VAT: A regressive tax

The Honourable Finance Minister has backed down on his decision to reduce VAT. Apparently this was to ensure disbursement of the IMF's tranches of Extended Credit Facility (ECF). In the words of the Honourable Finance Minister (as reported in the media), "We are not going to reduce the existing VAT rate. IMF feared that the rate would be cut. They set condition not to reduce it for releasing two tranches of ECF (Extended Credit Facility)." So, the current rate of 15% will stay.

There is almost unanimity among academic researchers and tax specialists that VAT is regressive; its incidence falls more on lower income group than on households in higher income brackets. That is, VAT hurts the poor disproportionately more than the rich. This is precisely the reason why VAT is not uniformly rated. Countries attempt to reduce the impact of VAT on the lower income groups by either exempting goods and services consumed mostly by them from VAT or having lower rates for these goods and services.

To address the problem of regressivity, food-stuffs that are typically consumed by the poor such as rice, lentils et cetera, are exempted in Bangladesh. At the same time, "supplementary duty" at a higher rate on certain luxurious and socially undesirable items seems to make the VAT system more equitable.

However, a 2010 study of UK tax system shows that VAT cannot be made progressive even with exemptions and differential rates. The study finds that "the poorest 20% of households in the UK have both the highest overall tax burden of any quintile and the highest VAT burden. That VAT burden at 12.1% of their income is more than double that paid by the top quintile, where the VAT burden is 5.9% of income. VAT is, therefore, regressive."

The IMF normally prefers a uniformly rated tax on the ground that differential ratings make the VAT system complicated and hence increases administration costs. For example, according to an IMF study in 1991, the total VAT collection, as a percentage of total tax revenue, was only 24% in Turkey. To achieve progressivity, half of it was given back as rebate to the lower income groups through a cumbersome mechanism that required monthly representation of receipts, their verifications, huge bureaucracy and a very high compliance cost.

In addition to administrative complexity (and hence increased administrative and compliance costs) as well as the possibility of court's involvement on questions of interpretation, exemptions and differential rates distort consumer and producer choices. Thus, it is argued that the advantage of progressivity gained by a whole host of exemptions, zero rating and multiple rates do not offset the disadvantages associated with the departure from an uniform or single rate and comprehensive base.

One may recall that VAT was introduced in Bangladesh in 1991 as part of the liberalisation programme backed by the IMF and the World Bank. Incidentally, it is also the period from when inequality in Bangladesh began to rise. The common measure of income inequality, the Gini coefficient, which remained more or less stable at around 0.37 since the 1970s until the late 1980s, rose to 0.46 by 2010. One wonders to what extent it was caused by the introduction of VAT.

If VAT is found to have contributed to the rise in inequality, the Honourable Finance Minister's decision has missed an opportunity to address the issue. VAT must be understood to be regressive and it should be replaced more and more by direct tax with a higher threshold, as it would be a more progressive setup.

Countries should be careful in following the advice of the IMF. It does not have a very good track record. Recall how it mismanaged the Indonesian economy when it was hit by the Asian financial crisis in 1997-98. It managed to recover only when it exited the IMF programme. Malaysia saved itself from the same fate as Indonesia by imposing restrictions on capital account against the advice of the IMF. Argentina, Brazil, and Turkey all have had the same experience – they were able to overcome their economic problems and began to grow at respectable rates only after saying 'good-bye' to the IMF programme.

The IMF not only failed to caution the countries of the impending global financial crisis in 2008, it in fact projected a rosy outlook! Its advice of premature fiscal consolidation in 2010 has been responsible for the abortive global recovery; Europe is still struggling to come out of the crisis.

The running record of the World Bank or the ADB is not much better. When Singapore was forced to leave the Malaysian Federation in 1965, the World Bank advised against its export-oriented development policy. We all now know the result of Singapore's defiance.

One needs to keep in mind that the IMF, World Bank, and ADB are lenders. Their survival depends on the profit they earn from the lending they make to developing countries. So, it is not to their interest that the borrowing countries become completely free of debt. They are happy to maintain the lifeline; but not when developing countries are completely out of the woods.

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Anis Chowdhury, is a former Professor of Economics from the University of Western Sydney, Australia.