One of the cardinal virtues of tax is its neutrality towards investment and consumption decisions. That is according to the theory. The theory is in consonance with what has been known all along as Laissez Faire. The extreme exposition of this theory was by David Henry Thoreau who famously said, “That Government is best which governs not at all”. This theory of abolitionism has now largely been replaced by dirigisme. In recent times private risk taking run amok has plunged much of the capitalist world into worst recession in decades. Partly in response to this, the governments have explored ambitious and new ways to expand the government's responsibilities which has now brought dirigisme to limelight. Dirigisme is the principle where the government exerts strong directive influence. To that extent the neutrality of VAT has receded.
In theory a tax is neutral if it is neutral between (a) labour and capital (b) choices for consumers and (c) allocations of resources. It should not cause distortion in consumer choice or investorsRs choice or savingsRs choice. It should not favour capital intensive against labour intensive investments. In general it should not distort the free play of market. Neutrality of tax actually amounts to opposite of tax subsidy or tax incentives. A neutral tax, for example, taxes all assets or savings identically. A neutral tax is one, which raises revenue in the least distortionary manner possible. The choice of investment is made not with reference to the tax burden but on the basic consideration of efficiency and profitability. VAT is claimed to be the most neutral tax compared to others. But by itself VAT is not a fully neutral tax in its basic design. Its neutrality is not so real because it does not tax capital and labour equally. While it gives credit for tax paid on capital, it does not do so for labour expenses (Weidenbaum-VAT Orthodoxy and Rethinking p 82). The choice of consumption (the choice between bought and un-bought) and the choice of investment (where and on what to invest) is severely compromised if there are exemptions. VAT ceases to be neutral when there are exemptions. (Tait p. 221 VAT-International Practice and Problems ,1988 edition, and Hemming and Kay in VAT –Lessons from Europe). In respect of the allocation of resources distortion takes place, for example, in the shifting from more capital intensive to more labour intensive venture if the tax is not neutral but favours one against the other.
So we find that even theoretically VAT is not fully neutral. What is established is also that VAT becomes non-neutral sometimes in developed countries as well and definitely so in developing countries. According to the Institute of Fiscal Studies in London, the tax system in the UK is not neutral. After the second World War the tax policy was designed to promote building houses and even in the normal times now there are numerous exemptions in developed countries.
The USA does not have a VAT but its tax policy is blatantly non-neutral in regard to anti-dumping duties. The one on steel was found by the WTO as unjustified because it was imposed only to product the steel industry against the permissible norms.
In India the proactive policy of the Government in giving enormous number of exemptions not only promotes certain type of industries, discourage certain others but even reallocates industries to underdeveloped States by exemptions suitable for the purpose. Taxation is being used as diversionary instrument in several ways such as, discouraging consumption of particular commodities, promotion of use of some factors of production vis-a-vis others, influencing the methods of production by varying the input costs, encouraging certain scales of production etc. Thus dirigisme has taken a complete toll on the neutrality of VAT. Whether it is desirable is another question.
The conclusion is that although VAT is superior to turnover tax in respect of neutrality, it is not universally neutral in theory and in any case not in practice due to the dirigisme that features prominently now in economic policies all over the world and particularly in the developing countries.
