What's Wrong with VAT and How to Fix It Without Changing the System

Value Added Tax

The main reason for overhauling the entire system of indirect taxation is this particular tax.

I described what VAT looks like and how it is calculated in my previous note.

To understand why the system needs to change, we first have to explain what is wrong with VAT.

In Kazakhstan, when something is wrong, the habit is not to fix it but to start over, which ends up costing more and is not necessarily any more effective.

I am in favor of improving the current system, especially in a time of crisis and uncertainty about the future of our economy.

So what are the main reasons for reforming VAT in Kazakhstan?

1. Sham entrepreneurship. Some companies issue invoices for fictitious work and services, supplying input VAT. That VAT is then claimed as a credit and reduces the VAT payable. The taxable base is thus understated and the budget loses VAT revenue, because the sham entrepreneur does not pay the VAT while the company claims it as a credit.

2. VAT optimization through SMEs. Many companies split up their operations and understate turnover to stay below the VAT registration threshold and avoid paying VAT. Under this scheme, input VAT is included in the cost of goods, and VAT is avoided only on the value added by that particular enterprise. Many also use this scheme to cash out funds, since there is no VAT or corporate income tax (CIT).

3. Export revenue of large taxpayers under large taxpayer monitoring. Such companies receive VAT refunds under a simplified procedure, and a supplier "pyramid" is not always built for them. If it is not built, then someone along the chain may have failed to pay VAT, and it is being refunded anyway.

4. The shadow economy. In Kazakhstan, part of the business activity takes place in the shadows: for example, market traders, middlemen who resell goods (say, produce from someone's private household plot), and Instagram sellers who bring goods from the US or Europe and register the imports in the names of 10–20 people, and so on. None of them pay VAT, and it is very difficult to combat them.

5. Investment VAT among exporters. After the investment phase, many companies accumulate a large volume of input VAT. As soon as a company meets the criteria of regular shipments and the 70 percent threshold, it files for a refund of all the accumulated VAT. As a result, during the investment growth of export companies, the state pays out large amounts of VAT that have not yet been passed on into value added, which creates distortions in the VAT structure.

In short, the state has many problems with understated VAT, but these problems create difficulties for business too:

1. If a company is not among the top 300 large taxpayers, recovering the VAT accumulated in its accounts takes a great deal of time, so the VAT it has paid cannot be used in its operations. This asset is frozen, and the company's investment phase gets longer.

2. The pyramid. To refund VAT, the tax authorities must conduct an on-site tax audit and build a pyramid of suppliers, and if any supplier has not paid VAT, that amount will not be refunded to you. This is a good method, but it has a very serious drawback: the pyramid is often built subjectively, because it is hard to determine whether your supplier failed to pay VAT on your goods, works or services (GWS) specifically, rather than on those of another counterparty. Tax officials do not look into this and act at their own discretion, which leaves room for corruption. Moreover, the taxpayer becomes dependent on its suppliers while, de facto, having no ability to influence them. In my view, if a supplier has not paid VAT, that is a problem for the supplier and the tax service, yet here it becomes the buyer's problem as well. Of course, this encourages companies to work only with trusted counterparties. But from a legal standpoint, the company has no connection to the supplier whatsoever, and in a normal country it would be in the right and could recover the VAT from the state through the courts. Here, that is problematic and expensive.

3. Regularity of shipments. One of the criteria for a company to be entitled to a refund of accumulated VAT is regularity of shipments, namely, continuous exports over three consecutive quarters. That is how I remember it, at least. I once worked at a company with 100 percent exports, and we shipped once every six months. Unfortunately, such a company did not meet the regularity requirement, and the tax authorities simply did not care that this was how our technology worked. That is a gap in the legislation.

4. Taxation of interest on loans issued by non-financial organizations. This is very inconvenient, especially for investment companies that cannot grant interest-free loans but allow deferred interest payments. As a result, the company pays VAT on income it has not yet received.

I could probably list many more distortions, but why was it decided to abandon VAT altogether rather than simply address these pressing problems?

To sum up, the main problem is the inability to control the payment of VAT and its claiming as a credit. How can this be tackled?

A system of electronic invoices is now being actively developed, and I believe this initiative will solve some of the problems.

But the core issue is how to make VAT payers actually pay VAT, so that it cannot be cashed out.

There are two possible solutions here:

1. Improving the judicial and law enforcement systems to identify and punish sham entrepreneurs, which requires that punishment be inevitable. Unfortunately, we have to admit that in our country such a change will not happen soon and will require major transformations.

2. Tightening or changing the VAT payment system itself. I think one option worth considering is to decouple the movement of VAT from the movement of goods.

In any case, we need to move in both directions.