Views of a Nepali Economist

Currently, in Nepal, there is a growing speculation that the government is going to increase the Value Added Tax (VAT) from the 13 percent that it is today to a higher percentage. Nobody knows for certain what it will be after the increase, but the general consensus is that it is rumored to increase. In this context, it seems reasonable to ponder if the increase is good or bad. Also, a more specific question that could be asked would be: is the VAT doing any good to Nepal?

The concept of VAT started in France in 1956, and, later, spread to other countries. It taxes the transfer of goods and services, and, thus, is entirely taxed on the consumer. In its initial implementations around the world, the VAT was imposed on top of the existing sales tax. But, in Nepal, as in other developing economies, the VAT has replaced the sales tax. The Inland Revenue Department of Nepal clearly mentions that VAT includes the value added to a commodity during each stage of its production, and that it is not an addition, but a replacement to the sales tax.

For years, nations have used the VAT to raise an incredible amount of money to finance the federal deficits. However, the VAT in Nepal has not, really, been for deficit reduction purposes. The government seems to have favored it simply because of its huge revenue generating capability. And, that is the major problem with VAT in Nepal. It has been implemented not for deficit reduction and economic growth but as a cash-cow for the government.

There is a popular misconception that VAT is a simple method to generate huge revenue for the government. Leading economists and policymakers in Nepal are not immune to this misconception. If anything, VAT is an immensely complicated system requiring different taxation policies for different types of goods and services. Given its complicated nature and a requirement of heavy personnel to monitor its implementation, we need to ask ourselves if the VAT is an appropriate taxation system for a poor country like Nepal. We do not have the necessary capital and manpower to monitor the VAT to avoid exploitation and evasion. It is not the right taxation policy for this country.

Yes, there are other alternatives of raising revenue, but they are mostly bad alternatives. According to Gregory Mankiw, the Economic advisor to President Bush during his term in office, VAT is the best among the bad alternatives. However, the label ‘bad’ still applies to it. Should the Nepalese, really, be choosing the best out of the bad? Is this what we have come to? Can’t we do better? Why can’t the policymakers come up with something that is not bad? It doesn’t even have to be excellent; a ‘fair’ taxation system will still be better than a bad taxation system.

Nepal got the idea to implement the VAT by observing its success in many European nations. The main reason why developed economies in Europe favored the VAT was because of improved compliance and lesser evasion when compared to a sales tax. Our Inland Revenue Department claims the low evasion to be the prime reasoning behind implementation of VAT in Nepal. And, their reasoning is quite sound given the general consensus among VAT implementing nations that VAT is not as easy to evade as the sales tax.

However, you don’t have to be a rocket scientist to know that non-compliance and evasion are still a major problem in Nepal. Anyone who has ever bought anything in the store or eaten lunch in a restaurant knows that VAT compliance in Nepal is severely lacking. Unlike the European economies, Nepal has a chronic shortage of resources—capital and human resource—to monitor the VAT compliance. Then, the question arises: should we really be using a taxation system that we are not capable to monitor and enforce?

Compliance and evasion issues are very significant when it comes to VAT in Nepal. In the UK, VAT related fraud like Carousel fraud and Missing-trader fraud resulted in a loss of 13 billion Euros in 2006. The UK has since then tried to improve their VAT system through various changes, but has only succeeded minimally. Europe loses around 180 billion Euros every year due to VAT related fraud. In case the magnanimity of that loss is not readily comprehensible, note that 180 billion Euros is the budget of the European Union for two years.

Therefore, to say that Europe loses a huge amount of money through VAT related fraud and non-compliance would be an understatement. If advanced economies in Europe with massive resources at their disposal are struggling to control VAT related fraud, we have no basis to be assured that such fraud has not occurred in Nepal.

Not only does VAT have a major non-compliance and evasion issue, it also hurts the economy. Yes, it fills the government coffers, but it hurts employment situation in the economy. Economists in the US have done research and discovered that even a small 3 percent VAT (which policymakers were proposing in the US) would destroy 2.1 million jobs by the fifth year of its implementation. If a VAT could have such an enormous impact in a big economy like the US, we can only imagine how much it has been hurting a growing and developing economy like Nepal. Also, some economists blame the current problems in the Greek economy to the 19 percent VAT in Greece. Do the Nepalese policymakers know if the VAT is helping or impeding our economic growth?

The VAT in Nepal, at 13 percent today, is already one of the highest VAT rates among the developing countries. In the thirst for quick revenue, government policymakers in Nepal seem to be forgetting the evidence from previous research that an implementation of VAT always results in higher prices in the market for consumers. This result has been shown to hold by numerous researches. Studies have shown that VAT seems good in the short-run, but it tends to slow the long-term economic growth.

Can a poor country like Nepal really afford to have higher consumer prices as a result of the VAT? We are a growing economy. The VAT is not helping our economy if consumers end up paying higher prices for all products. Anyone with the most basic knowledge of economics can tell you that higher consumer prices always slow down the economic activities. VAT in Nepal is really a bad policy if it has in any way hampered the long-term growth of our economy. Being a developing nation that we are, we do not really want anything to slow our economy. Therefore, in today’s context, VAT seems to be more of a problem than a solution in Nepal.

Another major problem with the VAT is the stage-wise levying of the tax. In simple terms, VAT is a multi-layered tax, and it is levied in each stage of manufacturing. This multi-layered levying of VAT provides increased opportunities of evasion and fraud in each stage. In addition, the multi-layered tax does result in higher cost of the final product, although policymakers claim that it doesn’t.

In today’s Nepal, the manufacturing industry is struggling to survive. Therefore, it seems to be the wrong time to implement the VAT in Nepal. Maybe it can be implemented later, in the future, when we have solid economic growth and our manufacturing industry is booming. But, given today’s economic scenario, VAT is not the best tax alternative for us to pursue.