Literature Review On Value Added Tax (VAT)

Introduction

In today’s global market, all companies and individuals are required to pay taxes. The general idea behind the imposition of taxes by the government is generally to balance the economy in terms of the redistribution of funds and income from the rich to the poor. Nowadays there is a global shift in paradigm, whereby the focus point is moving from a direct taxation policy towards an indirect taxation policy. This action led to the implementation of the Value-Added Tax (VAT). The VAT was undoubtedly the most fortuitous innovation of the last half-century with regard to taxation policy. No other taxes, not even the income tax, have made an impact so quickly and rapidly to such extent that the VAT now exists in over 150 countries around the world, including Mauritius and other African countries. This is so because the VAT is considered as an important source of government revenue and evidence has shown that the VAT is not only the least distorting tax, but can also be easily administered in most countries. Every country now makes use of the VAT and each year sees a new continent adopting it.

By definition, the VAT, also known as goods and services tax, is a broad-based tax impose on the various stages of production, starting from raw materials to the final product. A VAT is considered as a “regressive tax,” because it taxes all people the same amount regardless of their income level or ability to pay. It is mainly a form of consumption tax since it is intended to operate as a tax on final consumption. The most evident consequences of a VAT is that the local government will receive more revenue, and the price of goods will rise for the consumers. Other effects are currently under consideration. There are arguments that since the VAT is quite efficient and raises substantial amounts of revenue, it can cause other taxes to decrease. However, others argue that no country that has adopted a VAT has reduced its current taxes, but instead has used the surplus money to expand the size and spending of the state.

The value-added tax rate varies according to countries. While in the European states it ranges from 12.5 percent to 25 percent, in African countries, including the Southern African Development Community (SADC), it varies between 5 percent and 20 percent. Mauritius, which also forms part of the SADC, has a standard VAT rate of 15 percent.

Literature Review

The literature on VAT is relatively small compared to its rapid spread and seemingly attractive worldwide. This section reviews the literature, with particular emphasis on the impact of VAT as a consumption tax on consumption behavior and economic growth. The section consists of three main parts corresponding to theoretical and empirical effects of the consumption tax on consumption with a brief overview of the literature VAT. The last section concludes the study of literature.

Theoretical literature

Few studies have examined the theoretical link between the VAT and consumer behavior, focusing primarily on the results of a tax reform that aims to replace the income tax with a VAT. For example, Batina (1999) studied the effects of conversion of an income tax to a consumption tax in the presence of bequests. By using an overlapping generations model, the author finds that the taxation of bequests at the rate of consumption tax pushes the benefits of tax reform as savings and capital accumulation does not increase. Consequently, the bequest decision will be distorted, as bequests will then be affected since they will be taxed twice, and this can lead to a deduction in capital accumulation when the reform takes place, as there is less incentive saving for bequests.

Matsuzaki (2003) studied the effects of consumption tax on effective demand under stagnation. Using a two-class model with unequal distribution of wealth, the author noticed that under stagnation, a rise in consumption tax rate decreases (increases) effective demand with respect to heterogeneous households when the proportion of poorer households is large (small) in relation to the whole population. The author explains his findings in this way; Increasing the rate of consumption tax on the richer households does not alter their consumption because in this case the marginal utility of money reaches its lower edge. However, when the rate of consumption tax is raised on poorer households, it initiates two effects: the effect of pure consumption tax that increases the marginal utility of household’s money and therefore this always reduce consumption: and the redistribution effect (the government in a way gives back the consumption tax revenues in the form of lump sums to all households), which increases the consumption of poorer households. In addition, the effect of redistribution is less effective as proportion ratio of poorer households is larger compared to the total population. Therefore, the net effect of the consumption tax on poorer households depends on which of these two effect assumes more authority.

One of the few studies that examined consumption tax and growth was carried out by Turnovsky (1996). He assessed the role of consumption taxes in improving economic growth. The author showed that the trade-off between optimal income tax and consumption tax depends essentially on the externalities created by government spending on capital returns, which in turn depend two factors: (1) the level of public expenditure in relation to its social optimum, and (2) the degree of congestion. He noted that an increase in taxation of capital is offset by a reduction of the debt or the consumption tax will lower the growth rate of equilibrium, but an increase in the consumption tax is offset by debt reduction has no effect on the equilibrium growth rate, but if it is offset by a reduction in the taxation of capital it will raise the growth rate.

Finally, Petrucci (2002) investigated the effects of a consumption tax on capital formation and economic development using a simple model of endogenous growth sector with finite horizons. To be able to concentrate solely on the effect of the consumption tax on the relative price of consumption today and tomorrow, the author took the inelastic supply of labor to remove the distortion in the inter-temporal consumption-leisure brought about by the consumption tax. He noted that in the endogenous growth model with new generations constantly coming into the economy, the consumption tax decreases aggregate consumption and raises saving, stimulating capital accumulation and economic growth in two ways. First, when currently living consumers receive lump-sum for the tax, and second when the increase in the consumption tax is supplemented by a fall in public debt. The author contends that under the first scenario, consumption taxes influence aggregate savings by the intergenerational redistribution of income, since the younger consumers save relatively more than the older ones, which is performed by the distribution of tax revenues. Consequently, there is a positive impact of the consumption tax on saving and economic growth as a result of the demographic heterogeneity of households. On the other hand, in the second scenario, the reduction of public debt that occurs simultaneously with the increase in the consumption tax reduces the share of consumption in national income, promotes capital accumulation and long-term economic growth as the change public debt redistributes wealth between the age group, while consumption tax, by itself, is neutral. However, if the income is not redistributed inter-generationally between the actual generations and generations that are yet to be born because the resources of taxation have been used to finance unproductive government expenditure, the net outcome of the consumption tax on the rate of growth would disappear. This result creates a transitional adjustment of the economy, in which short-term effects of the consumption tax on real growth and the proportion of private consumption to national income are smaller than long-term results. In conclusion, the author recommended a policy that encourages the tax proposals seeking to reduce the output tax in place of the expenditure tax, since it creates less distortion and it will therefore stimulate capital accumulation and growth.

Empirical Literature

With respect to the impact of VAT on consumption behavior, Andrikopoulos et al. (1993) examined the short run effects of the VAT on consumption patterns in Greece. The aim of the study was to evaluate the influence of the VAT on individual commodity prices, consumer price index, shares and the allocation patterns of total consumption expenditures among groups of commodities. By making use of a time series data involving thirteen commodity groups in Greece for the period 1958-1986 and employing the full information maximum likelihood (FIML) approach to assess and test static almost ideal demand system (AIDS) model, some major empirical conclusions were made. Firstly, the VAT has altered the composition of the commodity prices at different rates, both positively and negatively. In fact, the VAT has raised the consumer price index by 4.7 percent above the rate supposed to occur without the presence of the VAT. Secondly, the VAT has changed consumption patterns or the distribution of total consumption expenditure between groups of goods and services under study. This is the result of significant difference between the prevailing and anticipated budget shares, and the considerable change in demands, both compensated and uncompensated.

Other studies made use of models such as Computable General Equilibrium (CGE) to determine the effect of either implementing the VAT in the economy or increasing its rate, that is, on determinants such as consumer prices, consumption, investment, and welfare. Most of these analysis were carried out on developing countries. For example, Rege (2002) identified that the immediate administration of VAT in India, in place of other indirect taxes, decreases welfare more than if its implementation has been progressive because it leads to a rise in the price of basic necessities. Consequently, he observed that when the essentials such as food, agriculture and textile are tax-free, welfare loss is halved.

Similarly, by studying the Fiji economy, Narayan (2003) noticed something interesting. Indeed, by assuming a 100 percent collection rate and approximately a 0.6 percent rise on real GDP, if Fiji’s VAT was increased by 25 percent, it resulted in about 4 percent increase in government revenue. Nevertheless, it caused investment, real consumption and national welfare to decline.

In other studies, the consequences of introducing the VAT in developing and developed countries have been examined. For example, Metcalf (1995) figured out the issues to be taken into consideration when developing a VAT and other important aspects such as how a VAT functions, its management and settlement costs, its economic impact on supply of labor and savings and its transitional and distributional repercussions if introduced in the US. With regard to its impact on savings, the author claims that VAT eliminates the distorted inter-temporal consumption created by taxing savings, and if the elasticity of savings relative to the rate of interest is positive, then the VAT will increase the amount of savings by raising the rate of return after tax savings. However, he highlights that there is still no definite answer on whether the implementation of the VAT would raise savings rate.

Likewise, Bird (2005) considers the significant implications of implementing a VAT in developing and transitional economies (DTE). Basically, the author noted that the VAT functions properly in most DTE and more effectively than any other kinds of general sales taxes. Secondly, the application of VAT depends on the “self-assessment”, which remains a problem for many DTE. Moreover, when designing a VAT, it is important to take into consideration the situations of the countries since they can change considerably over time and across countries. Finally, the main lesson derived is the ability to understand the political economy dimension of the VAT policy and administration. In addition, the author argues that the main challenge of empirical studies on VAT in DTE is to collect systematic, consistent and accessible information as there is lack of proper information about VAT in these countries.

Conclusion

Based on the above, although literature on VAT seems rare, one can derive that the VAT has a major influence on investment decisions, national welfare and mainly on consumer behavior. The VAT, primarily as a consumption tax, has been the subject of various studies throughout history, either to show its impact on demand and economic growth or simply to see how the VAT benefits all the parties involved. Others have analyzed the advantage of introducing the VAT and how it functions in developing countries. However, there are lots of controversies that have aroused since the information obtained about VAT from these developing countries are most of the time improper or inaccurate.