The ABCs of VAT

Since the 1990s, Egypt’s government, international financial institutions such as the International Monetary Fund and many independent economists have pushed for Egypt to adopt a value-added tax, or VAT for short.

While the interim government had been promising an impending draft law, putting VAT back in the headlines, it is unclear where the decision stands now after the Cabinet’s resignation on Monday. VAT is already in place in more than 140 countries, with the notable exception of the United States and member states of the Gulf Cooperation Council.

But what is VAT, how would it affect ordinary Egyptians, and is the switch a prudent move at a time of economic crisis?

What is a value-added tax and how is it different from Egypt’s current sales tax?

A VAT is more or less what it sounds like: A consumption tax based on the “value added” at each stage of production. In principal, this is not very different from Egypt’s existing general sales tax, which was introduced in 1991. Under existing legislation, most goods are subject to a 10 percent tax at each stage in the supply chain.

Imagine a very simplified production chain for a cotton T-shirt:

  • Stage 1: A farmer produces one unit of cotton, and sells it to a textile mill for LE9. At this stage of production, no sales tax is paid, since raw agricultural products are tax exempt.
  • Net gain for Tax Authority: LE0
  • Stage 2: The textile mill weaves the cotton into a length of cloth, which it sells to a garment factory for LE10, plus LE1 in sales tax, which it collects from the garment factory and pays to the Tax Authority.
  • Net gain for Tax Authority: LE1

  • Stage 3: The garment factory uses the fabric to manufacture a T-shirt, which it sells to a clothing store for LE15, plus a tax of LE1.5. The garment factory is responsible for passing this LE1.5 to the government, but it is also allowed to claim LE1 credit for the tax paid when it bought the fabric from the textile mill.
  • Net gain for Tax Authority: LE0.50

  • Stage 4: The clothing store sells the T-shirt to its customers for LE20, plus a LE2 sales tax, bringing the final consumer price to LE22. The store is responsible for remitting this LE2 to the Tax Authority, but can claim LE1.5 in credit for the tax paid in stage 3.
  • Net gain for Tax Authority: LE0.50

At each stage of production, the burden of the tax is borne by the purchaser. However, the companies involved are entitled to a credit for the tax they pay, neutralizing the effect of the tax for businesses. The consumer does not get a tax rebate, so the entire tax — LE2 in our example — ultimately comes out of his or her pocket.

A value-added tax would function in almost exactly the same way, with a few crucial differences. Most importantly, if the tax rate increases — reports from the government suggest that the rate could go up to 12 percent — consumers will be paying more, LE22.40 for a T-shirt instead of LE22. A VAT would also likely make more services taxable. At present, only 17 categories of services are taxed, including telecommunications, tourist services and private security.

Even if the tax rate remains at 10 percent, switching to VAT would cause some noticeable changes, explains Alaa Mahdy, senior tax consultant at accounting firm Hesham al-Tohamy.

First of all, a comprehensive VAT with a unified rate would greatly simplify the sales tax structure, which over the years has been modified in an ad hoc fashion to satisfy consumer and business demands.

At present, in addition to exemptions for things like basic food items and books, the tax code has a bewildering array of special tax rates. Cement and iron, for example, are taxed at 5 percent, mechanical pumps at 1.2 percent, while products considered luxury items, such as moisturizer or air conditioners, are taxed at 25 percent. Sugar lumps and sugar cubes have different tax rates, as does the same item in different packaging — water, for example.

“If your customer buys water in a bottle, there will be a 10 percent tax; if it’s sold from a truck, there is none,” Mahdy explains. “These different rates make companies confused.”

Even with the best of intentions, companies often pay their taxes incorrectly due to sheer confusion. And for those with bad intentions, the current tax scheme leaves plenty of room for evasion and fraud.

This sort of tax evasion and fraud has a huge impact on government revenues. Last year, Egypt collected roughly LE93 billion in taxes on goods and services. If, for argument’s sake, we assume 30 percent of economic activity happens completely outside of the tax system, and another 30 percent of businesses pay only half the sales tax they should, losses for last year alone would total nearly LE77 billion.

The most basic form of evasion, Mahdy explains, is when companies collect sales tax from their customers and pocket it as profit, never reporting it or passing it on to the government.

The current scheme of granting credit for taxes paid also leaves a lot of room for manipulation. Companies are allowed to claim cash rebates for the sales tax they have paid on goods they are unable to sell. If, for example, our clothing store claimed it could not sell any T-shirts, it could ask the Tax Authority to refund the LE1.5 paid in tax when it purchased each shirt from the garment factory. Then, it could sell the T-shirts off the books, pocketing the tax it collects from consumers. Short of inspecting the stock room of every store in the country, it’s nearly impossible for the government to police this kind of fraud.

In introducing VAT, the government would close this loophole by only granting credit for taxes paid when the company can produce invoices for both the purchase and sale of goods. This paper trail would also make it difficult for companies to engage in more complex fraud, such as creating false invoices to understate sale price and volume.

How will switching to VAT affect consumers?

This depends largely on the specific details of the VAT scheme imposed. If the tax rate remains at 10 percent, the same goods and services taxed, and the same types of businesses in the tax system, there will be little effect on the typical consumer.

However, if the rate goes up to 11 or 12 percent, or if additional services are taxed, the cost of living will increase. Likewise, if the imposition of a VAT is accompanied by a strong push to bring small and informal businesses into the tax system, Egyptians may find themselves paying consumption taxes for transactions that currently happen completely outside the system, such as purchases from street vendors.

Egypt’s informal sector is estimated to make up around 30 percent of the economy, with countless businesses and vendors unregistered and, in turn, not officially liable to the government in any way.

How will switching to VAT affect businesses?

Companies do not actually pay VAT, consumers do, so a change in rates should not, in theory, affect businesses directly. In many cases, when countries switch from sales tax to VAT, the cost of tax compliance rises for businesses. In Egypt, where companies at all stages of the chain of production are already required to process tax payments and credits, this may be less of an issue. In fact, simplifying the tax system could ultimately lead to savings, although it would require accountants and auditors to retrain.

A VAT should also make it more difficult for companies to evade taxes. VAT is often referred to as a “self-policing” system. Companies cannot get tax credits unless their suppliers and customers issue and file official invoices for all transactions, so they keep each other in line. (Or, alternatively, they are compelled to collude in more sophisticated forms of fraud).

Mostafa Bassiouny, an economist at the Signet Institute, a Cairo-based economic think tank, says, “It’s a more efficient system, but that assumes that Egyptians have strong accounting practices, which is not the case.”

How will switching to VAT affect the government?

This is a subject of some controversy. The current government is putting a lot of faith in VAT’s ability to increase tax revenues. The budget for the current financial year assumes revenue from taxes on goods and services will be around LE145 billion, up from around LE93 billion the previous year. So far, without a VAT, revenue is below expectation, at LE41.3 billion for the first half of the financial year, compared to LE44.8 billion in the same period in fiscal year 2012/13.

“It provides huge revenue for the government, and in a country like Egypt where we have a huge fiscal deficit that will be very helpful,” director of research at the Egyptian Center for Economic Studies, Omneya Helmy says.

There is no consensus among economists, however. Since VAT and sales tax differ only in the method of collection, simply switching to a new system may not bring in more money. To actually increase revenue, the government would have to raise taxes, either by taxing at a higher rate or by taxing more goods and services.

Doing so, notes Bassiouny, could quickly backfire by raising the cost of living and affect purchasing power, making Egyptians less able to buy consumer goods. Since consumer spending has been one of the few things keeping the economy limping along, anything that squeezes the public further could hurt the economy more than it helps.

“It will slow business,” says Bassiouny. “In general, with weak economic activity, it’s not advisable to raise taxes.”

What are the major arguments for and against VAT?

The primary arguments in favor of VAT are that it is transparent, efficient, relatively simple, effective at drawing companies into the tax system and can become a major revenue-raising mechanism for governments. This largely explains why the system has become so popular with governments around the world.

The most common argument against VAT is that it is regressive. The poor spend a larger percentage of their income on consumer goods than the wealthy, and thus are disproportionately burdened by VAT.

“The average family in Egypt spends half its income on food,” says Bassiouny, adding that the poorest spend even more. Many governments try to reduce the impact of VAT on the poor by exempting or setting a lower tax rate for essential goods and services. However, doing so reduces the efficiency and simplicity of the tax scheme, threatening to recreate the kind of patchwork, ad hoc system Egypt is trying to move away from.

Others counter that the state can balance out the regressive effects of the tax by spending the money collected on programs that benefit the poor, such as schools, healthcare and social benefits payments. This, of course, requires both political will and institutional capacity.

What should I pay attention to when the proposed VAT legislation comes out?

The most important variable is the tax rate. If it remains at 10 percent, the effects on both consumers and businesses may be slight, but an increase would cause an immediate rise in prices. Likewise, keep an eye on which goods and services are exempt from VAT or charged at a reduced rate.

Another important factor is the exemption threshold. Under the 1991 law, only businesses with annual sales of LE54,000 or more were required to register with the Tax Authority. That figure could move in either direction: Lower to bring more businesses into the tax system, or higher because the cost of monitoring and collecting taxes from small businesses can exceed the tax revenue they bring in.

Isabel Esterman 

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