Benefits and Disadvantages of Value-Added Tax

Value-added tax (VAT) is one of the world’s most successful and important tax systems. It raises about a fifth of all and is used by more than 160 countries.

VAT works by imposing a tax on every step in the production process, rather than on a single good at the end of the supply chain. This tax is designed simpler to administer and less prone to fraud than retail sales taxes, and the credit on input purchases makes it more likely that businesses will comply with the tax.

tax base is stable (VAT)

It’s less distorting of economic and growth performance. It also promotes savings and optimum labor supply decisions, which help to stimulate investment and growth.

The VAT also provides an incentive for companies to report their activities, which helps to reduce tax evasion. This is particularly the case when the VAT system is based on the principle of “self-reporting.”

Exemptions and zero or reduced rates (VAT)

Preferential tax treatment, cash subsidies to households, and offsets in other tax bases can lower gross VAT revenue. Those preferences can be particularly large for certain goods and services, which are more consumed by high-income and middle-income taxpayers than by low-income households. Nevertheless, these preferential policies do increase the overall progressivity of consumption taxes.

For example

If a country were to exclude from the tax base food consumed at home or private health expenditures, this would reduce revenue by more than 38 percent. This cut would decrease the yield ratio to 0.28.

In contrast, a country that offered preferential tax treatment on a wide variety of goods and services could raise the yield ratio to 1.05 percent. Using this approach, the government could raise a quarter of GDP in revenues without reducing regressivity.

Those benefits would off set (VAT)

However, the cost of narrowing the base is either through preferential treatment or by cash payments to households. This is because a narrower base would reduce other taxes and thus net business income. This reduction would lower other revenue and, therefore, the government’s net tax revenue. In addition, the cost of cash payments, if used to offset regressivity, would lower the overall revenue yield.

When a country imposes a VAT, it must balance its need for increased revenue with its desire to reduce the fiscal gap between public debt and GDP. To make this trade-off, policymakers must consider both the long-run fiscal implications of a new tax and the short-term economic effects.

The fiscal gap In turn, 

Is address through a combination of structural reforms that broaden the tax base and eliminate distortions in saving behavior? This is an approach that has been empirically tested in many countries and found to be both efficient and effective, producing substantial gains in efficiency and growth. READ MORE ABOUT THIS global tax revenue.

VAT is a time-tested policy

This a tool that can help to address the fiscal gap, and it should not be ignored. Nonetheless, the timing of a VAT should be carefully considered given the current financial and economic challenges. Instituting a new consumption tax during a weak recovery would be counterproductive.