Vol. 63, No. 3, pp. 583-622.

For a discussion of non-compliance experience in several countries with VATs, see Katherine O. Baer (2013), ‘What International Experience Can Tell Us about the Potential Challenges of Administering a VAT,’ National Tax Journal, Vol. 66, No. 2, pp. 447-478.

An ideal VAT refers to the conceptually pure version of a VAT. That tax would have the following features:

• Very broad base that includes all consumption expenditures;
• Single positive rate;
• Zero rate that applies only to exports;
• No exemptions;
• A registration threshold that depend on the collection costs and revenue foregone (calculated by the optimal threshold formula);
• Calculation of VAT liability using the invoice-credit method; and
• Levy VAT on a destination basis.

VATs in practice (hereafter real VATs) depart from this ideal, and sometimes substantially so. New Zealand’s Goods and Services Tax (GST) is believed to come the closest to the ideal VAT, followed by a number of countries with so-called modern VATs: Australia, Canada, Chile, Singapore, and South Africa. Departures from the ideal are explained by policy reasons and collection costs.

Experience with real VATs shows that several socio-economic policy objectives translate into departures from the ideal. All those objectives share one characteristic: they do not relate to the primary objective of a VAT which is to raise revenue in a relatively efficient manner. Examples of objectives include:

• Income redistribution;
• Formalization of the economy;
• Investment promotion;
• Price control or management;
• Protection against imported goods; and
• Promotion of competitiveness.

Implicit in some of those objectives is the acceptance of a notion of tax competition with foreign jurisdictions. Field experience shows that that VAT does a relatively poor job in meeting any of those objectives compared to other instruments. The most obvious failure is due to the lack of acknowledgement of the trade-offs involved.

A perennial debate in indirect taxation has been the choice between a turnover tax, a single-stage sales tax, and a multi-stage sales tax. The poor economic efficiency properties of the turnover tax have provided the impetus for the gradual replacement of turnover taxes by VATs in Europe. This leaves the choice between single-stage taxes such as a retail sales tax (RST) and multi-stage sales taxes such as the VAT.

The RST imposes tax on final sales to consumers, including households and non-registered businesses. Tax on investment goods and other input purchases may be partially relieved using an exemption certificate system or a “ring” system. In theory, the RST and the VAT should produce the same revenue outcome, albeit with different timing. In practice, the RST suffers from two operational flaws. First, it is difficult to ensure that only B2B purchases get exempted from tax. The ring or suspension system used to achieve this result – under which tax is suspended on sales by one registered business to another and until there is a sale to a party outside the ring of registrants – is both cumbersome and difficult to police. The VAT achieves this outcome cleanly using the invoice-credit system. Second, the entire collection rests on the least reliable link in the chain: the final sale to the consumer. In contrast, the fractional nature of the VAT means that collections will arise from earlier stages even if the final stage fails to do so. In that case, only the tax on the value-added of that final stage is lost, not that on the full value-added.

In practice, there are other important differences as well between single-stage sales taxes and VAT. Some relate to the different mechanics to relieve inputs of tax. Others relate to differences in enforcement and collection. The next table summarizes the differences between single-stage taxes (RST and manufacturer sales tax) and VAT. The manufacturer sales tax is a sales tax imposed at the pre-retail stage.

Differences between Single-Stage Tax and the Value-Added Tax

The RST model remains in use today, most notably in most U.S. states and three Canadian provinces. A natural question arises as to the transition from a RST to a VAT. The Canadian experience with this transition unfolded in two stages. First, the Goods and Service Tax (GST) replaced the Federal Sales Tax (a manufacturer sales tax) on January 1, 1991. The transition required extensive education campaigns, training, and the establishment of technical procedures such as the valuation of inventories on hand so that input credits could be calculated properly. Next, beginning with Québec and unfolding over a period of time, provinces converted their RSTs into VATs by harmonizing their sales tax bases with the federal GST base.

References and further reading:

On the relationship between RST and VAT, see Michael Keen and Stephen Smith (2007), VAT Fraud and Evasion: What Do We Know and What Can Be Done?, WP/07/31, Washington, D.C.: International Monetary Fund.

On the welfare effects of a VAT, see: Bob Hamilton and John Whalley (1989). Reforming Indirect Taxes in Canada: Some General Equilibrium Estimates. The Canadian Journal of Economics/Revue Canadienne D'Economique, 22(3), 561-575.

VAT can be operated in most economic environments but the use of a VAT in a small economy presents a number of challenges that relate to capacity, fixed costs, and the possibility of alternative taxes that produce an outcome similar to VAT.

First, operating and administering a VAT requires a minimum level of administrative capacity and resources. The VAT is not a simple tax. Second, setting up a VAT entails significant fixed costs so such costs must be reasonable in light of expected revenues in the future. The same applies to compliance costs which tend to be fixed and bear much more heavily on small businesses. Finally, small economies (and especially island economies) usually rely very heavily on imports while they generate little domestic value added. Domestic value added usually comes from services, not goods. Heavy reliance on imports means that much of the VAT on goods can be easily collected upfront by Customs. The case for VAT is more compelling if domestic value added in activities that are easily subjected to VAT is expected to increase.

Economic analysis provides a few important results. First, the potential revenue gain in moving from tariffs to a VAT is likely to be greater the higher consumption is relative to imports. Because the ratio of consumption to imports is expected to increase with country size, the advantage of VAT over a broad-based tariff is smaller in a small economy. Second, the change in deadweight loss from moving from tariffs to VAT is ambiguous. In a small economy where much of final consumption is imported, a broad-based tariff could function as a broad-based consumption tax considering that some local consumption of locally produced goods (e.g., from agriculture) would not be subject to VAT anyway. Finally, moving from tariffs to VAT will unambiguously improve productive efficiency.

Serious consideration of collection costs can upset the delicate balance between those economic impacts. The high fixed set-up and collection costs beg the question of whether there are taxes or combinations of taxes that could achieve an outcome similar to VAT in practice without its complexity and costs. Assuming a tariff is already in place, domestic consumption could be taxed through targeted excises on alcohol, tobacco, hotel rooms and other services.

Countries have considered or are considering options of the sort just described. Two examples of very small island economies can be useful. In the case of country A, two options were considered viable: either a VAT or a structure that taxes goods at import and levies a broad-based tax on the provision of domestic services. In the case of country B, the authorities rely on customs duties for about one-fifth of tax collections. They seriously considered the adoption of a general services tax (a turnover tax) applicable to a wide range of services supplied domestically. In both cases, the lower compliance costs of the hybrid systems (tariff plus tax on domestic services) were seen as very attractive to the authorities.

References and further reading:

Liam Ebrill, Michael Keen, Jean-Paul Bodin, and Victoria Summers (2001), The Modern VAT, (Washington, D.C.: International Monetary Fund), chapter 16.

The term e-commerce refers to a broad array of transactions that qualify as supplies of electronically supplied services and supplies of an intangible nature.. The challenge of taxing the former resembles that of taxing imported services in general: the intangible nature of the supply makes border adjustment impossible in a traditional sense, so taxation must rely on other information (proxies) to establish the place of supply or place of consumption.

B2B e-commerce remains more important and much less problematic for taxation. The ability to claim credit for VAT paid on purchases greatly reduces the incentive to evade VAT. Taxing B2C e-commerce, however, remains a tough challenge for tax authorities. Doing so on a destination basis deepens the challenge further. In general, the problem is simple: unless the tax authorities have access to a sufficient amount of data on the end of the B2C chain – the final (non-registered) consumer – the destination system cannot move past a pure self-assessment, with the predictable consequence of very low compliance and collections. Those challenges are not specific to the VAT: the income tax also suffers from the international tax system’s inability to extract tax properly from remote sellers in the market.

Fortunately, tax frameworks have evolved substantially over the last five years. A number of countries have released VAT rules to ensure that VAT on e-commerce gets collected from the correct party in the right location and at the right time. In the EU, for instance, new place of supply rules were introduced on January 1, 2015 to deal with electronically supplied services (understood as e-commerce) as well as supplies of other services such as telecommunications and broadcasting. The design of the 2015 reform on electronic services, telecommunications, and broadcasting intended to ensure taxation at destination on intra-EU supplies. Prior to that date, B2C transactions between an EU supplier and customer located in another EU member state were taxed where the supplier was located. Since January 1, 2015, the place of supply (perhaps more appropriately the place of taxation) rules for B2C supplies between a supplier located in one EU Member State to a final consumer (non-taxable person) located in another EU Member State falls to the place where the consumer has established her/his place of residence. The new rules rely on a number of presumptions (usually known as proxies) to establish the location of the customer. Those changes bring EU rules, at least on paper, in line with the destination principle. B2B supplies to registered customers located in other EU Member States, including transactions processed through a marketplace, continue to be treated under the reverse charge mechanism: those customers account for VAT in their own Member State.

Under the evolving Digital Single Market – Modernizing VAT for Cross-Border e-Commerce initiative of the European Commission, those new rules are supported by measures to alleviate the compliance burden of SMEs. The most important new facility is the option for the supplier to fulfill VAT obligation either by registering for VAT in each member state in which customers are located, or by registering for the VAT Mini One Stop Shop (MOSS) in the supplier’s own Member State. MOSS is a computerized system that allows businesses supplying electronically supplied services to (non-taxable) customers in another Member State to account for the VAT due on those services via a web portal in its own Member State. The EU plans to extend MOSS to low value consignments originating outside the EU and intra-EU distance selling, and eventually to all intra-EU supplies.

The OECD VAT/GST Guidelines now stand as the most comprehensive international standard on the application of VAT/GST to cross-border transactions. The Guidelines should be consulted in conjunction with local VAT/GST laws and regulations. Rules and processes to capture e-commerce and leveraging platforms should be harmonized to the extent possible to avoid creating obstacles to trade.

References and further reading:

For a discussion covering sales taxes in U.S. and worldwide, see David R. Agrawal and William F. Fox (2017), ‘Taxes in an e-Commerce Generation,’ International Tax and Public Finance, Vol. 24, No. 5, pp. 903-926.

For a fresh discussion covering the EU with ample references to recent EU communications and regulations, see Stephen Dale and Venise Vincent (2017), ‘The European Union’s Approach to VAT and e-commerce,’ World Journal of VAT/GST Law, Vol. 6, No. 1, pp. 55-61.

For a discussion of the issues with information technology solutions to tax digital supplies, see Marie Lamensch (2012), ‘Are ‘Reverse Charging’ and the ‘One-stop-scheme’ Efficient Ways to Collect VAT on Digital Supplies?’ World Journal of VAT/GST Law, Vol. 1, No. 1, pp. 1-20.

OECD (2017), VAT/GST Guidelines (Paris: Organization for Economic Co-operation and Development).

The term e-commerce refers to a broad array of transactions that qualify as supplies of services and intangibles online and supplies of goods acquired over the Internet. The challenge of taxing the former resembles that of taxing imported services in general: the intangible nature of the supply makes border adjustment impossible in a traditional sense, so taxation must rely on other information (proxies) to establish the place of supply or place of consumption.

B2B e-commerce remains more important and much less problematic for taxation. The ability to claim credit for VAT paid on purchases greatly reduces the incentive to evade VAT. Taxing B2C e-commerce, however, remains a tough challenge for tax authorities. Doing so on a destination basis deepens the challenge further. In general, the problem is simple: unless the tax authorities have access to a sufficient amount of data on the end of the B2C chain – the final (non-registered) consumer – the destination system cannot move past a pure self-assessment, with the predictable consequence of very low compliance and collections.

Fortunately, tax frameworks have evolved substantially over the last five years. A number of countries have released VAT rules to ensure that VAT on e-commerce gets collected from the correct party in the right location and at the right time. In the EU, for instance, new place of supply rules were introduced on January 1, 2015 to deal with electronically supplied services (understood as e-commerce) as well as supplies of other services such as telecommunications and broadcasting. Prior to that date, B2C transactions between an EU supplier and customer located in another EU member state were taxed where the supplier was located. Since January 1, 2015, the place of supply (perhaps more appropriately the place of taxation) rules for B2C supplies between a supplier located in one EU Member State to a final consumer (non-taxable person) located in another EU Member State falls to the place where the consumer has established her/his place of residence. The new rules rely on a number of presumptions (usually known as proxies) to establish the location of the customer. Those changes bring EU rules, at least on paper, in line with the destination principle. B2B supplies to registered customers located in other EU Member States, including transactions processed through a marketplace, continue to be treated under the reverse charge mechanism: those customers account for VAT in their own Member State.

Under the evolving Digital Single Market – Modernizing VAT for Cross-Border e-Commerce initiative of the European Commission, those new rules are supported by measures to alleviate the compliance burden of SMEs. The most important new facility is the option for the supplier to fulfill VAT obligation either by registering for VAT in each member state in which customers are located, or by registering for the VAT Mini One Stop Shop (MOSS) in the supplier’s own Member State. MOSS is a computerized system that allows businesses supplying electronically supplied services to (non-taxable) customers in another Member State to account for the VAT due on those services via a web portal in its own Member State.

References and further reading:

For a discussion covering sales taxes in U.S. and worldwide, see David R. Agrawal and William F. Fox (2017), ‘Taxes in an e-Commerce Generation,’ International Tax and Public Finance, Vol. 24, No. 5, pp. 903-926.

For a fresh discussion covering the EU with ample references to recent EU communications and regulations, see Stephen Dale and Venise Vincent (2017), ‘The European Union’s Approach to VAT and e-commerce,’ World Journal of VAT/GST Law, Vol. 6, No. 1, pp. 55-61.

For a discussion of the issues with information technology solutions to tax digital supplies, see Marie Lamensch (2012), ‘Are ‘Reverse Charging’ and the ‘One-stop-scheme’ Efficient Ways to Collect VAT on Digital Supplies?’ World Journal of VAT/GST Law, Vol. 1, No. 1, pp. 1-20.

Peer-to-peer (P2P) transactions have existed in one form or another for centuries, with bartering—used by the earliest civilizations before money was invented—as one of the earliest examples. In the current business setting, P2P activity has evolved to describe the range of transactions in which individuals trade goods and services with one another through digital platforms While both sides are typically populated by individual buyers and sellers, this does not preclude incorporated businesses from using platforms to enlarge their customer base (B2C activity), although they typically do not dominate it.

The digital platforms themselves are businesses, which help to reduce the transaction costs associated with setting up and running a personal business by providing, amongst other things, reputational and feedback mechanisms, payment intermediation services, and opportunities for advertising and marketing. Examples of P2P digital platforms include the auction site eBay, Airbnb in accommodation rental, and Didi Chuxing and Uber in ground transportation.

The notion of P2P activity for tax purposes may in some cases require an expansion of: (a) the legal definition of carrying on business in a particular jurisdiction, and (b) the scope of commercial activity (related to making taxable supplies in the jurisdiction in the course of a commercial activity engaged by the person in that jurisdiction). P2P activities raise a number of issues that are relevant to VAT policy, including:

• Substitution of P2P activity for B2C activity;
• Low income levels and frequency of engagement;
• Reporting obligations of sellers, buyers, and platforms;
• VAT-inclusive pricing.

These point to a number of challenges that will become more severe as the penetration of P2P activity intensifies. First, if growing P2P activity is displacing traditional B2C activity, revenue may be lost or foregone if the authorities do not design mechanisms to tap this base.

Second, the nature of P2P transactions means that even as the scale of P2P transactions increases, revenues are distributed across a larger number of sellers and therefore will be lower on average by taxpayer. This has implications for the choice of VAT threshold. On the one hand, the low-income levels associated with P2P engagement might call for lower thresholds to capture some of this activity. Evidence available for some services indeed shows that average incomes would fall under existing VAT thresholds in a number of countries. On the other hand, it could become prohibitively costly to enforce the VAT with a lower threshold, given the increased administrative and compliance burden for both the government and taxpayers. A related point is that compliance is likely to vary substantially across an increasing number of small taxpayers—and potentially be lower.

However, these issues could be mitigated to a certain extent if the tax authorities adopt new information technologies for monitoring, tracing and enforcement. Tax authorities will have to design rules that balance the search for revenues with administrative and compliance costs, including any encroachments on buyer and seller privacy.

The role of digital P2P platforms in intermediating transactions presents an opportunity for improving VAT administration. Platforms can cooperate with tax authorities in sharing information on the transactions they intermediate, or by acting as withholding agents on behalf of sellers. Digital platforms may in fact be required by some jurisdictions to levy VAT on all transactions they intermediate regardless of whether the individual sellers are registered for VAT, with implications for a seller’s ability to claim refunds of VAT paid on inputs. However, issues of privacy and data integrity cannot be ignored and so adequate institutional safeguards are essential to prevent misuse and abuse of private data.

References and further reading:

For a good discussion of the issues and some data, see Aslam, Aqib and Alpa Shah (2017), ‘Taxation and the Peer-to-Peer Economy,’ WP/17/187, Washington, D.C.: International Monetary Fund.

Historically, gambling activities and lotteries in many jurisdictions are VAT exempt and sometimes subject to specific transaction taxes specific to the activity, in addition to licensing and other fees.

In principle, elegant and simple methods are available to bring gambling under the ambit of the VAT and then eliminate inefficient transaction taxes. The value-added from gambling transactions – including gaming machines, lotteries, table games – can only be calculated accurately once the winners are selected and the winnings paid out. Consider for example the gambling activities of a casino: under a margin method, the value-added from gambling is simply calculated as the spread between bets placed and winnings paid out. Of course, non-gambling activities of the casino would remain taxable under VAT using the normal invoice-credit system.

As in the case of financial services and intermediation, there is no good a priori case to exempt gambling and lotteries or tax them using inefficient transaction taxes. Taxation under VAT is as straightforward as in the case of property and casualty insurance.

References and further reading:

For a more thorough discussion and numerical examples, see Alan Schenk (2008), ‘Gambling and Lotteries’, in R. Krever (Ed.), VAT in Africa (Pretoria: Pretoria University Law Press), pp. 47-70.

International tourism services constitute a special type of export since that export is consumed within the exporting country, not within the importer’s home country. In theory, this presents interesting opportunity for the tax policy in the host country that provides the services.

First, tax exportability may result whereby the burden of taxation may be distributed between the residents of the host country and nonresidents who consume the services locally. Second, the efficiency impacts of the taxation of tourism in the host country would disregard the welfare of non-residents, an outcome that would warrant heavier taxation of tourism activities, all else equal. Finally, taxing tourism activities may also improve the welfare and equity outcomes of residents considering that tourism services are complementary with leisure and that host country residents who consume local tourism services tend to come from higher income deciles.

Despite those apparent opportunities, tourism activities tend to be lightly taxed compared to other service sectors, and this is true in small countries highly dependent on tourism as well as emerging economies that try to develop the industry. In some countries, the main tourism service activities (hotel and restaurants) are subject to separate transaction taxes (e.g., hotel occupancy taxes) while in others those services are subject to VAT. The terms are highly variable however. In addition, there are related auxiliary services that may be important such as local tour operators, transportation, small accommodation, and so on.

Many destinations that depend on tourism impose a light burden on the activities, especially those of large hotels and resorts, through a complex mix of measures: reduced VAT rates on sector outputs (and sometimes inputs), import duty and excise exemptions – which reduce the effective VAT base at import, income tax holidays and waivers of other taxes and fees. Those measures are pushed in the guise of promoting investment in the sector.

Those preferential measures create significant non-neutralities in the tax system. Large hotel operators usually take the proceeds of those concessions in the form of higher profit margins rather than reducing retail prices. Those concessions also have a dubious impact on actual investment although they promote destructive tax competition (e.g., in the Caribbean region). Finally, they forego significant revenues and often transfer appropriable rents to non-residents. The result in some small tourism-dependent countries is that the treasury receives very little from the activities.

Because differential taxation of tourism activities is difficult to achieve and likely to be inequitable, the most appropriate policy is to subject all activities to the normal VAT regime at the standard rate, with a properly set registration threshold to exclude small operators. In cases where VAT is infeasible, specific transaction taxes on hotels, accommodation and restaurants provide a quick fix.

References and further reading:

Laurent Corthay and Jan Loeprick (2010), Taxing Tourism in Developing Countries: Principles for Improving the Investment Climate through Simple, Fair, and Transparent Taxation, DFID and Investment Climate Advisory Services, World Bank.

Alberto Gago et al. (2009), ‘Specific and General Taxation of Tourism Activities: Evidence from Spain’, Tourism Management, Vol. 30, Iss. 3, pp. 381-392.

Nishaal Gooroochurn and M. Thea Sinclair (2005), ‘Economics of Tourism Taxation: Evidence from Mauritius’, Annals of Tourism Research, Vol. 32, Iss. 2, pp. 478-498.

It is helpful to restate the role of the business sector in any VAT system to serve as a tax collection agent for the authorities. The central question that arises is: How far can the small business sector go in performing that role? To begin answering, it must be acknowledged that perspective matters. For example, how small is small depends on the specific situation at hand and on the economic structure of the country of interest.

In practice, the treatment of small business—or the belief about what it should be in a normative sense—remains one of the most confusing and confused areas of the nexus between tax policy and administration. From the point of view of VAT design, the VAT threshold can effectively serve as the first-line instrument to handle small business, especially if supported by a voluntary registration threshold that lies somewhere between zero and the threshold. The threshold policy decision determines the small business base since establishments with taxable supplies below the threshold are effectively subject to a VAT exemptions unless they voluntarily choose to register. Voluntary registration depends on the election being available in the law, and usually on the approval of the tax administration. Exempt small business do contribute to collections since they pay VAT on taxable inputs they purchase. In that sense, small businesses that are not registered for VAT pay VAT—on inputs—and save any compliance costs they would have to incur were they registered.

In a practical sense, this is fine. However, Ministries of Finance, tax administrations, and the medium and large business sectors often seem uncomfortable with the idea of leaving small business outside the ambit of VAT registration. This discomfort may stem from a misunderstanding of the nature of exemption, threshold, and collection (compliance plus administration) costs. Small businesses that are not registered are exempt. Yet, many VAT systems – in developing and developed countries alike – insist on attaching additional tax mechanisms to small businesses, oblivious to the fact that a reasoned decision on the VAT threshold already incorporates consideration of the trade-off between collections and collection costs. By setting the threshold to an amount of X, the authorities acknowledge that they should not deal with businesses with taxable supplies below X. If they wanted to, then they would set the threshold lower.

Authorities often insist in imposing duplicative policies that fall under the general heading of special regimes for small business. Special regimes can take several forms:

• Turnover tax for small business with turnover below the threshold;
• Flat-rate scheme; and/or
• Combination of input exemption, reduced (including zero) rates on inputs, and output VAT relief.

The turnover tax is quite widespread despite the fact that this is precisely the type of inefficient tax VAT meant to replace. It should also be noted that turnover usually exceeds taxable supplies so a turnover tax at a rate below the standard VAT rate may overtax the business. The turnover tax may also cause additional complications when authorities insist on harmonizing the turnover tax threshold for the business or income tax threshold, in an effort to design a tax that liquidates both VAT and income tax obligations. In that case, income tax-like problems contaminate the VAT.

All the above schemes require additional administrative resources and their own information so they impose collection costs that would not exist with a threshold alone. Field experiences with such schemes and variations on turnover taxes show that the extra revenues collected rarely justify the added collection costs. Policies could then better focus on the correct determination of the VAT registration threshold and the voluntary registration threshold.

Flat-rate schemes charge a presumptive VAT on sales from small businesses to large businesses in prescribed sectors. Eligible small businesses impute and retain this presumptive VAT as compensation for VAT on purchases. Large purchases in turn claim that VAT as input VAT. In practice, flat-rate schemes can over-compensate or subsidize small businesses and hence retard their development by removing any incentive to grow and lose the benefit of the scheme.

In practice, the damage to VAT from small business policy does not end with special regimes. It often extends to further weakening of the VAT by providing lower-than-standard (including zero) rates and exemptions of business inputs, regardless of whether they have dual use or not. The irony is that many developing countries with weak tax administrations push far in this direction.

Far better alternatives exist by way of policies that simplify compliance and administration: less frequent filing of VAT returns, alternate accounting methods, minimum threshold to claim refunds. Ultimately, choosing such policies should be based on benefit-cost considerations. An informed and deliberate decision on the threshold makes special schemes unnecessary. If the authorities believe that administrative simplification is insufficient, then they should consider raising the threshold and/or simplifying policies with respect to rates and exemptions.

References and further reading:

For a comprehensive discussion of special regimes, see Sijbren Cnossen (2017), 'VAT and Agriculture: Lessons from Europe,' International Tax and Public Finance, Vol. 25, Iss. 2, pp. 519-551.

Pierre-Pascal Gendron (2017), ‘Real VATs vs the Good VAT: Reflections from a Decade of Technical Assistance,’ Australian Tax Forum, Vol. 32, No. 2, pp. 257-282.