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Redistribution, efficiency and the design of VAT: a review of the theory and literature IFS Briefing Note BN212 Laura Abramovsky David Phillips Ross Warwick Redistribution, Efficiency and the Design of VAT: A Review of the Theory and Literature Laura Abramovsky, David Phillips and Ross Warwick Copy-edited by Sophia Ollard Published by The Institute for Fiscal Studies ISBN 978-1-911102-57-1 July 2017 2 Institute for Fiscal Studies Executive Summary The simplest form of value added tax (VAT) – and the form often advocated by international organisations – is one with a broad base and a single (‘uniform’) rate. In practise, most countries exempt and/or apply lower VAT rates on certain categories of goods and services. In this note we summarise the pros and cons of such ‘VAT rate differentiation’ that are highlighted in the economics and taxation literatures, paying particular attention to the applicability and relevance of each factor for low- and middle- income countries. Considering first the case for applying different rates – including zero rates – to different goods and services, we highlight theoretical arguments based on economic efficiency and a more practical redistributive argument. Considering the case for exempting particular goods and services from the VAT system entirely, we discuss a number of ‘special cases’ (such as small firms, public services and financial services) before focusing on the administrative and efficiency issues posed by exemptions more generally. Conclusions Our analysis of the pros and cons of differentiated rates has found that whether such differentiation is a good idea is to a significant extent an empirical question. How well targeted are reduced rates at helping poorer households and how does this compare to other instruments available to the country in question How much do evasion and other behavioural responses to VAT differ across different goods and services How costly and difficult is it to monitor the boundaries between different tax rates This briefing note is the first output from a broader project by researchers at IFS’s Centre for Tax Analysis in Developing Countries (TAXDEV). In future work, we will complement this note’s review of the theory and literature with an in-depth empirical analysis of the distributional impact of VAT exemptions and reduced rates in a range of low- and middle- income countries – including Ghana, Ethiopia, Tanzania and Mexico. This will include a comparison of these impacts with what could be achieved by scaling up existing cash transfer schemes or introducing new programmes that may allow better targeting of resources at poorer households. It will contribute important new cross-country evidence on the distributional case for applying different VAT rates to different goods and services. Institute for Fiscal Studies 3 1. Introduction Since the 1980s, increasing numbers of low- and middle-income countries have introduced value added tax (VAT), often as a replacement for pre-existing sales or turnover taxes. Consistent cross-country data on VAT revenues is sadly lacking, but general sales taxes (including VAT) now contribute around 32% of revenue in low-income countries and 37% of tax revenue in middle-income countries, a considerable increase from 1990 (Figure 1). Figure 1. General sales tax revenues as a percentage of tax revenue Source: International Centre for Tax and Development Government Revenue Database. Figures above are unweighted averages for those countries in this database; middle-income contains both lower- and upper- middle-income countries. All cases of missing data are excluded from analysis. The textbook version of VAT, applied at a common rate across all goods and services, has several advantages. Application of a single rate can reduce compliance and administration burdens, and reduce opportunities for tax avoidance at boundaries between product categories. In addition, the way in which it is collected incrementally at each stage of a production chain – with VAT-registered businesses charging VAT on their sales and reclaiming the cost of VAT levied on their purchases – can reduce the incentive for tax evasion and generate paper trails that can be useful for audit purposes.1 But few countries apply VATs that closely resemble the textbook version. A range of goods and services are either exempted from VAT – meaning that no VAT is charged on sales but neither can VAT paid on purchases be reclaimed – or are subjected to rates of VAT that differ from the usual or ‘standard’ rate. For instance, largely with equity in mind, many low-, middle- and high-income countries have exemptions or reduced or zero rates of VAT on goods like basic foods, to which the poor allocate a relatively large fraction of their expenditure. In this way, the relative burden of VAT on poorer households is reduced by 1 M. Keen, Taxation and Development – Again, IMF Working Paper 12/220, 2012. 0% 5% 10% 15% 20% 25% 30% 35% 40% 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 Low Income Middle Income High Income 4 Institute for Fiscal Studies more than for richer households. However, given the fact that richer households tend to spend more on food and other ‘necessities’ in absolute terms, such redistribution is not particularly well targeted. The question is thus: are there better ways available to channel resources to poorer households than poorly targeted tax expenditures In high-income countries, the answer is almost certainly ‘Yes’. Well-developed social protection systems with targeted cash transfer schemes for poor households mean one can redistribute much more effectively than via VAT.2 Low- and middle-income countries have traditionally lacked such targeted transfer systems, however. This has led a number of influential public finance and development economists to argue that reduced rates and exemptions have an important role to play in developing country VAT policy.3 In contrast, other authors emphasise the role a broad single-rate VAT can have in increasing the administrative and economic efficiency of tax collection, and in raising the revenues that allow the development of social protection programmes that can better redistribute.4 5 6 Indeed, with an increasing number of countries introducing cash and near-cash transfers to poorer households, there may already be an opportunity to raise more revenues and more effectively transfer resources to poor households by levying a broader-based VAT and expanding the scale and scope of these existing transfers. Redistribution is not the only reason that policymakers may favour different rates of VAT on different goods and services, however. If consumers respond more to tax on some goods and services, either by working less or producing more at home to avoid market purchases, and/or by shifting to informal traders who do not comply with their tax obligations, then one may want lower rates of tax on these items.7 8 9 On the other hand, inappropriate differentiation in VAT rates across goods simply distorts consumption (and potentially production) decisions, and adds to administrative and enforcement burdens. In this briefing note we briefly review the arguments for and against the use of VAT exemptions and reduced rates for reasons of administrative and economic efficiency, and for redistribution, from the perspective of low- and middle-income countries. We do not try to provide a comprehensive overview of all issues related to the operation of VAT in such countries. The briefing note is the first stage in a project that will generate new empirical evidence on the redistributive properties of VAT exemptions and reduced rates vis-à-vis more 2 J. Mirrlees, S. Adam, T. Besley, R. Blundell, S. Bond, R. Chote, M. Gammie, P. Johnson, G. Myles and J. Poterba, Tax by Design: The Mirrlees Review. Oxford University Press for Institute for Fiscal Studies, 2011. 3 R. M. Bird and P. P. Gendron, The VAT in Developing and Transitional Countries. Cambridge University Press, Cambridge, 2007. 4 E. Ahmad and M. Best, Financing Social Policy in the Presence of Informality, LSE Asia Research Centre Working Paper, No. 54, 2012. 5 A. S. Anton, F. Hernandez and S. Levy, The End of Informality in Mexico Fiscal Reform for Universal Social Insurance, Inter-American Development Bank, 2013. 6 L. Ebrill, M. Keen and V. Perry, The Modern VAT, Washington D.C.: IMF, 2001. 7 A. Atkinson and J. Stiglitz, The Design of Tax Structure: Direct versus Indirect Taxation, Journal of Public Economics, 6, 55–75, 1976. 8 H. Kleven, W. Richter and P. S rensen, Optimal taxation with household production, Oxford Economic Papers, 62, 584–594, 2000. 9 H. Cremer and F. Gahvari, Tax evasion and optimal commodity taxation, Journal of Public Economics, 50, 261– 275, 1993. Institute for Fiscal Studies 5 targeted mechanisms like cash transfers in a range of low- and middle-income countries, utilising microsimulation models (the results of which will be published by early 2018). The rest of the note proceeds as follows: In Section 2 we discuss the basic structure of the textbook VAT and deviations from this structure that are largely made for administrative efficiency – exemptions for small traders, financial intermediation, and the public sector. In Section 3 we discuss other pros and cons of exemptions and the application of different VAT rates to different goods and services, highlighting issues of particular relevance to developing countries. Section 4 offers some concluding thoughts and next steps. 6 Institute for Fiscal Studies 2. The basics of VAT In both principle and practise – if well implemented in terms of both design and administration – VAT has many attractive features compared to the taxes it has typically replaced (such as taxes on turnover/revenues or taxes on final sales only). These relate to the way the tax is designed to be collected. VAT taxes all sales, whether wholesale or retail, but allows registered traders to deduct any VAT paid on the goods and services purchased for business purposes (whether for resale or as an input into production). It is therefore a tax on the value added at each stage of the process of producing goods for sale to final consumers. Table 1 shows this for a simple three-stage production process. Table 1. A simple production chain with 20% VAT VAT charged on sales VAT reclaimable (I) or reclaimed on input purchases (II) Net VAT liability on transaction (I) or of firm (II) (I) Analysis of transactions Sale from firm A to firm B for $100 20 20 0 Sale from firm B to firm C for $300 60 60 0 Sale from firm C to final consumer for $500 100 0 100 (II) Analysis of firms Firm A 20 0 20 Firm B 60 20 40 Firm C 100 60 40 Source: Mirrlees et al, 2011, p.169. The top panel analyses VAT from the perspectives of transactions. It shows that the business-to-business sales (from firm A to B, and then firm B to C) are in effect untaxed under VAT because the VAT charged and remitted by the seller (e.g. firm A) can be reclaimed by the purchaser. This satisfies a key principle of optimal taxation: intermediate inputs (those that are themselves the result of a production process) purchased by businesses should generally be untaxed. Doing this avoids distorting traders’ production decisions (e.g. whether to purchase an input or produce it themselves), allowing them to choose what is most efficient.10 The final row of the top panel though shows that the final business-to-consumer sale is subject to an effective tax rate equal to the pre-tax sale price ($500) multiplied by the tax rate (20%). In this respect, VAT is effectively a tax on final sales to consumers. 10 P. Diamond and J. Mirrlees, ‘Optimal Taxation and Public Production: Production Efficiency’, American Economic Review, 1971, 61, 8–27. Externalities (such as pollution) associated with the use of certain inputs can provide a rationale for the taxation of these inputs, although as discussed in Section 3, VAT is unlikely to be a well-targeted instrument for addressing externalities. Institute for Fiscal Studies 7 However, it differs from a final sales tax in an important respect, as can be seen from the bottom panel of Table 1, which analyses VAT from the perspective of the taxes remitted by each firm. This shows that rather than being collected in one go at the point of final sale, the VAT system leads to VAT being collected in small chunks at each stage of the production process, based on the value added at each stage. For instance, firm B remits $40 of VAT based on the $200 of value added at its stage of production (given input costs of $100 and pre-tax sales of $300). The pros and cons of VAT Such a process has several advantages.11 First, incentives to evade VAT for any individual firm are lower relative to a final sales tax: the amount of tax due from the firm is based only on its own value added rather than the full sale price, meaning the tax that can be evaded is reduced. Second, unlike for a sales tax, there is no need for a seller to distinguish between whether a customer is a final consumer or a business: VAT is charged on the sale regardless (though a registered business can then reclaim or offset that VAT against its own liability). In the case of a retail sales tax sellers have little incentive to draw such a distinction accurately, meaning errors or deliberate misclassification (either on the part of the buyer or collusively) may affect both tax revenues and incidence. In contrast, under VAT, evasion of the tax requires omission or under-valuation of the sale in firm accounting records. Related to this, VAT is commonly implemented via self-assessment, and using an invoice- credit approach. To claim a deduction for input VAT, firms require an output VAT invoice from their supplier. This gives an incentive for purchasers to encourage compliance by their suppliers and the symmetric invoices provide a useful audit trail for tax authorities, allowing them to check that deductions have a corresponding payment. Indeed, some revenue authorities require firms to submit details of their transactions with different suppliers and customers (sometimes above a certain sales threshold) in order to collect such data automatically.12 Three recent papers examine the implications of such a VAT system for low- and middle- income countries. Ahmad and Best (2012)13 argue that in areas where tax evasion is high and administration weak, the information generated by the VAT chain can be used to improve tax administration and increase the revenues obtained from other taxes such as corporate income tax. This is supported by Keen (2012)14 who argues that by catalysing changes in ways of doing business, VAT could pave the way for the elusive strengthening of income taxation. 11 Ebrill, Keen and Perry, 2001, op.cit. 12 Such an approach has been adopted in West Bengal (L. Gadenne, T.Nandi and R. Rathelot, ‘Tax policy and firms: evidence from India’, mimeo, 2017), Brazil (A. De Paula and Scheinkman, ‘Value-Added Taxes, Chain Effects and Informality’, American Economic Journal: Macroeconomics,2010, 2, 195–221) and Uganda (M. Almunia, F. Gerard, J. Hjort, K. Knebelmann, D. Nakyambadde, C. Raisaro and L. Tian, ‘An analysis of discrepancies in tax declarations submitted under value-added tax in Uganda’, IGC Final Report 2017 (reference: S-43312-UGA-1)), for instance. 13 Ahmad and Best, 2012, op. cit. 14 Keen, 2012, op. cit. 8 Institute for Fiscal Studies De Paula and Scheinkman (2010)15 examine how the invoice-credit approach to VAT – whereby firms charge VAT on their sales and reclaim VAT on their inputs – affects the incentives of different firms to trade with each other and to comply with the tax system. They find (theoretically and empirically) that firms that comply with VAT are more likely to purchase from and supply to other VAT-compliant firms, whilst non-compli

ant firms are more likely to transact with other non-compliant firms. In sectors not subject to such an invoice-credit regime, such patterns are not found. There are two main implications of this. Firstly, higher tolerance for non-compliance at one production stage increases non- compliance in upstream and downstream sectors, hampering enforcement efforts. This suggests that tax authorities should pay attention to tax compliance across production stages (and not just the final or initial stage). Secondly, the VAT credit system can help spread compliance once enough firms are already complying. However, it can also spread non-compliance when compliance is particularly weak to start with. This suggests that the benefits of VAT require a modicum of administrative capability. The efficient use of the paper trails generated requires effective systems of audit and data- linkage and processing, which can be costly to set up and operate (especially if one wishes to capture and utilise data on transactions between firms automatically). A system for refunding VAT to firms who make losses on their VATable transactions or whose outputs are subject to lower rates of VAT than their inputs must also be put in place. Harrison and Krelove (2005)16 identify refunds as the ‘Achilles Heel’ of VAT systems in developing countries, with problems of fraud, corruption and denial of refunds by governments. Such denials happen in part because of concerns about fraud but are also sometimes related to treasury management. The keeping of purchase records – including records of which purchases were subject to VAT – as well as sales records may also increase compliance costs for businesses. Moreover, since the VAT system involves all sales as opposed to just those to final consumers, more firms and more transactions will be subject to a VAT system than a sales tax system. VAT exemptions for small businesses The costs of complying with and administering VAT are likely to be larger relative to profits and tax liabilities for smaller firms. To avoid posing significant administration and compliance burdens for relatively small amounts of revenue, it is therefore sensible to allow firms with turnovers below a given threshold (often termed the registration threshold) to be exempt from VAT. Such exempted firms need not charge VAT on their sales but cannot reclaim any VAT on their input purchases. This means such firms (and/or their customers) do in effect bear some VAT. Keen and Mintz (2004)17 show how three key factors affect the appropriate level of the VAT registration threshold: the revenue that is foregone from excluding firms below a given threshold from the scope of VAT; the administration and compliance costs saved from such exclusion; and the distortions to production, competition and firm growth resulting 15 de Paula and Scheinkman, 2010, op. cit. 16 G. Harrison and R. Krelove, ‘VAT Refunds: A Review of Country Experience’, IMF Working Paper, 05/218, 2005. 17 M. Keen and J. Mintz, ‘The Optimal Threshold for a Value-Added Tax’, Journal of Public Economics, 88, 559–576, 2004. Institute for Fiscal Studies 9 from such exclusion. The ‘optimal’ VAT threshold is one that balances the benefits of lowering the threshold (including the revenues) with the costs (such as the additional administration and compliance burdens). In the context of low- and middle-income countries, factors such as the difficulty of enforcing VAT (which may raise administration costs) would tend to point towards relatively high VAT thresholds, while the difficulty of enforcing other taxes (such as income tax) would tend to point towards relatively low thresholds. The sensitivity of the optimal rates implied by Keen and Mintz’s18 formulae to such factors, and the difficulty in quantifying such factors, means that in practise policymakers lack precise guidance for setting the VAT threshold. Firms not registered for VAT are sometimes required to register to pay other taxes based on their turnover. This is particularly common in low- and middle-income countries. For instance, in Ethiopia, firms with a turnover below the VAT threshold of 500,000 birr (or around $21,660) that do not register voluntarily for VAT are required to register and pay a 2% turnover tax on local sales of goods (and some services) and 10% turnover tax on local sales of most services. Similarly, in West Bengal in India, firms with a turnover of between 500,000 and 5,000,000 million Rs (around $7,700 and $77,000) that do not voluntarily register for VAT are required to pay a turnover tax of 0.5%. As with VAT itself, the extra revenue obtained from such a turnover tax on small firms needs to be traded off against the administration, compliance and broader efficiency costs of taxing them. To the extent that the administration and compliance costs associated with a turnover tax are lower than for VAT, it may be justifiable to collect a turnover tax on firms below the VAT threshold, but only if the rate is relatively low: high turnover taxes can cause significant economic distortions (discussed in Section 3). But it is also important to bear in mind that the introduction of simplified turnover taxes alongside VAT can sometimes end up increasing administration and compliance burdens. First, where such schemes are optional, they naturally encourage firms to estimate (at least roughly) their liability under both the simplified regime and VAT to see which is lower – indeed, tax advisors may explicitly advocate such an approach to avoid being found negligent if their client finds out they have chosen the ‘wrong’ option. Second, because the rates of ‘value added’ tend to vary by sector, in order to avoid a turnover tax imposing very different effective tax rates on value added across sectors (which could distort entrepreneurs’ sectoral choices), many countries (such as Ethiopia, mentioned above) apply different turnover tax rates to different sectors. But such differentiation means tax authorities need to police the boundaries between sectors, and can distort firms’ choices close to those boundaries. Governments of low- and middle-income countries should therefore be cautious in applying ‘simplified’ VAT regimes below the VAT threshold, and if they do so, should aim to make such schemes as genuinely simple as possible, perhaps making them compulsory rather than voluntary. 18 Keen and Mintz, op. cit. 10 Institute for Fiscal Studies Exemptions for financial and public services In addition to small businesses, it is also common – in both high income and low- and middle-income countries – to exempt financial services and public services from VAT. In both instances, there is often no transparent ‘price’ for the service in question: public services are often free at the point of use and funded by general taxation; and financial services companies earn much of their income by charging higher interest rates on the credit they provide than they pay on deposits, as opposed to explicit charges for services. Bringing such services under the scope of VAT would therefore require different measures of ‘sales’ and ‘purchases’ than are generally used. These need not be particularly complex: Mirrlees et al (2011),19 for instance, argue that taxing most cash inflows into banks (including deposits) and allowing deductions for most cash outflows from banks (including withdrawals) would be a relatively simple way of extending VAT to financial services. However, the effort expended in designing and implementing the extended VAT might not be reflected in higher revenues. VAT levied within the public sector simply represents transfers between spending departments and the central treasury. If VAT was extended to their activities one would presumably want to compensate departments by increasing their budgets. Levying VAT on financial services would lead to increases in tax revenues from ‘sales’ to consumers, but would reduce tax revenues from ‘sales’ to VAT-registered businesses (because financial-service providers and their business customers will be able reclaim any VAT paid). In the context of low- and middle-income countries where businesses are likely to be a relatively large share of financial firms’ sales, extension of VAT to financial services could even reduce VAT revenues. With such issues in mind, Bird and Gendron (2007)20 argue that low- and middle-income countries would be best served by focusing limited political and administrative capital on general improvements to VAT administration and structure, rather than extending VAT to public and financial services. But the changing nature of public services in many countries – including greater involvement of private sector firms in some services, and even competition between public and private sector providers – and the growing economic importance of financial services as both a business input and for final consumers, means this conclusion may change in future. The zero-rating of exports VAT is designed to be a tax on final consumption within a country. As a result, as well as applying to domestically produced goods and services, it is levied on (the full value) of imports. At the same time, to avoid double taxation of international trade, exports are zero-rated: VAT is not charged on export sales, and furthermore, exporters can reclaim any VAT paid on their purchases. Given the difficulty of operating VAT systems (particularly reclaims systems) across borders, and the benefits of such a ‘destination- based’ VAT more generally (named thus because the VAT rate that is charged on international trade is that of the importing – or destination – country), this approach 19 Mirrlees et al., 2011, op. cit. 20 Bird and Gendron, 2007, op. cit. Institute for Fiscal Studies 11 seems sensible. But the VAT refunds exporters require under this approach can also cause problems, including fraud. The archetypal fraud is ‘carousel fraud’, which involves a chain of linked firms across borders involved in the export, import, and re-export of goods.21 VAT is reclaimed by the exporting firms and is notionally charged by the importing firm on sales to intermediate firms (called ‘buffers’ who may or may not be aware of the fraud being perpetrated by the export and import firms). But the importing firm goes missing before remitting the import VAT to the tax authority. To reduce such risks, Harrison and Krelove (2005)22 recommend a risk-based approach to verifying refunds, including additional checks on new traders as well as traders and transactions identified as ‘high-risk’, combined with prompt refunds for firms with good compliance records. This should be less costly to both administrations and law-abiding firms than trying to check manually or verify all VAT refund claims. Summary Thus, while the textbook VAT involves a common rate applied to all firms, goods and services, there can be good practical reasons to depart from such an approach, although such departures involve costs of their own. In section 3, we consider in more detail the issues that arise with VAT exemptions, and the pros and cons of applying different rates of VAT to different goods and services. 21 IFS, CPB Netherlands Bureau for Economic Policy Analysis, CAPP, CASE, CEPII, ETLA, IFO, IHS, ‘A retrospective evaluation of the elements of the VAT system’, Report for the European Commission, 2011. 22 Harrison and Krelove, 2005, op. cit. 12 Institute for Fiscal Studies 3. What is the rationale for VAT-rate differentiation and exemptions This section considers the pros and cons of applying different rates of VAT to different goods and services. For ease of exposition we organise these into three (related) themes: administrative efficiency; broader economic efficiency; and distributional or ‘equity’ concerns. We then examine VAT exemptions, to consider whether they should be used for purposes other than those discussed in the previous section (small firms, financial services and public services). Our starting point for the analysis is the set of principles for a good tax system set out in the Mirrlees Review (2011).23 An important benchmark for the review was the idea of a progressive, neutral tax system, with each of the three key words of that formula – ‘progressive’, ‘neutral’ and ‘system’ – having implications for good tax design. Progressivity is key because redistribution between (e.g. rich and poor) taxpayers plays a central role in the tax system (albeit one where there can be a trade-off with economic efficiency). Neutrality requires that similar activities are taxed equivalently unless there are good reasons to do otherwise, to avoid distorting taxpayer behaviour and creating opportunities for tax-avoidance. Finally, the word ‘system’ emphasises that the way taxes fit together is what ultimately matters – the collective effect of each tax within the system. Not every tax – such as VAT – needs to be ‘green’ and ‘progressive’: what matters is whether the system as a whole is green and progressive. Related to these points, the Mirrlees Review24 argues that there is merit in simplicity, stability, and transparency. Simple, stable systems that are well understood by both taxpayers and tax administrators are typically easier to administer, enforce, and comply with, and will generally – although not always – cause less distortion. With all this in mind, the Mirrlees Review25 also argues that for a high-income country like the UK, a good VAT system would involve a broad base (including most goods currently exempted or subject to a zero rate) and a single rate. Zero rates should be restricted to exports and a few specific services like childcare (which can be important in allowing parents to re-enter or remain in employment) and housing (the consumption of which could be taxed via a property tax rather than at the point of sale). So, what is the rationale for this position And how applicable is it to low- and middle- income countries 26 Administrative issues with VAT-rate differentiation A range of authors argue that having multiple rates of VAT is likely to increase administration and compliance burdens.27 23 J. Mirrlees et al., 2011, op.cit, 24 J. Mirrlees et al., op.cit. 25 J. Mirrlees et al. op.cit, 26 In what follows, we draw on the analysis in L. Abramovsky, P. Johnson and D. Phillips, ‘Tax Design in Turkey and Other Middle Income Countries: Lessons from the Mirrlees Review’, Economic Research Forum Research Report Series, Ko University,2013, which considers the application of the Mirrlees Review’s principles and recommendations to middle-income countries. Institute for Fiscal Studies 13 Firms buying or selling goods taxed at different rates need accounting and invoicing processes that ensure they reclaim or charge VAT at the right rate on each transaction, and can properly reflect this in their (more complex) tax filings. The administrative burden on tax authorities is also likely to increase. Audits are more difficult: not only total sales and purchase values have to be verified, but also the amounts for goods and services subject to different tax rates (firms will have an incentive to misclassify sales as being subject to lower tax rates and purchases as being subject to higher tax rates). The number of VAT refunds is also typically higher – consider a firm whose sales are subject to a low rate of tax but many of whose purchases are subject to a high rate of tax – which as discussed earlier can pose significant problems for tax authorities. Differences in tax treatment of similar goods and services may also lead to legal and political challenges. Firms and tax authorities may need to go to court if they disagree over how any given good or service should be classified.28 The presence of reduced rates for some goods and services may also lead to the lobbying for such preferential treatment for other goods and services (especially similar ones), potentially resulting in the slow erosion of the VAT base.29 Given lower administrative capacity in most lo