9002lirpA IN PRACTICE investment climate BUSINESS TAXATION 4.on 48315 Introducing the Value-Added Tax Considerations for implementation Farid Tadros Successfully implementing a value-added tax (VAT) system is complex Farid Tadros (ftadros@ifc.org) and must be approached strategically and realistically in order to advises client governments as maximize company participation, create an efficient filing and audit a member of IFC's Business Enabling Environment Advisory administration, and encourage private sector growth. The active Services in the Middle East and involvement of both the government and the private sector is essential to North Africa. His work focuses delivering sustainable results. This note presents the fundamentals of the on regulatory reforms for busi- ness taxation and the mining VAT: how it works, the challenges of introducing it, a menu of good- industry that will reduce barri- practice options, and lessons learned for implementation. ers to compliance, investment, and growth in developing countries. How the VAT works and investment; firms pay tax on the sale of both This note and others in the consumption and investment goods. series of IN PRACTICE notes Value-added tax (VAT) is the core transaction "Cascading" occurs when a good is taxed more on business taxation reform tax for most countries. It involves every process than once as it makes its way from production to of production and consumption along the value final retail sale. As a result, firms tend to self- were developed as part of a chain, and requires not only administrative supply taxable goods and services rather than joint program between the capacity on behalf of the government entity purchase taxable goods or outsource taxable United Kingdom's Department (revenue authority), but also on the part of the services, since both activities give rise to for International Develop- private sector through accounting and reporting. irrecoverable VAT on inputs (Bird and Gendron ment (DFID) and the World As such, the implementation and structure of 2005). In the case of single-stage retail tax, Bank Group's Investment the VAT have direct implications on the business administering the system is challenging because environment in which investors operate in terms the revenue authority must depend on the final Climate Department (CIC). of cost of compliance and formalization. seller to the public for tax collection--typically The program focuses on op- fragmented small businesses. erational issues in tax reform, The VAT is one of three core tax instruments at particularly those related to the disposal of tax policymakers deciding how to The VAT addresses these issues by withholding micro-enterprises and small deliver on their policy objectives. Alternative tax at each stage of production through a system businesses. The CIC business instruments (for example, turnover tax1 and of credits and refunds. Thus, it achieves the goal single-stage retail tax2) while widely used, tend of taxing only consumption. In addition, if tax is taxation product line helps gov- to cause economic distortions and avoidable evaded at the retail stage (the final stage of ernments implement effective administrative burdens. By nature, turnover tax consumption), the VAT forgoes only that part of tax systems to spur investment is unable to differentiate between consumption the potential tax base consisting of the retail and economic growth. margin (Bird and Gendron 2005). There is less incentive for firms to self-supply as value-added is The VAT Across the Supply Chain no longer taxed multiple times. (See box, left). One of the key principles behind the VAT is that it This example assumes a plastic factory is the beginning of the supply chain is a broad-based tax which is levied on multiple (that is, the factory does not make input purchases from other suppliers). stages of production. The VAT is not a tax on It sells its product, malleable plastic, in bulk to a toy factory at a price of production, but rather a tax on consumption; $100, plus $10 in VAT ($10 is owed to the government in tax). hence, VAT credits and returns play a critical role in the overall system. Companies can offset their The toy factory's purchase price is $110 and sells it to a retail outlet for VAT tax liability with VAT credits accrued when $300 plus $30 in VAT [in this case, only $20 is owed to the government in they pay for the inputs of their production. If tax ($30 in VAT; $10 VAT credit for the tax paid on the input)]. credits exceed the liability (typically the case for exports, which are exempt from the VAT), a refund The retail outlet's purchase price is $330 and sells it to a consumer for $350 is provided. plus $35 in VAT [in this case only $5 is owed to the government in tax ($35 in VAT; $30 VAT credit for the tax paid on the input)]. The use of self-assessment, which requires that taxpayers determine their VAT credit or liability to the revenue authority, is critical for a VAT system Plastic Factory Toy Factory Retail Outlet to work effectively. To perform a self assessment, a firm must have the capacity to track its revenue Purchase Price 0 110 330 and purchases and maintain financial records. In developing countries, many firms do not yet have Sales Price 100 300 350 this capacity. VAT* 10 30 35 VAT Credit How the private sector 0 10 30 views the VAT VAT payment to government 10 20 5 When any tax is introduced, it is natural for the private sector to be apprehensive. In the case of the * Assume VAT at 10%. VAT, the private sector is not only paying the tax, but also collects the tax on the government's behalf. Thus, the private sector views the VAT as having Total multiple costs to business: i) the value of the tax itself; ii) the cost required to comply with VAT Gross VAT Collected 75 filing and returns; and, iii) the impact on firms' Gross VAT Credited 40 working capital and cash flow. Net Government Revenue 35 These costs may lead firms to conclude that the only reason to participate in the process is to comply with the law. However, it has been At the end of the process, the companies have collected $75 in VAT on behalf of the suggested that because informal companies outside government, but are able to recover any VAT they paid on their inputs; in this case, the VAT system are unable to claim VAT credits on $40 in VAT credits. Accordingly, the net amount to the government of $35 represents their inputs, they have an incentive to formalize in the tax paid by the consumer--hence, the term consumption tax. order to reap this benefit (Bird 2005). Source: William 1996. However, there is a "chicken or the egg" syndrome when talking about VAT credits as an incentive to formalize. For instance, the incentive for an individual firm comes into play only when a critical mass of firms actually comply with the system [that is, if the company providing the IN PRACTICE BUSINESS TAxATIoN 2 inputs is not complying with the VAT, then there is Weak administrative procedures for a much less incentive for the purchaser to comply as complex process. well. (See Figure 1.)] Due to the nature of the system, it is important to identify and address complex and unclear The implementation strategy should aim to ensure administrative procedures that provide that the VAT does not push more firms into the opportunities for corruption. Ambiguous rules informal sector, but rather acts as an incentive to and procedures not only reduce the efficiency of formalize. This can be accomplished by focusing the process itself, but lead to increased discretion on the two opposite sides of the value chain on the part of tax administrators. spectrum (the initial input creators and exporters), as shown in the figure. The revenue authority honoring its side of the deal. The VAT collection and payment system must be The VAT refunds can be a point of friction between simple enough that there is an incentive (or rather the private sector and the revenue authority. The a lack of disincentive) for the initial input creators revenue authority needs to provide timely refunds to register and comply. At the other end of the to the private sector, and the private sector needs to value chain, the implementation team can use comply with the processes and present accurate major exporters in building formal supply chains and complete information. that will encourage their suppliers to also formalize. Misrepresentation on the part of the firms applying for refunds. Addressing the challenges Misrepresentation by firms takes many forms. It of introducing the VAT can be in the form of inflated refund claims, in which firms create fake invoices for purchases Not all countries are ready for the VAT, and for never made. Underreporting sales is also common, those that are, there is no universal approach to especially among smaller firms. Fictitious traders introducing this tax instrument. Challenges that may be created by registering fake companies, arise in introducing a VAT system typically relate which are used to submit export VAT refund to three issues: claims. Domestic sales can be disguised as exports by firms using fake export invoices. Figure 1: Incentive to Formalize Across the Value Chain Value chain: Initial input creators The rest of the supply chain Exporters (raw materials) (processing, packaging, manufacturing) (finished goods) VAT credit is not VAT credit is a reason to VAT credit is a significant Incentive to formalize: a compelling reason to formalize, but only if the firm reason to formalize comply / formalize has "access" to formal inputs (will have substantial VAT (this is beginning of supply chain) (collect input VAT) credit to collect) Source: Author. IN PRACTICE BUSINESS TAxATIoN 3 These issues are addressed by improving the instituting simple and transparent laws and capacity of the revenue authority, and by clarifying procedures; fostering a cooperative environment and simplifying the procedures the private sector between the government and the private sector; must follow. When introducing the VAT, it is and setting realistic timelines and targets. The important to assess both the revenue authority's following are examples of good VAT practices: administrative capacity as well as the private sector's capacity to comply with the VAT. Keep tax laws simple with limited exemptions, a zero rate for exports, and a high threshold. The role of revenue authority should be based on its Setting a higher VAT registration threshold relieves current and future capacity to assist taxpayers in smaller firms, which represent a small portion of understanding their obligations and entitlements, total VAT revenues, from the need to comply. A identify non-compliers, and shift to a culture of higher threshold also relieves the revenue authority trusting the taxpayer. Self-assessment is critical to from the cost of administering the tax. Good successfully implementing the VAT, and convincing practice has been to set a high VAT registration governments to change old habits can be difficult. level (how high is subject to the country context), The use of risk-based assessments for audits, which and to allow voluntary VAT registration for minimize the pool of companies that needs to be businesses that are below the threshold so that they audited and allow the revenue authority to target are able to participate and benefit from VAT high-risk companies, is a good way to free up and refunds (Engelschalk 2007). focus the audit function's administrative capacity. Simplifyfiling,payment,andrefundprocedures. When assessing the private sector's capacity to Determining the appropriate filing frequency is comply, there are two important questions to con- important--the lower the filing frequency, the sider: To what extent does the average firm use lower the compliance cost to the taxpayer bookkeeping and track financial records? Will com- (Engelschalk 2007). Reducing the number of VAT pliance costs make up a significant amount of the rates is a key step to simplifying the system. Good firm's cost, thus becoming an overwhelming burden? practice in VAT is that only one rate is applied to reduce compliance cost and uncertainty VAT registration thresholds (the criteria used to (Engelschalk 2007). This eliminates confusion on determine what firms should participate in the the part of the private sector, reduces the likelihood VAT system) should be at a level that can be of incorrect VAT filing, and eliminates discretion realistically managed by the revenue authority and on the part of tax officials. absorbed by the private sector. The weaker the capacity of the revenue authority and of small and VAT refunds are a key point of tension between medium firms to comply, then the higher the VAT the private sector and the government, largely a registration threshold should be. A higher result of the low capacity of revenue authorities to threshold reduces the number of firms participating make timely refund payments. Most VAT refund in the system and accordingly, the administrative payments are made to large exporters (exports are burden on the revenue authority. To help set an typically zero rated and exempt from the VAT as appropriate VAT registration threshold, the the goods are consumed abroad). For instance, implementing team should provide a realistic Lesotho has upfront refund payments for textile assessment of the private sector's and the and garment exporters who are compliant and government's respective capacity to determine have monthly claims exceeding $15,000 (FIAS reasonable targets and longer-term goals. The 2007). targets are likely to be in the form of a phased road map that grows in complexity as capacity increases. Map the detailed processes before stream- lining them. When launching VAT reforms, it is important to Applying lessons learned to take stock of both the current processes that the VAT implementation taxpayer must follow to comply with the VAT as well as the back office procedures that tax officials When rolling out the VAT, ensuring that good apply. Mapping the process provides a baseline for practices are adopted largely depends on: discussion and a clear indication of where the IN PRACTICE BUSINESS TAxATIoN 4 streamlining should focus (see Figure 2). In compromise needs to be forged. Regular working addition, once the government has a clear picture groups and steering committees are useful in of the current processes, key decision-makers can bringing the groups together to discuss key issues. take direct measures to streamline and develop an Identifying "champions" for specific issues, tasks, action plan for the short and medium term. After and initiatives is a proven way to assign ownership the streamlining has been completed, a re-map of and accountability. the finalized processes provides a guide for tax officials in administering the new processes. Transparency is essential; the government should share pertinent information with the private sector Foster a cooperative environment. early in the process in order to gather inputs, create A strong sense of cooperation and commitment trust, and encourage ownership among key between the private sector and the government stakeholders. Such was the case during the reform of must be developed and maintained throughout the Egypt's income tax law. At various stages of the reform process. Reforms should include key reform process, key articles, issues, and eventually government and private sector stakeholders' the law itself were shared and discussed with business contributions, and a culture of trust and associations, accounting firms, and the media. Figure 2: A Process Map Before Streamlining Each step identifies the cost and time associated REYAPXA Signed Step 1 Step 6a Forms T yes Step 2 Step 5 Decision SSESSMENT EPARTMENT A D no point ssecorPrenw O egraL tinU reyapxaT Step 3 Step 6b Step 7 eciff Step 4 Step 8 O Forms MG Documents/ Forms This figure illustrates a complex process across multiple "process owners" and its incremental time and cost for taxpayers. Source: Author. IN PRACTICE BUSINESS TAxATIoN 5 Set realistic timelines and targets. In order to successfully carry out VAT reforms, the Setting realistic targets from the outset and phasing implementation team needs to consider the these targets along a timeline will maintain the dynamics of the current environment. Within this momentum and prevent the government, context, good practice can be applied to the overall stakeholders, and reform team from becoming strategy and target objectives to fit the plan, while overwhelmed with the size of the task. Phasing taking into consideration the capacity of the allows for i) quick wins, ii) gradual development of revenue authority and the private sector. From a the revenue authority's learning curve and practical perspective, the process requires expansion of its capacity, and, iii) mobilization of developing a solid client-advisor working private sector resources to systematically address relationship (with both the revenue authority and compliance issues. Also, the implementation team the private sector as key constituencies), filtering must set a clear exit strategy to ensure that the through the political economy and reality of the government follows through on the reform agenda country, and aiming for tangible results. A typical after the VAT is introduced. outcome is the development of simplified laws and procedures that will help reduce the administrative Conclusion burden on both the private sector and the revenue authority and maximize transparency of the The VAT instrument has been successful in many process. countries, both in providing a key source of tax revenue and in shifting the tax burden from The benefits of a successfully functioning VAT production to consumption. However, in some system go beyond increasing tax revenue. Countries cases, governments have introduced the VAT with a working VAT system have benefited from without the support of the private sector, their improved ability to administer their income overlooked simplifying laws and procedures, or set and personal tax regimes, a foundation for unrealistic milestones and timelines that do not interaction between government and private take into account the capacity of the revenue sector,andtheVAT'spositiveimpactonproduction authority and private sector. (value-added) activities. IN PRACTICE BUSINESS TAxATIoN 6 Endnotes References IN PRACTICE 1 Turnover tax is a tax on revenue from the Bird, Richard M. 2005. "Value-Added Taxes in beginning to the end of the value chain. Developing and Transitional Countries: Lessons The IN PRACTICE note series 2 Single-stage retail tax is a tax on all final retail and Questions." International Studies Program is published by the Investment goods (at the consumption stage). Working Paper 05­05, Georgia State University, Climate Department (CIC) of the Atlanta, Georgia. World Bank Group. It discusses practical considerations and Bird, Richard M., and Pierre-Pascal Gendron. approaches for implementing 2005. "VAT Revisited: A New Look at the Value Added Taxes in Developing and Transitional reforms that aim to improve Countries." University of Toronto. Paper prepared the business environment. The for Development Alternatives, Inc. and presented findings, interpretations, and at the "USAID Workshop for Practitioners on conclusions included in this note Tax," May 4, 2005, Washington, D.C. are those of the author and do not necessarily reflect the views of the Engelschalk, Michael. 2007. Designing a Tax System for Micro and Small Businesses: Guide for Executive Directors of the World Practitioners. Washington, D.C.: International Bank or the governments they Finance Corporation. http://rru.worldbank.org/ represent. Documents/Designing_Tax_Systems.pdf. FIAS (Foreign Investment Advisory Service). About the Investment 2007. "Sector Study of the Effective Tax Burden: Climate Department Lesotho." Report prepared for the Lesotho Ministry of Finance & Development Planning, World Bank Group, Washington, D.C. http:// CIC assists the governments www.fias.net/ifcext/fias.nsf/Content/Pubs_ of developing countries and BusinessTaxation/. transition economies in reforming their business environments, William, David. 1996. "Value Added Tax." In Tax with emphasis on regulatory Law Design and Drafting, ed. Victor Thuronyi, vol. simplification and investment 1, 164­230: Washington, D.C.: International Monetary Fund. http://www.imf.org/external/ generation. CIC relies on close pubs/nft/1998/tlaw/eng/. collaboration with its donors and World Bank Group partners-- International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA), and the World Bank--to leverage value and deliver tangible results for client governments. CIC is the operational center for IFC's Business Enabling Environment Advisory Services and FIAS, the multi-donor investment climate advisory service of the World Bank Group. IN PRACTICE BUSINESS TAxATIoN 7 www.FIAS.NET