Why should Pakistan go for VAT?

By Waqar Wadho
(University of Aix-Marseille, France)

Since its inception in 1954 in France, where ever it has been initiated,
the VAT has been debated more extensively than any other tax
structure. Today, for more than hundred countries of the world, VAT is
the mainstay of their tax systems. The specific reasons behind
adopting VAT may differ from country to country but the central claim
has been that it raises more revenues and with lower economic and
administrative costs than any other broad based consumption taxes.
What makes it more fascinating than GST or other sales taxes is that
VAT generates higher revenues in very neutral fashion. A
comprehensive VAT does not cause individuals or firms to budge their
economic choices, such as goods or locations etc. It does not
discriminate the capital intensive or the labor intensive firms,
specialized or the integrated firms, or corporate or the non-corporate
firms. In terms of its coverage, three models can be observed around
the world. Most of the countries have adopted a VAT with extended
coverage through the retail stage, but there has been the cases where
its coverage been bunged till the wholesale or the manufacturing
stage. A VAT with reduced coverage i.e. through the wholesale or the
manufacturing stage can not sustain its neutrality. It becomes
exceedingly distortive and it causes the burden of taxes to be
distributed unevenly and results in stern regressive dynamics. The
present sales tax system in Pakistan can be claimed a VAT with
coverage up to manufacturing stage. Another salient facet of the VAT
is that it’s the first consumption tax to integrate the taxation of
services with the taxation of goods. Today, most of the countries have
been taxing services comprehensively along with the goods. In a
country like Pakistan, where services account more than 50 percent of
the GDP, taxing services comprehensively would fetch much more
revenues required to bridge the alarming budget deficits.

VAT is also called the money machine due to its revenue generation
capacity. In OECD countries, it raises revenues up to 5 to 8 percent of
the GDP, while its share is between 15 to 20 percent of the total tax
receipts. In Pakistan where sales tax accounts for more than 60
percent of the tax receipts, an introduction of VAT will certainly bring a
much needed boost in the tax revenues. The underlying reasons for
why should Pakistan adopt it are associated with very basic features of
the VAT. 1) Tax coverage: manufacturers, wholesalers and retailers
would all be registered. The extension through the retail stage would
not only make this sector documented but also it would ensure the tax
neutrality. In contrast to the general perception, the VAT will condense
the regressive effects of the conventional sales tax system. Even a
quasi- progressiveness can be achieved by levying two to three
different tax rates. For example in France the normal VAT rate is 19.6
percent, but for tourisms, cultural services, transport, restaurants and
water etc the rate is reduced to 5.5 percent, which is further reduced
to 2.1 percent for the medicine, press etc. 2) Tax base: VAT taxes the
broadest possible range of the goods and services. It ensures the
comprehensive taxing of the services that brings in efficiency as
compare to the conventional sales tax system. First, by not taxing
services comprehensively, the tax rate for goods will be higher, which
would enlarge the excessive burden of the tax. Second, since Pakistan
is developing economy and in its process of the development, the
productivity gains of the industrial sector are likely to be larger and
taxing only goods would be equal to taxing these gains in the industrial
sector that would further erode the development process.
Furthermore, the income elasticity of demand for most services
exceeds unity and thus taxing services will have overall progressive
impact. The efficiency argument of comprehensively taxing services
does not rule out the role of exemption on the social grounds. Thus,
education, health, social and public services can be exempted. Even, it
would be better to introduce zero rates for these services as they could
claim reimbursements of the inputs they used.

The voice against the VAT is build around an illusion that it would feed
a spiral of tax, prices and wages that would lead to inflationary impacts
on the economy, and it will adversely impinge on the poor. For its
adverse effects on the poor, since it stretches up to the retailers and
since it comprehensively taxes the services; the VAT is less distortive
than the existing general sales tax. Regarding inflation, VAT by itself,
can never lead to a sustained increase in the rate of change of prices
(it may change the level of price). Second, there is no evidence from
the previous studies that VAT has actually caused any inflation. Third,
when we talk about the price hike due to VAT, one need to take into
account the existing tax to whom it will replace. The prevailing general
sales tax can be cascading i.e. the tax is imposed on every stage of
supply chain without deduction of the tax paid in early stages. On the
other hand, the comprehensive VAT avoids the GST cascading. Fourth,
as I have explained before that VAT enforces tax neutrality, hence,
there would be no changes in the aggregate demand and thus would
not have any impact on the aggregate price level. Besides, the
government must employ a massive campaign to inform the general
public about the possible effects of VAT, which not only will enhance its
credibility but also will mitigate the possible inflationary effects, if any.