The Hindu Business Line : The drag of a VAT on freefall

THERE is general belief amongst many economists that tax should be neutral. In theory a tax is neutral if it does not distort the free play of market. Neutrality of tax actually amounts to the opposite of tax subsidy or tax incentives.

A neutral tax, for example, taxes all assets or savings identically. For a truly neutral tax there are many supporters. It is favoured by those who believe that a neutral tax is good, because decisions to spend, invest, hire, fire, and borrow are not determined by tax advantages or disadvantages. A neutral tax raises revenue in the least distortionary manner possible.

However, opinion on this is not unanimous. In fact, there is every reason to doubt if VAT is all that neutral and if neutrality of tax is all that desirable. Those who are against tax neutrality argue that a non-neutral tax is necessary to promote wider political, economic and social goods.

Examples include extraordinary post-war growth of home ownership in the UK, which must have been partly due to the commitment of successive governments to offer tax-based incentives to encourage mortgage borrowing for owner-occupied housing (Institute of Fiscal Studies, London — Neutrality in the Taxation of Savings).

Is VAT truly neutral tax?

Neutrality of VAT depends much on its design. It can be neutral if it is made to apply equally to as broad a base as possible, including all goods and services, extend beyond the first point of sale and go as close as possible to consumers, not stopping at intermediate stages of trade, that is, going up to the retail stage (NIPFP — Report of a Study Team, 1994, Reform of Domestic Taxes in India).

That is to say, the design should be destination, and not origin, based (NIPFP Report, 1994). To the extent VAT is not designed as above, it will not be neutral. Regarding the choice between labour and capital, VAT is not neutral 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.

"Many observers consider VAT to be in essence, a tax on labour and therefore not neutral, for a deduction is allowed for capital acquisitions but not for labour expenses." (Murray L Weidenbaum — `Orthodoxy and Rethinking')

Although VAT is superior to turnover tax, it is not as universal or neutral as is often believed. Exemptions and reduced rates make serious inroads into the tax base (Sijbren Cnossen — `VAT, Lessons from Europe', edited by H. J. Aaron). It ceases to be neutral when there are many exemptions and exceptions and rates (Alan A Tait — VAT 1989. Also, Humming and Kay — `VAT, Lessons from Europe'). Zero rate (nil rate) VAT is universally applied to exports and lower rates or full exemption to food (Richard W. Lindholm — `Value Added Tax').

Should tax be neutral in a developing economy?

The next and more fundamental question is whether a neutral fiscal policy is at all desirable in a developing country. Some economists have held that an active policy of fiscal dirigisme or guidance, such as providing incentives to private sector saving and investment, would be a desirable fiscal policy in a developing economy.

Neutral tax policy for avoidance of interference with the allocation of resources is a principle in a developed economy (J. F. Due — `Government Finance, 1959'). A tax policy should not be neutral but diversionary and pro-active towards development by incentives and disincentives to a desired degree, that is, for dirigistic purposes until (F. G. Reuss — `Fiscal Policy for Growth without Inflation, 1963') possibly the economy is strong enough to rely more on free market. (Fiscal dirigism is from Finanz Dirigimus in German.)

Is tax neutral in developed countries?

Even in developed countries such as the UK and the US the tax system, which is a part of the general economic policy, is not always neutral, though theoretically it is regarded as the ideal to follow. According to the Institute of Fiscal Studies, London, the tax system in the UK is not neutral. So far as the US is concerned, there are many policies which are blatantly non-neutral.

The anti-dumping duties on steel imposed by the US were found by the WTO as unjustified. It was imposed only to protect the steel industry.

The US gives enough protection to agriculture. It resorts to quota system, which is a non-tax (non-tariff) barrier against import of textiles to the US. The WTO is, of course, forcing the abolition of such quotas in 2005. The US has debated seriously about the policy to regulate the outsourcing of information technology work to other countries. This is a raging controversy in that country.

Is neutrality suitable for India?

Neutrality may not be the correct policy for optimal allocation of resources for planned growth. In the context of planning, the role of taxation is more that of a diversionary instrument of economic growth (sometimes control) geared to the attainment of these planning objectives.

Such a tax policy would amount to what is called fiscal dirigisme defined as a policy aimed at the achievement of planning objectives through the insertion of a variety of incentives and disincentives into the taxation system.

Taxation may be used as diversionary instrument in several ways, such as discouraging consumption of particular commodities, promotion of use of some factors of production vis-à-vis others, influencing the methods of production by varying the input costs, encouraging certain scales of production, and so on (F. G. Reuss — `Fiscal Policy for Growth without Inflation').

The opposite of neutrality is not distortion but dirigisme. In the era of fiscal dirigisme, neutrality of a tax is precisely the opposite virtue. It is no virtue but a drag in a developing country. Neutrality is more relevant to a developed country than, say, India, which needs more of fiscal dirigisme than passive neutralism. In essence, neutrality remains only an ideal. VAT is not fully neutral but it is certainly more neutral than other taxes in its pure form, which is rare.

VAT is not neutral between capital and labour and it is not neutral when it has multiplicity of rates and exemptions. An imperfect VAT is as much distortionary as an imperfect income-tax or excise or sales tax.

(The author is former Member of the Central Board of Excise and Customs.)

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