VAT and Tax Reforms: Some Ideas

Due to the Covid-19 pandemic and the associated economic crisis, countries will see different impacts on their capacity to raise revenue, depending on the structure of their tax system. As in the financial crisis of 2007–08, consumption tax revenues, such as value-added tax (VAT), will likely rebound first even as incomes remain suppressed.

The workhorse of budgets for decades in many countries has been VAT, and this will continue to be the case in the foreseeable future. However, in many countries, VAT also remains a source of controversy related to policy design and legislation.

VAT is, on average, one of the largest sources of tax revenue for Organization for Economic Co-operation and Development (OECD) and non-OECD countries. On average, OECD countries raised 20% of their tax revenue from VAT. While countries raise a large share of their tax revenue from VAT, the percentage differs significantly from one region to another. By region, almost 17% of Asia’s tax revenue comes from consumption taxes, compared to 21% in the Pacific Islands, 26% in Latin America and the Caribbean, and 30% in Africa.

VAT has been steadily increasing in popularity, with new countries still introducing it. Accordingly, the share of revenues delivered by VAT has been increasing across country groups, and countries with a VAT tend to raise more revenue.

There are good reasons for the popularity of VAT: it is a growth-friendly tax and has built-in safeguards to protect revenue even if the VAT chain breaks. However, this assumes that the design remains as intended—broad base, with few or no exemptions or other special treatments. There is still considerable variation across countries, such as in the number of VAT rates and the level of the registration threshold.

OECD Study

Numerous studies have found that VAT appears to be regressive when measured as a percentage of current income. Nevertheless, an OECD paper used household expenditure microdata from 27 OECD countries to reassess this frequently made assertion that VAT is regressive.

The paper first assesses the competing methodological approaches used in previous distributional studies, highlighting the distorting impact of savings patterns on cross-sectional analysis when VAT burdens are measured relative to income.

As argued by the Institute for Fiscal Studies, measuring VAT burdens relative to expenditure—thereby removing the influence of savings—is likely to provide a more meaningful picture of the distributional impact of VAT. On this basis, VAT is found to be either roughly proportional or slightly progressive in most of the 27 OECD countries examined.

Nevertheless, results for a small number of countries highlight that broad-based VAT systems that have few reduced VAT rates or exemptions can produce a small degree of regressivity. Results also show that even a roughly proportional VAT can still have significant equity implications for the poor—potentially pushing some households into poverty.

This emphasizes the importance of ensuring the progressivity of the tax-benefit system as a whole in order to compensate poor households for the loss in purchasing power from paying VAT.

In the broader context of the Covid-19 crisis, the findings of the paper suggest there may be scope in many countries for VAT reform to help address revenue needs, as this revenue may be generated with less significant distributional effects than previously thought.

While standard VAT rates are high in many countries, OECD evidence shows that scope exists to broaden VAT bases. Nevertheless, any VAT increases, including VAT base-broadening measures that impact the poor, should be accompanied by compensation measures for poorer households, such as targeted tax credits or benefit payments.

Tax Reforms

Tax reform, by definition, consists in changing the structure of one or more taxes or the tax system in order to improve their functioning for achieving their objectives. Every time a tax reform is proposed there must be certain elements or steps to be followed for its success and implementation.

First, the tax reform proposal must have a description of the proposed ideal tax system—that is, what the reform is intended to do and where it is intended to go. It is essential to make an accurate diagnosis of the current system. I consider that as long as the tax system is analyzed, the whole public spending of the country should be analyzed together, and also what is known as tax expenditure.

Second, in order to carry out a tax reform, it is essential to compare the current system and that which the reform is intended to achieve. It is then necessary to analyze the steps to reach the proposed ideal system.

It is also key throughout the reform process to know the causes of tax evasion, since only in this way is it possible to build a strategy for fighting it which can be included in the proposed tax reforms.

In Tax Policy Reforms 2020 (OECD) it is concluded that the stabilization of standard VAT rates observed in recent years is continuing, while VAT base changes have involved a mix of base-broadening and base-narrowing measures.

High standard VAT rates in many countries have limited the room for additional rate increases. Instead, many countries have concentrated their efforts on the fight against VAT fraud and on ensuring the effective taxation of cross-border online sales to raise additional revenues and strengthen the functioning of their VAT systems.

On the other hand, an increasing number of countries have narrowed their VAT bases by expanding the scope of their reduced VAT rates, which suggests a slight departure from trends in previous years, where the predominant objective of VAT reforms was to raise additional revenues.

Simplicity of Tax Structure

As we can see, the topic of tax systems and VAT reform proposals is extremely complex, with multiple variables to analyze, which vary in each country and time. it is therefore relevant to stress the importance of avoiding repeating errors in many countries that without further analysis implement tax reforms that may have yielded results in other jurisdictions, but can in no way help the country involved.

I consider it essential to work for simplicity of the tax structure since it is clear that complex tax systems favor evasion and avoidance, as they create uncertainty about the scope of tax rules, raise the costs of control, increase compliance costs and multiply the mechanisms of evasion and avoidance.

Modern technology is a great ally for simplicity of tax structure. Technology should simplify taxes by reducing compliance costs for taxpayers and system administration costs. A very important role in simplification is to have broad-based taxes, single quotas and very few preferential treatments such as tax exemptions or exceptions.

No less important is the issue of acceptance of the tax system, since if taxpayers perceive the tax system as unfair, they will be less inclined to comply.

Therefore, as countries are looking to boost their revenue and at the same time protect the poor, policymakers should focus on simplifying consumption taxes and making them more efficient and neutral by broadening their tax bases, lowering tax rates, and eliminating unnecessary tax expenditure. It is very important to estimate tax expenditure in order to bring transparency to the tax policy, to measure the potential of the tax system and the performance of the administration.

The difficulties faced by developed and developing countries are very different. The main concern for the former is to capture financial and digital transactions, while the challenges arising from the very large informal sectors is of particular concern for the latter. Nevertheless, any VAT reforms, including VAT base broadening, will have distributional effects that will impact poorer households. Thus, countries might want to put in place or evaluate existing compensation measures for poorer households, such as targeted tax credits or direct transfers to low-income earners.

Structural reforms to broaden the VAT base and remove reduced rates and exemptions are challenging, but the current crisis may provide opportunities to establish a link between efforts aimed at expanding the welfare state and reforming social safety nets with the broadening of the VAT base.

There is no clear role for VAT to pursue equity objectives. VAT is an instrument for mobilizing revenue in order to pay for public spending. I believe that progressive personal income taxation and social spending instruments (cash and in-kind transfers) are superior in efficiently targeting equity objectives. However, in light of the OECD research, governments should not shy from VAT as a tax policy tool due to concerns about regressivity.

Governments should focus on neutral and competitive reforms to existing taxes for sustainable financing and to support economic growth.

In short, any VAT reform that a country intends to address should consider all the above aspects and many more that may emerge from studies conducted by experts from both the public and private sectors.

This column does not necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Alfredo Collosa is a consultant and tutor in Tax Administration at the Inter-American Center of Tax Administrations (CIAT), professor, investigator, author of books and publications, and lecturer. He holds an Official Masters in Public Finance and Tax Administration (UNED-IEF).

The author may be contacted at: aecollosa@gmail.com