The nature of VAT

01 April 2010 Robert W Vivian, University of the Witwatersrand

Nowadays we live in the three-letter acronym age. In tax, we started with GST, then migrated to VAT. In this first article of a two part series, we consider why GST or VAT exists. In the next article the change from GST to Vat will be examined.

To understand where we are, we must understand where we came from and how we arrived at our current position. To do this, one need simply track the history especially the UK tax history which is the easiest to follow. History soon reveals the truth.

Tax developments

Our modern invasive and pervasive income tax system depended on a number of developments. The first was the development of the monetary economy. For a long time, tax was not paid in money. Peter the Great of Russia was the first to insist that tax be paid in money. The second development was modern accounting systems, and the third, the computer and its current perfection, the Internet. Via the Internet, SARS can and does raid bank accounts and takes what it wants.

The longest known form of tax was the land tax. This existed due to the fact that society was mainly agricultural and the bulk of wealth was in the form of land. So, for a long time, the bulk of taxes were paid by the owners or occupiers of land, usually the aristocracy. Tax was not an issue for the man in the street. The land tax was in fact an income tax. In the absence of a monetary economy and a well-defined accounting system, tax was imposed on land as a proxy of income - the bigger and more valuable the piece of productive land, the greater the tax. It was therefore a crude form of income tax, paid by a few. The majority paid no tax.

Co-existing with the land tax is another long established tax, the customs tax - a tax levied on trade on international goods. It was used by governments to regulate and promote international trade. A customs tax is a transactions tax on goods, and it was the first form of sales tax.

Extending the tax base

The shift from an agricultural-based economy to an industrial, wage-based economy prompted government to reconsider only taxing goods sold internationally. Why not a tax on all goods sold? In this way, the tax base could be extended to persons other than land possessors and owners.

Of course, the customs tax had a particular international role to play, so the idea was not to incorporate the customs tax into broader sales tax but to introduce an inland tax. This new inland tax was called the excise tax. And so the broad based sales tax was implemented: customs for international goods and excise for inland goods. The excise tax was a specific tax. Only specific items were taxed, and at different rates. This highlights the significance of a general sales tax: a tax on all items sold, except a small range of exclusions, at one common rate.

Shifting the tax burden

David Hume (1711-1776) pointed out that one can be very sure that every man will do his best to shift the tax burden from himself to others. With the introduction of the excise tax a subtle change had taken place. The land tax fell on the aristocracy. With the introduction of the excise tax, the tax burden would, for the first time, fall on the poor.

Since the aristocracy controlled parliament, the tax burden was shifted from the land tax to the excise tax. This is clear if one examines the relative contribution of land and excise taxes from 1066 to 1800. The excise was more suited to low value items most likely to be paid for with money. So, not surprisingly, excise was levied on items such as beer and not on items likely to be consumed by the aristocracy.

The high point of this audacity came in 1733 when the aristocracy attempted to abolish the land tax and have only specific excise taxes on items consumed mainly by the poor. For all practical purposes, the aristocracy would have exempted themselves from taxes by shifting the full tax burden onto the poor – a situation which did exist in France and eventually led to the French Revolution. The 1733 attempt to extend the excise tax very nearly plunged England into another civil war, before sanity prevailed and the attempt was abandoned.

Introducing income tax

By 1799 society had developed to the point where income tax could be introduced. Since income tax is a direct tax on income, other indirect methods of assessing income could be phased out. Thus, the land tax, as a proxy for income, could be phased out. The excise tax, however, remained. As a result, two forms of taxes remained: income tax, a direct tax on income, and excise tax, an indirect tax.

Initially when introduced, income tax, like the land tax, was a tax on the wealthy. It has been accepted for centuries that the necessities of life are to be exempted from taxation. Accordingly, when income tax was introduced in 1799 and continuing right down to the 1960s, income tax was not levied on the poor or middle class. It was a tax for the wealthy. The poor and middle class paid income tax via excise duty.

VAT - the poor man’s income tax

To illustrate, if someone earns R10 000 per month, only enough to cover the necessities of life, and the excise tax is 14%, an amount of R1 400 will be paid in taxes since the full R10 000 will be spent on the necessities of life. This is exactly the same as paying an income tax of 14% on an income of R10 000, without any excise tax. So, correctly understood the excise tax is the income tax paid by the poor.

By levying a general tax on all purchases, a general sales tax, the same result is achieved as having an income tax without any deductions for the necessities of life.

The general sales tax is thus the income tax of the poor and middle class. It is often said that South Africa has a population of 47 million, but only 5 million taxpayers. That is clearly incorrect: all South Africans pay tax via the VAT system.

Excise tax is not paid, it’s collected

It is often said that GST (VAT) is paid by companies. The reality is that GST (VAT) is paid by the public and collected by companies. The company is the tax collector, not the payer. This is an important distinction.

Some important issues in this regard should also be mentioned. Firstly, the tax collector should be paid for collecting the taxes. The state should bear the costs of collection of taxes. If the state does not bear the cost, it distorts the costs of the tax. Taxes which appear to be profitable may well be unprofitable. Secondly, the risks associated with tax collection should rest with the state, not the company.

Correct role of VAT distorted

The simple system of the wealthy paying direct income tax and the poor paying income tax via the sales tax has been distorted by a number of developments. Firstly, the idea of a flat tax for income tax, which existed from 1799 to 1908, was abandoned. This resulted in the introduction of the marginal tax system, with increasing marginal rate on the wealthy and, at the same time, an income tax that increasingly encroached on the poor. GST (VAT) simply became a tax on tax.

By the time Margaret Thatcher introduced her reforms, income tax was being paid by persons below the poverty datum line and the top marginal rate exceeded 100%! The only way to reduce the tax burden was to reduce government expenditure. This she could not achieve. She did manage to reduce the top rate but at the expense of increasing GST (VAT). She was able to do what the 1733 government could not - shift the tax burden further to the poor.

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