Vat invoice

This query is : Resolved

Querist : Anonymous

Querist : Anonymous (Querist)

23 September 2011 Under the Invoice Method of calculating VAT, the seller is supposed to denote VAT separately to arrive at the aggregate selling price.

But then how are the VAT invoices prepared under:

1) Addition Method
2) Subtraction Method

Please enlighten.
Thanks.

C A S.S.Agarwal, M.Com.,LL.B,

C A S.S.Agarwal, M.Com.,LL.B, (Expert)
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24 September 2011 The VAT Mechanism
1. The value added: how to measure it
The VAT, by definition, is the tax on the value added at each stage of a
production-distribution chain. The value added, in turn, can be defined in two alternative
ways. First, value added is equivalent to the sum of wages to labor and profits to owners
of the production factors including land and capital. Second, value added is simply
measured as the difference between the value of output and the cost of inputs. The two
ways of definition of value added give rise to three major alternatives for computing the
VAT liability as described below.
2. Three alternatives in VAT computation
2.1. The addition method
The tax liability is equal to the tax rate multiplied by the value added defined as
the sum of wages and profits. If t1 and t2 are the rates on wages and profits respectively,
then the tax liability will be the sum of (t1*wages) and (t2*profits). The addition method,
in practice, would be politically hard to sell to the public, as taxpayers would simply view
the VAT as an additional layer of tax burden on top of corporate and personal income
taxes. On the other hand, the structure of the tax implies that the VAT, theoretically, can
be used to replace both personal income tax and corporate income tax.

2.2. The subtraction method

This argument forms part of the core of the long-debated topic of tax reform in the United States (see, for
example, Slemrod and Bakija (2000)).
10The tax liability at any stage is equal to the tax rate multiplied by the tax base or
value added measured as the difference between the values of outputs and inputs.
2.3. The invoice-based credit method
This is the most common method of the VAT computation. Under the invoicebased credit method, a firm at any stage of the production-distribution chain charges its
customers the VAT on its output, submits the tax to the treasury, and then claims for the
VAT already paid on its input purchase. Let t1 and t2 be the tax rates on output and inputs
respectively, then the tax liability is the difference between (t1*output) and (t2*inputs).
2.4. Which VAT computation is the best practicable
The invoice-based credit VAT apparently has advantages over both addition and
subtraction methods. The addition method relies on accurate information on wages and
profits which are hard to obtain in developing countries, and thereby runs into the same
problems faced in income taxation. The subtraction method, on the other hand, requires
an explicit estimation of the tax base—this would be fine for a VAT with a single rate
structure but would result in serious problems for a multiple-rate VAT regime. For the
purpose of illustration, let us look at a simple case: assume a firm purchases a single type
of input (I) subject to a tax rate of ti and produces two types of output subject to different
rates of t1 and t2, respectively. To properly refund the tax on inputs to the firm, the tax
administration needs to know how to apportion the input (I) into the two types of outputs.
Misaligned information, and the resulted monitoring problem inherently make the
subtraction method practically hard to apply.
On the other hand, under the invoice-based credit method, the VAT on outputs
and inputs is, essentially, assessed and collected separately, and the refunds are credited
11on the basis of the invoice on input purchases. As the tax base does not need to be
directly calculated, the system handles a multiple rate structure more efficiently than does
the subtraction method.
An extra benefit of the invoice-based credit mechanism is that it
requires firms to retain invoices and hence self improves the general record keeping
practice. “Self-policing,” a desired character of the VAT, is specifically related to the
invoice-based credit VAT.
3. Three types of VAT base
3.1. GNP type (Product-typed)
A GNP-typed VAT taxes all final goods and services except for intermediate
goods. Investment costs also enter the tax base—no capital expensing or depreciation is
allowed. The advantage of this type of the VAT is that the base is relatively large. The
big disadvantage is, however, that the investment items will bear the full tax burden.
3.2. Net national product type (Income-typed)
This type of the VAT excludes from the base the value of intermediate inputs and
depreciation. The base is, therefore, similar to the one in income taxation.
3.3. Consumption type
The base excludes the value of both intermediate inputs and investment items from
the gross value of goods and services. The base—as defined—is close to the one in retail
sales taxation.
Most countries apply the consumption type VAT but introduce various ways of
giving credit for capital goods. Rarely do countries allow for immediate and full credit of
the tax charged on capital goods. They generally limit the credit in a certain period to the
Note, however, the invoice-based credit method cannot escape from the apportionment problem in some
complex cases, for example, where a firm produces both exempt and taxed output.
12level of the VAT chargeable on output and allow the remaining credit to be carried
forward to offset the tax in later periods (for example, this is a common practice in Latin
America). On the other hand, some countries selectively grant immediate exemption of
the VAT on the purchase of capital goods as part of an overall package of fiscal
incentives to priority industries.
There are two important notes. First, both product and income-typed VATs entail
cascading effect as they more or less charge the tax on investment items. Thus, they are
not production-efficient. The income-typed VAT allows for partial and delayed refunds
of tax: investment items are not immediately expensed but gradually deducted from the
tax base over a specified period in the project’s life—the investment items, therefore,
bear partial tax burden in present value terms. However, the GNP or income tax base is
relatively larger than the one of the pure consumption-typed VAT and is not commonly
applied in practice—China and Brazil are among a few exceptional cases, which apply
the GNP-typed VAT (China apply the GNP-based VAT at state level). On the other
hand, the pure consumption base would relieve production from tax burden and hence
makes the VAT more production-efficient. In addition, as a general consumption tax, the
consumption-typed VAT does not distort the investment and saving behavior (discussed
in section II).
IV. Calculation of VAT and Performance Measures
1. Some further basic concepts in VAT: exemption v. zero rating
An exempt stage is completely eliminated from the production-distribution chain:
an exempt firm is not required to collect the tax on output sold to its consumers, but it is
13not entitled to claim for the credit of the tax the firm has already paid on its input
purchase.
A zero rated firm charges no VAT on its consumers—equivalently put, the firm
charges the rate of zero percent on its sales—and then, it claims for refunds of the VAT
previously paid on its input purchase. In essence, zero rating does not break the link
between the zero-rated stage with others in the whole production-distribution chain—zero
rating can be thought of as an extreme case of reduced rate on output of eligible products.
2. How the VAT is calculated: some illustration
The following examples are set up to illustrate the mechanism of the VAT
calculation and to make contrast between the invoice-based credit method and subtraction
method.
Let us look at the case of, say, producing bread. At the first stage, a farmer sells
wheat to a miller. In stage 2, the miller makes flour and sells to the baker. At the final
stage, the baker makes bread and sells it to final consumers. For simplicity, let us assume
that the value added at the first stage makes up the total value of the output sold (i.e.,
wheat).
Let P1, P2, and P3 be the price of wheat, flour, and bread respectively. Likewise, t1,
t2, and t3 are the VAT rates on wheat, flour, and bread respectively.
2.1. No exemption, no zero rating
Under subtraction method, the VAT in the whole chain would be calculated as
follows:
Tax liability = t1*P1+t2*(P2-P1)+t3*(P3-P2) (1)
Under credit method:
14Tax liability = t1*P1+[t2*P2-t1*P1]+[t3*P3-t2*P2] = t3*P3 (2)
In a single rate system, the tax liabilities in (1) and (2) are the same, and the
effective tax revenues are equivalent to the ones received under a retails sales tax system.
2.2. Exemption
We now introduce exemption in the tax structure and analyze its revenue
implications.
2.2.1. Exemption of the first stage
Under subtraction method: Tax liability = t2*P2+t3*(P3-P2) (3)
Under credit invoice method: Tax liability = t2*P2+[t3*P3-t2*P2] = t3*P3 (4)
Note, under the invoice-based credit method, the tax revenues are the same in
both non-exemption and first-stage exemption cases. On the other hand, under the
subtraction method, the revenues may be lower or higher in the first-stage exemption
case than in the non-exemption case, depending on the relative magnitudes of t1 and t2.
2.2.2. Exemption of the second (middle) stage
Under subtraction method: Tax liability = t1*P1+t3*(P3-P2) (5)
Under invoice-based credit method: Tax liability = t1*P1+t3*P3 (6)
With the middle-stage exemption, the tax revenues under invoice-based credit
method are higher than the ones without exemption. This is the case, because the
exemption of the middle stage effectively eliminates this stage from the whole chain:
the second firm (the miller) cannot claim for refund of its input tax (the tax paid by the
firm on its purchase of wheat)—the tax burden hence carries on. This generates
“cascading effect,” which is typical in turnover taxation. The subtraction method, on the
15other hand, collects less revenue when the middle stage is removed from the VAT chain
(the value added generated in the second stage is effectively removed from the tax).
2.2.3. Exemption of the third (last) stage
Under subtraction method: Tax liability = t1*P1+t2*(P2-P1) (7)
Under credit invoice method: Tax liability = t1*P1+[t2*P2-t1*P1] = t2*P2 (8)
Under both methods, the tax revenues are less than the ones collected in the nonexemption case. As the last stage is out of the tax net, the value added in this stage
escapes the tax. This indicates that the overall tax burden could be reduced by exempting
the last stage.
2.3. Zero rating
2.3.1. Zero rating of the first stage
Under subtraction method: Tax liability = t2*P2+t3*(P3-P2) (9)
Under credit invoice method: Tax liability = t2*P2+[t3*P3-t2*P2] = t3*P3 (10)
Zero rating of the first stage does not change the effective tax revenues under
invoice-based credit method. However, the tax revenues would be lower under
subtraction method: the value added generated in the exempt stage (first stage) is not
taxed.
2.3.2. Zero rating of the second (middle) stage
Under subtraction method: Tax liability = t1*P1+0*(P2-P1)+t3*(P3-P2) (11)
Under credit invoice method:
Tax liability = t1*P1+[0*P2-t1*P1]+[t3*P3-0*P2]=t3*P3 (12)
16Under invoice-based credit method, zero rating of the second (middle) stage does
not change the VAT revenues. Under subtraction method, the value added generated in
the second stage is free of tax.
2.3.3. Zero rating of the third (last) stage
Under subtraction method: Tax liability = t1*P1+t2*(P2-P1)+0*(P3-P2) (13)
Under credit invoice method: Tax liability = t1*P1+[t2*P2-t1*P1]+[0*P3-t2*P2]=0 (14)
Under invoice-based credit method, the tax revenues for the whole chain become
zero if the last stage is zero rated. This implies that to completely relieve exports from
the VAT burden, zero rating, but not export exemption, must be applied. A destination
VAT regime (to be discussed later) zero-rates exports, but taxes imports.
Summary
- Under invoice-based credit method, zero rating of any stage prior to the final one
does not affect the total tax burden borne by the whole chain. The tax revenues will,
however, be eliminated if the last stage is zero-rated. Under subtraction method, zero
rating of the last stage is equivalent to exemption: the value added in the last stage is
relieved from the tax burden, but tax revenues are still collected on the value added
generated in all preceding stages.
- If any middle stage is exempted and invoice-based credit method is applied,
higher tax revenue is expected due to cascading effect: the exempt stage is eliminated
from the chain, and the tax burden on the value added generated in all stages prior to the
exempted one remains and carries on in the whole production-distribution chain.
17- Under invoice-based credit method, exemption is expected to provide some tax
relief if it is applied to the last stage. In this case, the value added generated at the last
stage is not taxed.
3. VAT performance measures
The concepts of tax buoyancy and elasticity can generally be used to evaluate the
performance of the VAT or any other type of tax or the whole tax system.
7
Tax
buoyancy is defined as the ratio between the real growth rate of tax revenues and the real
growth rate of GDP or GNP. The data on revenue collection used in estimating tax
buoyancy incorporates the impact of any discretionary changes in the tax rate or base or
both during the reporting period.
Tax elasticity is defined in the same way as tax buoyancy. However, the data on
revenue collection used in estimating elasticity excludes the impact of any discretionary
changes during the reporting period. Thus, tax buoyancy measures the efficiency of both
underlying tax structure and discretionary changes, whereas tax elasticity measures the
efficiency of the fundamental tax structure. In general, the VAT performance is
considered to be satisfactory if the buoyancy or elasticity is greater than or equal to one:
in this case, the VAT collection keeps up with the growth of the economy.
Other diagnostic tools for the VAT performance include efficiency ratio and Cefficiency ratio (for detailed discussion, see Ebrill et al. 2001, pp. 40-42). Efficiency
ratio (E) is defined as the share of the VAT in GDP divided by the standard VAT rate.
An efficiency ratio of, say, 30 percent, implies that if the standard VAT rate is increased
by one percentage point, the shares of the VAT revenues in GDP is expected to increase

Shome (1988) provides detailed discussion on tax buoyancy and elasticity in the context of developing
countries.
18by 0.3 percentage point. In general, the higher the ratio E, the better the performance of
the VAT. The IMF survey shows that small islands and members of the European Union
(EU) have the most effective VAT systems: their estimated efficiency ratios attained at
48 and 38 percent respectively, while the worldwide average was 34 percent. Note, the
efficiency ratio is an imperfect and, even misleading, statistic. First, there exist problems
in measuring GDP, especially in countries with relatively large informal sector. Second,
in general, the GNP-typed VAT—where only intermediate inputs are exempted from the
base, and hence there exists some degree of cascading—tends to improve E, but for
economic efficiency, the consumption-typed VAT—which can get rid of the cascading
effect if the tax is properly applied—is actually more desirable (discussed in section II).
8

The C-Efficiency ratio is defined as the share of the VAT in consumption divided
by the standard VAT rate. This statistic—based on consumption rather than GDP—is a
more reliable diagnostic tool than the efficiency ratio E. The index may be higher or
lower than 100 percent. Some caution should be noted. A too high ratio E, especially,
the one far above 100 percent—that may be derived from multiple exemptions in the
middle stage or inclusion of investment costs in the base (e.g., GNP-typed VAT)—does
not necessarily mean the VAT is efficient but may instead indicate probable cascading
problem. In general, the further the index deviates from 100 percent (either lower or
higher the 100 percent benchmark), the less efficient the VAT system is. Consistent with
the prediction under the efficiency ratio E, the IMF survey shows that the small islands
and the EU achieve the best C-efficiency ratios of 83 and 64 percent respectively.

The consumption-based VAT, by definition, relieves investment costs from the tax base and thereby
minimize any potential cascading problem.
19V. VAT Design Issues and Policy Implications
1. Origin versus destination principle
Under destination principle, the tax is imposed at the point of consumption (tax on

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