DISCUSSION PAPER Report Noo DRD222 LESSONS FROM THE J)u.AZILIAN EXPERIENCE WITH THE VAT By Carlos Longo University of Sao Paulo September 1986 Development Research Department Economics and Research Staff World Bank The World Bank does not accept responsibility for the views expressed herein which are those of the author(s) and should not be attributed to tl1e World Bank or to its affiliated organizationso The findings!~ interpretations!~ and conclusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Banko The designations employed!~ the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion tvhatsoever on the part of the World Bank or its affili.ates concerning the legal status of any country, territory~ city, area, or of its authorities, or concerning the delimitations of its boundaries 1 or national affiliationo I'! LESSONS FROM THE BRAZILIAN EXPERIENCE WITH THE VAT By Carlos Longo Univ£rsity of Sao Paulo September 86 The World Bank does not accept responsibility for the views expressed herein which are those of the author(s) and should not be attributed to the World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are the result8 of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed; the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or con~erning the delimitations of its boundaries, or national affiliation. AB.STRAC:r The paper reviews thef-'Bta~ilian· experience with the state VAT introduced in 1965 in place of a turnover sales tax that had existed for more than 30 Y.~ars. The basic state VAT is described, the major exclusions and exemptions are discussed, and issues of interjurisdictional tax coordination are raised. An estimate of the revenue effect that result~ due to a lack of this coordihation is" presented. The paper finally ''brings 'together conclusions and the main policy implicat.ions. This paper was prepared for the Conference on Value Added Taxatibn in Developing Countries, sponsor~ci by the Public Economics Division, Development Research Departm~nt, The World Bank. LESSONS F~OM THE BRAZILIAN EXPERIENCE WITH THE VAT Table of CoQtent£$. :. I. Taxation at the National Level , • • • • • ~ • e e .• e • • ~ • 111 ct e e • e • • ct • • • ' e el l VAT Basic Structure •••••••.• r ••• ,f ••. ~ • • • • • • • • • • :" • ,. ••••. e ••• " ~ •.• 5 3. Exclusions and Exemptions ····························••o:..••• 12 4. Issues on Federalism .............. " ....................... . 15 Concluding Remarks • e e e e • e • o 111 • • • ct e e e e • • • a e • e e • • e • e • e w e e • • • • !II • • • • 21 List of Tables 1. National Tax Revenue •••••••••••••••••••••••••••••••••••••••• 3 2. Federal Ta~ Revenue ••••••••••••••••••••••••••••••••••••••••• 7 3. State Tax Revenue, 1985 •••••••••••••••••••••••••••••••••••"• 9 4. Change in State VAT Collecti~n, 1980 ••••••••••••••••••••••• 10 LESSONS FROM BRAZILIAN EXPERIENCE WITH THE VAT I. Taxation at the National Level Until the mid-thirties, major taxes were virtually non-existent in Brazil. Federal and state governments collected the bulk of their revenues from a variety of limited taxes and tariffs, imposed under different names on trade and business. Tax provisions contained in the 1934 Constitution were a first effort to put together scattered levies to reach the basis of a larger scope. As a result, an incipient personal income tax was assigned to the federal government, a turnover sales tax was attributed to the states, and an urban property tax to local governments. These taxes, however, did not become relevant sources of revenue until a later date. Effective contributions to the federal budget then were import tariffs and excises on liquor and tobacco, while states depended heavily for revenues on their export and import taxes. In 1966, the last year the old tax regime was in place, income taxes and various single-stage wholesale consumption taxes (cigarettes, liquor and luxuries) accounted for about 75 percent of total revenue at the federal level -- excluding social security. At the state level, taxes on trade gradually gave way to the highly productive turnover sales tax, which became their most important source of income 80 percent of total revenue. States had for a long time absolute freedom to legislate over their own base and rate; thus, tax rates differed from one state to another according to local conditions ~nd needs. By 1959 rates stayed in a 3 to 5 percent range, and grew swiftly to a 4 to 7 percent range on the eve of the reform. - 2 - National tax revenues -- excluding social security -- as a percentage df GDP dropped from about 17 to 12 percent in the last 20 years. This abrupt reduction came about largely because ~xpenditures with traditional public sector activities {education, health, defence, law and order, etc.) gave way to the expansion of public s~rvices financed with specific contributions or own revenues -- social security and government enterprises. Currently, the federal government collects 56 percent, the states 38 percent, and municipalities 6 percent of the total national revenues. Allowing for intergovernmental transfers, however, the federal government disposes of 46 percent, states 36 percent and municipalities 17 percent. In the last 20 years, the federal government and municipalities share of total revenues increased at the expense of the states; highly centralized tax legislation and pressing needs of local governments -- urged by accelerated urbanizaticn explain, to a great extent, this redistribution effect (See Table 1). The 1965 tax reform was enacted by the Administration, through constitutional amendment, later utilized with negligible changes, in writing the National Tax Code (Law 5172/1966). Existing taxes were then grouped in four categories according to their economic base -- external trade, income and wealth, production and "special" taxes -- and assigned to specific levels of government. This reform abolished numerous taxes applied on specific activities, licenses and stamp taxes ("Industria e Profissoes", "Diversoes Publicas, etc.) and approximated the cascade turnover taxes to its real economic base. - 3 - Table 1: NATIONAL TAX REVENUE .Year Federal States 11unicipalities' Percent Before Intergovernmental Transfers 1965 51.,0, 43.0 6.0 1970 54.0 42.0 4.0 1975 58.0 37.0 5.0 1980 58.0 36.0 6.0 1983 57.0 37.0 6.0 f984 56.0 38.0 6.0 1985* 56.0 38.0 ·6.0 After Intergovernmental Transfers 1965 39.0 48.0 13.0 1970 46e0 39.0 15.0 1975 50.0 36.0 14.0 1980 49.0 35.0 16.0 1983 48.0 35.0 17.0 1984 46.0 46.0 18.0 1985* 46.0 36.0 18.0 * Estimate Source: MINIFAZe Secretaria de Receita Federal Coordenacao de Atividades Especiais - 4 - The state turnover and the federal wholesale taxes were replaced by a state and a federal value-added tax./1 Also, specific local taxes on business and trade were transformed into a municipal service tax. Exports as well as imports became exclusive bases of federal taxation, at which level revenues continued to be collected on fuels (gasoline, oil, gas), electricity and· minerals. Real estate remained, albeit insignificant, a local source of revenue. With small changes in the previous tax sharing regime the 1965 reform attributed on an equal basis, to states and muncipalities, 20 percent of the federal income and value added taxes. This percentage was shortly after diminished to only 10 percent, but gradually returned to its previous level by 1975 and, since then, grew to the current 30 percent level. Federal excises collected on energy and minerals continued to be shared with lower levels of government -- various sharing schemes apply and weights depend on factors such as revenue source, population and the inverse of income per capita. Also, the reform established that 20 percent of the state value-added tax pertained to the municipalities where it was raised. Traditionally the constitution and federal laws disposed of the basic tax structure of lower levels of government in Brazil. This pattern was accentuated by the 1965 reform which was enacted, rather than discussed in the Congress. This centralization became even more effective. As an outcome of this tax reform states lost their limited power to create new taxes. Furthermore, absurd rigidities were introduced in the law; rates and exemptions of state value added taxes had to be practically uniform across commodities and jurisdictions. - 5 - Value-added taxation was introduced in Brazil at a time when the European Economic Community was still considering it. In a sense, even today the Brazilian experiment has a pioneer flavor. The nature of issues that states face when a new tax is adopted in a federal country, as opposed to a free trade area, are not equivalent. Furthermore, it may not be the same whether the VAT is a substitute for major sources of revenue or is merely considered to be complementary to existing taxes. Interjurisdictional tax conflicts generated by discrepant rates and exemptions are minimum when the new tax is simply an additional source of revenue within a single level government./2 Even though the Brazilian state value-added tax is fairly comprehensive and was meant to be just an impovement over its predecessor the turnover method of tax collection -- not a new tax in any fundamental sense, it immediately developed conceptual and practical difficulties. Continued disputes among state representatives and between them and the central government, concerning the proper distribution of the tax base still exist./3 2. VAT Basic Structure At the federal level the VAT is a selective tax which subjects a list of manufactured goods to various rates -- from 4 percent on cement to 365 percent on cigarettes. Revenue collection is highly concentrated on cigarettes, beverages and automobiles (altogether they make up for 60 percent of the VAT revenue). The credit method of tax collection is adopted, imports - 6 - are taxed -- deferral is all~wed until first sale -- exports are exempt and cash rebates are usually granted. In the late sixties, this tax accounted for half of total federal revenue, but now is reduced to about 20 percent; meanwhile new forms of indirect taxation were cr~ated -- taxes on gross revenues and wage contributions earmarked to social security and public investment and expenditures toward the poor -- and most recently the increased role of income taxation displaced the federal VAT (see Table 2). The state VAT encompasses most stages of production and distribution, including retail sales. It is applied according to the credit method of tax collection; cash rebates are not granted, except for exports. In practice, an approximation of the consumption variant of VAT was enforced until recently. Sales of a broad list of capital equipment were exempt, but credits were not allowed in the purchase of permanent assets. Thus office machines, furnishings, transport equipment and similar items were included in the tax base, since they were not explicitly exempt. Through 1987, however, this exemption will be phased out, except on interstate sales from southern states. Thus, a gross product type of VAT will be enforced./4 The state VAT coverage falls short of a comprehensive base in many respects. The service sector is excluded from its scope, along with a number of activities, such as fuel, electricity and mining, taxed as excises at the federal level. A few exemptions are granted by interstate covenants, subjected to tight federal controls. There are not many exemptions and preferential treatment in the form of explicit rate differentiation. Many exemptions that do exist have been granted by the constitution; books, - 7 - Table 2: FEDERAL TAX REVENUE (Percent) Income Value Added Tax on tax Added finance Tariffs Excises Charges Other Total 1968 21.85 51.03 8.20 18.00 0.92 100 1969 26.15 46.89 7.49 17.83 1.64 100 1970 26.55 46.11 7.21 18.28 1.85 100 1971 26.20 45.97 7.28 17.67 2.88 100 1972 29.03 43.29 7.67 17.09 2.92 100 1973 27.50 42.65 8.20 15.97 5.67 100 1974 28.83 41.62 10.14 13.64 5.77 100 1975 38.25 35.86 9.52 11.57 4.80 100 1976 36.72 31.93 9.13 17.93 4.29 100 1977 39.72 30.22 3.57 6.95 15.13 4.41 100 1978 40.54 29.91 3.77 6.39 14.26 4.28 0.85 100 1979 42.62 28.92 4.25 6.41 12.75 4.20 0.85 100 1980 40.03 25.97 10.18 9.33 7.34 6.21 0.94 100 1981 42.01 26.09 12.15 6.60 6.04 5.56 0.95 100 1982 43.96 27.72 11.67 5.06 5.60 4.93 0.86 100 1983 53.36 25.02 7.09 6.38 5.06 3.32 0.77 100 1984 56.78 21.45 8.20 5.49 4.86 2.50 0.72 100 1985 58.97 20.91 5.48 6.58 4.11 1.83 1.99 100 Source: Ministerio da Fazenda, SRF, CAE - 8 - newspapers and printing paper, as well as exports of manufactures. A limited number of unprocessed and agricultural produced goods are also exempt. The value-added tax, as its predecessor on the eve of the reform, has been, essentially, the only source of tax revenue administered at the state level. It doesn't follow, however, that all states depend exclusively on this ta~~ or else borrow -- which is not easy, due to stringent federal controls. Many states, mostly the poor ones of the North and Northeast count heavily on federal transfers -- revenue sharing from income and federal value added and excise taxes -- to pay for as much as half of their expenditures (see Table 3). The current state VAT rate is 17 percent for sales within its jurisdiction and the rate applied to interstate sales is 12 percent -- in the case of shipments from the south and southeastern states to the north, northeast and middlewestern states a 9 percent rate applies. The tax itself i9 included in the tax base, so the effective rate is higher. As the tax paid to the state of origin is set off against the tax liability in the state of destination, the importing state appropriates the difference between the internal and the interstate rate (see Table 4). Distribution problems of interstate tax revenues, although not peculiar to the VAT, come into sharper focus here as compared to the pr11 vious turnover tax regime. Unless goods that cross the border may be double-taxed, levying of VAT requires specification of an appropriate principle of border tax adjustrnent./5 Applying the origin or the destination principle may - 9 - Table 3: STATE TAX REVENUE, 1985* Own tax revenue Total (ICM, ITBI & taxes) Revenue sharin~ Cr.$ billion Percent Cr.$ billion Percent Cr.$ billion Percent North 2,172 100.0 708 32.6 1,463 67.4 'A"C're 255 100.0 21 8.3 234 91.7 Amazonas 485 100.0 254 52.4 231 47.6 Para 724 100 .. 0 366 50.5 358 49.5 Amapa 176 100.0 176 100.0 Rondonia 364 100.0 66 18.4 297 81.6 Roraima 166 100.0 166 100.0 Northeast 9,442 100.0 5,593 59.2 3,848 40.8 Maranhao 711 100 .. 0 253 35.6 457 64.4 Piau! 448 100.0 119 26.6 329 73.4 Ceara 1,201 100.0 719 59.9 482 40.1 Rio Grande do Norte 420 100.0 141 33.6 279 66.4 Paraiba 654 100.0 308 47 .. 1 346 52.9 Pernambuco 1,670 100.0 1,151 68 .. 9 518 31.1 Alagoas 632 100.0 406 64.3 225 35.7 Sergipe 373 100.0 123 33.0 250 67.0 Bahia 3,328 100.0 2,370 71.2 957 28.8 Middle-West 3,926 100.0 2,548 64.9 1,377 35.1 Mata Grosso 1,238 100.0 679 54.9 559 45.1 Mato Grosso do Sul 783 100.0 630 80 .. 4 153 19.6 Goias 930 100.0 772 82.9 158 17.1 D.F. 973 100.0 467 48 .. 0 506 52.0 Southeast 31,699 100.0 28,671 90.4 3,028 9.6 Minas Gerais 5,493 100.0 4,614 84.0 878 16 .. 0 Espirito Santo 919 100.0 590 64 .. 3 328 35.7 Rio de Jan~iro 6,483 100.0 5,983 92.3 500 7.7 Sao Paulo 18,803 100 .. 0 17,482 93.0 1,321 7.0 South 10,281 100 .. 0 8,814 85.7 1,467 14.3 Parana 4,146 100.0 3,666 88.4 480 11.6 Santa Catarin~ 1,516 100.0 1,101 72.6 415 27.4 Rio Grande do Sul 4,617 100.0 4,046 87.6 571 12.4 Brazil 57,522 100 .. 0 46,336 80.6 11,185 19.4 Source: flo I~' Revista de Fi.nancas Publicas 11 vol. 45, no. 361 (January/March 1985), pp .. 85-87. * Est1.mate - 10 - Table 4: STATE VAT RATES North-Northeast-Middle west South-Southeast Internal Interstate Export Internal Interstate Export Year -------------------------Sales (percent)--------------------------- 1967 15.0 15.0 15.0 15.0 15.0 15.0 18.0 18.0 18.0 1968 18.0 18.0 18.0 15.0 15.0 15.0 16.0 15.0 15.0 17.0 15.0 15.0 1969 18.0 18.0 17.0 15.0 15.0 15.0 1970 18.0 15.0 15.0 17.0 15.0 15.0 1971 17.5 14.5 14.5 16.5 14.5 14.5 1972 17.0 14.0 14.0 16.0 14.0 14.0 1973 16.5 13.5 13.5 15.5 13.5 13.5 1974 16.0 13.0 13.0 15.0 13.0 13.0 1975 15.5 12.0 13.0 14.5 12.0 13.0 1976 15.0 11.0 13.0 14.0 1L.O 13.0 1977 15.0 11.0 13.0 14.0 11.0 13.0 1978 15.0 11.0 13.0 14.0 11.0 13.0 1979 15.0 11.0 13.0 14.0 11.0 13.0 1980 15.0 11.0 13.0 15.0 11.0 and 10.0 13.0 1981 16.0 11.0 13.0 15.5 11.0 and 9.5 13.0 1982 16.0 11.0 13.0 16.0 11.0 and 9.0 13.0 1983 16.0 11.0 13.0 16.0 11.0 and 9.0 13.0 1984 17.0 12.0 13.0 17.0 12.0 and 9.0 13.0 1985 17.0 12.0 13.0 17.0 12.0 and 9.0 13.0 1986 17.0 12.0 13.0 17.0 12.0 and 9.0 13.0 * 12 percent for sales within region and 9 percent for sales to north, northeast and middle-western states. Source: Boletim do ICM -- CAE-MINIFAZ - 11 - benefit unduly (net} exporter or (net) importer states, if the tax coverage is not comprehensive and or trade is not balanced./6 The Neumark Committee recommended for the EEC, though in vain, adoption of the origin principle for intercommunity trade -- under the unnecessary assumption that this principle would be required if border controls were to be abolished. The Neumark prescription may have been an important factor in Brazil when decisions had to be taken on how to treat interstate sales./7 Since no tax rebates were ever considered in the previous tax regime -- the turnover sales taxation -- the origin principle was adopted for interstate trade, but immediate difficulties, which were not then anticipated, led Congress, shortly after the new tax was in effect, to pass laws introducing slight rate differentiation among states (classified by regions) and type of transaction (whether internal or interstate). Interstate trade statistics reveal that southern industrialised states have had, for many years, perennial surpluses with the rest of the country, and deficits on their external trade. At the same time, poorer states of the north and northeast are net importers from the south and net exporters abroad, giving place to a clear pattern of triaP-gular trade. Thus, in order to avoid revenue redistribution in favor of the southern producer states, Congress passed a 3 percentage points differential rate to be enforced between the internal rate of the importing states and the rate that applied for interstate exports at the state of origin. However, this gap proved insufficient to redress revenue losses, so the rate differential was gradually increased to the current 8 percentage points. - 12 - The 1965 tax reform excluded exports of industrialized goods from the state VAT base through a constitutional provision. This was a direct outcome of federal trade policy; at a certain point in time, basically 1967-75, federal laws even required states to dou~le VAT tax rebates on exports, at their own expense. Tax rebates then were extended even to domestic activities indirectly related to exports, such as shipbuilding and domestic sales of trading corporations. Rebates on exports of primary goods are granted on a very limited basis, through interstate tax agreements induced by the federal government. States lost as a result of those incentives a significar-t amount of revenue. Since 1975, however, this trend has been reverted. Increased revenue sharing tax rates and fewer rebates have all gradually moved in favor of stateso Exports of primary goods did not benefit from constitutional exclusion because most non-industrialized states, being net exporters on external trade would be specially harmed by this provision. Thus they are basically taxed, though at a sli~htly reduced rate (13 percent). The law has been loosely interpreted, however, since rebates are not granted, unless the costs of primary goods exceeds half of the export price. 3o Exclusions and Exemptions The state VAT base does not include fuels but simple foodstuffs, like rice and beans, are fully taxed, the reason being that poorer states depend on this source of revenue. The sale of energy, minerals, and transport and communication transactions are currently taxed by the federal government. Tax - 13 - collection from these sources are earmarked to finance public expenditures in related infrastructure, hydroelectric, steel and oil plants, and the expansion of communication s·ervices. Their inclusion in the federal tax base dates back to the forties and fifties. Investment in these sectors no longer depends on tax revenue. Profits generated by public enterprise own revenues -- sale of products and services -- as well as domestic and external banking finance, provide for most of their capital expenditure today. The amount of tax collection from energy, minerals, electricity and communications services does not represent more than 10 percent of the annual investment of public enterprises operating in these ~ectors. The tax revenue from these sources, which once counted for about 20 percent of federal revenues, are now reduced to less than 5 percent. Thus, it seems desirable to abolish these taxes at the federal level and allow states to expand correspondingly their base. Exemptions become effective -- foods are zero-rated -- when granted in the last stage of the productive process, and taxpayers are allowed full credit for taxes paid on purchases; or, ineffective, when taxes collected on previous stages are not rebated in the exempt sector. In this case, a link is broken in the credit system and the effective rate on the final product will not be easily determined. Unless a "presumptive credit" -- granted as if taxes were paid -- is allowed in the exempt sector, the exemption will not be carried forward./8 There are few cases of zero-rated goods -- except for exports. The sale of some agricultural goods -- vegetables, fruits and dairy products - 14 - are exempt if sold unprocessed. However, most agricultural products, and this includes raw food like rice, beans, corn, etc. are taxed, even when sold unprocessed. Tax collection may be deferred if these products are sold as inputs for industrialized goods. Thus industry collects 68 percent of the state VAT revenues and agriculture only 6 percent, even though their shares in national income are 35 percent and 11 percent, respectively. Agriculture is largely spared of tax collection as an administrative device. However, as pointed out, it is not exempt, since tax revenue from their value added is mostly collected down the line in the industrial or trade sector. In order to avoid double-taxation, the sale of many agricultural inputs, such as fertilizers, rations and seeds are exempt. To enforce zero- rate on vegetables, fruits and dairy products and a limited number of items, retailers such as restaurants and cafes, are allowed "presumptive" credit on the purchase of these products. A municipal service tax is applied with various rates on the gross revenue of a large number of local activities, ranging from construction, advertising, maintenance, entertainment and professional services (doctors, lawyers etc.). A service list containing 66 activities on which municipalities may raise revenues appears in the National Tax Code. By federal law, services taxed by municipalities are excluded from the state VAT. Hybrid activities such as construction and advertising are required to single out, for tax purposes, the sale of merchandise from the value of services provided. Needless to say, the existence of this "gray area" causes frequent fiscal disputes between states and municipalities. - 15 - 4. Issues on Federalism A major source of difficulties with the Brazilian state VAT, as suggested above~ relates to its constrained base and centralized tax structure. States cannot tax most of the value added in its territory and have little degree of freedom in setting rates and exemptions, on their own major source of revenue. Models of fiscal federalism are not to be taken literally, of course, but they often provide useful hints on taJ: policy. According to textbook exegesis, a country, especially a continental one like Brazil, could benefit immensely if ability-to-pay taxes were assigned to the central government, while subnational jurisdictions employ broad-based indirect taxation. Benefit levies, as property taxes are usually characterized, are extremely useful if. properly explored at the local level. The Brazilian tax structure is a far cry from the optimal framework. At the federal level, income taxes are not personal, since most of its burden is paid, not by individuals, but by the corporate and financial sectors. Municipalities depend heavily, for most of their finance, on transfers from higher levels of government, and states have limited base and autonomy. For the purpose of this discussion, tax policy alternatives at the state level only will be focussed. A standard result that emerges from the literature of indirect tax coordination is that, the choice of border tax adjustment (BTA), may have - 16 - interjurisdictional allocative and revenue effects, unless we are prepared to assume the most stringent conditions. If we assume that government expenditure benefits accrue primarily to consumers, it turns out, a sufficient condition that defines a neutral system of BTA is the adoption of the destination principle, for domestic as well as external trade. In this case, since exports are zero-rated and imports are taxed at the internal rate, each community's public service is financed with revenues collected on value added consumed within the community. This is true also when exemptions and rates differ among jurisdictions and trade is not bilaterally balanced./9 Destination based taxes meet major difficulties with the Brazilian state VAT -- fiscal autonomy and economic neutrality. On administrative and compliance grounds, however, they are superior to origin based taxes, since revenue collected on the whole value added of traded products is att~ibuted to the importing jurisdiction -- it does not give rise to issues of valuation of interstate trade flows./10 The destination principle is enforced in every country which adopts a VAT. A basic concern of the Sixth Directive of the Council of the European Communities (1977) was to narrow down the wide latitude in the definitions of exclusion, exemptions and administrative procedures of the VAT base among member states. A uniform basis of assessment was agreed upon and a common list of exemptions were allowed. These include banking, financial transactions, insurance, postal services, health care, educational and cultural activities, non·-commercial radio and television broadcasts. Except for the United Kingdom, VAT applies even to the sale of new buildings, but exempts the sale of previously occupied residential property. Special - 17 - treatment is usually allowed for the agricultural sector and small business./11 The level and structure of the VAT rates differ significantly among member countries of the European community. The standard nominal rate ranges from 10 percent to 30 percent. Most member states impose reduced rates on goods and services regarded as essential, such as food, drugs, newspapers and transportation. Some count?ies extend their reduced ratet which in some cases become zero-rated, to items such as clothing, shoes, electricity and fuels. There are countries that impose higher rates on "luxuries" (cars, electronic equipment, jewelry, fuels, perfumery, cosmetics etc.}. The EEC countries have a much broader base, as well as greater latitude on the level and structure of the VAT than the Brazilian states. Basically, all transactions (goods and services) are covered by the European VAT, except activities which are usually exempt from indirect taxes -- the financial sector, radio and TV broadcasting -- or are excluded altogethex -- health services, culture, post office~ etc. Thus, since EEC countries did not abandon the destination principle for intracommunity trade, each state may enjoy a wide degree of freedom in setting their own rate and administrative procedures. Nothing of this sort is of course possible in Brazil, where problems of horizontal, and vertical, interjurisdictional tax disputes are aggravated by the existing system of mixed BTAs. The foregoing discussion ie an illustration of why the state VAT base in Brazil should be broadened and its administration made more flexible. - 18 - Inevitably such a move will have revenue consequences. Transition costs and gains may not be significant though: the net impact in each state will probably be negligible, if all changes are pooled together in a fiscal package. Some evidence of this revenue effect is presented below. Interstate exports are taxed at reduced rates; thus adoption of the destination principle, certeris paribus, would lead to lower revenues at the state of origin, while importers would lose theirs, correspondinglys Based on interstate trade statistics, Eris and Kadota estimated that most states would gain from this shift, while Sao Paulo, Bahia, Espirito Santa and Amazonas would lose (see Table 5, column 1)./12 As pointed out above, exports of primary goods do not benefit from zero-rate; exports of non-manufactured goods are basically taxed at a slightly reduced rate (13 percent). These authors also quantified the negative impact, on each state finance, which would follow from the adoption of zero-rate on goods currently taxed at the border. Except for a few northern states and net exporters in the extreme South, revenue losses are not statistically significant in this case (see Table 5, column 2). Although most states would like to exempt essentials, not all of them can afford to. Southern industrialized states would be prepared to give away some revenue for administrative as well as for equity reasons./13 Poorer states, however, who depend heavily on agriculture would be less willing to apply special treatment to these products -- food is still an important share of its production and consumption base. Eris and Kadota estimates show that - 19 - Table 5: CHANGE IN STATE VAT COLLECTION, 1980 (Percent) Zero rate Zero rate Exemption Integration on inter- on taxed of basic of federal Inclusion state trade exports food VAT of fuels Acre 18-1 -0 .. 8 -82.3 136.3 57 .. 06 Amazonas -65.7 -1.1 -73.0 32.3 19.55 Para 53.3 -13.5 -42.8 87.2 43.56 Maranhao 57.1 -1.0 -48 .. 0 71.2 29.26 Piaui 46.7 -1.7 -37.8 . 52.0 28.81 Ceara 30.0 -8.6 -28.1 34.9 24.66 Rio Grande do Norte 39.7 -3.5 -24.8 73.9 25.22 Paraiba 20.1 -2.1 -30.9 34.3 23.75 Pernambuco 12.1 -6.0 -19.2 20.5 20.58 Alagoas 23.6 -14.5 -22.2 25.5 25.23 Sergipe 42.1 -30.6 -20.8 27.8 26.76 Bahia -9.3 -9.4 -22.5 18.8 21.59 Mata Grosso 29.5 -3.7 -21.1 35.9 32.00 Mato Grosso do Sul 1.8 -1.8 -16.6 22.2 Goias 10.5 -o.s -30.5 44.2 33.05 Distrito Federal 61.8 -13.9 48.7 35.72 Minas Gerais 9.1 -0.4 -14.5 49.4 22.80 Espirito Santo -5.8 -0.6 -16.0 19.1 17.91 Rio de Janeiro 4.0 -o.s -15.7 30.4 21.09 Sao Paulo -14.8 -1.1 -12.0 16.8 15.64 Parana 6.7 -9.4 -14.9 26.0 26.24 Santa Catarina 6.7 -6.1 -10.5 17.4 17.96 Rio Grande do Sul 9.4 -9.4 -11.1 18.7 19.95 Source: Column 1-4, Eris and Kadota, ibid. Column 5: Ueda and Torres, ibid. - 20 - many states would lose as much as 30 to 40 percent of their VAT revenues, if a basket of basic foods are zero-rated (see Table 5, column 3). /14 A potential source of revenue to the states is a partial integration of federal VAT with the state VAT. It has been proposed to leave the most productive sources of revenues as they are cigarettes, beverages and automobiles -- to the federal government, but to transfer the remaining taxable goods to the state VAT base. In this case, the states could raise their rates on these products, by the same amount of the current federal VAT, which would in turn be reduced to zero. According to Eris and Kadota an integration of this type may increase state revenue by an average of 20 to 40 percent (see Table 5, column 4). Additional revenue gains for the states would result from the inclusion of oil, minerals, electricity, etc. in their base. This revenue gain may be estimated by applying to the value added in these sectors the state VAT rate. Data on value added though is not available. A crude and partial estimate was presented by Ueda and Torres for each Brazilian state in the case of fuels only (see Table 5, column 5). /15 Most states would increase its VAT revenue by more than 20 percent, if only they could add this product to their base. This outcome of course overestimates the contribution of fuels to state revenues, to the extent that fuels are intermediary products; in this case, fuels are alr~ady taxed as costs, which add to the price of currently taxed goods and services. - 21 - Concluding Remarks The 1965 tax reform was a great step forward in the direction of rationality, especially at the state level, where a multiple stage turnover tax was replaced by a VAT, as their major source of revenue. But in the process, state base and administrative capabilities were crippled by numerous exclusions and rigidities. In particular, their freedom in setting rates and exemptions across goods and jurisdictions is now severely limited. At the federal level, a VAT applied on manufactured goods under various rates replaced various single stage wholesale taxes on consumption. At the municipal level, a specific tax on services replaced a myriad of small taxes and fees enforced on local activities. A major purpose of the tax reform was to achieve a higher degree of centralization of the tax legislation, so as to avoid interjurisdictional tax disputes and ''facilitate'' stabilization and distributive policies. In spite of tax reform objectives, interjurisdictional tax disputes became a serious problem as a result of a lack of interjurisdictional tax coordination. Producer states benefited and consumer states lost revenues, with the adoption of the origin principle for domestic trade. Furthermore, states that were net exporters lost revenues, and net importers gained, since an approximation of the destination principle prevails for international trade. This type of arrangement not only redistributes revenues arbitrarily among states, but also is unfair, since the poorer states are usually net importers domestically and net exporters abroad. Some of this redistributive effect bas been attenuated through the application of lower rates to interstate exports at the state of origin, with the difference, between the lower rate and the internal rate, being collected by the importing state. - 22 - The st~~e VAT. base does not cov~r numerous products .. and services qurrently taxed by federal or local governments. Fuels, minerals, electricity and other goods and services are currently excluded from the VAT. Undesirable consequences of this tax assigQment include lQss of states potential revenues and inefficient border tax adjustments. Attempts to redress these difficulties in the last couple of years aborted because they were incompatible with the prevailing stabilization policies at the central level. Since the early 80s, there is a general feeling that the 1965 basic tax strQcture is due for reform, this time in the direction of decentralization. Rec~nt state and municipalities claimfJ to a larger piece of national tax revenues, were provisionally attended by inc:reased revenue sharing, but not out of greater autonomy. Shortly after inauguration, in March 1985, the Sarney Administration installed a special committee, chaired by his planning minister, to study the structure and propose reform of the Brazilian tax system.. The committee plans to report in the coming Fall, when the president should ~lend a version of this proposal to the Congress, which will be partly renovated in the November elections. There is now wide consensus within the CommitteE~ that the state VAT system should be decentralized and its ba~e made more comprehensive. Some freedom for states to legislate over their own base and 1~ates seems to be the likely outcome. In general, decentralization implies non=uniform rates and exemptions across products and states. These goals should be attained by - 23 - broadening the current state VAT base and moving borde·r tax adjustments to full destination principle, -in all transactions;""domest.Eic as :~ell as foreign • •• - 24 - FOOTNOTES 1. The federal wholesale tax has been in fact a value added tax since 1958. 2. For a lucid discussion of these issues see, in this volume, S. Poddar, "Value Added Tax at the State Level". 3. See C.A. Longo, "Restricted Origin Principle under Triangular Trade Flows; Implication for Trade and Tax Revenues", Journal of Development Economics, no. 10 (1982), pp. 103-112. 4. For a detailed description of the VAT basis and collection methods see this volume, Carl S. Shoup, "Criteria for Choice Among Types of Value- added Tax". 5. With a turnover tax, the impact of double-taxation is blunted by the cumulative nature of the levy itself. 6. For documented review of this literature see this volume, S. Cnossen, "Interjurisdictional Coordination of Sales Taxes". 1. Prof. Shoup, a member of the Neumark Committee, acted briefly as consultant to the Brazilian Tax Reform Commission. - 25 - B. For the concept of zero-rating and its administrative implications see this volume, C.S. Shoup, ibid. 9. For this result to hold overall community trade must be balanced. See C.A. Longo, "Tax Coordination Under Benefit Taxation", National Tax Journal, vol. 31, no 4 (December 1978), pp. 385-89. 10. For an elaboration see this volume, S. Poddar, ibid. 11. See s.• Cnossen, "Harmonization of Indirect Taxes in the EEC", in Tax Assignment in Federal Countries, C.E. McLure, Jr. (ed.), ANU Press, Canberra, Australia, 1983, pp. 150-68. 12. c.c. Eris and D. Kadota, Reforma Tributaria e Federalismo Fiscal, FIPE.SRF, Relatorio de Pesquisa, Sao Paulo, 1983. 13. Since rates are high, there is an incentive for tax evasion, particularly when primary goods reach consumers unprocessed. 14. Basic data sources are budget surveys. Major items in the food list include rice, beans, bread, oil and meat. 15. E. Ueda and I. Torres, Estrutura Tributaria Estadual, IPE.USP, Sao Paulo, 1984. - 26 - BIBLIOGRAPHY Cnossen, S.: 1986~ "Interjurisdictio~al Coordination of Sales TalCes". : Paper presented at.the Confereflce on Value-Added Taxation in Developing Countries, ·April 1986. Washington D.C.: The World Bank, processed. 1983. ..Harmonization o.f Indirect Taxes in the EEC", in Tax Assignment in Federal Countries, in C.E. McLure, Jr. {ed.), ANU Press, Ca~berra, Australia, PP.• 150-68. Eris, C.C. ~nd D. Kadota. 1983. 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'. Y. Kislev and W. Peterson. · ...... ,:,;~:.t.t 204. Optimal Corporate Debt Financing and Real Investment Deci~ioris under Controlled Banking Systems, by M. Dailami. 205. Optimal Profit-Sharing Contracts and Inves·tment in an Interest;_Free Islamic Economy, by N. Haque and A. Mirakhor. 206. Stabilization and Economic Growth in Developlng CountTies, by· M. Khan., 207. Contr9lling Inflation: Korea's Recent Experience;. 'by V. ·Corbo and· S.. W. Nam. 208. The Recent.Macroeconomic Evolution of the:Republic of Korea: An Overview, by V. Corbo and s.w. Nam. 209. Fiscal Policy and Private Saving Behavior in Developing Countries, by N. U. Haque. ·... .,n · 210. US-Korea Disputes on the Opening of Korean Insurance }ffirket: Some Implication, by Y.J. Cho. 211. On the Excess Burden of Tax Evasion, by S. Yitz~aki. 212. Public Finance for Market-Oriented Developing Countries, by A. Lindbeck. 213. Building Agricultural Research Capacity: India's Experience with t~e Rockefeller Foundation and its Significance for Africa, by U. Lele. 214. Export Mix Adjustment to the Imposition of VERs: Alternative License Allocation Schemes, by T. Bark and J. de Melo. 215. The Political Economy of Industrialization in Primary Product Exporting Economies; Some Cautionary Tales, by D. Lal. 216. Markets, Mandarins and Mathematicians, by D. Lal. 217. Foreign Trade Regimes and Economic Growth in Developing Countries, by D. Lal and S. Rajapatirana. 218. Ideology and Industrialization in India and East Asia, by D. Lal. 219. Minimum Wages and Average Wages, Analyzing the Causality: The Cases of Argentina, Bra2il & Chile, by M. Paldam and L.A. Riveros. 220. The VAT and Financial Services, by M. Gillis. 221. The Value Added Tax in Korea, by s.s. Han.