One of the advantages attributed to VAT is its neutrality in relation to decisions made by economic factors, such as capital and labour, and by consumers.
These decisions should be made based on their economic merits and not for tax reasons.
In some cases, however, neutrality cannot be realised and policy makers have to accept a certain level of distortion as inevitable.
Also, policy makers may give preference to other specific goals over neutrality. In practice, it proves difficult to find an adequate balance between neutrality and other goals.
For VAT, a distinction is made between internal and external neutrality. Internal neutrality relates to the domestic impact of VAT on economic decisions by traders, consumers, workers and capital providers.
External neutrality relates to relations with other countries. In turn, internal neutrality is sometimes divided into legal and economic neutrality.
Legal neutrality refers to equal treatment in the sense that each consumer should pay tax in accordance with his level of consumption.
There should be a direct relation between the quantity of consumption and the tax incurred by an individual consumer.
To accomplish this, VAT is measured as a percentage of the retail price. In addition, the tax rate should be the same for identical goods and services.
Economic neutrality is realised when VAT does not unduly influence the optimal allocation of resources.
To achieve this, the tax base should be as broad as possible, i.e., VAT should be levied on the most possible types of economic activities and have the least possible exceptions and exemptions.
In addition, rate variation should be avoided because this would distort the relative prices of goods and services and may artificially steer consumers to lower-taxed and less desirable outputs.
In some cases, policy makers deliberately depart from the principle of neutrality to achieve specific policy goals, such as combating the presumed regressivity of VAT, encouraging the use of some products by imposing lower tax rates and discouraging the use of others, such as alcohol and tobacco products, through higher rates.
However, VAT is not the best tool to accomplish such policy goals.
In addition to distorting choices, non-neutralities in the tax system also result in socially wasteful efforts by firms to change the form or substance of their activities to reduce their tax payments, for example by hiring lawyers and accountants to structure their transactions in a manner that minimises tax liability.
In the context of VAT, external neutrality relates to the border tax adjustments required to create fair competition between domestically produced goods and imports.
The tax levied on importation has to be equivalent to the tax imposed on similar domestic products, otherwise it would become a protective measure; and the relief provided to exports in the form of input-VAT credits may not exceed the actual domestic tax, otherwise it would, in fact, be an export subsidy.
In the VAT design for the GCC, as laid out in the Framework Agreement, external neutrality is fully realised. Rate variation is minimal.
There is a standard rate, and a zero rate applied to only a limited list of products. A few economic sectors are either zero-rated or exempt from VAT.
The VAT Framework Agreement is reasonably well designed from the perspective of neutrality. It is not perfect, but no VAT system in the world is.
Dr Robert F van Brederode is of counsel to Horwath Mak Ghazali in Oman. He is a tax lawyer, practitioner and scholar with over 30 years of experience in global VAT.
He served Crowe Horwath International as the global indirect tax leader, and was the national practice leader of the US member firm Robert is the author of dozens of academic journal articles and 8 books. He can be reached at Robert.brederode@crowehorwath.om.
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