Replacing VAT with a Sales Tax: Who Benefits and Why It Is Risky

While we wait to see how the new sales tax will be presented, I would like to reflect on why it was decided to reform VAT and who stands to benefit.

Any reform of VAT should start from the system of goals and objectives the tax is meant to serve.

But first, let us look at a simple example of how VAT works.

Suppose there is a company X that manufactures a product.

For example, the product costs KZT 100,000, including:

Raw materials and supplies: KZT 50,000

Wages and taxes: KZT 30,000

Profit: KZT 20,000

The raw materials and supplies are imported from abroad.

Let us calculate how much the state receives from the sale of the product under two options:

Option 1: sale within the country

Option 2: export abroad

Under the first option:

On import, the company pays VAT:

50,000 x 12% = KZT 6,000

Then, on sale to the end consumer, VAT of KZT 12,000 is charged,

and the company pays an additional KZT 6,000.

In total, KZT 12,000 goes to the budget.

Under the second option:

On import of the raw materials and supplies, KZT 6,000 is paid.

On shipment for export, the company becomes entitled to a refund from the budget of the KZT 6,000 of VAT it paid earlier.

In total, budget revenue is KZT 0.

If half of the product goes abroad, the budget receives KZT 6,000.

Now let us see how a sales tax would work in a simplified version.

In its classic form, a sales tax is levied only on retail sales to the end consumer. So let us assume that this is the version that will be introduced in Kazakhstan.

This leaves the question of the rate. If only retail sales are taxed, it is logical that the rate should be 12%, the same as VAT, in order to collect the same KZT 12,000 in revenue when all sales are domestic.

But if the rate is lower than 12%, the budget will lose part of its tax revenue.

Now, the main current problems with VAT.

From the state's point of view:

VAT is an important source of tax revenue for the state. Of the KZT 5 trillion in national budget revenue, roughly KZT 1.2 trillion comes from VAT (24% of all revenue). Naturally, given this importance, the state wants to collect as much of this tax as possible.

That is why, when it comes to refunding export VAT, there is always a temptation to minimize refunds to exporters. The state's main motive is the fight against sham entrepreneurship.

In my estimation, the main scheme works as follows.

A supplier sells goods to a sham entrepreneur for KZT 112 (hypothetically). The sham entrepreneur then sells them to an exporter for KZT 224. The exporter ships them abroad for, say, KZT 200 without VAT. The sham company cashes out KZT 112. No taxes are paid, and the company is a fly-by-night shell. The exporter is left with KZT 24 to be reimbursed from the budget. As a result, the budget initially receives KZT 12 from the first supplier, then refunds KZT 24 to the exporter, and the state suffers a direct loss of KZT 12.

The only way to recover this VAT is through a corrupt deal, because when the chain is unwound, it turns out that the sham entrepreneur did not pay VAT.

From the exporter's point of view:

There are two points here:

1. The exporter should at the very least receive the KZT 12 of VAT paid by the first supplier, since the original supplier did pay VAT.

2. The exporter cannot be held responsible for its counterparty, and cannot influence it (unless there was collusion), and collecting taxes and fighting sham entrepreneurship is not the exporter's job.

Exporters therefore have an interest in resolving the VAT problem, and abolishing VAT would be a good solution for them.

For the state, however, introducing a pure sales tax would not be the best solution, because besides preserving tax revenue, it would have to deal with a number of problems:

1. Accumulated VAT balances. Either they will have to be refunded to everyone with a positive VAT balance, and there are a great many such companies, since VAT refunds are very difficult to obtain, or they will have to be written off as losses by all companies, which would shrink the corporate income tax base and reduce budget revenue.

2. Separating retail sales from sales to businesses. Sales to businesses should not be subject to the sales tax. That would require controls over individual entrepreneurs. The number of individual entrepreneurs would grow many times over, since registering as one would allow people to buy goods and services without the sales tax. This would cause a significant drop in budget revenue.

3. The shadow economy. It is very hard to monitor the write-offs and sales of SMEs, and introducing a sales tax would require very extensive controls, because the final seller, selling at markets without documents, will avoid the sales tax. Consequently, budget revenue would fall once again. Under VAT, an intermediary pays VAT to the supplier, and even if he sells without VAT, VAT has already been paid on the bulk of the value, so he evades VAT only on his profit. Under a sales tax, he would evade taxes entirely.

4. Imports raise two problems. The first is that the seller will pay the equivalent of import VAT only when selling to the end consumer. That is a time lag, and budget revenue would again suffer in the short term. The second is that, whereas under the current system taxes arise when import VAT is paid even if the goods are later sold on the gray market, under a sales tax a gray-market sale would allow taxes to be avoided completely.

Introducing a sales tax would therefore require major changes in the control of retail sales, and in a country where most sales take place without cash registers, it would be very difficult to implement. Such an implementation would take years.

In my view, the problem lies not with VAT but with the fact that law enforcement and the judicial system in Kazakhstan work rather inefficiently. Until punishment becomes inevitable, even if we resolve the VAT issue, we will then be left wondering what to do about gray-market dealers.