Tuesday, 30 August 2016

Primer: Everything you never wanted to know about the VAT — and were afraid to ask

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After much hemming and hawing, we are finally staring down the barrel of a value-added tax (VAT). Egypt has been wringing its hands on replacing the current general sales tax with VAT to broaden the tax base and boost revenue, but plans were put into high gear in recent weeks after the International Monetary Fund (IMF) made enacting a VAT as a condition for Egypt to receive a USD 12 bn, three-year extended fund facility.

The House of Representatives approved on Sunday a baseline rate for the tax — ringing in at 13% in year one (FY2016-17) and then 14% in year two — and as of yesterday, we have a law that will apply to all goods and services in the nation, with exemptions for both specific goods and services by name and a number of state authorities.

What follows here is a deep dive into the policies and frameworks that lay the groundwork for a successful VAT — and those that tend not to be terribly helpful. Think of it as your primer on the VAT.


The idea behind the VAT is that it will widen the tax base and tax businesses at each stage of production rather than a single tax at the end, or what we call a general sales tax (GST). Egypt currently has a standard GST rate of 10% charged to the end consumer, with a list of goods and service-specific clauses that move the rate from 1.2% up to 45%.

Under a VAT regime, businesses get taxed each time a good changes hands or a service is rendered along the supply chain — from raw material to consumer product. Companies can then claim credit for taxes it paid when purchasing. The tax applies to domestic and imported goods as well as services rendered.

VAT is as the European Commission explains, “a general tax that applies, in principle, to all commercial activities involving the production and distribution of goods and the provision of services.” Typically a service provider has to meet an annual turnover threshold to have to collect the tax, which isn’t a charge on business, but a consumption tax charged as a percentage of price. This means “the actual tax burden is visible at each stage in the production and distribution chain.”

VAT is collected fractionally, via a system of partial payments. VAT-registered businesses “deduct from the VAT they have collected the amount of tax they have paid to other taxable persons on purchases for their business activities. This mechanism ensures that the tax is neutral regardless of how many transactions are involved.”


By implementing a VAT instead of GST, governments streamline the tax system and reduce tax evasion. A VAT system essentially becomes “self-policing” as parliament puts in place a system that requires businesses to file tax paperwork for transactions with suppliers and customers before they can claim credit and also give incentives for small informal business to migrate to the formal economy.

More pressingly, international lenders, particularly the IMF and World Bank, have set implementing VAT as a requirement for giving Egypt access to funding. Domestically, we’re also looking at VAT to increase revenues, improve economic efficiency and expand the formal economy.

A VAT could arguably have more revenue potential compared with alternatives in indirect taxation and has more advantages than a turnover tax or single-stage tax, according to a World Bank paper. As a tax on consumption, as opposed to income, it encourages savings and investments.


Overall, Christophe Grandcolas, an IMF tax administration and policy adviser, sets out ten requirements for the successful implementation of VAT:

  1. A government that is committed to its implementation of VAT;
  2. A well-designed implementation timetable;
  3. A well-designed VAT law with few exemptions, “no zero rating for domestic consumption and an adequate threshold to limit the number of taxpayers to reflect the tax administration’s capacity;”
  4. A well-designed and client-oriented administration to administer the VAT and large taxpayers;
  5. Cooperation between the revenue administrations with a single taxpayer identification number system;
  6. Well-trained tax staff;
  7. A comprehensive public education campaign;
  8. A refund mechanism;
  9. A computerized compliance system with an effective penalty structure;
  10. An effective audit programme.

First, we need an approved VAT law. That law would identify the tax base, dictate the tax rate, registration threshold and exemptions list. For Egypt, we’ll reach this step once the law that passed the House of Representatives yesterday is approved by President Abdel Fattah El Sisi.

The first phase of the implementation stage will involve a lot of communications work to educate both officials and taxpayers: training sessions on legal issues, taxpayer education and assistance, registration, filing and payment procedures, compliance control, and correct pricing of products, among others. Many of these may require the help of international experts or development partners — possibly for a significant period of time.

A VAT registration system has to be set up, where businesses that pay and collect VAT will be given a taxpayer identification number and will have to update their information in the taxpayer register. Officials must ensure that those with turnover volume larger than the registration threshold are registered.

Next, the government would engage with businesses directly to educate them on the filing and payment procedures as the VAT usually entails a long trail of invoices that help improve tax compliance and enforcement. As part of VAT record keeping, businesses are usually required to keep records of all sales and purchases they make in every stage of production. The government will specify how far back to keep VAT records, which may include copies of all receipts issued and received, debit or credit notes, import and export records and records of all exempted items. In other words: You’re looking at a lot of paper to store, ladies and gentlemen.

The government may also have to create a system to deal with VAT refunds and to identify who would be eligible for them. VAT refunds are generally claimed by tourists who purchase goods and services at a certain threshold as specified by law.

Once the basic setup is in place, only VAT-registered businesses would then be able to issue VAT invoices, paper or electronic, to their customers. These may show the following: name, address and VAT registration number of the business, description of the goods and services supplies, the total amount payable by the customer including the VAT and the rate of tax applicable to the supply.

Incentives such as lotteries and income-tax discounts can make VAT enforcement even more efficient, generate greater revenues, and encourage citizens to enforce and benefit from the process. Tax invoice lotteries were pioneered in Taiwan and have been implemented across the world since with notable success (with the exception of Georgia, where the tax receipts lottery was terminated in 2012 on lack of financial resources).

Portugal, Malta, and Slovakia are among the countries that have a tax lottery scheme in place to encourage increasing the issuance of receipts in business-to-consumer transactions. This makes them more likely to migrate from the shadow economy to the formal one, according to a European Commission paper, by giving incentives to the parties to a transaction to demand tax receipts.


Success stories and cautionary tales abound: VAT systems exist in over 140 countries worldwide, with the majority of them being successful transitions. Only five countries have ever lifted a VAT after implementation: Grenada, Malta, Belize, Vietnam, and Ghana, with all except Belize re-implementing it at a later date.

“In all the five cases … there were some common features that led to the repealing of VAT: – political commitment (i.e. politicians had promised to repeal the VAT if elected); – poor performance due to poor planning prior to its introduction; and – an inadequate definition of registration threshold, which resulted in an excessive number of taxpayers to be administered,” according to a 2005 paper by Grandcolas.

VAT has been notably successful in European countries, particularly France, but this does not mean that a successful transition was exclusive to developed economies only. The cases from Gabon and Mauritius are particularly noteworthy.

Gabon, for one, benefited from two years of technical assistance from France and the IMF before VAT was introduced, putting together a special VAT Department, implementing a computerised tax framework, and setting up a comprehensive tax education system for both government staff and citizens — a number of the issues we have already identified as keys to a successful migration from GST to VAT.


According to IMF researchers, there have been some significant weaknesses in VAT implementation in developing and “transition” economies such as “lack of coordination of the direct and indirect tax administrations … difficulty of implementing workable self-assessment systems…the need for effective audit programs based on risk-analysis selection methods; and the need to give prompt refunds of excess credits to certain taxpayers, particularly exporters.”

Implementing VAT has been associated with reduced trade volumes on delayed and incomplete refunds as well as exchange rate appreciation. Also, enforcing VAT could be expensive for governments as resources are spent in collecting and processing information and penalising those who refuse to comply.

When Grenada introduced VAT in 1986, it was unsuccessful within months, seeing frequent amendments to the broad-based 10% rate. The biggest reasons for its failure? To protect the benefits of previous tax exemptions, many domestic goods were zero rated, meaning the VAT left a substantial portion of domestic manufacturing untaxed. “This not only reduced the potential tax base but also discriminated against imports. Moreover, the number of tax refund requests overwhelmed the tax administration,” according to Grandcolas. There also existed “no overall framework to address the necessary changes in administration to implement a VAT including staffing, training and procedures.”

The extent of VAT exemptions often dictates the chances of failure. Besides reducing government revenues, they may present technical challenges, particularly when a company produces both exempt and taxable items. Some economists claim it threatens the sustainability of the VAT, and that the exemptions list should be kept to minimum. China has a pretty slim exemptions list — as does Portugal. Nigeria runs a number of VAT exemptions including on all medical and pharmaceutical products, basic food items, and educational materials.

Niger implemented the VAT in 1986, but instead of increasing tax revenue, it witnessed a decline, creating a major fiscal crisis, according to a paper by Robin Barlow and Wayne Snyder. The country’s economic crisis meant “a switch from privately financed investment, which would normally have been at least partially subject to the VAT, to international financial aid which is tax exempt. This alone probably accounts for nearly one-quarter of the absolute decrease in tax receipts.”

Although VAT is currently still implemented in the country, the authors cite several other reasons for its failure such as a large informal sector unwilling to keep accurate records, lack of taxpayer education, failing to simultaneously lower or eliminate other taxes, and a lack of manpower and administrative resources to put it into practice.

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