VAT for non-governmental organizations?

The key problem is to balance the objective of applying taxation to the non-governmental organizations (NGO) sector as a source of revenue with the prevention of distortions that arise under the exemption system. Revenue-short countries should in principle apply VAT as widely as possible to goods and services provided by both public-sector bodies and nonprofit organizations and charities. In doing so, however, they should also avoid multiple rates, nonstandard exemptions, and excessive zero-rating. To implement such advice successfully, countries may employ any of the approaches set out earlier in this section. In practice, however, approaches like exemptions with rebates and zero-rating that create (rather than resolve) complexities are unpromising.

At present the NGO sector is treated in many different ways by VAT regimes around the world. As is true for any sector under a VAT, the goods and services supplied by the PNC sector may fall into one of four categories:

Taxable. Seller is entitled to a refund of the VAT incurred on input purchases undertaken to make taxable sales (supplies in the usual language of the law).

Zero-rated. Even though the seller does not collect VAT on zero-rated supplies, it is nonetheless entitled to a refund of the VAT incurred on input purchases. (Under the usual destination-based VAT system, exported supplies are zero-rated.)

Exempt. Seller also does not collect tax when making an exempt supply. In contrast to the zero-rated case, however, it is not entitled to a refund of the VAT incurred on input purchases undertaken to make exempt supplies.

Nontaxable. The economic effects of being outside the scope of the VAT and hence nontaxable are the same as for exempt supplies.

In all countries much NGO activity is exempt under one label or another.

In addition, in some countries special VAT refund schemes may apply to certain parts of the NGO sector (the redistribution of income and wealth, the provision of public goods and services, and the provision of goods and services that are similar to those supplied by the private sector).

Redistribution is a transfer and does not in itself create value added, although organizations involved in transfers inevitably incur some VAT on inputs. Although it is often feasible to measure consumption and to charge prices for such services as health care and education, whether provided by a public agency or otherwise, it is generally considered socially undesirable to do so presumably (though sometimes tenuously) on externality grounds or for distributional reasons.

Many NGO activities are essentially similar to those of the private sector, electric and water utilities, postal services, radio and television broadcasting, organizing trade shows, providing recreation facilities, and so on. Even in these cases, however, many outputs are exempt, either for distributional reasons or sometimes because they are considered hard to tax for a variety of conceptual, compliance, and administrative reasons.

In principle, it is wrong to treat the NGO sector as the final consumer of the goods and services it provides simply because it provides such services for free (or below cost). As with any exempt activity, some revenue is generated from inputs purchased by registered traders along the supply chain, but the revenue that would have been obtained from final sales (to nonregistered traders and consumers) is of course lost.

Two distortions result. First, because the effective tax rate is lower than on other activities, demand patterns are influenced. Second, at the same time cascading the charging of tax on tax (or multiple taxation of the same value-added) may occur if downstream firms using exempt services increase prices to cover the cost increase due to the tax. Input choices are distorted because the exemption of components used as inputs makes VAT on some intermediate inputs irrecoverable. Producers further along the chain have an incentive to substitute away from those inputs. The net effect on revenue depends on the stage at which the exemption occurs. A particularly interesting example in the case of many developing countries is the common exemption from VAT of goods financed by international aid to developing countries, which both costs the country revenue and distorts the pattern of economic activities.

If the current exemption system for the NGO sector is unappealing, two alternatives may be considered: one might modify the exemption system or replace it. One modification that might be considered in other countries would be to adopt what Gendron (2005) calls the Canadian system. In this approach, all supplies made by organizations in the NGO sector are within the scope of the VAT.

However, some services are taxable, some are exempt, and some are zero-rated. Input taxes that such organizations incur to deliver taxable or zero-rated supplies are fully creditable. However, in the case of exempt supplies the Canadian VATs depart from the pure exemption model by granting rebates in whole or part of tax paid on inputs used to make exempt supplies.

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.

In practice, the EU regime for the NGO sector is highly complex and has given rise to conflicts between community law and national law as well as the occasional court case.

Life is of course never quite this simple. For example, in Australia special rules apply to charities, gift-deductible entities, and government schools. To get the flavour of the way real-life VAT law often reads it may be worth spelling out these rules a bit. For example, sales of donated second-hand goods, raffles and bingos, and noncommercial sales of goods or services by these organizations are GST-free (zero-rated) if the amount charged for the good or service is less than 50% of the market value or less than 75% of the amount the organization paid for the goods or services. However, if they so choose, these organizations may also simplify their lives (if perhaps complicating those of their prospective customers and competitors) by electing to make sales at a fundraising event input taxed (exempt). Similarly, noncommercial supplies of accommodation are also zero-rated if the amount charged is less than75%of the market value or less than 75% of the cost to the organization of providing the accommodation.

In such conditions, when might it make sense to extend VAT to the NGO sector?

Experience suggests to many that one key to VAT sustainability in developing and transitional countries is to do it right, right away.

But does this mean beginning with full taxation of NGO?

We think not. With respect to financial services taxation (see tomorrow discussion), beginners are best advised to stick to tried and proven approaches.

To implement such advice successfully, countries may employ any of the approaches set out earlier in this section. In practice, however, approaches like exemptions with rebates and zero-rating that create (rather than resolve) complexities are unpromising.

Developing or transitional economies that wish to move in the direction of a better VAT would seem best advised to begin simply by taxing user fees for NGO services, and then perhaps gradually move in the direction of what we have called the Canadian system.

Those that are able and willing to do more or that do not yet have a VAT in place might be best advised to consider the Australian-New Zealand approach. These countries do not have a perfect system, but it is probably about as close as any country is likely to get in practice.