Imposition of VAT: principal issues
Value-added tax is economically efficient as it does not distort spending and savings 
of individuals and firms, and does not discriminate between different sectors and businesses. The validity of its efficiency is, however, questionable in the country’s 
case due to its peculiar economic structure

By Jamil Nasir

At least one thing is common between the USA and Pakistan these days that in both countries introduction of value-added tax (VAT) is under debate. The difference, however, is that the USA has no deadline and serious deliberations will take place before VAT is levied. There is also a possibility that the USA finally decides not to introduce this tax if collective wisdom so warrants. But in our case, we are required to implement this tax as part of conditionality for loan from the International Monetary Fund (IMF). If we resist, the IMF will withhold the next tranche of its loan, the pain of which cannot be borne by us due to high level of dependence we have on the fund for resuscitating the economy.     

What makes VAT such a special tax? The text book argument is that it is economically efficient as it does not distort spending and savings decisions of individuals and firms, and does not discriminate between different sectors and businesses. Hence, welfare loss to the economy is minimal as compared with other types of taxes. The validity of its efficiency is, however, questionable in case of the country due to the peculiar structure of the economy.

Imposition of VAT will be uniform and have an impact across different sectors and businesses if the economy is fully documented. We, however, have a huge informal sector. According to different estimates, the informal economy approximately constitutes 50 to 60 per cent of total GDP of the country. The enforcement of VAT will actually be a tax on the formal sector and is likely to result in widening of the informal sector. Squeezing of the formal sector will have an impact on growth of the economy negatively, eventually causing unemployment.

Our financial sector lacks depth. Most of the financial institutions are located in the urban areas. Furthermore, financial instruments are not diversified. VAT is good for an economy where financial institutions are well-established and most of the transactions take place through banking channels and credit cards. The rationale is that if there is a well developed financial sector, then it is easy to keep the trail of the business transactions and a business transaction cannot escape from the levy of VAT. In context of the country, most of the transactions take place through cash and escape the tax net. Thus successful implementation of VAT requires that steps should be taken to develop, expand and diversify the financial sector.

VAT regime of taxation requires that an effective system be in place for keeping the trail of business transactions between individuals, firms and businesses. When we say that VAT is a self-policing and self –assessment system, it means that people transacting business under VAT mode have an incentive to report their business transactions. For example, firm B buying from firm A has an incentive to report its transaction with firm A as under VAT firm B will adjust tax paid while making purchases from A, when it will sell its product down the line after value addition. But if both firms collude with each other, then both have an incentive for under reporting. Self-policing mechanism of VAT does not work under this scenario.

Weakening of self-policing mechanism can be compensated through effective, corruption free and strong tax machinery. The element of corruption in tax machinery in developed countries is almost non-existent. But such is not the case with the developing countries. Corruption in tax machinery is a big issue in the developing countries. Therefore, tax design based on VAT in a developing country should take into account the element of corruption.

If the tax collector also colludes with the businesses then instead of tax collection from VAT, government has to pay back from its treasury to fake companies. Several big scams have come to surface in the past where millions of refunds were paid against fake invoices and spurious exports. Hence, refund becomes a big source of corruption under VAT, for dubious businesses and corrupt tax collectors. Genuine tax payers on the other hand find them in dire situation due to delay in release of refunds.

VAT requires that any loopholes in its implementation should be taken care of by an effective audit function. Pakistan’s experience reveals that the audit function has comparatively been very weak. Complaints of corruption have been high. It was against the background of plethora of complaints of corruption that the audit function was suspended by the Federal Board of Revenue in the past.

Succinctly speaking, the argument about the efficiency of VAT is doubtful in case of a developing country like Pakistan on administrative grounds as well. Most of the businesses in developing countries are built on a small scale, so cost of keeping records goes disproportionately high for the small businesses. The cost of raising this tax will also be high due to various loopholes in the trail of business activities. It will therefore be beneficial that the calculus of VAT should be properly understood, examined and debated before it is introduced in the country.

The writer is a graduate from the Columbia University in Economic Policy Management