Implications of value added tax for the public sector
One of the main policy decisions to be made is how to treat government procurement and supplies made by public bodies. The activities of the public sector can be divided into three groups: (a) wealth;
(b) provision and services; and
(c) provision of goods and services similar to those supplied by the private sector.
The first category (a) does not constitute consumption or create any value added but is effectively a transfer of funds between different income groups via the intermediation of the government. As such, it should remain out of the scope of VAT and, consequently, within the current VAT system, no (direct) recovery of input VAT would be possible.
The provision of goods and services in competition with the private sector (c) should ideally be taxed to meet the requirement of economic neutrality. The tax base should include any grants and taxes directly received as consideration for these supplies, and redistribution of income and of public goods public bodies should be eligible for full credit of input VAT incurred in relation to the provision of private goods and services.
The supplies of public services and goods (b) constitute consumption by the individuals receiving them and should in principle be taxed. However, special treatment for public bodies, whether by exempting or through zero rating their output, is currently the norm. Naturally this complicates the VAT system.
Under zero-rating, economic distortions may occur when public bodies are allowed to make VAT-free supplies in relation to activities that compete with the private sector. Such situations are rather frequent.
Most notably are education, healthcare and social services, but also transportation, waste management, car parking, air traffic control, radio and television broadcasting, recreation, and utilities. Even when the government is the exclusive supplier of certain services as may be the case with railway transportation, distortion may still occur insofar as railroad transportation competes with privately owned bus lines for passenger transportation or with trucking companies and river barges for the transportation of commodities.
In many instances, a level competitive playing field is created by providing similar relief to private providers rendering the same services as public bodies. This is typically the solution chosen for services considered to be meritorious in nature, such as educational and healthcare services. However, this only enlarges the scope of the derogations from the general VAT system.
Exempting government output evokes the same adverse effects as exempting the private sector. Classification problems may likely arise between what constitutes a commercial activity and a public service.
Outsourcing is discouraged and insourcing (self-supply) preferred, leading to economic inefficiencies. Input tax allocation issues may arise where a public body is engaged in both commercial and government activities. Moreover, the ineligibility to input tax recovery leads to tax cascading when subsequent supplies are made to the business sector.
Finally, public bodies may engage in tax-avoidance planning to avoid the cost of the input-VAT.
The lesson to be learned is that it is best from both a theoretical and a practical perspective to include government in the VAT system to the widest extent possible.
New Zealand and Australia are the only countries that apply a VAT system that includes the provision of goods and services by the public sector. The rationale for taxing pubic bodies can be found in administrative simplicity, accountability and transparency of government operations; comprehensiveness of coverage; and sound economic management.
Several countries have responded to these difficulties by reimbursing public bodies for the VAT incurred on input related to their exempt activities. The GCC Framework Agreement allows member states to determine that government entities can make purchases without paying VAT or receive a refund of VAT paid.
Dr. Robert F van Brederode is of counsel to Horwath Mak Ghazali in Oman. He is a tax lawyer, practitioner and scholar with over 30 years of experience in global VAT.
He served Crowe Horwath International as the global indirect tax leader, and was the national practice leader of the US member firm. Robert is the author of dozens of academic journal articles and 8 books. He can be reached at Robert.brederode@ crowehorwath.om.