Changes in VAT may not have intended effect
The benefit principle is often used to justify the imposition of indirect taxation
RECENT reports in the media suggest that we may expect changes to the Value-Added Tax (VAT) rate, especially against the background that SA will need to increase tax revenue to fund the proposed national health insurance scheme to be introduced in 2012.
Certain South African tax commentators argue for a multiple VAT rate system (over and above the 14% and 0%) which should include a luxury rate applicable to luxury goods and services. Views have also been expressed that the scope of exempt and zero-rated supplies should be extended. Examples mentioned include critical goods and services which relate to medical care and education. The argument is made that extended exemptions and zero ratings would make these goods and services more affordable to everyone, not only the poor, and that it could be funded by the VAT collected on luxury goods and services which would result in a nil net cost to the fiscus. It was also mooted that the VAT rate should be marginally increased to 15%.
Adam Smith articulated the principles of a good taxation system in 1776 in his “An Inquiry into the Nature and Causes of the Wealth of Nations” which gave modern tax specialists and authorities guidelines to develop and administer tax systems. Smith formulated canons of taxation which measure a good tax system against its compliance with neutrality; equality; invisibility; certainty and simplicity; and minimum compliance and administration costs.
A tax system complies with the principle of neutrality if the imposition or increase of the tax does not materially alter consumption or expenditure patterns. Interference by the tax instrument in the economic choices of taxpayers often causes unwanted economic effects or distortion, which leads to the misapplication of the scarce resources available. The equality principle encapsulates the “ability to pay” and the “benefit” principles.
The benefit principle is often used to justify the imposition of indirect taxation and mandates that those who benefit from the use of commodities or services should be required to pay for such benefit or use. The principle of invisibility relates to the notion that the best taxes are those which extracts the spending power from the private sector before it has accrued too obviously to any particular individual.
The principle of certainty and simplicity demands that the nature and quantum of a taxpayer’s liability and the administration costs of the tax system should be simple to determine and observe. The tax system should therefore be as transparent and simple as possible. The principle of certainty and simplicity necessitates that the assessment, collection and administration of a tax should be certain and simple so as to keep the costs to the taxpayer and the fiscus as low as possible.
By its very design, any tax system results in administration costs for government and compliance costs for the taxpayer.
One should first assess the difference in effect between extending VAT exemptions as opposed to extending zero ratings and then assess the desirability of such extension and an increase in the number of VAT rates against the canons of taxation.
Although VAT exemptions and zero ratings may seemingly have the same “no VAT” effect, nothing can be further from the truth. VAT exemptions remove VAT from the supply but blocks related VAT on expenses incurred in the hands of the supplier as input tax deductions. Where the supplier pushes some or all of this VAT cost (indirectly through increased prices) to the recipient, the ultimate cost of the supply is partially or fully inflated by the VAT cost. VAT exemptions are, as a result, generally distortive and not advisable. Exemptions can, however, not be completely avoided in a VAT system and examples of these include the components in financial services which does not constitute final domestic consumption. Exemption increases the cost of compliance of the supplier as it affects system codification and controls and also has a VAT apportionment effect.
Zero rating, on the other hand, has quite the opposite effect. While zero rating also removes VAT from the supply, related VAT on expenses incurred can be claimed as input tax deductions by the supplier. This frees the supply from any VAT cost and pushes (supposedly) the VAT benefit through to the final consumer. Zero rating also increases the cost of compliance as it impacts system codification and controls but does not effect apportionment.
Assessing the extension of the scope of zero ratings and increasing the number of VAT rates against the canons of taxation tends to demonstrate that it may not always be desirable. However, in specific instances one could justify the extension of VAT zero ratings.
The existence of a multiple VAT rate system or extension of the scope of zero-rated supplies may distort consumption or expenditure patterns and may, as a result, not always comply with the neutrality principle. A multiple VAT rate system and the extension of the scope of zero-rated supplies may strictly also not adhere to the equality and more specifically the benefit principle of taxation as a multiple VAT rate or extended zero rate system could be seen to favour certain and discriminate against other commodities. Finally, the imposition of multiple VAT rates or extension of the scope of zero-rated supplies definitely decreases the simplicity of the tax while increasing the compliance and administration costs evidenced by systems, codifications, and controls.
Ferdie Schneider is a partner at KPMG Services.