Friday, October 21, 2005

The notorious input VAT cap

A reader has requested me to discuss the notorious EVAT provision capping the input VAT credit:

Could you help explain the dissenting opinion of SC Justice D. Tinga regarding the 70%/90% cap. He quotes people like Monsod, Wallace, and the PWC head in his dissent. While I am all for VAT, I just want to understand what the dissent was all about so that I get the whole picture. A copy of the dissent is in the website (as well as a copy of the decision).
Remember my discussion on how the VAT works? All sales transactions - including sales between businesses - gets slapped a VAT rate, say 10% (unless there are exemptions). Every quarter the business needs to pay government the VAT on its sales, or the output VAT. However, what makes the VAT a "value added" tax is that it can subtract that VAT it has paid on its inputs. So what it pays for is VAT for the difference between its sales, and the cost of inputs, which is the "value added".

Sometimes (depending on timing of input purchase and output sales) the input VAT can exceed the output VAT. This excess can be carried over to the next quarter's net VAT calculation - and so on. (But if net VAT is positive, no carryover - pay at once! Nothing so sure as death and...)

The new law contains a provision: the input VAT + carryover (if any) that you can subtract from the output VAT, every quarter, in computing for that quarter's net VAT, cannot exceed 70% of the output VAT per quarter.

Let's give an example: Suppose the law is not yet effective. In year1-quarter4 you incur 1,000,000 output VAT, but you paid 1,200,000 input VAT. You have an excess of 200,000. You carry that over to year2-quarter1, when the new law is in effect. For that quarter you owe 1,000,000 in output VAT, but paid 600,000 input VAT. Of course, government owes you 200,000 from the previous quarter. You add that in - so total subtraction from current output VAT is 600,000 + 200,000 = 800,000. Sorry! Since you paid 1,000,000 output VAT, you can only subtract a maximum of 700,000; so you end up paying 300,000. You're entitled to a refund of 300,000 - 200,000 = 100,000; just carry that over to the next quarter. And so on.

If you're a business that is often claiming input VAT below 70% of output VAT, the excess refund owed to you eventually disappears. But if your input VAT is consistently higher than that, you have a big problem. The carryover continues indefinitely, as long as the business exists. The carryover is a fiction!

The VAT therefore excessively penalizes businesses with low margin (small value-added); because of the cap, effectively they are slapped a higher rate on their value-added. This is distortionary and reduces economic efficiency. The VAT should be implemented in its original form; any cap (to curb cheating) should be set close to 100%.

Benefit-cost-wise, the EVAT still puts us ahead. If there is any room for amending the law, this is it- take out the stupid 70% VAT cap. Not re-exempting power and fuel. Now that's piling one stupidity after another.


Anonymous said...

Now that was a clear explanation! Thanks!

Paul said...

That 70% cap translates into an effective 3% sales tax.

If anything, this cap will force businesses to manage inventories even more closely in order to avoid a situation where inputs will exceed outputs.

I can see a lot of "creative invoicing" ahead in order to avoid this situation.

Econblogger said...

Right Paul - a 3% sales tax is the minimum VAT collection from a business. (Kind of weakens the definition of VAT, doesn't it?)

Close managing of inventories would be needed to avoid depositing money into a government account that bears zero interest.
However some businesses may not even have this option - i.e. their value added is persistently below 30% of sales. (Think of some wholesalers.)

I agree with your prognosis about business creativity. Put in a lousy tax policy, get lousy compliance.