EKN 310 Chapter 16 Notes

Taxes on Goods and Services

Indirect Taxes
What are indirect taxes?

• Taxes on commodities (goods/services) & market transactions

• Examples:
- VAT
- excise duties
- customs duties
- fuel levies

Main characteristic of indirect taxes:

• Indirect taxes can usually be shifted to someone else.

• Meaning that the person legally paying the tax may not actually bear the
burden.
• Example: A business pays VAT to SARS, but shifts the burden to
consumers through higher prices.

Single-stage vs Multi-stage Commodity Taxes:

• Single-stage commodity tax = collected once only.

- Example: A tax charged only at retail stage
• Multi-stage commodity tax = collected more than once, at different stages
of production.
- Example: VAT
- VAT is charged at:
1. raw material stage
2. manufacturing stage
3. wholesale stage
4. retail stage

- So VAT follows the product throughout production.

Types of indirect taxes:

1. Selective (narrow-based)

• Taxes on specific goods only.

• Examples: excise duties or customs duties

2. General (broad-based)

• Taxes applied broadly across many goods/services.

• Example: VAT without exemptions or zero-rating.

Excise duties

o Selective taxes levied on specific goods / specific transactions

o It can apply to domestic goods and imported goods
o Customs duties / tariffs = when excise duties are imposed on imports
o Types of excise duties:
1) Specific (unit) tax
- Fixed amount per unit.
- R5 tax per cigarette pack.
2) Ad valorem tax
- Percentage of value.
- 15% tax on luxury cars.
- Tax = " × Value of Commodity

o VAT vs Excise Taxes:

- If VAT:
§ has no exemptions
§ has no zero-ratings
§ then it is: broad / general
- Excise taxes
§ Excise taxes are highly selective
§ They target specific products.
- BUT if government introduces:
§ many exemptions
§ many zero-rated goods
§ then VAT becomes less general and more selective
§ \VAT starts behaving more like an excise tax.

o Sumptuary (Sin) Taxes = selective excise taxes imposed to reduce

consumption of certain goods.
o Examples: carbon taxes, tobacco taxes, liquor taxes, sugar tax
 o The purpose is NOT just to raise revenue but also to discourage harmful
behaviour (higher cigarette taxes aim to reduce smoking)

Critical Assessment of Indirect Taxes

Merits (Advantages) of Indirect Taxes

1. Helps raise revenue from people outside the tax net

• Indirect taxes are practical because even people not paying income tax
still contribute when they buy goods/services.
• This links to the benefit principle.
• Everyone benefiting from government services should contribute
something.

2. Fiscal illusion

• Indirect taxes are included in prices of goods.

• Consumers often do not notice them directly.
• This is called fiscal illusion.
• People pay taxes without fully realising it.
• Advantage of fiscal illusion
- less tax resistance
- easier politically to collect taxes
• Disadvantages of fiscal illusion
- Indirect taxes are less transparent.
- Good governance usually requires transparency about
taxation.

3. Taxpayer has some control

• Unlike direct taxes (personal income tax), indirect taxes can sometimes
be avoided.
• Ways to avoid = do not buy taxed product / substitute another product
• Example: If cigarettes become heavily taxed, people may switch to vaping
or stop smoking.
• BUT some taxes are unavoidable ® VAT on necessities cannot fully be
avoided.
• People still need food, transport, electricity etc.
4. Used for multiple policy objectives

• Indirect taxes can influence behaviour.

• carbon taxes → reduce pollution
• tobacco/liquor taxes → reduce harmful consumption
• taxes on luxury imports → shift production toward necessities

5. Ad valorem taxes automatically adjust for inflation

• Because tax is a percentage of the price, tax revenue rises automatically

when prices rise.
• If VAT rate = 15% and the product price rises from R100 to R120, then VAT
rises automatically from R15 to R18
• No new legislation needed.

6. Simple to administer

• Indirect taxes are relatively easy to collect.

• Usually collected from businesses, not millions of individual consumers.

7. Easier to enforce

• Consumers have limited ability to evade indirect taxes.

• Compliance enforcement is easier.

Disadvantages of Indirect Taxes:

1. Regressive nature

• Broad-based taxes may violate the ability-to-pay principle

• Thus, indirect taxes are often regressive in the sense that poor households
spend larger percentages of income on consumption.
• Therefore they bear proportionally larger burdens.
• Example:
- A poor household may spend nearly all income on VAT-able
goods.
- A rich household saves more income.
- So VAT hurts poor households relatively more.

• Exemptions and zero-rating reduce neutrality.

- A neutral tax does not distort choices (substitution effect)
- Selective taxes distort consumer behaviour.
 • South Africa uses exemptions & zero-ratings ® This means VAT is no
longer fully general.
• This introduces selectivity, inefficiencies and non-neutralities

• Sin taxes may still hurt the poor

• Even though luxury/sin goods are associated with rich consumers ®
poorer households also consume them.
• Example: Poor households may still buy alcohol, cigarettes, sugary drinks
• Therefore these taxes can still be regressive.

2. Selective excise taxes create inefficiencies

• Heavily taxed luxury goods may

- motivate people to work harder to afford them (income effect)
OR
- discourage consumption entirely (substitution effect)
• This changes work/leisure decisions.
• High taxes may reduce incentive to work ® people may decide extra work
effort not worth taxed prices.

3. Policy conflicts

• Indirect taxes are often expected to achieve many objectives at once.

• This creates conflicts (equity vs efficiency conflicts)
• Example:
- Equity: Luxury goods should be taxed heavily because rich
people consume them ® This supports progressive taxation.
- Efficiency: Luxury goods are often price elastic so high taxes
on elastic goods creates large substitution effects and excess
burden.
• Equity says- tax luxuries heavily but Efficiency says - tax elastic goods
lightly (this links to the inverse elasticity rule)

Inverse elasticity rule:

Þ goods with low elasticity (inelastic) should face higher taxes

Þ goods with high elasticity should face lower taxes.
"
Þ "! ∝ ∣$ ∣
!
Þ Meaning: lower elasticity → higher optimal tax.
 • Conclusion: tax policy often cannot fully achieve equity AND efficiency
at the same time.

4. Inflationary effects

• Indirect taxes can increase prices.

• If workers demand higher wages to compensate, then inflationary
pressures increase further.

• Cascading effect of multi-stage taxes

- Taxes paid at earlier stages become embedded in prices,
causing taxes-on-taxes.
- This is called cascading.

• Vertical integration response

- To avoid cascading firms may combine production stages
internally.
- This is vertical integration.
• Problem with vertical integration is that it may reduce competition and
increase market concentration.
• These changes occur because of taxes, not because of economic
efficiency.
• \This creates excess burden.

Value-Added Tax (VAT)

How it works

• VAT is a multi-stage sales tax

• levied on value added at every stage of production.
• Value added = The increase in value created at each production stage.

Value Added = Output Value − Input Value

• Example:
• Stage A: Raw material supplier
- Supplier sells raw materials: R100 000
- Adds VAT:15%
- VAT charged: 0.15 × 100000 = 15000
- Invoice: R115 000
- Supplier keeps R100 000 & pays SARS R15 000
 • Stage B: Manufacturer
- Manufacturer: buys inputs worth R100 000
- & adds value of R50 000
- Total before VAT: 100000 + 50000 = 150000

- VAT: 0.15 × 150000 = 22500

- Selling price: 150000 + 22500 = 172500

- BUT manufacturer already paid: R15 000 input VAT.

- So, he can claim credit (VAT credit)
- \Effective VAT paid to SARS:

22500 − 15000 = 7500

• Stage C: Retailer
- Retailer buys stock for R150 000
- & adds value of R150 000
- Total before VAT: 150000 + 150000 = 300000

- VAT: 0.15 × 300000 = 45000

- Consumer price: 300000 + 45000 = 345000

- BUT retailer already paid: R22 500 input VAT.

- So, they can claim vat credit
- \Effective VAT paid to SARS:

45000 − 22500 = 22500

NB

• Each business only pays VAT on the value it added.

• The final consumer bears the full VAT burden.

Types of VAT

1. Consumption-type VAT

o Tax base = consumption.

o This is the VAT used in South Africa.
 o In a closed economy: 012 = 3 + 4 = 5 + 2 + 6
- C = consumption
- I = investment
- W = wages
- P = profits
- D = depreciation
o Therefore, VAT base is 3 = 5 + 2 + 6 − 4
o So, when consumption is taxed, investment excluded.

2. Income-type VAT

o Tax base = income.

o Investment is included in this base.

VAT in Open Economies

Origin Principle

• Exports are taxed and imports are zero-rated

• This means that tax is based on where goods are produced.

Destination Principle

• Exports are zero-rated and imports are taxed

• This means that tax is based on where goods are consumed.
• South Africa uses destination principle

Why ?

1) Fairness
Þ All goods sold in South Africa are subject to VAT.
Þ Otherwise, untaxed imports would unfairly compete with local
goods.
2) International competitiveness
Þ Exports are zero-rated so South African products remain
competitive abroad.
Þ Otherwise, SA exports would become more expensive
internationally.

VAT Rates

• VAT may be levied at single rate OR multiple rates.

 • South Africa uses a single rate of 15% with exemptions and zero-rating.

Economic Effects of VAT

1. Revenue generation

• VAT is famous as a “money machine”.

• Reason being it raises large amounts of revenue effectively.
• VAT is the second-largest share of government revenue in SA.

2. Efficiency implications

• Broad-based uniform taxes most efficient.

• Economists often argue that they creates fewer distortions (resembling
lump-sum taxation).

• Problem 1: Ignores equity

• A perfectly broad VAT: taxes necessities and luxuries equally.
• But this may hurt poorer households more.

• Problem 2 : Uniform VAT ignores elasticities.

• Even with one VAT rate (15%), goods differ in elasticity
• Some are elastic (luxuries), others are inelastic (necessities)
• Inverse elasticity rule says for efficiency…
- necessities (inelastic goods) should be taxed more
- luxuries (elastic goods) should be taxed less.
• So, a uniform VAT violates the inverse elasticity (Ramsey) rule.

Why does SA still use uniform VAT ?

o Multiple VAT rates become extremely difficult administratively.

o So governments prefer broad base + uniform rate.

3. Equity relief for the poor

• Governments assist poorer households through

- Exemptions
- Zero-rating
 • Exemptions is when certain goods/services are not charged VAT.
• SA examples: financial services, taxi industry and rentals
• Zero-rating is when the VAT rate = 0%.
• Basic goods often zero-rated.
• Examples: certain food items consumed heavily by poorer households

Important distinction: Exemptions vs Zero-rating

To consumers they both appear VAT-free BUT economically they are very
different.

Zero-rated goods

• Retailer charges 0% VAT

• But they can still claim input VAT credits.
• As a result - all VAT is removed from production chain.
• So, no stage in production chain bears VAT.

Exempt goods

• Retailer cannot charge VAT AND cannot claim input VAT.

• Therefore VAT already paid earlier remains embedded in costs.
• Retailer may shift these costs onto consumers - especially if markets are
not competitive.

Problems with zero-rating and exemptions

1. Erodes tax base

- government loses revenue.

2. Poor targeting tool

- rich households also buy zero-rated goods
- thus benefits are not limited to poor
…

- Katz Commission finding: Approximately two-thirds of

benefits from zero-ratings go to the top half of income
distribution.

3. Small suppliers problem

- Small suppliers are not registered for VAT and so they cannot
claim input VAT credits.
- This may over-tax them.
4. Administration considerations

VAT administration is generally easier to administer because:

• Tax is collected in stages throughout production

• Tax is collected from businesses – businesses keep invoices and records
of everything
• Businesses also have incentive to keep records to claim VAT input credits

Problems with administration

• Tax evasion (businesses try avoid paying VAT)

• Fake invoices
• Informal businesses are not registered to pay VAT (cannot claim input
credit)
• Administrative burden on small firms (over-taxed)
• DiGiculty monitoring compliance

Personal Consumption Tax

Personal consumption tax taxes what people spend, not what they earn.

Þ Tax Base = Income – Savings

Þ Income that is saved is not taxed
Þ Only income used for consumption is taxed

Main Purpose

• Personal income tax= attempt to address the problem of regressivity

associated with consumption taxes.
- Normal consumption taxes (VAT) are regressive because
poorer households spend larger percentage of their income
on it.
• Personal income tax can be more progressive because unlike VAT, which is
indirect, this tax is linked directly to the individual consumer – which
means govt can…
- tax high consumption more heavily
- exempt basic necessities
- apply higher rates to luxury consumption
Is Personal Consumption Tax Feasible in SA?

Possible Advantages Possible Disadvantages

Because savings are untaxed Govt needs accurate info on
o households may save more o income
o investment may increase o savings
o economic growth may improve o spending
o This is administratively diGicult
o more progressive/ fairer than
VAT because heavy/ luxury SA has a large informal sector
consumers can pay more o Many transactions not recorded
o \harder to monitor
consumption accurately

Tax avoidance
o People may hide income or
o Manipulate savings reporting

People may consume less to pay less

o Business suGer
o Economic growth slows

Conclusion: Personal Consumption tax may be fairer (progressive) and

encourage saving BUT it is administratively diGicult to implement in SA.

\VAT remains more practical.

International Experience
Why countries want to reform taxes:

1) Raise more revenue (govts need more money for infrastructure/

healthcare/ education etc.)

2) Non-revenue goals (redistribution, eGicient resource allocation or simply

tax system)

3) Political change (diG govts prefer diG tax systems – some prefer
redistribution, others prefer lower rates and eGiciency)
 4) International Influence (may want reform bc trade/ globalization pressures
increase)

Empirical studies show the following trends….

1. Countries realize that taxes alone cannot achieve horizontal equity and
vertical equity ® thus govts using targeting spending instead on relying on
taxation
2. Modern tax reform focuses on ® eGiciency, broad tax base and lower tax
rates

This is one reason many countries have increased reliance on

consumption taxes (VAT)

BUT relying less on income tax means we are eroding the power of automatic
stabilizers (income tax is able to counter economic fluctuations – this eGect is
weakened)

How International countries reform tax:

1. “Untax” the poor

- Reduce tax burden on low-income households through
exemptions, zero-ratings and lower tax rates.
2. Broaden the tax base
- Make tax applicable to more goods/ services/ income
sources to generate more revenue.
3. Lower tax rates
- Lower rates will reduce tax avoidance/ evasion and improve
compliance
4. Simply tax system
- Try make system administratively easier with lower
compliance costs
5. Green/ carbon taxes
- Taxes aimed at reducing pollution (internalize the
externality)
Patterns of Taxation in Developing Countries
The tax system in a country depends on the country’s history, level of
development and administrative capabilities

® there is no general tax system applicable to every country

Industrialized Countries Developing countries

• Rely more on income taxes • Rely more on indirect taxes like
• And have boarder tax bases VAT.
• Bc they have stronger • Because it is easier to
administration administer and collect

SA’s Position = More like the industrialized countries (but we have lower social
security contributions)