Value added tax, part 1
By CFAL Economic View
Nassau, The Bahamas
Much has been written in the press recently on the need for a new tax system in The Bahamas. Value added tax, or VAT, has emerged as the frontrunner to supplement or completely replace our system of customs duties.
In this first of a two-part article, we will examine why we need to change our tax regime in the first place, give an example of how VAT taxes work in practice and describe the basic structures that will be needed by both the government and private sector to make VAT work.
Next week we will highlight Barbados’ experience in moving to a VAT system in the late-1990s and continue with a discussion of the challenges and opportunities of moving to a similar system here in The Bahamas.
Finally, we will review other tax methods that can potentially raise government revenues and increase competitiveness for a key segment of our economy, financial services.
So why all the fuss over taxes? Quite simply, our government’s spending is outpacing our tax revenue by a greater and greater amount, especially since the recession of 2008. In other words, we have been running increasingly large government deficits and borrowing the difference. According to the Central Bank, our deficit has increased from $182m in fiscal year 2006/2007, hitting $361m in 2008/2009 and is now estimated to be over $550m for 2012/2013.
As former Central Bank governor and Minister of State for Finance James Smith remarked in a recent article, this revenue gap now appears “structural” in nature, meaning it will not correct itself on its own through normal reduced spending or increased collection of the existing taxes on the books.
What ultimately is needed is a concerted effort to either cut public spending, raise more revenue or some combination of the two. Both Moody’s and the International Monetary Fund (IMF) have warned that our growing financial deficit at approximately 4.7 percent of GDP is unsustainable. Central Bank statistics show that government debt has ballooned from $3 billion in 2007, or about 31 percent of GDP, to over $4.3 billion in 2011, or 53 percent of GDP.
Studies have shown that as debt approaches 60 percent of GDP, the need to service that debt and pay the interest begins to slow the growth rate of the economy. With official unemployment at almost 16 percent and over 40,000 people unemployed, the last thing The Bahamas needs is to have its already anemic growth rate slow even further.
So what is wrong with our current tax system based on customs duties? Most obviously, it is not providing the government with the revenue it needs to support current expenditure (of course, this could also be framed as a government spending problem – more on this next week). According to the CIA World Factbook, The Bahamas ranks 167th out of 210 countries in terms of tax revenues paid to the government as a percentage of GDP.
Our government takes in about 19 percent in taxes versus the global average of 29 percent. By comparison, Jamaica takes 27 percent, Barbados 28 percent, Trinidad & Tobago 34 percent, Canada 39 percent, Brazil 40 percent and most of Europe between 40 percent and 60 percent. The United States, with the largest economy in the world, takes a tax haul of 15 percent of GDP, highlighting the “fiscal space” it still has to address in contrast to Europe which is looking increasingly “maxed out”. It is clear that we are lightly-taxed in this country by global standards.
Secondly, by putting most of the tax burden on imports, our tax base is fairly narrow and completely leaves out our dominant service-based economy. It also requires merchants to pay their taxes upfront, prior to making the final sale to consumers, thereby tying up capital unnecessarily.
Therefore, if we can broaden the tax base we can tax everyone at a lower rate and still provide the government with the revenue it needs to help balance the books and even start paying down its debt.
A final reason for changing our tax system is the fact that The Bahamas has entered into a number of international trade agreements, including the Economic Partnership Agreement, or EPA, with Europe. Moreover, the current administration continues to work towards full membership for The Bahamas in the World Trade Organization, or WTO. Our high rates of duties will most likely be viewed as a barrier to trade by these bodies, forcing us to either reduce them or eliminate those tariffs completely. So the clock is already ticking – The Bahamas’ EPA obligations with Europe require us to reduce tariffs on EU imports by 2014.
What is VAT?
So what exactly is a value added tax? VAT is a consumption-based tax, much like a sales tax, but it is collected “in pieces” along the production chain. It is estimated that over 70 percent of the world’s population live in countries which apply VAT.
Unlike customs duties, it is applied on all sales, including goods and services. VAT tax rates generally vary between 10 percent and 20 percent and the final rate selected for The Bahamas would depend on how much revenue needs to be raised to replace other taxes as well as to close the deficits mentioned earlier.
Let us look at an example of how VAT actually works, taken from The Atlantic Magazine, May 2010. Consider a loaf of bread you buy in a grocery store for a dollar. You have a farmer, a baker, and a supermarket along the production chain. Finally, let’s set the VAT rate at 10 percent:
1. The farmer grows the wheat and sells it to the baker for 20 cents. The VAT is two cents. The baker pays the farmer 22 cents, and the farmer sends two cents in VAT to the government.
2. The baker makes a loaf and sells it to the supermarket for 60 cents. The VAT is six cents. The supermarket pays the baker 66 cents, of which six cents is VAT. The baker sends the government four cents, which is the six cents in VAT on the bread sale less a two cent credit from the government for the VAT he paid when he bought the wheat.
3. The store sells the loaf to me for a dollar which costs me $1.10, including tax. The store sends the government four cents total – the 10 cents it collected in VAT on its sales, minus the six cents it paid to the baker in VAT, which it gets back in a credit. In total, the government gets two cents from the farmer, four cents from baker, and four cents from the store. That equals 10 cents on a final sale of a dollar for a 10 percent VAT.
If that sounds overly complicated, you might be asking yourself why not simply add a sales tax on the final transaction? Believe it or not, it is easier to collect VAT than a sales tax because of these various stages and built-in paperwork along the chain.
A retail sales tax would have been very easy to avoid because there’s no counterparty to the transaction besides the end consumer.
Look at the baker in the VAT. The baker may want to avoid paying the VAT to the government but he knows the grocery store will report the purchase in order to claim its VAT credit. If it is paying attention, the government should be able to go to the baker and say “you forgot to report your 60 cents of sales and six cents of VAT which you owe”.
That mechanism represents the system of checks and balances within the VAT system. A lot of research suggests that sales taxes are difficult to enforce when you get to rates above six to 10 percent because people find ways around them, such as under-invoicing or unreported cash sales that occur under the table.
From the example above, it is clear that the introduction of a VAT system will require significant changes on the part of the government, as well as from the private sector, which would be forced to assume the role of tax collector.
Government would need to address organizational issues such as setting up a separate VAT or Tax Office, staffing requirements and training, deciding how much lead-in time is necessary and informing the general public of the transition.
Companies involved with VAT administration will face significant invoicing and bookkeeping requirements, will have to coordinate filing and payment requirements and will ultimately be subject to VAT audits, refunds and penalties.
Next week we will look at the Barbados experience with implementing VAT and the lessons learned for The Bahamas. We will also make the argument for why a modest corporate tax should be included in the discussion.
• CFAL is a sister company of The Nassau Guardian under the AF Holdings Ltd. umbrella. CFAL provides investment management, research, brokerage and pension services. For comments, please contact CFAL at: firstname.lastname@example.org
Jul 04, 2012