The Allure of the Value-Added Tax

• Author: Liam Ebrill, Michael Keen, Jean-Paul Bodin, and Victoria Summers
• Position: Assistant Director in the IMF's Policy Development and Review Department/Advisor/Deputy Division Chiefs in the IMF's Fiscal Affairs Department

The VAT began life in the more developed countries of Europe and Latin America but, over the past 25 years, has been adopted by a vast number of developing and transition countries. A recent IMF study concludes that the VAT can be a good way to raise resources and modernize the overall tax system-but this requires that the tax be well designed and implemented

The rapid rise of the value-added tax (VAT) was the most dramatic-and probably most important-development in taxation in the latter part of the twentieth century, and it still continues. Forty years ago, the tax was barely known outside theoretical discussions and treatises. Today, it is a key component of the tax system in over 120 countries, raising about one-fourth of the world's tax revenue.

What is the VAT? It is a tax levied on all sales of commodities at every stage of production. Its defining feature is that it credits taxes paid by enterprises on their material inputs against the taxes they must levy on their own sales. Unlike a retail sales tax-under which tax is collected only at the point of sale to the final consumer-revenue is collected throughout the production process. Unlike a simple turnover tax-which levies tax on all sales, intermediate or final-producers can reclaim the tax they have been charged on their inputs. Because the VAT does not affect the prices firms ultimately pay for inputs, it does not distort production decisions and does not create "cascading"-the "tax on tax" that arises when tax is charged both on an input into some process and on the output of that same process. This also makes the effects of the VAT transparent. All firms whose annual turnover exceeds a specified threshold must participate-not only those involved in making final sales to consumers. But, in the end, only the net value of those final sales forms the base of the tax so that the VAT-if it is functioning as intended-is thus a tax on final consumption. While there are other ways in which one can try to tax consumption-such as a retail sales tax-the feature of the VAT that tax is collected throughout the production chain gives it a considerable practical advantage.

Suppose Firm A sells its output (assumed, to keep the example simple, to be produced using no material inputs) for a price of $100 (excluding tax) to Firm B, which in turn sells its output for $400 (again excluding tax) to final consumers. Assume now that there is a VAT with a 10 percent rate. Firm A will then charge Firm B $110, remitting $10 to the government in tax. Firm B will charge final consumers $440, remitting tax of $30: output tax of $40 less a credit for the $10 of tax charged on its inputs. The government thus collects a total of $40 in revenue. In its economic effects, the tax is thus equivalent to a 10 percent tax on final sales (there is no tax incentive, in particular, for Firm B to change its production methods or for the two firms to merge), but the method of its collection secures the revenue more effectively. If, for some reason, Firm A were to omit charging tax to Firm B, for example, the government would still collect $40 from B (which would have no credit to set against its output tax). If Firm B omitted charging tax, the government would at least collect the $10 from A. This last observation also illustrates a key advantage of the VAT over a retail sales tax, hinted at above. Imagine now that B is a retailer, and somehow manages to avoid paying any tax. Under the VAT, the government still has the $10 paid by A; under a retail sales tax, it has nothing.

Before the VAT's introduction, domestic indirect taxes were typically limited to narrowly defined products, such as alcohol and tobacco, and to sales and turnover taxes. Distortions associated with turnover taxes, combined with governments' need to increase their revenues-particularly, in many cases, to replace import tariff revenues lost as a consequence of trade liberalization-created an...