51626 The World Bank JUNE PREMnotes 2009 N U M B E R 136 TAX POLICY Taxing Consumption Richard M. Bird* Domestic consumption in most countries Why VAT is the Sales is taxed through general sales taxes, ex- Tax of Choice2 cise taxes on specific commodities, and There are essentially only three types a variety of miscellaneous taxes on such of general sales taxes: a turnover tax, services as hotels and transfers of prop- a single-stage sales tax, and a VAT. A erty. This note considers only the first turnover tax is in some ways the easiest to two of these categories, with particular administer. Tell me your turnover, and attention to general sales taxes.1 I'll tax you on it. The basic administra- Consumption taxes are obviously tive problem is to determine and verify related both to customs duties and other the turnover (sales) of a taxpayer and to taxes on imports and also to produc- collect the tax. The idea is simple but its tion taxes like those often imposed on execution can be difficult. The basic way agricultural output. In some countries to evade such a tax is also simple: hide elements of both import and produc- (under-report) sales. The easiest way tion taxation remain. These aspects are legally to avoid the tax is by integrat- not further explored in this note--other ing vertically with one's suppliers since than to note that the original form of `within-firm' sales are not taxed. The general sales taxes often consisted of other side of this coin, however, is that a sales tax imposed on imported and a turnover tax is by far the economically domestic manufactured goods. most distorting form of sales tax. Only Most countries have now replaced in the unlikely event that one wishes to such "pre-retail" sales taxes by taxes that discourage exports and investment and fall primarily on consumption rather to induce firms to integrate up and down than on production and, it is hoped, are the chain of distribution and production both more responsive to revenue needs are the allocative effects of such a tax and easier to collect effectively and effi- likely to be welcomed. Moreover, since ciently. However, excise taxes on specific the final tax burden borne by any partic- commodities are often still imposed at ular transaction depends essentially on the production stage. how many prior taxed transactions are *The views expressed in this note are the author's and must not be represented as those of The World Bank. This note was reviewed by Milan Brahmbhatt, Tuan Minh Le and Eduardo Ley. FROM THE POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK embodied in its sales price, its distribu- taxes in theory avoid the bad effects tional impact is indeterminate. Govern- (though in practice they are unlikely to ments that impose turnover taxes have do so very cleanly) but they are difficult little idea of the effects of such taxes on to administer well. either allocation or distribution. Enter the VAT. In principle--and, To avoid all these problems, one when properly set up and run, in prac- obvious solution is to impose a single- tice--VAT combines the good features stage sales tax--commonly called a retail of both its competitors while avoiding sales tax (RST)--on the final sale to con- the bad features for the most part. It sumers (households or nonregistered does this through two features: First, VAT firms).3 Investment goods purchased collects the equivalent of a single-stage by registered firms, like other inputs retail sales tax through a multi-stage col- purchased for business purposes, are in lection process that collects tax at each principle freed from tax, as are exports. stage of the chain of production and The allocative and distributional effects distribution preceding the final sale to of such a tax are much clearer than those households. By doing so, in the end it of a turnover tax. The government can achieves the (presumed) goal of taxing figure out what it is doing. Unfortu- only consumption. Moreover, even if nately, experience with RSTs even in evasion occurs at the final retail stage countries with good tax administrations only that part of the potential tax base demonstrates that this approach has two consisting of the retail margin escapes fatal flaws. First, it is extremely difficult tax. Second, by crediting taxes on inputs to ensure that inter-firm purchases used including capital goods, VAT avoids dis- to produce taxable goods and services-- torting economic choices with respect to and only those purchases--are exempt production technology. It also eliminates from tax. The `ring' (or suspension) taxes on exports by crediting taxes paid system used to achieve this result--un- on inputs at prior stages. der which tax is `suspended' on sales by With an RST as with a turnover tax one registered firm to another and so on the basic way to evade is simply to avoid and on until there is a sale to someone reporting sales. This can be done by re- outside the ring of registrants--is both maining in the shadow economy, by not cumbersome to police and easy to abuse. keeping proper books, or by not report- Second, the entire tax collection process ing correctly to the tax authority. It takes rests on the least dependable link in only one to evade. With VAT, however, the chain--the final sale to a consumer there are two ways to evade: by under- (someone outside the `ring' of licensed reporting sales or by over-reporting firms). The fragmented and usually taxable purchases (thus claiming excess small-business-dominated retail trade input tax credits and, in some cases, sector is notoriously difficult to police even refunds). On the other hand, with in any country. VAT it also takes two to evade--a seller Hence the dilemma: turnover taxes and a buyer. Moreover, since the two are easier to administer but have bad sides of the transaction are recorded in economic effects; single-stage retail sales two sets of books the task of the admin- 2 PREMNOTE JUNE 2009 istration in detecting evasion should be do, should keep them and improve them easier with VAT. as necessary; countries that do not have Indeed, in principle, the task of VATs should consider adopting them. the taxman is made even simpler be- cause the two parties involved in any Some Key Issues in VAT Design potentially taxable transaction (buyer The key design issues in any general and seller) have conflicting incentives. consumption tax include such matters Buyers want to overstate purchase prices as rates, exemptions, the treatment of to inflate credits, while sellers want to small businesses, the treatment of excise understate sales to reduce output taxes. goods, and the appropriate treatment of For this reason, some early writers even imports and exports. Only a few critical claimed that VAT was at least to some points about sales tax design are noted extent `self-enforcing'. In practice, in here.4 For example, the best sales tax some instances, this apparent strength with respect to both efficiency and ad- of VAT has proven to be a weakness in ministration is undoubtedly one with the sense that it perhaps induced some a single uniform rate applied to all taxable countries to rely too heavily on tax transactions. The usual reason for impos- design (the VAT approach to sales taxa- ing more than one rate is that it is more tion) to do the work that only good tax `equitable' to do so, but this conclusion administration can really do. A major is disputable for a number of reasons: form of VAT evasion in many developing more rates make it harder to administer and transitional countries plays on this a sales tax, differentiated rates mean feature of VAT: a firm creates a `shell' that a higher average rate is required to company and then `sells' inputs to itself raise a given amount of revenue (thus in- at a false price that then serves as the creasing the economic costs of imposing basis for an input tax credit or refund the tax), higher rates on `luxury' goods claim. It is easier to get away with this are an ineffective means of increasing dodge when the alleged supplier is in the progressivity of the fiscal system, another country (as in the case of the so- and, most importantly, lower tax rates called `carousel' frauds in the EU). But on `necessities' are generally poorly when the tax administration is as weak targeted and ineffective. The rich may as it is in many developing and transi- spend relatively less of their income on tional countries it is not hard to create `basic food', but they are likely to spend and register fictitious firms domestically absolutely more and hence receive more in order to operate such frauds. benefit from such concessions. Nonetheless, despite such problems, Although the most broad-based both in principle and practice it remains consumption taxes in the world (such simpler to enforce a sales tax applied as the New Zealand VAT) come close to in an incremental `value-added' form including most final (private) consump- to a chain of transactions than when tion in the tax base, most VATs in de- all stands or falls on honest reporting veloped countries probably encompass of a single transaction (the final sale). 50-60 percent of such consumption. The Countries that have VATs, as most now general sales taxes found in developing JUNE 2009 PREMNOTE 3 countries generally do considerably the system voluntarily since it will be so worse in this respect, often tapping little clearly in their interests to do so. If they more than 30 percent of the theoretical do not, in so far as they deal with the consumption tax base. The broader the registered sector they will pay a fiscal base the better since the rate required penalty and the interests of both equity for any revenue is obviously lower, which and competitive efficiency should, at means that the efficiency cost of raising least roughly, be served. revenue is correspondingly lower. With a broader base, administration is also Excise Taxes6 simpler because there are fewer avenues In most tax systems around the world of escape. selective taxes on consumption, or ex- Full taxation of consumption can cises, produce a significant amount of never be achieved because it is not pos- revenue. Excises on alcoholic beverages, sible to tax some consumption (such as tobacco, motor vehicles, and fuels are home-produced consumption). It may generally the only items with sufficiently also be economically inadvisable to high revenue yields to warrant special do so, or there may be no net revenue attention.7 Such taxes have proven to be gain from doing so, or it would be too both administratively feasible--the im- costly to do so. Examples found in most portation, production, and consumption jurisdictions in addition to financial of excise goods are reasonably identifi- services are public sector consumption, able and reachable by the tax admin- education, health, and agriculture. istration--and politically acceptable. Most countries simply exempt activities They produce considerable revenue carried out under these headings from without giving rise to excessive evasion tax. This common practice obviously and resistance. In addition, excises on leaves a lot of consumption out of the these items may reduce externalities tax base and creates a number of eco- associated with drinking, smoking, and nomic inefficiencies and administrative driving.8 complexities. On the whole, these products should Finally, in part because VAT compli- in principle be taxed at rates set both ance costs are particularly high for small to offset externalities arising from their business, many countries have intro- consumption and for revenue reasons.9 duced various forms of special treatment Specific taxes levied as a flat amount for small traders. Current thinking is per physical unit of the good greatly that in practice most developing coun- simplify administration. The tax in- tries should likely have relatively high spector only needs to be able to count, thresholds--say $100,000--at which to and does not have to worry about the require firms to register for VAT. 5 Reg- often troublesome issue of valuation. istrants should, of course, be required to In addition, to the extent one objective keep at least minimal books--essentially of excise taxation is to discourage the records of sales and purchases. If the consumption of the taxed good, as in VAT is moderately well designed and the case of alcohol and tobacco, it seems operated, registrants should come into only sensible to impose the tax on, say, 4 PREMNOTE JUNE 2009 the alcoholic content of the beverage ducers or commercial importers, such and not on value. Of course, specific control at the production and import taxes also have problems: for example, level seems essential in most develop- they may prove difficult to change in ing countries. Since vehicles need to be the face of inflation, with the result that registered and licensed, there is also an real revenues may fall in the face of price opportunity to exercise the high degree increases, and they may discriminate of control needed to enforce high rate against relatively cheaper products. On excise taxes. the other hand, ad valorem taxes raise valuation problems, hence complicat- Notes ing administration, and discriminate in 1. For a detailed discussion of service taxes favor of cheaper products. In practice, in a specific context, see "The Taxation of the choice of specific or ad valorem rates Services," in Roy Bahl, ed., The Jamaican Tax usually comes down to how one weighs Reform (Cambridge, MA: Lincoln Institute the administrative advantages of the of Land Policy, 1991), pp. 433­600. Taxes former against the potential revenue on property transfers are considered in R.M. loss in the face of inflation. Although Bird and E. Slack, International Handbook it is seldom done, in principle specific of Land and Property Taxation (Cheltenham, rates should be periodically adjusted to UK and Northampton, MA: Edward Elgar, keep real tax rates constant. 2004). A good recent overview of consump- On the whole, international experi- tion taxation in developed countries may ence suggests that the specific tax ap- be found in OECD, Consumption Tax Trends proach is probably best in administrative (Paris, 2006). terms when one attempts to impose 2. The section draws on R.M. Bird and high taxes on a few products that can P-P. Gendron, The VAT in Developing and be fairly tightly controlled. Moreover, to Transitional Countries (Cambridge University the extent excise tax policy is designed Press, 2007), chapter 3. with social objectives in mind, the spe- 3. Few other forms of single-stage sales cific approach is also indicated. Periodic taxes (those imposed prior to the retail level) review and revision of specific rates is of exist, and all suffer to varying extents from course needed in order to maintain both the problems of turnover taxes. revenue and social objectives in the face 4. For detailed discussion of these and of inflation. other issues, see the book cited in note 2 The effective administration of a above. high-rate excise tax fundamentally de- 5. See Michael Keen and Jack Mintz pends upon establishing an adequate (2004), "The Optimal Threshold for a Value- system of control of the physical com- added Tax," Journal of Public Economics, 88: modity. Physical control may be costly, 559­76. and may open the way to corruption 6. For an excellent recent discussion of (since the tax inspector can be paid off excise taxation, see S. Cnossen, Theory and to certify tax payment). Nonetheless, for Practice of Excise Taxation (Oxford: Oxford alcohol, tobacco, and petroleum prod- University Press, 2005). Aspects relevant ucts, where there are generally few pro- in developing countries are discussed in JUNE 2009 PREMNOTE 5 Cnossen, Excise Tax Policy & Administration in Southern African Countries (Pretoria: Uni- versity of South Africa, 2006). 7. Instead of applying differential VAT rates to such products, best practice is to apply the standard VAT rate to the price of the product including excises. 8. The economically relevant externalities arising from these activities are of course not the costs directly imposed on the user but rather the consequences that his actions may impose on other members of society. 9. Motor vehicle taxes are usually progres- sive in their distributional impact and, both for this reason and because it is administra- tively not difficult, are often subject to ad valorem rather than specific taxes. This note series is intended to summarize good practices and key policy findings on PREM-related topics. 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