GST and Exemptions: The Pros and Cons

Treasury Minister Philip Ozouf has been insisting that the Budget that he and his advisers have drafted is such a carefully constructed set of proposals that there can be no deviation from what it recommends. As well as undermining the idea that the budgetary sums can be made to add up in only one way, proposals to exempt food or fuel would cast doubt on a principle that has so far underpinned the operation of GST in this Island - the single uniform rate. It has been consistently argued by the executive that this is the only way in which excessively costly administrative overheads can be avoided.(1)

In fact, by November 22, 2010, Philip Ozouf had already considered the option of allowing a debate on tax exemptions on food and domestic fuel, but with GST at 6% (a tax neutral option, as it has the same effect as GST at 5% on everything). However, he is still against exemptions.

His argument against exemptions is twofold:

(1) He is of the opinion that 5% is the absolute threshold at which we can't bring in exemptions, but that if we sort out our finances, we should not have to go above 5%. Given his failure to keep it at 3%, which, in fairness, was in part due to circumstances beyond his control - the world economic downturn - this seems an unduly optimistic assumption.

(2) He argues that 5% is the better option because it is simpler for retailers, and also has higher compliance rates, and the evidence is that exemptions bring about more difficulties with complying with the GST law because it is based purely on the value of goods rather than contents. Once exceptions come in, mislabelling and other avoidance strategies increase the amount of work done to check goods, especially imports.

In "The Economics and Management of Small Business", Graham Bannock provides a degree of support for that argument. After looking at various studies, including one by the OECD, Bannock notes that:

the real resource costs absorbed by regulation per firm are very large indeed (about £1,700 on average for all firms in the United Kingdom with fewer than 250 employees), and these resources have alternative uses.(2)

Bannock comments that:

There are, of course, other reasons for high administrative compliance costs. As noted in the discussion of taxation above, regulatory systems have become more complex in an effort to achieve fairness. As an example, if VAT were levied at a single rate with no exemptions and on the whole of consumer expenditure, the compliance cost of the tax would be greatly reduced. Pressure for exemptions (food, for example) prevents achievement of this simplicity in most countries.(2)

This is found in Denmark and New Zealand, precisely because they have simpler systems:

Denmark and, to a lesser extent, New Zealand, have very straightforward VAT systems. However, Denmark is being forced to complicate its system in the interests of European tax harmonisation. (2)

Here is where the effect of "distortions" of the market, comes in, because there is a cost to complying with exemptions, and the more complex the rates of VAT and exemptions, the more this regulation costs the retailer or service provider:

There is no such debate about regulation, the costs of which are unknown to the electorate - and, indeed, until recently, to the legislature. The public is largely unaware that there are any costs to regulation. Where they are aware of costs, it seems to be assumed that these costs will simply be borne by business instead of, by large firms at least, passed on to the public. (2)

But of course, at least part of the cost of compliance will undoubtedly be passed onto the consumer. Most local businesses are quite hard pressed financially anyway, and with rents still going ever up (despite the recession), they will not be able to absorb all the costs, and the consumer will end up paying more:

Where regulations increase market distortions, then costs (in addition to compliance costs) are incurred in the economy. These costs are known as 'excess burdens', 'efficiency costs' or 'deadweight losses'. Excess burdens are difficult to assess but are thought in some cases to be a multiple of compliance costs. (2)

The fact is that VAT is inherently a complicated tax that is costly to administer in business... The best VAT systems are those with single rates covering virtually the whole of consumer expenditure. Political pressures resulting in multiple rates (e.g. higher rates for luxury items) or exemptions (such as food) create additional compliance costs for firms dealing in goods with different rates, as well as economic distortions. (2)

If Jersey did decide to go for exemptions, the simplest solution regarding food would be to use the lists already available in the UK. These have some patent absurdities - for example, a sandwich may be free of VAT but a toasted sandwich, classed as cooked food, attracts it - but at least if we were tied to UK lists, it would avoid costly litigation.

The other area which a more complex GST system with exemptions would impinge upon the public would be increased staffing costs. In "Public Sector Economics for Developing Countries", Michael Howard notes that:

Staffing of the VAT office is a significant aspect of VAT administration. The staffing requirement is a function of a large number of variables, including the tax treatment of various sectors of the economy, the extent of exemptions, the frequency of returns, the complexity of tax rates, and the existing computer systems. For example, the higher the level of transactions omitted from the VAT, the more staffing needs are reduced. Further, if a large amount of the VAT is collected by the customs at the import stage, this reduces the demands for staff in the VAT office. Finally, the more complex the VAT, the greater is the need for staff to administer it. A multiple rate VAT requires more staff than a single rate VAT. (3)

This is necessary, not least because a more complex system, with more exemptions or different rates, leads to increased forms of tax evasion. At present GST leveled on imports is simple - it is based on the value of the goods imported. But if exemptions are allowed, then large imports by retailers (where foodstuffs were involved) would require a more careful check and breakdown of the inventory, to ensure that mislabeling (a common means of evasion) is not taking place, and that requires more staff.

Like New Zealand, Singapore adopted simpler systems precisely because of this problem with complexity:

Singapore had learnt from the experience of other countries that operate VAT systems with multiple rates and multiple exemptions. These administrations had encountered many difficulties arising from countless disputes with the businesses on the scope of tax. Multiple rates and exemptions also pose higher compliance burden on the businesses. It was also recognised that a complex system with multiple rates could potentially lead to more abuses. (4)

But against these arguments, the question is really whether 5% is a permanent solution, or whether the tax rate will have to go up. If GST has to increase, then it makes better sense to go to 6% - an increase of 1% - and introduce exemptions on food and domestic fuel - rather than have to introduce exemptions later, when the increase in GST with exemptions would have to be considerably larger to account for the loss of revenue.

Moreover, the experiences of New Zealand and Singapore - both countries with simple GST systems - cast considerable doubt on whether the tax can remain low. In New Zealand, GST was brought in on October 1, 1986 at 10%, and later increased to 12.5% on July 1, 1989, and was increased to 15% on October 1, 2010. In Singapore, GST was implemented at a single rate of 3% on 1 April 1994, with an assurance that it would not be raised for at least five years. This promise was kept, but it was later increased to 4% on 1 January 2003, and 5% on 1 January 2004. It was raised again to 7% on 1 July 2007. Keeping a lid on the rate is not as simple as one supposes. Denmark, while it has one rate for VAT, has it at 25%

The other argument is that while GST goes up, targeted assistance is provided to lower-income families. The trouble with this is threefold:

(1) deciding the amount of assistance is problematic, and can fall below the threshold of what is really needed because it is extremely complex to assess the needs of individual families, and consequently the analysis of needs works from a simplified model;

(2) there are always people at the margins, who are hit by GST, but who are just above the level at which they could claim for assistance. While the GST bonus scheme can address some of this, there still seem to be marginal cases, just above various thresholds for claiming support, who are penalised and find it more difficult. It is particularly areas such as food costs and domestic fuel that they have to struggle with. The Parish Welfare system was very good at proactively identifying cases of hardship, but this seems a weakness of the more simplified and centralised income support system, which increases in GST will only exacerbate

(3) rapid changes in market prices, such as a large increase in domestic fuel (which does occur), for example, will invariable not be offset by immediate increases in the amount of assistance; there is a time lag in reviewing the figures, and taking decisions, which increases the chances that the targeted aid will simply not be sufficient.

I can see the merit of some of Philip Ozouf's arguments, but I can also see the problems at the lower end of the scale, and I remain unconvinced that targeted assistant works efficiently enough, either at its thresholds, or if economic situations (as with fuel) change rapidly. Given that GST will probably have to increase yet again - the experience of Singapore and New Zealand suggests that it will do so - I think that the GST at 6% with exemptions on food and domestic fuel is the wisest option.

References:
(1) http://www.thisisjersey.com/2010/11/29/exemptions-now-will-ease-the-pain-later/
(2) The Economics and Management of Small Business: An International Perspective, Graham Bannock, 2005
(3) Public Sector Economics for Developing Countries, Michael Howard, 2001
(4) GST in Singapore: Policy Rationale, Implementation Strategy & Technical Design, 2004