Nigeria, the giant of the West African sub-region and arguably Africa as a whole, charges a value-added tax (VAT) rate of 5%. The average VAT rate across the West African sub-region is 18%. Ghana is the only country (among those surveyed) with a lower VAT rate of 15%, but it imposes an additional consumption tax of 2.5% as National Health Insurance Levy, which takes the combined rate of consumption tax payable to 17.5%.
It is therefore not surprising that there has been a lot of talk about increasing the VAT rate in Nigeria. The conversation, which has been ongoing for years (in fact, there was a short-lived increment in the VAT rate in 2007 which was subsequently reversed under pressure from trade unions and other pressure groups), has gathered steam in recent years with the significant budget deficit posted by the Federal Government (FG) over the last few years.
The 2020 budget of the FG anticipates a deficit of 2.18 trillion Nigerian naira ($6 billion). The FG therefore finally decided to increase the VAT rate to 7.5% with effect from February 1, 2020: this new rate is still significantly lower than the sub-region average.
The key point of those against an increase in the VAT rate has always been the high poverty rate in the country. As at 2018, over 86 million Nigerians (46.7% of the population) are reputed to be living below the poverty line, defined as earning less than $1.90 per day. Therefore, any increase in consumption tax would effectively impact these people more, and might even be the basis for many more people to move below the poverty line.
The FG has, however, argued that VAT is a consumption tax. It will only impact those who consume; so one can easily avoid it by deciding not to consume. Items such as basic food items, educational and medical supplies are exempted from the tax. Therefore, only those looking for more than just mere survival would be impacted by the increase. The FG has also tried to address the concerns by proposing a form of luxury tax on certain items, although this will not form part of the changes which come into effect on February 1, 2020.
A number of independent commentators have expressed other concerns. Is an increase in VAT rate the real issue in Nigeria? Will an increase in VAT rate yield an increase in the long-term revenue due to the FG? What are the real changes required under Nigeria’s VAT Act and are there any other avenues to increase revenue from VAT without an increase in rate?
Value-added Tax or Sales Tax
The Organization for Economic Co-operation and Development (OECD) defines VAT as “a tax on goods and services collected in stages by enterprises and which is ultimately charged in full to the final purchasers.”
This is not actually the case in Nigeria. There are many instances under the Nigerian VAT system where the tax is not transferred to the final consumer, or not directly anyway. Nigeria’s VAT has an input and output element, seen in most countries. However, unlike most countries, there are only limited instances where it is possible to offset your input VAT against the output VAT. Input VAT is VAT paid by an individual or corporation on goods or services consumed, while output VAT is the tax charged by the individual or corporation.
Given that VAT is a consumption tax that should be borne by the final consumer, all parties within the value chain should be able to recover the cost of their input VAT from that of their output VAT. In this case, they would only be expected to remit the excess of their output VAT over their input VAT. This achieves the purpose of transferring the cost to the final consumer without directly impacting the profitability of the individual or corporate enterprise.
Nigeria, however, limits the input VAT that can be offset against any output VAT to the VAT incurred on goods that qualify as stock in trade used in the direct production of a new product or goods purchased or imported into the country for resale. VAT incurred on other goods or services should be expensed and treated as a deductible expense for income tax purposes.
The first major impact of this is that companies are only able to obtain a 32% benefit (companies incorporated in Nigeria pay a combined income and tertiary education tax rate of 32%) for the VAT so expensed, rather than 100% that would have been due if they were able to recover the entire amount from the value of input VAT charged and collected.
Formal Versus the Informal Sector
It may be useful to use an example most people can relate to in emphasizing this point.
A department store in a large shopping mall will incur rent as a significant cost. This rent is subject to VAT at the rate of 5% but this VAT is not recoverable from the output VAT charged on the goods sold by the store. It can only recover the VAT paid on the goods sold in the store from the VAT charged on the same goods. The VAT on rent, maintenance services, professional services and any other services is expected to be expensed. Any increase in the VAT rate would increase the cost of rent and other services, which would ultimately increase the store’s cost of doing business in that country.
This should not be an issue in the long term for the department store, as this cost should be transferred to its customers, but this assumes that the demand for the store’s goods is inelastic. It is not. Many of the goods stocked by the department store can be purchased at any of the large informal markets in Nigeria. The traders at this informal market do not typically incur significant costs on rent and other administrative charges when compared to the department store. More importantly, it is highly unlikely that they incur or pay VAT. Therefore, the indirect cost absorbed into the cost of the products purchased from the market is likely to be a lot less than that at the department store. This may ultimately make their prices cheaper.
You might expect that this should also mean that they have a higher profit margin and therefore pay more in income tax: they most likely do not pay any income tax at all.
A counter argument to the above has always been that no one avoids payment of VAT as these goods are either produced or imported by large businesses with visibility to the tax authorities and would have either charged the tax or at least paid it over at the ports of entry when the goods were brought into the country. The fact that the middlemen across the value chain are not registered for, or do not charge, the tax does not mean they did not pay it to either the manufacturer or importer and are therefore transferring it to the customer as part of their cost. However, the government is short-changed as it does not get full value from the final consumer and both the manufacturer and importer are able to recover the VAT paid from that charged anyway.
Also, it is more likely that the VAT cost which is unrecovered by the informal trader is insignificant compared to the unrecoverable VAT cost for the department store, therefore the informal trader would most likely be able to sell at a cheaper rate than the department store.
Potential Impact on Employment and Growth
To continue the example above, an increase in VAT rate may most likely lead to a far larger increase in the cost of goods sold at the department store than at informal markets. This increase would have to be passed on to consumers; otherwise, the department store’s long-term profitability and viability may be impacted.
When we factor in that the department store pays income tax, provides government with the opportunity to collect more VAT, and employs more people who also pay taxes on their income, it is debatable whether a policy which may negatively impact their ability to continue to operate in the country is the right way to go.
A number of people have argued that these department stores have their own niche market that would rather shop there than go to the informal market. However, this hits at the heart of the argument of the trade unions. The higher the cost of shopping, the less appealing the niche market would be as the costs rise to a point where a number of these niche customers can no longer afford it. It is simplistic to assume that their reaction would be to stop buying at all, rather than switching to a different market. And even if they were to stop buying completely, would that be a positive for an economy which is looking to consumer spending to drive growth? Clearly not.
Consequently, it is obvious that government really needs to reconsider the proposal to increase the VAT rate at this time, given its likely impact on businesses and consumer spending in the country.
Would the FG be better off trying to increase the coverage of the tax rather than increasing the rate? Is there a way to increase coverage without significantly driving up the cost of collection? This is because the argument that has been made in the past is that the cost of collection from the informal sector may be too great to cover the anticipated revenue from the sector.
Nigeria’s informal sector makes up over 60% of the economy. If there are options that can be deployed to extend the coverage of the tax to this sector rather than increase the burden on the already compliant formal sector, then they should be welcome. It is, therefore, necessary to consider what these options may be and if they are feasible in a country like Nigeria.
VAT Increase as a Way of Increasing Compliance?
One option that may be considered is to increase the rate of VAT: increase the rate, but not in the manner currently being contemplated. Today, participants in the informal sector avoid accounting for the tax even though they may have paid it over to the manufacturer or importer (the recently signed Finance Act, 2020 seeks to exempt small business from the administration of the tax, thereby exempting small players in the informal sector from registering for and charging the tax).
To use numbers, an item which has a retail price of 100 naira should attract tax at the rate of 5 naira that should be paid to the tax authorities. Assuming the retailer bought the item at 50 naira from the manufacturer, whose direct cost of production was 40 naira, then the amount that would be paid to the government would be 2.50 naira rather than 5 naira, a 50% loss in revenue as the manufacturer would be able to recover the 2 naira it must have paid to its own vendors, thus paying only 0.5 naira of the 2.5 naira that it would have charged on the cost of the goods to the retailer.
To cover for that potential loss, the FG can opt to increase the rate of tax on goods sold to parties in the informal sector who do not show evidence of VAT compliance—the VAT certificate typically issued by the tax authorities in the past may serve as appropriate evidence. The large manufacturers typically maintain extensive records of their customers anyway, and run computerized systems, so it may not be too difficult to request them to obtain the evidence of VAT compliance issued by the tax authorities as part of the set-up system (several companies already make this request from their vendors). A higher VAT rate would, therefore, apply to those unable to provide it.
This would also apply at the port of importation where importers of goods above a certain volume threshold (to exclude imports for personal use) would have to provide evidence of VAT compliance; otherwise they may be subject to the tax at a higher rate.
There may be potential issues with the cost of compliance for companies, especially small and medium-sized enterprises which are otherwise compliant, as they would have to maintain multiple records in order to ensure that they charge the appropriate rate to their various consumers.
Full Deployment of a VAT System
Another option may be to review the VAT system in order to ensure that it is actually a VAT, and not a sales tax. This would entail removing the restriction on what a company can claim input VAT on and allowing them to claim all VAT paid on all VAT charged. This would ensure that any increase in VAT rate does not impact the cost of doing business even if it does impact the cost of purchase by the final consumer.
This impact is what the trade unions would like to avoid, but it can be addressed by ensuring that we extend the items covered by the exemption to provide more clarity. An example is the exemption given to “basic food items” in the VAT Act, without any attempt to define the term (it is therefore noteworthy that the Finance Act, mentioned above, enumerates certain food items that qualify as “basic food items"). Nonetheless, there is the possibility that what may qualify as a basic food item to an individual is dependent on taste and purchasing power and cannot be regulated by law.
It may have been more pragmatic to exempt all food items, except possibly food items which have been established to cause health issues, to discourage people from expending their resources on these items.
Use of Technology
There is also the option of employing the use of technology in driving compliance. This has often been discussed, but sadly the focus again has been on the more formal sector and how technology can be utilized to make this sector bear a lot more of the burden than it already does.
A case in point is the VAT at source software, which the tax authorities have been looking to deploy at various companies, that is able to track the VAT being charged at source and notify the Federal Inland Revenue Service (FIRS) of this amount without recourse to an audit. This may be commendable, but it would also need to be extended to the informal sector, as a number of the companies approached for the deployment of the software so far file their returns on a monthly basis without fail, and also pay the tax due.
There may be cost implications, but this cost, which would have to be borne by the FIRS, should clearly be offset by the additional collection. There may be instances of disagreements with the FIRS as to the current interpretation of several aspects of the law but this is expected in any robust tax compliance system, which is why there are established avenues for resolution of those issues.
The Bank Verification Number (BVN) may provide a basis for the deployment of technology to apply the tax on the informal sector. Nigeria has a significant “unbanked” population, while a good number of the registered BVNs are active (37% of Nigeria’s population are unbanked). However, there are more active BVNs today than registered taxpayers across the country. The FIRS has commenced the use of bank accounts to track tax defaulters, but their search is limited to taxpayers with banking turnover over a certain threshold.
We would, however, like to recommend a system that puts all BVNs and account holders in play. All banks are expected to conduct a know your customer (KYC) process on all their customers at the point of opening accounts for them. It is, therefore, not improbable to expect that details of the addresses of these customers should be with the bank and can be accessed at any point in time.
The FIRS can, therefore, in conjunction with the various state tax authorities, establish a lottery system whereby all BVNs are put into the mix at the end of the year. A certain percentage of BVNs would be picked on an annual basis and any BVN picked would be subject to an audit to determine their level of tax compliance. Though companies do not have BVNs (as they would have used the BVN of their directors) the BVN of any signatories to a company’s account will form the basis for the audit of that company.
The penalties for non-compliance should also be better administered, for any non-compliance noted. It is possible that this may deter many people from opening or operating bank accounts, but these people would also be realistic about the growth of their businesses without access to a bank and its facilities. The chances that an individual may be picked for a routine audit and punished if found wanting may increase their desire to do the right thing when it comes to tax compliance.
This should serve to increase tax compliance among the populace, as even individuals in paid employment can be subject to the audit. Today, many individuals with multiple streams of income do not feel the need to register and account for taxes, including VAT, on these other income streams, but only focus on their employment income. They would after all be able to provide a tax clearance certificate if required for any purpose solely based on the taxes paid on their employment income alone.
This would not remove the need for the compliance audits and investigations currently being conducted on formal entities, though it should reduce the number of these audits, as they can only be conducted based on strong evidence of fraud, willful misconduct or negligence. This evidence must be presented before an independent tribunal for adjudication in order to obtain approval to conduct a more comprehensive exercise.
This should increase the level of compliance without necessarily increasing the cost of collection. It would also improve the ease of doing business in the country, as companies would no longer be bogged down by routine audit exercises and investigations without course.
The road to increased tax collection in Nigeria has some obstacles, but they are surmountable. There are no shortcuts and no easy fixes, as every option has its own merits and demerits. There is also a dearth of information which makes things more difficult. However, the FG has to choose not only the option that appears to bring it the most revenue but which also has the least negative impact on businesses in the country.
The desire to increase government revenue is intrinsically linked to the desire to have resources to spend in order to drive growth. We therefore cannot opt to implement an option that may increase revenue, but has the potential to limit the growth of businesses and the economy in the long term.
It is time for government to think outside the box.
Martins Arogie is an Associate Director and Kelechi Inyama is a Senior Adviser at the Tax, Regulatory and People Services Division of KPMG Advisory Services in Nigeria.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.