Value added Tax

Advantages, disadvantages and economic effects

Table of Contents

Introduction
1- The concept of value added tax
2- Different kind of value added tax
3-The reasons of practicing the law of value added tax in Iran
4- The advantages of value added tax
5- The disadvantages of value added tax
6- The economic effects of VAT
Conclusion







Introduction

Recently Iranian taxation organization reviewed the existing taxation laws at the
context of third economic, social and cultural plan of government and in the sake of
improving the existing taxation system, introduced a new kind of taxation model
which is called "value added tax". Value added tax by transferring the tax basis from
income to consumption increases the motivation of investment and prepare the
required resources for investment by encouraging the saving of people and
discouraging the transfer of capital from production sector to services sector. By
practicing the new taxation system, the distortion in production and investment
decisions will be decreased and the tax incomes of government due to the vast
character of tax basis of this model will be increased.


1- The concept of value added tax


Value added tax is kind of indirect tax on consumption and domestic sales of goods
and services; this kind of taxation is a multiphase taxation that in each phase of
production cycle until final consumption will be collected according to the value
added creation. Value added tax is multiphase sales tax which frees the buyers of
intermediate goods and services from tax payment.

The value added of a business unit is the difference of sales income of goods and
services minus total costs or payments for buying the intermediate goods and services.
At the scale of national economy, gross national product is in fact the total sum of
value added of all business units of the country, because total final sales transaction
minus total intermediate transaction is equal to value added. Therefore the value or
worth of final sales is equal to the worth of wages, interest rate, rent, depreciation and
other payments to the production factors at nation scale which is equal to gross
national product.


The following equation shows that at the national scale the value added is the other
coin side of gross national product.

GNP= interest + wages + depreciation + rent final sale (total transaction
intermediate transaction) value added


According to the above equation it can be said that the total value added produced by
all the business units in different stages of an economy is another kind of definition of
gross national product. Therefore the tax basis of value added tax is equal to the total
incomes of sales minus the cost of buying the production factors from other business
units, which by excluding whatever bought by business units from the outside
taxpayer from tax calculation, it is refused from multi tax collection. In other words,
the tax is obtained from total sales of business units and simultaneously the tax credit
of buying from other business units transfer to the next business unit. In fact the taxes
paid by the preceding units are subtracted from the tax of the final business unit. So
using the value added tax system and calculating tax on value added of business units
requires keeping the record all business units invoices, because each business unit in
order to get his taxation credit should be able to declare and show all the taxes paid by
his previous supplier. This feature of VAT and this need encourage the buyer to force
his supplier to pay the taxes (which were already invoiced to him) to the government.




2- Different kind of value added tax

There are three kind of value added tax: value added tax of production type, value
added tax of income type, value added tax of consumption type. Each type of value
added tax according to the basis of origin, starting point or destination can be
calculated.

According to the origin of starting point, value added tax include the worth of all
goods and services produced in national economy in the calculation of tax, but in the
origin of destination, value added tax just include all the goods and services consumed
in the national scale.

2-1- product- value added tax

In general meaning, product value added tax of the starting point origin, include all
the government expenses in the gross national product at the calculation of tax (except
government expense for wages which can not be included in calculation of value
added tax).

By considering the assumption of using the starting point origin, export which has the
internal origin will be included in tax calculation; but import which has the external
origin excluded from tax calculation. Therefore, we can say that the basis of product-
value added tax (P-VAT) is equal to all the government expenses in the gross national
product except government wages expenses.


In product-value added tax (P-VAT), the total tax calculated on sales. In general, this
kind of value added tax can be either calculated on the consumption and investment
goods basis. In this method, investment goods and their depreciation are not free from
taxation; in other words, we can say that the tax credit doesn't include the purchaser or
buyer of investment goods, so this kind of value added tax decrease or weaker the
investor motivation.


2-2- Consumer- value added tax (C-VAT)

In consumer- value added tax (C-VAT), depreciation and investment costs are
excluded from tax basis calculation. In fact, by excluding the investment cost from
production cost, what is remaining is equal to the value or worth of the production of
consumption goods. The value added tax system which is used by European
community members is the type of this kind, and the tendency of some of the
developing countries is to this kind of value added tax model, especially due to the
freeness of investment goods from tax which increase the motivation of investment.
In addition, this kind of value added tax (C-VAT) from practical point of view is
easier than the two other types.


2-3- Income - value added tax (I-VAT)

In income - value added tax (I-VAT), depreciation doesn't include in tax calculation
and thus the net investment costs doesn't include in tax calculation.

The tax basis in this model is equal to total payment of government to production
factors after deduction of government wages expenses and for this reason this kind of
tax is called income value added tax.

In general, in this kind of value added tax, the total tax basis, is equal to incomes of
production factors. Income value added tax is different from consumer- value added
tax model; because in the first model (I-VAT), the business units can exclude the
depreciation cost from tax calculation, but in the second type (C-VAT), the business
units has the right to exclude the gross investment cost from tax calculation. So the
tax on income-value added tax model at the same amount of the differences of gross
investment and depreciation is more than the amount of tax on the consumer value
added tax model.





2-4 The comparison of three type of value added tax


From the above 3 kind of value added tax model, product- value added tax (P-VAT)
generate the largest tax basis, and the consumer- value added tax (C-VAT) generate
the smallest tax basis.


As the product value added tax (P-VAT), include the gross purchases of investment
goods (without excluding the depreciation), in fact it create an obstacle for
investments. In addition if the tax calculation in this model calculated on the basis of
invoices, that group of activities which has not succeeded to transfer some portion of
their investment costs to next accounting or taxation period, will cause a multi tax
payment, which in income- Value added tax model ( I-VAT) this problem lower in
minimum.

From the 3 type of value added tax, the consumer value added tax (C-VAT), which
create the smallest tax basis in fact, it is a general tax on consumption (if it use the
origin of start point, the net worth of export should be include in tax
calculation).therefore, from the above 3 mentioned type, the majority of countries
chose the consumer value added tax model. It should be noted that under this type
of value added tax for creating the ideal income return required to the highest tax rate,
and for this reason , some of the countries try to enlarge the tax basis of consumer
value added tax by including some portion of investment goods.



3-The reasons of practicing the law of value added tax in Iran

The necessity of reforming Iranian taxation system with a group of course of actions
such as foundation of an taxation organization, restructuring the law of direct taxation
and introducing and implementing the value added tax as a complimentary of existing
direct law of taxation and as an efficient and co-ordinate tools with the economical
situation of the country has been foreseen in the third socio-economic, and cultural
development plan (3
rd
-E.S.C.P) of Iran.

In reforming the law of direct taxation system due to the decreases of different rates
of taxation- in the sake of increasing the investment and the opportunity of
employment and also increasing the productive activities resulted decease of
government income. On the other hand, the government of Iran for achieving the
objectives forecasted in the 3
rd
plan need to the new sources of income. In achieving
this objective implementation of new law of value added tax as a one kind of general
tax on consumption and sales in the same direction of decreasing taxation load on
productive sectors can increase the government tax incomes.

Another reason of suggesting the implementation of the law of value added tax, it can
be point to the fact that it is a good replacement for many other fees and indirect
taxes, which has the vast distortion effects in the productive sectors and on the
welfare and behavior of the consumers. As you can see in table 1- omission of indirect
taxes and fees causes a great decrease in government income. Thus, value added tax
in addition of reparation of the income decrease of government can also increase the
government tax incomes according to the forecasted amount in the 3
rd
plan.

Table: 1 the comparison of indirect tax incomes with the total tax incomes of
government in 2000 and 2001.

Actual 2000 Actual- 2001
Tax incomes 41722.6 62415
Indirect tax incomes 22986 33631
Tax on import 11778 21783
Custom duties (11378) (20472)
Others (400) (800)
Tax on commodities and services 6957 7001
Total tax incomes 7357 7801
The ratio of commodities and services tax on
total tax incomes
17.76 12.5


In the introduction of feasibility report of the value added tax bill which was approved
by committee of government, the reasons of implementing the value added tax system
are described as follows:

1. Increasing the government tax incomes with the relay on new and reliable
sources and on the consumption basis.
2. Decreasing the tax screw on production sector and productive investment by
restructuring the tax rates on income.
3. Increasing the efficiency of taxation system by decreasing the costs and time
of collecting tax incomes.
4. Concentrating all the activities of the collection of taxes and omission of all
other fees and indirect incomes in one organization.
5. Increasing the co-operation of people in collecting tax incomes and
encouraging the self assessment.









4- The advantages of value added tax


During the last 40 years that the value added tax system has been used, the number of
countries which added to the user of this kind of taxation system increased to more
than 120 countries. This taxation system which was used at the beginning only by
European countries, gradually with an increasing rate used by many developed and
under development countries.

By reviewing the reports of those countries which has been using the value added tax
system, all of them demonstrate their satisfaction of using it. The advantages counted
for the value added tax system are as follows:

Income generator for covering the government expenses
Stability
Minimizing the tax evasion
The ease of auditing control
Disciplined trade
Improving foreign trade
Rebuilding the economy
Effective support
The minimum negative effect on allocation of resources
Facilitating the entrance to regional protocols
Resolving the negative effects of taxation on economy
Etc...

In order to better understand the reasons of using the value added tax system by the
countries that are choosing it as their taxation system in the following sections we
discussed each of the above advantages in more detail.

4-1- Income generator for covering the government expenses

Due to the vastness of tax basis of value added tax system which usually includes the
majority of goods and services, this kind of taxation called by governments as a
"money producing engine". The reason of using this metaphor is the tax basis in this
model which includes the vast groups of goods and services and also the large and
floating incomes which it generates for the governments. Taxes which were collected
by the objective of balancing the distribution of incomes or achieving economic
efficiency usually has the smaller tax basis and higher tax rates. On the other hand,
increasing the tax rates due to the fact that decreases the investment and production
motivation causes the black-market and prepares the situation for tax evasion and
ultimately decreases the government income. But due to the vastness of tax basis in
value added tax system, the governments can use the lower rates of taxes on all the
final sales related to all economic sectors and as a result can generate more income for
covering their expenses without decreasing the investment motivation.



4-2 minimizing the Tax evasion

In the value added tax model due to the lower rates of taxes in comparison to other
type of taxation system with the limited tax basis, the tax evasion decreases and as a
result the a reliable source of income made for governments. On the other hand if one
firm (seller) "cheats" it means another firm ( the buyer) loses, because both firms
have to report their transactions and they have opposing interests, the system is self-
enforcing and that makes evasion difficult.

4-3- Facilitating the entrance to regional protocols

Some of the regional protocols due to the reasons such as: The necessity of unified
model of taxation system in economical relations between the members of protocols,
creation of unified tax screw, motivating the members toward efficiency, development
of industries, using the benefit of neutralization and increasing the internal
competition, made the admission of the value added tax as one of the criteria for
acceptance of the members in protocol.


4-4- restructuring and improving the taxation system

As the structure of economy growth and become more complicated, the necessity of
keeping accounts in different small and big size business units increases. Thus, in
value added tax system, each business unit required to keep it's account in a
comprehensive manner, so the use of computers for record keeping and processing
data in order to produce timely information is more than the traditional tax system
models and thus it will result the renewal and deep change in old and traditional
taxation system and a dramatic improvement in times and jobs of tax system
personnel.

4-5- The ease of auditing control

Due to the fact that in value added tax system, the invoices of sales are the base of tax
calculation and the amount of sales of goods and services recorded in the specified
columns of invoice and according to that value added tax calculated and collected and
also because the invoices recorded in the general journal and ledgers of the firms, so
(especially in the case of unique tax rate) the system of auditing is simple and
effective.


4-6- The minimum negative effect on allocation of resources

From economical point of view, value added tax is a neutral tax; because it has no
effects on production factors ( investment, employment and etc..) and also has the
minimum negative effects on economical decisions of the business units. The reason
is because in value added tax system the tax calculated on value added generated by
production factors in production cycle and thus it hasn't any bias to an any kind of
production method. According to the above mentioned points ,It is said that the
value added tax has not any distortion on market forces in relation of optimized
allocation of resources. The neutrality of value added tax is one of the key reasons of
acceptance of it by the central and eastern European countries.



5- The disadvantages of value added tax


Usually the governments and their policy maker who have the value added tax system
in their agenda , due to the following reasons are worry about the implementation of it
as their taxation system:

5-1- the diminution effects of value added tax

As the value added tax in practice is a tax on consumption and usually calculated with
a fix rate on predetermined commodities, therefore the screw of taxes on low income
peoples is greater than the other groups of income. So it is why those countries that
starting to use VAT for the first time are worry about the diminution nature of it.

There is an answer to above critics and that is as follows: 1) value added tax is not
following the social equity objective and the inequity of tax rates by implementing
other supporting polices of governments from low income groups can be justified. 2)It
can be asked the same question from the opposition of VAT, Do the traditional tax
systems really completely fulfill their social equity objectives ? and finally because a
portion of governments incomes are indirect taxes , the effects of diminution of VAT
in comparison to the other kind of taxation especially tax on sales in different stages is
significantly lower.


5-2- The effects of value added tax on increases of prices level

Some times the above mentioned sentence appear as a criticism against VAT, but the
experience of those countries which implement and used the VAT shows that there is
not any thing to be worry about, because first of all the opposition of VAT can't
propose any rational reasons for increasing the general price levels and secondly
using the VAT system cause a deflation on economy and as a result has a deflation
effects on economy.






5-3- Practical difficulties of implementing VAT


One of the main reasons of opposition of VAT, is the practical difficulties of
implementing the VAT. These problems are as follows:

1- The difficulties of calculating the VAT of retailers and small professional jobs
2- The way to deal with agricultural foodstuff
3- The way to deal with capital commodities
4- The problems of calculating VAT of services firms such as banking and
insurance

The explanations of the above problems are as follows:

Problem 1: This problem exist in many countries especially in under developing
countries, because the number of retailer in these countries are too high. Therefore the
solution is a reengineering in economic and cultural structure.


Problem 2: The experiences of countries that used the VAT , shows that the majority
of countries which used the VAT for two reasons exclude the agricultural foodstuff
from tax basis: 1) due to the social equity and the policy of supporting the low
income groups and 2) the implementation problems of this kind of taxation.


Problem 3: In relation of capital commodities, the under developing countries due to
the need of motivating investment, excludes the capital commodities from tax basis or
decreased the tax rates of this group of commodities to the minimum or zero. Or the
tax fees correspond to capital goods of business units will be deducted once or
proportionally from their sales tax.


Problem 4: In relation of financial services units ( especially banking and insurance
companies), these group of business units are excluded from tax basis due to the
following reasons:

The difficulties of assessment of value added in this kind of businesses
The lack of specified and clear criteria for assessment of the value added of
this group of businesses, the assessment of value added done by the method of
tax agent self judgment.
The transferring of financial investments due to the taxation costs will be
decreased.
The assessment cost of value added in these businesses is greater than the
resulted income.





6- The economic effects of VAT


The economical effects of value added tax system can be categorized in two groups:
1) the macro economic effects such as the effects of VAT on economic growth , level
of prices, investments, government incomes, consumption and etcand 2) the micro
economic effects such as the effects on efficiency, social equity and etc


6-1- The effects of VAT on prices level

Some of the countries said that one of the main reason why they didn't use the VAT
,is because they think there is a positive relation between the VAT and inflation rate.
On the other hand, the experience of countries which have been using the VAT
doesn't show the correctness of the above reason; but the financial experts believed
that using the VAT like other kind of taxation systems, is a deflation policy, therefore
the use of VAT will be resulted a decrease in monetized economy. So we can say that
the use of VAT has a deflation effects on economy. Other experts believed that if by
using the VAT the total demand increases more than total supply ,it will cause a an
increase in prices level, but the demand surplus and the shortages of supply may be
the result of many other reasons and it is not fare to relate it only to VAT. In addition,
the International Monetary fund (IMF) had a survey on 35 countries which are using
the VAT and reached to the following results:

The use of value added in 22 countries hadn't any major effects on price level of
goods and services or had a minimum effects. In 8 countries the use of VAT was
resulted by an increase in whole seller indices of goods and services but among these
8 countries only in one case the inflation rate increase and in other 7 countries the
trend of price levels didn't show any abnormal increases. In other word , the use of
VAT , in 29 countries or 83% of the countries reviewed didnt cause increase in
inflation rate and only in 6 countries or 17 % of them the use of VAT followed by an
increase in inflation rate, because in these later countries the use of VAT
simultaneously followed by a monetary and wages inflation policies and due to this
fact it can't be reached to this conclusion that the use of VAT cause the inflation. The
result of international monetary foundation ( IMF) shows that , the use of VAT in
majority of countries which used it, has no inflation effects , but even if the use of it
cause an increase in inflation rate, it can be justified by price controlling polices.


6-2- Motivation of investments


In general taxation is one of the important tools of governments for motivation and
directing investments. For example; the government policies in tax abatement and tax
discounts can be increase the final efficiency of investment and as a result increase the
profitability of the investments and in this way can increase the motivation of
investments in economy. In addition if the financial policies of governments be in a
manner which increases the effective demand on certain goods, the motivation of
increasing the rate of capital formation of capital will be increase. On the other hand
in analyzing the effect of taxation on motivation or dimotivation of investment,
factors such as the aim of investment, the reaction of people in saving, domestic and
external investors toward capital flow on international scale and the motives of
taxation should be considered. Those who are agree with VAT , believed that this
kind of taxation motivate the investment. By tax excluding the capital commodities or
by tax shielding the capital goods bought and used in the flow of production ,the level
of the saving and investment will be increase in economy. The experience of countries
shows that by excluding the capital goods from tax basis the investment rate increase
in economy.


6-3- The neutralization character of VAT


The neutralization of any economic polices means that, it has no effects on economic
resources; because it made no changes on relative prices. This character shows itself
on value added tax, because it requires a fixed rate of taxation not only in section of
economics, but also in all sectors. In other words, if the tax rate in one sector be
higher than the other sectors of economy, or tax reduction or zero tax rates exist in a
economy will influence the resource allocation and then it can't be said that is neutral.
Any way, if the aim of tax basis on VAT system is vast and the tax rates have no
differences , the degree of neutralization of VAT will be greater.


6-4 Increase of economic growth


In Majority of developed countries, value added tax system is a substitute of the tax
on consumption and other taxes, especially company tax. By using the VAT , it is
expected that this substitution make an positive effects on production and economic
growth. Now, the question is, if in a certain economy this kind of taxation, introduced
for the first time and the aim of using it be achieving to the increase of government
income from taxation, is this expectation be valid ? In fact, the effects of VAT on
economic growth depend on the design and especially the aim of substituting it for the
other methods of taxation, and it can't be foreseen from the beginning.


6-5 The efficiency of economy


In relation of the VAT on economy efficiency, some of the economist believes that
due to the fact that value added is calculated from the following equation, using this
kind of taxation system doesn't work against none of the production factors. And thus
it increases the economic efficiency.

Value added = wages + interest + rent + profit


6-6- Balance of payments


On of the indirect effect of VAT, is the positive effect of it on the balance of
payments of the VAT user country. It is obvious that this conclusion can be made,
when the VAT cause a change on the relative prices of importing commodities than
on exporting commodities; in other word if after using VAT , the exporting goods
prices become cheaper and the importing goods prices become expensive or
unchanged, then we can hope that the balance of payment will be improve. As in this
case, we can't expect any changes on foreign exchange rates and the only possible
change will be from using VAT. This conclusion depends on many factors, although ,
it is possible that the experience of some countries prove this positive effects of VAT
on balance of payment, but it's theoretical base doesn't prove it as a definite result in a
certain direction.



6-7 The enlargement of public sector


Some of the critics believed that using the VAT will cause the enlargement of public
sector and the power of financial decision maker will be increase. According to this
critic , any decrease in government incomes can be substitute by increasing the tax
basis or tax rates. In addition , it is said that, the substitution of value added tax in
stead of taxes on limited tax basis, due to the largeness of tax basis, will be increase
the tax incomes. On the other hand, using the higher rate of taxes may be motivate the
producer to work more and by development of productions, the tax incomes of
government will be increases. On the other hand, due to the two side controlling
character of VAT system, the opportunities of tax evasion will be decrease. All the
above mentioned factors are reasons of increasing the government incomes and the
enlargement of public sectors.




Conclusion:


Value added tax is a kind of taxation on multiphase sales, which is calculated
on the base of a percentage of value added on each stage of production.
The VAT has three type : production, consumption and income. The
production type ( P-VAT), has the largest tax basis, and the consumption type
( C- VAT) has the smallest tax basis , many of the European countries as well
as other developed countries use this type of value added tax system. The
income type of VAT ( I-VAT) calculated on the basis of gross national
product.
Value added tax has it's own advantages and disadvantages. The advantages of
VAT are : the neutrality , the minimization of the opportunity of tax evasion,
the minimum negative effects on resource allocation, the facilitation of
entering in regional protocols, the ability of income generation for government
and etc..The disadvantages of VAT are: the diminution effect of VAT,
increasing the price level and the difficulties of implementation.
The VAT, has economical effects on macro and micro level; variables such as
efficiency, price level, balance of payment, investment, and saving .
The main reasons of using VAT by governments are : increasing the income
tax of governments, decreasing the tax screw on production and investment on
productive sector and also the increase of efficiency in taxation system.