Public services, developing countries and VAT

Most countries do not apply VAT to goods and services supplied by public sector bodies (including governments). The main reasons seem to be concerns about social and distributional issues.
Surprisingly little effort has been made to assess the distortions and compliance, and administrative costs that may arise from these provisions. While nonprofit and charitable activities are seldom critical issues in developing and transitional countries, these countries too are frequently concerned about impeding further development of these sectors.

Moreover, the role of the state sector is often critical in such countries. Some European countries also have rebate systems that compensate public bodies for input VAT paid to make exempt or nontaxable supplies. In the EU, activities of public sector bodies in education and health are exempt while other activities of public sector bodies in their role as public authorities are nontaxable. An example is a local government that collects refuse. Both nontaxable and exempt activities are considered outside the scope of the VAT in the EU, although derogation of nontaxable status is possible in the event of a significant distortion of competition.

The VAT refund schemes for public bodies on the other side, could be justified in the specific context of refuse collection apply generally to nontaxable or exempt activities of local governments. The main aim is to compensate suppliers for VAT paid on inputs in order to level the playing field between government and private sector supplies. Although we do not have information on the specific refund rates, it seems likely that they are usually less than 100% and vary by activity.

The Netherlands provides refunds for VAT incurred in the Netherlands or in other EU member states.

With the exception of the UK refund scheme, which is funded by the central government, all these schemes in effect require local authorities to pay for most refunds through reduced grants by the central government since increased VAT receipts are reportedly insufficient to pay for the refund schemes. Local public bodies may thus have to increase local property taxes or other local levies while central governments receive a small windfall.

A possible modification would be to permit some degree of departure from a pure exemption system, for example, by including goods and services that are otherwise outside the scope of VAT in the scope of the tax or by converting exempt goods and services into taxable or zero-rated goods and services. A variant would be to tax explicit fees charged for public sector outputs.

This approach seems especially appropriate in cases when the fee represents the full consideration and is therefore equal to the market value of the supply, as is sometimes the case when goods and services compete directly with those supplied by the private sector (e.g., municipal golf courses in some countries).

In reality, however, it appears to be not conceptual but political difficulties that block action in the EU. Developing countries do not carry the specific political baggage of the EU.

But they too are unlikely to follow the Australian and New Zealand examples, for both political and administrative reasons. Problems other than the proper treatment of the public-sector loom larger on the VAT policy horizon of most such countries.

Nonetheless, more thought should be given to this question in countries such as Egypt and other present and prospective VAT countries in the Middle East and elsewhere in which the state sector constitutes a major component of the formal economy and hence of the potential VAT tax base.

For example, the 100% rebate to municipalities under the Canadian system is equivalent to zero-rating. Zero-rating is consistent with full taxation in the case of public services supplied for nil or nominal consideration. But zero-rating is unlikely to be sensible in the context of most developing and transitional countries.

First, it reduces revenue.

Second, neutrality is violated if private goods supplied by public bodies are zero-rated while private goods supplied by the private sector are not.

Third, choice between taxable and zero-rated goods is also distorted.

Fourth, complexity costs are increased since rules defining the goods and services to be zero-rated must be designed and their implementation monitored.

Finally, to reduce the refund problems, developing countries should avoid any domestic zero-rating if at all possible.

Should countries without well-developed and sophisticated tax administrations consider following similar paths?

Once VAT becomes well established, could be that in some instances they should perhaps do so. No country is given a good VAT administration. It must grow one over a (sometimes) long period. Much the same is true with respect to growing a taxpayer base that makes the essentially self-assessed VAT a feasible revenue source for any country. No tradition of voluntary compliance exists in most developing and transitional countries, tax morale is low or nonexistent, and self-assessment is essentially an alien concept.

The illiteracy of small traders, widespread under reporting of tax liabilities, weaknesses in tax administration, and lack of taxpayer service compound the problem.

On the whole, countries seem well advised not to build the ideal system for their circumstances but rather to combine off-the-shelf software in ways that fit their particular circumstances.