Higher Tax Does Not Always Mean Increased Gov’t Revenues
Unless businesspeople see VAT as tax on their business or think that it is too excessive and discourages buyers, there should be no reason not to charge their customers.
In the European Union (EU), companies with VAT registration numbers must charge VAT from their customers whenever they make a sale, but they are allowed to claim back the VAT they pay to their suppliers. VAT is charged but reclaimed all the way up the chain. In this way it emerges as a final tax on consumers without being a burden on the finances of businesses. The number of transitions is irrelevant and does not affect the cost of the product at the customer’s end.
If a business buys raw material for 100 Br, it pays an extra 15 Br in VAT. When it sells the product for 150 Br, it will charge the consumer 22.5 Br in VAT, after which it can deduct the 15 Br VAT it paid from the 22.5 Br it collected and pass the difference, which is 7.5 Br, to the taxman.
That is how it works, so far as this writer understands it, elsewhere; why it is portrayed as a tax-on-tax in Ethiopia, is unclear.
In principle, the proclamation on VAT (No. 285/2002) has all the elements of a modern VAT system. Businesses are entitled to a rebate of VAT where goods or services are used for the purpose of the registered business’s taxable transactions, according to Article 21 (1) (a) and (b). The tax authority has to refund the business within two months [Article 27 (1)], if not it is entitled to a refund and interest, set at 25pc higher than the highest commercial lending interest rate, according to Article 27 (6).
However, if this procedure is not followed and no rebate is given to businesses, it would turn into tax-on-tax. Should the first and second business in the chain be asked to hand over the VAT, 15 Br and 22.5 Br, to the taxman, the cost of the product at the consumer’s end will increase by 37.5 Br, while the taxman gets extra revenues which it is not entitled to by law.
Similar confusion and irregularities in implementing VAT would increase the cost of the product with each transaction, resulting in huge inflation in the economy and generating excess revenue for the state.
Although the proclamation on VAT appears to be impressive lawyers’ work, it gives no clue as to how VAT should be calculated. It is probably left to the accountants at the Ethiopian Revenue and Customs Authority (ERCA) to issue procedural manuals for implementation but, if such documents exist, this writer could not locate them.
Most of the published documents available online are related to the EDP’s manifesto and the responses it triggered in various papers and websites.
The EDP promised to cut VAT by half, from 15pc, and to reduce the tax burden on small businesses. The logic behind tax cuts is to stimulate consumption and business start-ups to broaden the tax base. That way it can maintain expenditures in infrastructure developments, without putting too much burden on consumers and businesses, the party argued.
It was election time, and it is understandable that the government’s supporters discredited the idea as “voodoo economics,” a cliché used to discredit Roland Regan’s economic policy, a.k.a. Reganomics. However, the reasons for deriding this legitimate proposal was not explained. Ethiopia, with a deficit that is close to 20pc of the annual budget, needs all the taxes it can raise, but the question is whether 15pc VAT is too large a burden on society.
Income and profit taxes are progressive with income, but VAT does not discriminate between the poor and the rich. While more tax can be raised from direct profit and income taxes to address social imbalances, the government can also generate revenue from direct business activities and transfers of assets such as land, service charges, and external aid. Alternatively, the government can learn to reduce waste and spending. Tax is about finding the balance between all these parameters.
Tax has been around since the time of state formation. The Egyptians, the Chinese, and Ethiopia’s own Axumite civilisation collected taxes to create strong governments and institutions. However, VAT is a relatively new form of tax that started in France, in the 1950s.
“The rise of VAT has been the most significant development in tax policy . . . [and] modern tax administration,” according to Michael Ken, of the IMF, and Ben Lockwood, at the University of Warwick.
VAT is now implemented in 130 of 195 independent countries in the world and the IMF is somehow blamed for its spread. Its rate ranges from three per cent in Iran and five per cent in Japan and Canada to 25pc in Norway, Sweden, and Denmark.
Despite the popularity it has gained in such a short time, there are at least 60 countries that have not yet adopted VAT as an instrument of enhancing government revenues. A notable example is the United States (US). VAT was not introduced in the US because it was viewed with mistrust as a “money machine” to increase the state’s power.
The US uses sales tax of four to eight per cent, depending on the state. In fact, there is no sales tax in New Hampshire, Delaware, Oregon, Montana, and Alaska.
The US example shows that VAT is not as popular or universal as it was portrayed during Ethiopia’s 2010 election debate. However, even the President’s advisory panel that reviewed the introduction of VAT in 2005 “could not reach a consensus, because some panellists were concerned that introducing VAT would lead to higher total tax collections over time and facilitate the development of a larger federal government,” Ken and Lockwood said.
Though the US government is democratically elected, its constitution does not assume elected government officials to be benevolent or to have the interests of their citizens at heart, hence the strong checks and balances that reduce the concentration of power in the government.
“If men were angels, no government would be necessary,” James Madison observed.
The implication of excessive tax, in principle, could lead to an undesirable increase in the size of government that could undermine the rights of citizens.
There are also many criticisms of VAT on political, moral, and economic grounds. There is a strong moral argument against VAT, since it is a disproportionate tax on the poor. Contrary to progressive taxing based on income or profit, VAT is indiscriminate. If a street beggar has one Birr to spend at a local café, the government insists on taking 15 cents in tax out of the meal that the poor man may need for survival.
VAT is a regressive tax where the poor get penalised more than the rich on the basis of income to tax ratios, some economists argue. VAT distorts supply and demand to reduce overall tax collection by the government.
As the price of goods and services rises, for example by 15pc, the quantity of goods and services traded may decrease. Consumers may scale down their demand, delay purchases, or totally abandon transactions that would otherwise have generated tax revenues for the government. These economists call this price elasticity of demand, which is the rate of the response of demand due to price changes.
Particularly, high value purchased goods can be disproportionately affected as prices increase. If 200,000 Br worth of material is needed to build a house, the owner needs to find another 30,000 Br to pay for VAT. This price increase could easily swing him against building a house, generating zero revenue for the state from VAT and zero revenue from payroll taxes of the workers to build the house.
Hence, the face value of VAT may appear to be more money for the state, but VAT could also lead to a reduction of economic activity and a loss of revenues, some economists say. Since VAT is a tax on consumption, when consumption declines, production also goes down, causing a drop in gross domestic product (GDP).
The last argument is about getting more value for money. The state is inherently inefficient, wasteful, and bureaucratic and wastes taxpayers’ money, some say. Giving more money to the state is a sure way to increase waste.
This is not to say that the state can survive without taxes. Tax has to be collected to provide services and to invest in long-term infrastructure development. However, the tax system should not discourage consumption and production or unfairly penalise the poor.
Ethiopia needs to have a compelling argument about why VAT is a better tax instrument than other forms such as income, corporate, or excise tax.
What is the rational behind fixing VAT at 15pc in a country where the vast majority of people have no disposable income? Why not 7.5pc as suggested by the EDP or three per cent like Iran or, on the other hand, 25pc as it is in Norway?
Is 15pc affordable? What is its overall impact on consumption, production, and GDP? Will it contribute to higher inflation? Will it encourage tax evasion?
What is the impact of VAT on low-income people, since it is argued to affect them disproportionately? Should the poor, including people who live on the streets, have to pay tax to the government? If they are taxpayers, what services should they expect in return?
To avoid the disproportionate impact on the poor or to encourage better lifestyles, some countries have different VAT rates for different goods and services. The United Kingdom (UK), has no tax on health products, freight, children’s clothes, publications, food, and education. A reduced rate of only five per cent is imposed on domestic energy consumption, solar panels, heating systems, and safety seats. Full VAT, at 17.5pc, is imposed on other consumable items.
Ethiopia, too, has about 27 category items that are exempted from VAT (Article 8). These are food items, cooking oil, publications, rent, chemicals for pest control, and transport. Yet, there is no discounted category.
Does Ethiopia need discounted categories on essential items?
The last and the most controversial issue is the application of VAT. Is it really a tax-on-tax?
Companies are entitled to rebates, the proclamation clearly states. If VAT is not deducted with each transaction, it would accumulate to increase the cost of the product and inflate government tax revenues. A product that started at 100 Br worth of materials could be sold at 198.72 Br, including 25.92 Br VAT at the final sale after four transactions.
If VAT is not deducted from the cost of materials at each transaction, the cost of the product at the customer end could reach 302.2 Br, with 103.62 Br VAT included. The other scenario is a tax-on-tax, which would subject the end customer to 77.7 Br in extra tax.