The rise of value added tax

The Value Added Tax (VAT) is probably the ideal tax from a conservative point of view. As a broad-based tax on consumption, it creates less economic distortion per dollar of revenue than any other tax - certainly much less than the income tax. If conservatives are successful in defeating a VAT, the alternative inevitably will be significantly higher income tax rates, which will do far more damage to the economy than a VAT raising the same revenue. The conservatives' preference for consumption taxes over income taxes has a long history dating back at least to Thomas Hobbes. In Leviathan (1651), he argued that consumption was what people took out of society, while saving added to society's wealth. Therefore consumption was the best base for taxation, while saving should be exempt. That view has been endorsed by every conservative tax theorist from David Hume and Alexander Hamilton in the 18th century, to John Stuart Mill and Alfred Marshall in the 19th century, to Irving Fisher and Nicholas Kaldor in the 20th century, and to Martin Feldstein and many others today.
Hamilton emphasised that taxing consumption was the method of taxation most consistent with freedom because people could more easily reduce their consumption than their income. As he wrote: It is a signal advantage of taxes on articles of consumption, that they contain in their own nature a security against excess. They prescribe their own limit; which cannot be exceeded without defeating the end proposed, that is, an extension of the revenue.
When applied to this object, the saying is as just as it is witty, that, ''in political arithmetic, two and two do not always make four.'' If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them [Bruce Bartlett, (1992)].
Politicians are, however, mindful that foreign leaders who impose VATs often suffer electoral defeat as a consequence. After enacting a VAT in Japan in 1986, Prime Minister Yasuhiro Nakasone was defeated the following year largely because of it. Canadian Prime Minister Brian Mulroney imposed a VAT in 1991, and it was considered a major factor in his 1993 defeat. Although Australian Prime Minister John Howard survived enactment of a VAT in 1998, his party suffered major losses as a consequence.
It is an article of faith among the conservatives that the VAT is a money machine that must be fought to the death. The Wall Street Journal continually rails against it on the grounds that if the US were ever to adopt such an insidious form of taxation, it would quickly become just like Europe, as if that entire continent is one big gulag instead of someplace where, by and large, the people are just as free and prosperous as Americans [Peter Baldwin, 2009].
I want to make two points about the money-machine argument. First, it is often implied that the VAT trends to continuously rise upward. That is wrong. According to the Organisation for Economic Co-operation and Development (OECD), seven of the 29 member states with a VAT have lower rates today than they had in the past: Canada, the Czech Republic, France, Hungary, Ireland, the Netherlands, and the Slovak Republic. And Australia, Finland, Korea, and Poland have never increased their VAT rates. Indeed, the average VAT rate in OECD countries is actually lower today than it was in 1984: 17.79 per cent then versus 17.61 today.
The VAT rates commonly referred to are statutory rates but that don't necessarily tell us anything about the effective tax rate. Conservatives just assume that VAT covers everything and has the same structure in every country. In fact, every country with a VAT exempts many items and usually imposes lower rates on some things and higher rates on others. The rates one tends to see discussed are the basic rates that apply to most things that a VAT covers. But the share of consumption covered by the VAT varies enormously from one country to another.
Unless one believes that budget deficits have no effect on growth and prosperity, one has to accept that there are times when higher taxes are the lesser of evils and can actually stimulate growth. Unfortunately, ideological dogmatism, rather than serious analysis, seems to underlie most of the opposition to a VAT among conservatives. When, economic conditions eventually force them to live in the real world - instead of a fantasy world where the budget can be balanced by abolishing Medicare - think they will support a VAT just as European conservatives did [Junko Kato, (2003); Harold Wilensky, (2002)].
Dongwon Lee, Dongil Kim, and Thomas E. Borcherding (2013) in their paper examined the claim that the adoption of a VAT increases the size of government. Their analysis suggested that introducing the VAT has little impact on government growth due to two factors: (1) the substitution of the VAT for other tax sources, and (2) the low price elasticity of demand for public goods. In contrast, demand-side changes may have a more significant impact on government size, thus reversing the direction of causality. Using a panel of 29 OECD countries over a period of 38 years (1970-2007), we confirm these hypotheses. Their findings imply that the demand for government spending markedly influences the tax structure of society. Using a broad concept of tax costs, introduction of a VAT increases social welfare because it reduces compliance costs, rent-seeking, and efficiency costs. Accordingly, increased usage of VATs during the 20th century should be understood as a collective choice to accommodate growing demands for public expenditure.
The tax structure in developing countries: The poor tax to gross domestic product (GDP) ratio is a common experience in most of the developing countries. Alink and Kommer (2011) have identified a number of factors which limit the ability of the developing countries to increase their tax revenue. The factors include: a) weak institutions including tax administration, Corruption and a lack of transparency, b) a tax system characterised by numerous tax exemptions and still heavily reliant on cross-border tariff,  c) existence of large informal sectors, d) outflow of funds to tax havens,  and e) high pressure from international investors within the context of global tax competition.  The list of the factors would have been more comprehensive with the inclusion of the lack of tax awareness that stems from the low rate of literacy, among other things.
Many studies, for example, Burgess and Stern (1993) and Bernardi (2005), have shown that those indirect taxes prevail over direct taxes in most developing countries. The pattern of tax structure among developing countries is similar in their heavier reliance on indirect taxes than on direct taxes. This common experience specifically applies to the South and East Asian countries (Bernardi, Fumagalli et al. 2006) with the exception of Japan. Ahmad and Stern (1991) point to the similarity of the revenue systems of the Indian sub-continent with those of many other developing countries in terms of low shares of taxation in GDP compared to developed and many developing countries, increasing demand on revenue, low contribution of income taxes and a heavy dependence on indirect taxes, particularly trade taxes. In his discussion on the relationship between taxation and development, Newberry's (1987) argument can be put forward to explain this situation; he argues that personal income taxes in developing countries are a relatively ineffective tax instrument as they cover a small portion of the population. In this respect, despite the desirability of income taxes, indirect taxes will remain a major source of tax revenue.
Tanzi (2006) considers this predominance of indirect taxes in the South and East Asian countries as an outcome of their lack of concern towards equality expressed through the tax system. Further, he also sees broad based VAT with higher rates than many European countries as some East Asian countries' relative indifference to equity concerns. The prevalence of consumption taxation in developing countries has been explained by Sandford from the perspective of trade liberalization and its impact the economy of developing countries. He (2000) argues that against the backdrop that most developing countries cannot rely on direct tax for their tax revenue and their yield from international trade taxes is declining due to international pressures from GATT and the World Trade Organization to reduce trade taxes in the interest of free trade, their reliance on domestic consumption taxation is becoming greater than ever before.
There are both economic and political constraints in devising the most appropriate tax system in developing countries. Newbery (1987) argues that although political constraints are important, most economists feel uneasy about taking them into account. Bird (2004) persuasively argues that it can be highly counterproductive to ignore the political feasibility of a given tax proposal. Considering the factors that account for the design of a tax structure in developing countries, their overwhelming dependence on indirect taxes will also aid in explaining the extent to which taxation has evolved into an effective social contract. In the context of the present research, it would be interesting to see how the socio-political milieu, including an enduring legacy of certain tax cultures, coupled with the global socio-economic scenario, paved the way for a new tax system - VAT - as an indirect tax to play the leading role in fiscal policy in different countries the world. Thus, the adoption of VAT in developing countries is significant - economically, politically and socially.
prominence of VAT: Having understood the relationship between taxation and state-building and good taxation contributing to good governance and vice versa, we can now turn to VAT - a specific form of taxation - and its emergence in the domain of fiscal policy. Before we go onto relate it to good governance, it would be better to focus on some technical aspects of VAT.
Although a major tax increase wouldn't be a good idea while the economy is still recovering slowly from recession, the announcement of a future VAT could be stimulative in the current period. Announcing that the price of consumption goods will be raised in the future or gradually over time via a phased-in VAT would encourage people to spend more now, when the economy needs the stimulus. That effect may not be very big, but it is still beneficial.
The VAT has been called a ''money machine'' because of its ability to raise substantial amounts of revenue. That is a helpful feature if the revenues are used to close deficits, but it poses a problem if the boost in revenue simply fuels further unsustainable growth in federal spending Some analysts reject any source of extra revenue, including a VAT, on the grounds that less government revenue leads to smaller government. In general, this ''starve the beast'' theory does not apply to most taxes, nor does it reflect recent experience. Romer and Romer (2009) find that tax cuts designed to spur long-run growth do not lead to lower government spending and that if anything, tax cuts lead to higher spending. This finding is consistent with that of Gale and Orszag (2004b), who argue that the experience of the last 30 years is more consistent with a ''coordinated fiscal discipline'' view, in which tax cuts were coupled with increased spending (as in the 1980s and 2000s) and tax increases were coupled with contemporaneous spending reductions (as in the 1990s). Given the widely recognized need for both spending cuts and revenue increases to balance the budget, it is likely that any new revenue stream would be accompanied by reductions in spending. Some observers argue that the VAT is such an efficient and invisible tax that it has been and would be used to fuel government spending increases through a gradually increasing rate. Bartlett (2010a, 2010b) addresses this claim by noting that increased VAT rates in OECD countries were common among early adopters, who operated a VAT in the high-inflation environments in the 1970s, but that they were far less common among countries that adopted a VAT after 1975. Of the 17 countries that instituted a VAT during the post-1975 period of relative price stability, four have not changed their VAT rate and four have decreased it; the average rate increase across all late adopters of the VAT is less than 1.0 percentage point. The average VAT in OECD countries has been roughly constant since 1984 at or just below 18 per cent.

Jamaluddin Ahmed PhD FCA is the General Secretary of Bangladesh Economic Association and a member of the Board of Directors of Bangladesh Bank.
 jamal@emergingrating.com