[This post has greatly benefitted from conversations with Mwansa Mushinge on the practical aspects of the VAT]
This past Friday, the Minister of Finance, Margaret Mwanakatwe, presented her maiden budget address to the National Assembly of Zambia. One of the biggest announcements of her address was the proposed re-introduction of the Sales Tax to replace the Value Added Tax (VAT). The VAT was introduced in 1994 to replace the then Sales Tax (so we are about to go full circle). Given that the VAT finances about 17% of the national budget, it is important to think through the implications, if at all any, of what appears to be a fundamental shift in tax policy.
A VAT and a sales tax are all consumption taxes and are paid by the final consumer of goods. In theory, it doesn't matter whether a country levies a VAT or a sales tax because they raise equivalent amounts of revenue if levied at the same rate. Their only theoretical difference has to do with the way they are collected.
With a sales tax, the tax is only collected at the final stage of the production process (at the retail stage). The VAT, on the other hand, is collected at every stage of the production process but is only paid by the final consumer of the good.
An example to illustrate: suppose Zambia levies a sales tax of 10% on bread. And suppose, for the sake of argument, that the final retailer of bread wants a sales revenue of K20 from every loaf of bread. Given a sales tax of 10%, a loaf of bread will retail for K22 (K20 + 10% of K20). The retailer will keep their K20 and remit the K2 sales tax to the Zambia Revenue Authority (ZRA).
Given that the sales tax is only supposed to be paid by the final consumer, businesses that buy goods that are inputs into their production processes need to obtain exemption certificates that exempt them from paying the tax. So in our bread example, the bakery where the bread is baked and the retail shop where the bread is finally sold will need to obtain such exemption certificates.
Now suppose that the country does away with the sales tax and introduces a VAT of 10% on bread. To see how the VAT is collected, we will have to break up the production of bread into different stages.
At each stage, "value is added" and the VAT is then levied on the value added. Suppose at the first stage, the baker buys flour from a miller for K5.50. The miller returns K5 as sales revenue and remits K0.50 (10% of K5) to ZRA as VAT. The baker uses the flour to bake bread which he/she sells to the retailer for a VAT inclusive price of K11 (K10 sales revenue and K1 VAT). The baker, however, doesn't remit the full K1 to ZRA but nets-off (recovers) the K0.50 that he/she paid as VAT to the miller. So the baker ends up remitting K0.50 to ZRA as VAT. The baker is allowed to net-off precisely because the VAT, being a consumption tax, should only be paid by a final consumer. The retailer then retails the bread for K22 (K20 sales revenue and K2 VAT). The retailer, given that he/she is also not the final consumer, does not remit the full K2 but nets-off (recovers) the K1 that he/she paid to the baker as VAT. So the retailer remits K1 to ZRA.
In this VAT example, the total money paid to ZRA is K0.50 from the miller + K0.50 from the baker + K1 from the retailer = K2. So the same amount of money is raised with the VAT as with the sales tax! Notice, however, that the only person who doesn't net-off is the final consumer. Therefore, just like in the sales tax scenario, the final consumer is the only one who pays the tax [1].
So if the VAT and the sales tax raise the same revenue why do so many countries prefer a VAT over a sales tax? For example, the Organisation for Economic Co-operation and Development (OECD) counted about 165 countries as operating a VAT in 2016.
The reason for the popularity of the VAT over the sales tax has mainly got to do with the fact that tax payers are more likely to comply with a VAT than with a sales tax. Tax compliance rates with a VAT tend to be higher than those with a sales tax precisely because of the netting-off process described above. For example, in netting-off K0.50 from the K1, the baker is saying to ZRA that they paid K0.50 to the miller as VAT which they are claiming back. Knowing that the baker will likely claim from ZRA forces the miller to remit the K0.50 to ZRA instead of holding on to it. Similarly, the retailer has an incentive to claim the K1 that was paid to the baker as VAT. Knowing that the retailer will likely claim forces the baker to comply by correctly remitting their portion to ZRA. With a VAT, ZRA can easily uncover tax evaders because the system self-enforces. A netting-off not backed by an earlier remitting of funds sets off red flags.
This is not entirely the case with a sales tax. The only time taxes are collected with a sales tax is at the final stage with the consumer. And the consumer, being the last person in the chain, cannot net-off from someone else. Therefore, the retailer faces a huge incentive to not remit the sales tax collected from the final consumer. The retailer also faces an incentive to not charge the final consumer a sales tax because doing so makes his/her products cheaper.
So if compliance rates are higher with a VAT than a sales tax, why is the Zambian government re-introducing a sales tax? The Minister of Finance in her address did not give the reasons for the re-introduction of the sales tax. However, in reading between the lines, it appears that the system of "VAT refunds" has not only been a headache for ZRA to administer but has also added unpredictability to the country's revenues.
The question is how do VAT refunds arise in the first place? In the scenario presented above, refunds do not arise because every producer nets-off what they pay along the value chain. However, instances do arise where what a producer pays in VAT is greater than what they collect in VAT when their product is sold to the next person in the chain. In such a scenario, netting-off will not be sufficient to fully recover what was paid in VAT.
The mines particularly suffer from this. Often the mines might buy lots of expensive capital equipment on which they pay VAT but for one reason or the other the copper exported may not result in VAT to the same extent. In this case, the difference will have to be refunded from ZRA. The same is also true for entities that sell products that are zero-rated or exempted from VAT. These entities might buy inputs that attract VAT but their products are not allowed to attract VAT. So netting-off will not lead to a full recovery hence the need for refunds from ZRA.
In theory, processing refunds shouldn't be a headache -- the mines paid VAT on some equipment. This VAT was remitted to ZRA by the mines' equipment supplier. All the mines are asking for is for this VAT, which they paid, be refunded. In practise it tends to be a headache. Audits have to be performed to track whether VAT was actually paid or not. Second, this situation creates instabilities in the country's tax revenues. ZRA receives VAT from equipment purchased by the mines hoping that the mines will recover this money on their own in the value-chain. ZRA then sends this money to Central Government and Central Government spends it. The mines later come back asking for this money given that they are unable to recover it in the value chain. Government is now out-of-pocket and has to find this money somehow.
The Zambia Chamber of Mines estimates that the mining industry is owed some US$300mn in VAT refunds. And it is possible that the country has already spent this money!
So the need to do away with refunds seems to be what has motivated the Minister's proposal to re-introduce the sales tax. But one hopes that the Minister and her team have properly weighed the headaches involved with the VAT refunds against the real risk that tax compliance will be lower with a sales tax, possibly resulting in lower tax revenue.
Notes
[1] As a technical point, note that that at each stage, the VAT is levied on the value-added, hence the term "Value Added Tax". The miller added K5 of value to wheat to make flour. Therefore the VAT at this stage is 10% of the value-added = K0.50. The baker obtains a sales revenue of K10 from the bread implying he/she added value of K5 -- this once again attracts a VAT of K0.50. The retailer then obtains a sales revenue of K20 implying a value addition of K10 and consequently a Value-Added Tax of K1 (10% of K10). So the total value-added in the production chain is K20 hence a VAT of K2.
