The Value Added Tax has become one of the most important instruments of revenue mobilisation in the developing world. A recent and growing body of research highlights its strengths and some of the challenges it faces.
Today, Value Added Taxes (VAT) exist in more than 160 countries, including in many developing countries that have modernised their tax systems in the past decades. Eighty percent of countries in sub-Saharan Africa have adopted the VAT, and it is now responsible for typically raising around one-quarter of all tax revenue (Keen, 2016). Moreover, countries continue to adapt and reform their VAT systems, sometimes substantially, such as India and Ghana did in 2017.
In principle, a VAT has several advantages compared to other tax instruments prevalent in developing countries, which arguably explains its widespread adoption around the world. It is seen as superior to an import tax or a turnover tax in terms of ‘production efficiency’ (Keen, 2016). This means it can avoid the typical distortions to firms’ production decisions caused by these tax instruments. It is also seen as superior to a retail sales tax in terms of revenue mobilisation (Kopczuk and Slemrod, 2006), as it features compliance incentives for business-to-business transactions (B2B), and can generate revenue earlier in the supply chain, even if retailers fully evade their tax liabilities.
Until recently, there was limited empirical work using administrative microdata on the functioning of the VAT in developing countries. Yet in the last few years, there has been an exciting and rapidly growing body of empirical research on tax policy in developing countries using data from detailed tax records. This is attributable, in part, to the information and communications technology (ICT) revolution, which has led to substantial improvements in data availability and quality.
This brief discusses lessons from several of these studies, which have shed new light on the strengths and weaknesses of VAT systems. It also highlights important topics that could benefit from better evidence.
- VAT systems incentivise accurate reporting on B2B transactions, but evasion and administration challenges still exist. VATs aid revenue mobilisation, as they create incentives for firms to report accurate information in B2B transactions. But they still present opportunities for evasion, production inefficiencies, and administrative difficulties.
- VAT administration faces a last-mile problem. Retailers often fail to report sales to final consumers. This non-compliance could be transmitted upstream along the supply chain, hampering revenue mobilisation. Several countries have introduced policies incentivising consumers to ask for receipts to improve compliance at the last-mile.
- ICTs present enforcement opportunities to strengthen VAT systems but also new challenges. Electronic filing and receipts provide new enforcement opportunities to strengthen VAT systems, but collecting detailed receipt data creates new tax administration and data management challenges.
- Exemptions in VAT systems can negatively affect supply chains and revenue mobilisation. VAT systems where all firms must register would be costly to enforce and comply with. However, exemptions can weaken VAT compliance and distort firms’ choices along the supply chain.