Sukumar Mukhopadhyay: VAT and the neutrality of tax

Is VAT really a neutral tax? And does India need one?

One of the reasons theoreticians claim Value Added Tax (VAT) is a better consumption tax is that it is supposed to be a neutral tax. But opinion on this is hardly unanimous. In fact, there is every reason to doubt if VAT is all that neutral and whether neutrality of tax is desirable in any case.

In theory, a tax is neutral if it is neutral between (a) between labour and capital; (b) choices for consumers; and (c) different allocations of resources. In general it should not distort the free play of market.

According to Neutrality in the Taxation of Savings published by the Institute of Fiscal Studies, London, tax neutrality amounts to the opposite of tax subsidy or tax incentives.

A neutral tax is one that raises revenue in the least distortionary manner possible. It minimises the impact of the tax structure on the economic behaviour of the agents in the economy.

Those who are against the neutrality of tax argue that a non-neutral tax is necessary to promote wider political, economic and social good.

For example, the extraordinary post-war growth of home ownership in the UK must be partly due to the commitment of successive governments to offer tax-based incentives to encourage mortgage borrowing for owner-occupied housing.

Theoretically there can be a completely neutral tax but in reality a non-distortionary tax system is not completely attainable, said Joseph Stiglitz.

Nor is a neutral tax measurable because the effects of taxation are never completely clear or predictable. If a tax rate is reduced, there can be two contrary effects. On one hand, the substitution (or incentive) effect is to increase savings as the net return from investment increases.

On the other hand, people have to save less to hit a particular level of saving for future consumption. This is the income effect. The substitution effect and income effect work in opposite directions. Prima facie we cannot say which of these effects will dominate.

Now we will examine whether VAT is really a neutral tax. Regarding the choice between labour and capital, VAT is not neutral because it does not tax capital and labour equally.

As M L Weidenbaum has pointed out, while it gives credit for tax paid on capital it does not do so for labour expenses. (VAT Orthodoxy and Rethinking).

On the consumption side a neutral tax does not distort consumer choice. It means that a general VAT that does not distinguish between all goods and services leaves consumers with the choices of unbought (so untaxed) and bought (so taxed) equally.

This is true only in the case of general VAT, which hardly exists. It ceases to be neutral when there are exemptions. In any case, the neutrality between bought and unbought goods is an ephemeral concept that can satisfy a philosopher but hardly a consumer.

Regarding the allocation of resources, the Canadian government's Royal Commission of Taxation says that distortion takes place, for example, in the shifting from more capital intensive to more labour intensive ventures if the tax is not neutral (volume II).

But this could be true only if the VAT is levied "at a uniform rate on the entire consumption base" (Weidenbaum).

Usually there are multiple rates if we take into account the exempted rates, as in Belgium, Canada, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, UK and many more. The same Royal Commission report points out that exemptions distort the allocation of resources.

The next and more fundamental question is whether a neutral fiscal policy is desirable in a developing country.

James Cutt (Taxation and Economic Development in India) has argued that "the principle of neutrality, whereby the tax system seeks to avoid interference in private allocation of resources, is defensible is a developed economy but is of little relevance to the problem of economic development".

F G Reuss has pointed out that a tax policy should not be neutral but diversionary and pro-active towards development by incentives and disincentives to a desired degree (Fiscal Policy for Growth Without Inflation) until the economy is strong enough to rely more on the free market.

Efficiency in resource allocation and by extension the neutrality advantage of VAT cannot be attained if prices continued to be controlled by the government and enterprises continue to be subject to proactive fiscal direction, wrote Sijbren Cnossen in his article in VAT Monitor in November, 1992. India is certainly not the proper field for the neutral game.

(The writer is former member, Central Board of Excise and Customs)