Disadvantages of Value Added Tax (VAT)

1) VAT is regressive:

It is claimed that the tax is regressive, i.e its burden falls disproportionately on the poor since the poor are likely to spend more of their income than the relatively rich person. There is merit in this argument, particularly if it attempts to replace direct or indirect taxes with steep, progressive rates. However, observation from around the world and even Guyana has shown that steep tax rates lead to evasion, and in the case of income tax act as a disincentive to effort.

Further, there is now a tendency in most countries to reduce this progressivity of taxes as has been done in Guyana where a flat rate of income tax has been introduced. In any case VAT recognises and makes room for progressivity by applying no or low rates of tax on essential items such as food, clothes and medicine. In addition it allows for steep rates of tax on luxury items, although this can create problems for administration and open opportunities for evasion by way of deliberate misclassification, a problem incidentally not peculiar to VAT, and which takes place extensively in the area of customs duties.

2) VAT is too difficult to operate from the position of both the administration and business:

(a) The administration: It is often argued that VAT places a special burden on tax administration. However, it is worth noting that wherever VAT was introduced one of its effects was the rationalization and simplification of the previous indirect tax system and its administration. Each of the previous indirect taxes such as customs duties, purchase tax and excise duties replaced by VAT had its own rate structure as well as a different tax base and separate administrative procedure. The consolidation and incorporation of numerous indirect taxes into the VAT would simplify the rate structure, tax base, and administration of the indirect tax system, thereby eliminating the overlapping auditing practices that had plagued those systems.

In addition, the abolition of a number of alternative indirect taxes releases experienced personnel to focus on a single tax. It also means reduction in the number of forms used, legislation to be applied and returns and accounts with which the business person has to contend.

(b) Business: It is true that the VAT is collected from a larger number of firms than under any form of income tax or single state sales tax; to the typical smaller firms the complexities of the tax and the need for more extensive records (for example, to justify deductions) are likely to prove serious. However, it is often overlooked that businesses already function with considerable administrative responsibility for a number of laws including the National Insurance Act and the Income Tax Act.

Under the Income Tax (Accounts and Records) Regulations of 1980 every person, without exception is required to maintain detailed and extensive records of all its transactions. Compliance with this will certainly ensure compliance with VAT regulations, and since there is an actual benefit to be derived from accounting for VAT paid on input there is an incentive for proper record-keeping.

As we have noted before, VAT also allows for the exemption of small businesses from the system.

Under any form of sales taxation, small businesses have to be granted special treatment because of their inability to cope with the requirements of keeping adequate records which larger enterprises can handle at a reasonable cost. The intent of the special treatment is to reduce the administrative burden on small enterprises, but not the taxes that normally would be charged on the goods and services they supply. The revenue loss at the final link in the commercial cycle is limited only to the value added at that stage, whereas in the case of income tax or sales tax the entire tax is lost. To recover the loss from exemptions, a flat tax on turnover may be applied.

3. VAT is inflationary:

Some businessmen seize almost any opportunity to raise prices, and the introduction of VAT certainly offers such an opportunity. However, temporary price controls, a careful setting of the rate of VAT and the significance of the taxes they replace should generally ensure that there is no increase if any in the cost of living. To the extent that they lead to a reduction in income tax, any price increases may be offset by increases in take-home pay. In any case, any price consequence is one time only and prices should stabilise thereafter.

4. VAT favours the capital intensive firm:

It is also argued that VAT places a heavy direct impact of tax on the labour-intensive firm compared to the capital- intensive competitor, since the ratio of value added to selling price is greater for the former. This is a real problem for labour-intensive economies and industries.

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