Submission on VAT to Davis Tax Committee

Comments to the Davis Tax Committee (DTC)


on the


DTC’s First Interim Report on Value Added Tax (VAT)




About the Free Market Foundation

The Free Market Foundation is an independent public benefit organisation founded in 1975 to promote and foster an open society, the rule of law, personal liberty, and economic and press freedom as fundamental components of its advocacy of human rights and democracy based on classical liberal principles. It is financed by membership subscriptions, donations and sponsorships.



The DTC’s ad hoc VAT subcommittee in June 2014 called on interested parties to make submissions by July 2014 on VAT as outlined in the DTC’s Terms of Reference.[1] Twenty-two submissions were received.[2]


VAT as outlined in DTC Terms of Reference

The DTC’s Terms of Reference[3] say the DTC must evaluate the tax system by¾

Examining the appropriate mix between direct and indirect taxes;


Assessing sustainability of the VAT-to-GDP tax ratio, the economic and social impact of the tax system, and whether the tax structure can generate sufficient sustainable revenues for government spending priorities;


Examining the impact of the tax system in the promotion of small and medium size businesses, including compliance costs, possible further streamlining of tax administration and simplifying the legislation. 


The DTC has to consider¾

VAT treatment of financial services and VAT apportionment in the financial sector;


VAT efficiency and equity, and advisability of dual rates, zero rating and exemptions;


The impact of e-commerce on VAT revenues; and


Progressivity of the tax system.


The DTC is obliged to take into account the tax system’s objectives, including¾

Revenue-raising to fund government expenditure; and


Building a cohesive and inclusive society through a progressive tax system and raising revenue to redistribute resources.



DTC First Interim Report on VAT

The DTC submitted its First Interim Report on VAT to the Minister in December 2014.


The Minister authorised release of the report for public comment. The Report was made available in July 2015 and comments are invited by the end of September 2015.[4]


Our preference remains Low Flat Income Tax: a progressive consumption tax

Our first preference remains the introduction of a Low Flat Income Tax. (An income tax that is simple, flat and low, with a generous allowance that exempts the poor from paying tax.)[5] [6]


Limiting the burden of taxes on the poor is a central principle of tax reform. The Flat Tax is progressive and thus superior to VAT. A flat rate, applied to all income above a generous personal allowance, provides progressivity and equity.[7]


The Flat Tax, like VAT, is a tax on consumption. While the Flat Tax is a comprehensive income tax (the base is GDP), it is a consumption tax because it removes all investment spending from the tax base. Over time, each act of investment traces back to an act of saving; thus exempting investment from the tax base amounts to exempting saving.[8]


 If the Flat Tax is not instituted, alternatives for relieving the poor from the most onerous aspects of the VAT system are justifiable.


VAT a regressive tax

Indirect taxes such as VAT are nearly always regressive, taking a greater proportion of income from the poor than from the rich. 


Unsurprisingly, the wealthy tend to spend more money than the poor, but the poor tend to spend all their money, and since most spending goes on items that are subject to VAT or other indirect taxes, a larger proportion of income is taken in indirect taxation from the poor than from the rich. Tax can be the biggest single source of expenditure for those who live in poverty.[9]



The DTC Report observes[10] that like most VAT jurisdictions South Africa zero-rates some basic foodstuffs, which addresses regressivity to an extent.


But, the Report notes, this approach is not optimally efficient economically. The concession is of greater benefit to affluent households. Zero-rating is thus an inferior way to achieve equity. Theoretically it must be better to collect the revenue and redistribute it by targeted transfers to the poor on the expenditure side of the budget.[11]


However, the DTC considers that it would be difficult to eliminate current zero-ratings. At best, items could be retained that benefit poor households, such as maize meal, brown bread, rice and vegetables; and items consumed by the affluent could be withdrawn, such as fruit and milk,[12] and possibly (the figures suggest) vegetables and eggs.[13]


The DTC’s strong recommendation is that no further food items be considered for zero-rating.[14]


We reiterate our proposal that the government consider including essential medicines in its list of zero-rated VAT products. Taxes on medicines are highly regressive and severely penalise the poorest and most vulnerable members of society.[15]


VAT exemption of non-fee-based financial services and resultant VAT cascading

The Report says VAT exemptions are regarded as an aberration from the logic of VAT. Exemptions go against the core principle of VAT as a tax on all consumption, and undermine VAT’s efficiency and neutrality. South Africa has a few VAT exemptions, including non-fee-based financial services.[16]


The Report observes that (non-fee-based) financial services are exempt because they are considered hard to tax. There may be agreement that supply of financial services to a final consumer should be subject to tax, but determining the consideration for the supply is elusive. Often no explicit charge for the supply is made. Hence most jurisdictions exempt financial transactions and South Africa is no exception, though it imposes VAT on explicit charges.[17]

The Report regards the VAT cascading resulting from exempting financial services as an important area that needs addressing. VAT cascading arises because a financial institution providing exempt financial services is denied input tax relief for VAT borne by it on the acquisition of goods and services from third parties. VAT levied by a supplier to the financial institution becomes a hidden cost because it cannot be deducted by the financial institution.


To the extent that the financial services are supplied to businesses who themselves would have been entitled to input tax relief had the financial institution on-charged the VAT paid by the financial institution, the VAT paid by the financial institution becomes a cost. This cost will usually be absorbed in the price charged by the business to its customers – which in turn will attract VAT resulting in tax cascading.[18]


The Report contains an Annexure[19] assessing the merits of different foreign jurisdictions’ methods of addressing VAT cascading (New Zealand’s zero rating of financial services supplied to vendors; Singapore’s treatment of exempt supplies to taxable persons as taxable supplies; Australia’s reduced input tax credit (RITC) scheme; the European Union member states’ option to tax; Quebec’s former zero rating of financial services).[20]


The Annexure recommends that consideration be given to allowing financial-services organisations to claim a reduced input-tax deduction at a fixed rate on certain inputs, similar to Australia’s RITC scheme. The RITC scheme allows suppliers of financial services to claim a percentage of the tax paid on specified inputs.[21] Although a fixed input-tax deduction may not accurately reflect the value added by all financial-services organisations, it eliminates the cascading effect of VAT, and is simple to implement, control and administer; and all financial-services organisations are treated equally.[22]


But the DTC does not fully embrace the Australian model recommended in the Report’s Annexure, and the Report says only that the DTC, after considering approaches in other jurisdictions to mitigate VAT cascading in the financial-services sector, is of the view that they should receive further urgent consideration by the National Treasury and SARS.[23]


We strongly support the adopting of the Australian or another suitable method of mitigating VAT cascading in the financial-services sector. The hidden costs caused by exempting financial services from VAT add to the costs of businesses, particularly small and medium size businesses, and other users of credit and financial services.


Raising the VAT rate

The Report says the DTC is cognisant of the fact that the fiscus may need to generate additional tax revenue at some point in the future. For example, if National Health Insurance is to become a reality, the tax-to-GDP ratio will need to rise significantly. To this end, the Committee requested the National Treasury to undertake a modelling exercise to investigate the impact of increasing VAT from 14% to 17%. There was no particular rationale for choosing a 3% hike, the example being simply illustrative. For comparison, the DTC asked the Treasury to simulate an increase in personal income tax (PIT) rates and in the headline corporate income tax (CIT) rate, such that each of these taxes individually raised revenue by the same amount as 3% increase in VAT, i.e. to generate an additional R45 billion. The increase in PIT would need to be 6.1% and the increase in CIT would need to be 5.2% to realise the same revenue as a 3% VAT increase.[24]


The Report notes that an increase in VAT would be inflationary in the short run, since prices of most consumer items would rise overnight. In contrast, an increase in personal or corporate tax rates would have a smaller impact on inflation. A VAT increase would have a negative impact on real GDP and employment particularly in the short term, but the impact would be less severe than that of a rise in PIT or CIT. It was thus clear that from a purely macroeconomic standpoint a VAT increase is less distortionary than an increase in direct taxes.[25]


However, a VAT increase would have a greater negative impact on inequality than an increase in PIT or CIT. According to the modelling, inequality (measured as the ratio of the richest decile relative to the poorest four) would rise very slightly in the VAT scenario, but would decline in the PIT and CIT scenarios. This is because primarily high-income households are affected by an increase in direct taxes.


It was thus clear that there is a trade-off between efficiency and equity. Raising VAT will have a negative impact on inequality (albeit a very small one), but will be much more efficient than increasing direct taxes. It was also important to consider the longer term: increases in direct taxes dampen growth, which in turn leads to reductions in tax revenues and constrains the ability of the state to reduce inequality through the expenditure side of the budget.[26]


The Report concludes that, should it be necessary to increase the standard rate of VAT, it will be important for the fiscal authorities to think carefully about compensatory mechanisms for the poor who will be adversely affected by the increase. A range of measures should be considered, such as increases in social grants or the strengthening of the school nutrition programme.[27]


The media have concluded that the Report “opens the way for a ‘moderate’ increase in the VAT rate”.[28]


This prompted the DTC to issue a clarification statement that no explicit recommendations were made to increase the VAT rate and reports to that effect are simply inaccurate.


The clarification statement emphasises that, to the extent that the economic evidence points to VAT being the most effective source of additional revenue, a VAT increase without significant recycling of revenue in favour of poorer people is inherently retrogressive. Hence were government to consider an increase in the VAT rate, then the increase would have to be accompanied by sustainable measures that mitigate the retrogressive effects.[29]


We, the Free Market Foundation, submit that, although some individuals might find the idea of raising VAT to fund National Health Insurance (NHI) politically palatable, raising VAT is a bad idea as it will disproportionately affect the very people that it is supposedly trying to assist. A poor developing country such as South Africa cannot afford a nationalised system of healthcare given the increasing burden of disease, the small tax base, the antiquated infrastructure within the public health sector, the country’s aging population, the inevitable increase in demand that will result from promised “free” health care, and the inadequate number of medical personnel. Nationalised healthcare will impose an impossible burden on taxpayers.


if we use the Council for Medical Schemes average cost of providing Prescribed Minimum Benefits of R510 per person per month (R6,120 per annum), with a population of about 54 million people, NHI will cost about R330 billion per year. When one considers that total revenue from personal income tax collections is only R311 billion, we get some idea of the futility of this ambitious proposal.


The government does not have to provide “free health care to all” and finance the healthcare needs of the entire population – this is a disastrous use of scarce taxpayer resources. Additional spending in any one area of the economy necessarily comes at the expense of spending in another. The more government spends on healthcare, the less it will have available to spend providing other critical services such as education, water and electricity.


When it comes to health care, government should concentrate its efforts and scarce taxpayer resources on the poor. For these individuals, government could act as financier but let them decide for themselves where to spend their money – and for those who can afford health care, leave them alone to seek out the cover that would suit them best.


An increase in VAT will not only retard economic growth and exacerbate South Africa‘s chronic unemployment problem but will also raise inflation and increase inequality – precisely the opposite of what is required to help the poor.[30]


The size of government measured by the levels of government consumption expenditure, transfers and subsidies, government enterprises and investment as a share of total investment, which are determinants of taxation levels, have a significant influence on economic activity. Excessive levels of government involvement in the economy and takings in taxes from the productive sector have a dampening effect on economic activity.[31] 


Gary Moore

Consultant to FMF

[1]     The Davis Tax Committee Calls For Submissions, Media Statement, 3 June 2014.

[2]     DTC First Interim Report on VAT to the Minister of Finance, December 2014, pp 5, 40.

[3]     DTC, About Us – Our Terms of Reference (TOR), 2013.

[4]     DTC, Release of Davis Tax Committee First Interim Report on VAT for Public Comment, Media Statement, 7 July 2015.

[5]     Free Market Foundation, Submission to the Davis Tax Committee, January 2014, pp 7-11, “Hall and Rabushka Flat Tax System”.

[6]     Free Market Foundation, Comments to DTC on First Interim Report on Macro Analysis, August 2015, pp 2-3 “Minimise distortion, broaden tax base, a low tax rate”, pp 3-4 “Tax equity, fairness and progressivity”, pp 4-5 “Redistribution on the expenditure side”.

[7]     Robert E. Hall, Alvin Rabushka, The Flat Tax, 2d ed, 2007, pp 78, 81.

[8]     Robert E. Hall, Alvin Rabushka, The Flat Tax, 2d ed, 2007, pp 62-63.

[9]     Institute of Economic Affairs, “Aggressively Regressive,” IEA Current Controversies Paper No. 47, C. Snowden, October 2013, pp 8-9, 45.

[10]   DTC First Interim Report on VAT, pp 7-8.

[11]   DTC First Interim Report on VAT, p 21.

[12]   DTC First Interim Report on VAT, pp 8, 24.

[13]   DTC First Interim Report on VAT, p 25 Table 3.

[14]   DTC First Interim Report on VAT, pp 8, 26.

[15]   Free Market Foundation, [first] VAT Submission to the Davis Tax Committee, March 2014. See also BDLive, 15 July 2015, Letter: “Merits of a flat tax rate overlooked,” Jasson Urbach (economist, director of Free Market Foundation).

[16]   DTC First Interim Report on VAT, p 8.

[17]   DTC First Interim Report on VAT, p 30.

[18]   DTC First Interim Report on VAT, pp 8-9, 30, 47.

[19]   DTC First Interim Report on VAT, Annexure B: Financial Services, pp 41-65.

[20]   DTC First Interim Report on VAT, Annexure B esp pp 47-60.

[21]   DTC First Interim Report on VAT, Annexure B at pp 48-50, 55-56.

[22]   DTC First Interim Report on VAT, Annexure B at p 60.

[23]   DTC First Interim Report on VAT, p 9.

[24]   DTC First Interim Report on VAT, pp 37-38.

[25]   DTC First Interim Report on VAT, p 10.

[26]   DTC First Interim Report on VAT, pp 38-39.

[27]   DTC First Interim Report on VAT, p 10.

[28]   Mail & Guardian, 30 July 2015, “VAT system changes call for caution,” Ferdie Schneider (BDO South Africa national head of tax). See also Moneyweb, 13 July 2015, “The Davis Committee’s VAT report unpacked,” Amanda Visser.

[29]   DTC, Media Statement: Clarification of Points in the First Interim Report on VAT, 17 August 2015.

[30]   Free Market Foundation, “SA just cannot afford ambitious health plan,” 3 August 2015, Jasson Urbach (economist),

[31]   Free Market Foundation, Submission to the Davis Tax Committee, January 2014, Eustace Davie and Jasson Urbach (directors, Free Market Foundation).

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