Is the re-introduction of a sales tax a good idea?

[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.

How important is foreign "assistance" to Zambia?

Yesterday Zambians woke to the news that the United Kingdom had frozen aid funding to the country. This follows allegations of corruption amounting to some $4mn in the administration of the country's Social Cash Transfer (SCT) programme. The SCT is meant to benefit the poorest of the poor in Zambia. Other donor countries (known formally as "cooperating partners") have since followed suit. Ireland, Finland and Sweden have announced the suspension of their own aid initiatives to the country. The president has since called for a speedy inquiry and in the interim dismissed the Minister responsible for overseeing the SCT. 

The diversion of money meant for the poor is definitely something to be upset about. And I, like many other Zambians, are angry that something like this happened. My intention, however, with this post is not to defend the despicable acts of those who were involved in the spiriting away of SCT money. Rather, my intention is to take the opportunity presented by this week's happenings, as ghastly and as indefensible as they are, to engage a long-running narrative on the importance of foreign assistance to Zambia.

Discussions about "cooperating partners" in Zambia often take place under the presumption that foreign aid is gravely important in funding our day-to-day operations as a country. For example, the huge sense of public panic seen this week following withdrawals and threatened withdrawals of donor funding betrays a presumption of such importance. Some are arguing that the president's uncharacteristically swift reaction to the SCT scandal is itself illustrative of the degree of the financial importance of our cooperating partners.

But how important are donor funds for our finances? To get a sense of the orders of magnitude, I have looked at each and every budget address since 2007 (2007 being the earliest date for when budget addresses are available on the National Assembly's Website).

In presenting the national budget to parliament, the Minister of Finance, among other things, presents estimates of expenditure for the year ahead in addition to estimates of revenue that will support such expenditures. Revenue sources are split into two major parts: (1) Total Domestic Revenues and Domestic Financing and (2) Total Foreign Grants and Financing. It's the latter segment that is of importance to this post.

Below I construct several series showing percentage shares of different segments of donor assistance in the total budget. [Ideally I should construct these series using realized quantities as opposed to forward looking estimates (2018 appears in the below series because it's an estimate made in 2017). Sadly, the budget speech rarely contains information detailing expenditures and revenues for the previous year. Information on realized quantities is supposed to be contained in the Annual Financial Reports prepared by the Ministry of Finance. Sadly only 4 of these are available on the Ministry's website. In any case, looking at the 4 available financial reports, one gets the sense that any differences between estimates and realized quantities are small].

Figure 1 below shows the percentage of the total national budget that is due to the donors. The figure shows that in total, donors supported about 30% of the budget in 2007 and this has come down somewhat to settle at around 20% -- which is the average over the 11 year period. Stated differently, the information in Figure 1 shows that the people of Zambia, on average, funded 80% of their country's operations over the period 2007 to 2018.

Figure 1: Total Foreign Assistance as a percentage of the total budget
Source: National Budget Speeches, 2007 to 2018

The information in Figure 1 is a little misleading. Total foreign assistance is made up of two parts -- a part that is given as a grant to government (given "free of charge") and another part that involves loans that are to be paid back. So we shouldn't really think of the loans as "assistance" because we are borrowing that money ourselves and are going to pay it back in the future -- and it's presumably a win-win because the donors stand to earn a return on the transaction. (You wouldn't say your bank was "assisting" you in granting you a mortgage to buy a house).

Figure 2 disaggregates total assistance into a grant component and a loan component. As before, the blue line is total assistance. The orange line shows the pure grant component (given "free of charge") that one can think of as pure assistance. The gray line shows the loan component that I argue is quid pro quo and is not to be thought of in the same way as one would think of a grant.

Figure 2: Different components of total assistance as a % of the total budget
Source: National Budget Speeches, 2007 to 2018

Figure 2 shows that the grant component of aid in the total budget has declined from about 20% in 2007 to 3% in 2018. Subsequently, the component due to donors loaning us money that we will eventually pay back has increased from about 10% in 2007 to somewhere between 15% and 20% in 2017/18. Figure 2 shows that increasingly we are largely effectively self-financing our budget  -- the grant component in the national budget has come down to very low single digits. And it's also quite likely that we could do away with the entire grant component if we set our spending priorities right as a country.

Figure 3 below is a different representation of the information in Figure 2. It shows the percentage split between grants and loans in the total donor "portfolio". Figure 3 shows that the loan component has become increasingly important for donors in their dealings with the country. They've reduced the share of grants in their "assistance" programmes and ramped-up the loan component -- a component that we as a country will eventually pay back. This can hardly be thought of as assistance or aid in the everyday usage of these terms. 

Figure 3: Components of the portfolio of donor "assistance"
Source: National Budget Speeches, 2007 to 2018

To conclude, donor assistance, in as far as funding our national budget is concerned, is not as significant as implied by every day conversations around this topic. The part of such assistance that can be thought of in purely altruistic terms (the grant component) has declined from a double digit budget share in 2007 to a very low single digit share in 2018. It's very likely that we can do away with this component if we got our spending priorities right as a country. 

I also acknowledge that donor assistance, in as much as it may not be important for the overall budget, is important for certain sectors. Anecdotal evidence suggests that a non-trivial portion of public expenditure on education and health is funded by the donors (difficult to pin down exact magnitudes given the aggregated nature in which this information is presented in the budget). Second, donors are also important in funding civil society organisations that play a vital role in safeguarding democratic tenets in the country.