Rationalizing the New Indonesian VAT Reform

Despite the surging of Covid-19 cases in Indonesia, the polemic of the government's current effort to reform its taxation policy has become increasingly heathen up in public. The issue of the inclusion of necessities, education, and health services in the new VAT net, has become a discussion from the policy-making level to the household level. Mostly, however, are holding a firm belief that the government took the wrong step by pushing the inclusion of those sectors and suggesting the application of multiple VAT rates.

What should we know about the government’s VAT reform?

A good tax system should always be relevant to the evolving economic situation both at the domestic and global levels. The last existing VAT regulation is law number 11 of 2020, an omnibus law on job creation that amends several laws, including VAT. However, law number 11 of 2020 does not significantly change the VAT policy, let the VAT base and rate remain the same. Benchmarking VAT practices in several countries, the government found that the current VAT base is too narrow and the rate is lower than the global average rate. Hence, the government views that VAT reform is needed to keep the regulations stay on the same pace with the evolving global situation while maintaining its taxation principles. 

The government's proposal mainly consists of two things. First, the new VAT system should lessen the negative list of VAT, and include more goods and services in the system. The currently exempted goods and services, such as necessities, education and health services are within the proposed list. The government argued, that the current negative list is ineffective and benefit the rich more. In substance, the government try to take out the goods and services that only consumed by the rich from the exemption list.

Secondly, the government propose a multiple VAT rates system, replacing the current single rate VAT. There would be three types of rates; standard rate; reduced/below standard rate; and increased/above the standard rate. In several countries, the reduced rate is applied to specific basic items such as basic food, fresh fruit, vegetables, and other basic needs. Depend on the rate formulation and exemption arrangement, items consumed by the low-income group will be taxed at a lower rate or no tax at all. 


Should VAT ignore equality?

The main argument from those who oppose the idea of full-inclusion and multiple VAT rates evolves around the regressive nature of VAT. That is, low-income earners pay VAT in a higher proportion of their income compared with high-income earners. Because of this nature, people argue two things. First, we should ignore equality when talking about VAT, and second, the government should compromise the regressivity with more pro-poor programs. These two arguments are completely reasonable. However, in real life, even our current single rate VAT fails to match the first notion.

The fact that our current VAT system has many exemptions and incentives show that our current system tries to use VAT as a policy tool to achieve equality. The main reason for the exclusion of necessities, education, and health from the system is to protect the low-income group from the regressivity of VAT itself. Nonetheless, these basic goods and services are not only consumed by the low-income group, but also those from the high-income bracket as well. Many studies that analyze the tax incident of this kind of policy has found that exemptions and incentives benefit high-income people more than low-income ones. 

In real life, for example, we can see how the rich can enjoy a high class of education, without paying VAT. On the contrary, low-income earners are unable to access this high-class education service even when it is VAT-free. Including education in the system, will enable the government to separate "regular education" and "high-class education". This separation would let the government taxing the rich and leave the normal education out of the system. The tax money then can be used by the government to improve the quality of the public school system, the most common education system used by the poor.

The new proposal of the VAT design would let the government taxing the rich more, which will match the ability-to-pay philosophy of taxation: those who earn more should pay more. This principle will only work if full inclusion is adopted. As discussed before, full inclusion would let the government separate the high class' consumption from the list. This is where the multiple rates model comes into play. After separations of goods and services based on who consume which is made possible, multiple rates can be a useful tool to tax consumers progressively. Goods and services that are commonly consumed by the poor, can be taxed at lower rates. A combination of multiple rates and full inclusion would result in a more equitable VAT system, with a broader tax base.


Some drawbacks

There is no perfect policy. This full-inclusion VAT policy, of course, has drawbacks. It is true it will raise both the cost of compliance and administration. Under this approach, taxpayers would need to separate their products, and categorized their products based on the product's VAT rate. This separation will cost taxpayers their time, effort, and money, resulting in higher compliance costs. The Directorate General of Taxes would also need more resources to ensure that the categorization made by taxpayers match with the prevailing VAT regulations. This will raise the administration cost, although the collection cost ratio will not increase significantly as tax collection increases simultaneously.


The Challenge of Low Tax Elasticity

There is a reason why the Directorate General of Taxes has failed to meet its target since 2008. While the economy is growing, it is strange to see the tax ratio go down. Logically, when the base expands, the tax ratio should grow as well. This mismatch indicates low tax elasticity. Compared with personal income tax and corporate income tax, VAT's elasticity is the lowest. It is estimated that the current VAT elasticity is around 0.76 percent. This number represents that each 1 percent increase in GDP will result in a 0.76 percent increase in the VAT revenue.

The top potential contributing factor to the low VAT elasticity, other than compliance, is the excessive tax expenditures on VAT. In 2019, the tax expenditures on VAT, in the form of exemptions and incentives, was accounted for 64.89 percent of the total tax expenditure during the same period. The list of exempted goods and services, which has been in place since 2009 right after the last time DGT meeting its target, is ranging from goods, such as necessities and raw mining products, to services, such as financial, religious, education and health. This long list of exempted goods and services has resulted in a narrow tax base. Not to mention, the abundant tax incentives given to various sectors in the economy has eroded the tax base even further. The high share of ineffective VAT exemptions and miss-targeted incentives are the culprit behind the inability of VAT to proportionately generate income as the GDP grows. Thus, it is important to free the VAT system from all forms of incentives and adopt full inclusion.


More pro-poor programs, not tax incentives

Together, full-inclusion and no VAT-incentive policy will generate higher tax revenue. The most important point right now is the challenge to design an effective categorization that promotes equality. However, it does not mean this policy can completely compensate for the regressive nature of VAT. The main tool to achieve equality and income redistribution is through public budgeting. Therefore, the government needs to use the extra revenue gained from the reform to support pro-poor programs in their budget or create more pro-poor projects, which aim at poverty alleviation and the improvement of life quality in general. After all, with more resources comes more responsibility, right?


*This article was published by The Jakarta Post on July 13, 2020 http://www.thejakartapost.com/paper/2021/07/12/rationalizing-the-vat-reform-make-the-rich-pay-more.html


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