Effect of cascading effect
Value Added Tax (VAT) is a tax imposed based on consumption. As a result, the taxable amount that has to be collected by the Inland Revenue Department cannot exceed the consideration actually paid by the consumer.
This is because the tax base at each stage of production and distribution does not include the tax paid at the earliest stage. This is referred to as negating the cascading effect of tax. If there is cascading effect, the tax paid by the final consumer will be much higher than the official tax rate. For instance, if the official rate of Turnover Tax is 10%, due to the cascading effect, the ultimate rate of the tax paid by the final consumer could be as high as 15%-20%.
Broadening the tax base and encouraging compliance
Under the VAT system, due to the mechanism of claiming input VAT, all suppliers in the distribution chain will insist on a VAT invoice in the purchase of goods and services. As a result, the tax net will increase with greater compliance.
Under the Turnover Tax system, as there is no input tax and such supplier will not insist on an invoice. Instead, suppliers will try not to pay the Turnover Tax in order to keep the prices low. This will result in a loss of revenue.
Upfront cost of tax
Currently, VAT provides relief in the form of deferment of input VAT during a project implementation phase, in order to give relief against heavy cost of tax before commencing commercial operations as against Turnover Tax, which will not have a facility to grant upfront relief on investments due to the nature of the tax.
Under the VAT system, the export of goods and services are tax neutral. Under the Turnover Tax regime, generally in the absence of a mechanism to claim input tax, cost of imports will increase and all goods and services exported from Sri Lanka may become subject to tax, thereby making them uncompetitive in the world market.
Due to the above reasons mentioned, VAT serves as a superior form of taxation which is adopted by most developed and developing countries. In fact, most countries are moving towards VAT. Foreign investors will feel comfortable due to the familiarity in the indirect tax regimes between their countries and Sri Lanka, under a VAT system.
As an alternative, the Government may if there is revenue shortfall, remove the exemptions, other than on essential goods and services and thereby make the entire chain of goods and services liable to VAT, thus effectively increasing the tax base.