WP Reimbursement of VAT on written-off Receivables by Bjarne Florentsen, Michael Møller and Niels Chr. Nielsen - PDF

WP Reimbursement of VAT on written-off Receivables by Bjarne Florentsen, Michael Møller and Niels Chr. Nielsen INSTITUT FOR FINANSIERING, Handelshøjskolen i København Solbjerg Plads 3, 2000 Frederiksberg

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WP Reimbursement of VAT on written-off Receivables by Bjarne Florentsen, Michael Møller and Niels Chr. Nielsen INSTITUT FOR FINANSIERING, Handelshøjskolen i København Solbjerg Plads 3, 2000 Frederiksberg C tlf.: fax: DEPARTMENT OF FINANCE, Copenhagen Business School Solbjerg Plads 3, DK Frederiksberg C, Denmark Phone (+45) , Fax (+45) ISBN ISSN Reimbursement of VAT on written-off Receivables a Bjarne Florentsen b, Michael Møller and Niels Christian Nielsen Department of Finance, Copenhagen Business School Key Words: bad debt, receivables taxes, trade credits, VAT a Revised version of Florentsen, Møller and Nielsen, Momsafløftning og Kreditforvridning (in Danish), Working Paper 99-8, Department of Finance, Copenhagen Business School b Solbjerg Plads 3, DK-2000 Frederiksberg, Denmark Fax: Phone: Abstract 1 In many OECD countries, a seller has a right to reimbursement of VAT (RVAT) she has paid on goods sold, but for which she has not yet received payment. Such reimbursement of VAT on receivables is economically inefficient. It leads to: Distortion of credit markets, by subsidizing direct credit at the cost of financial intermediaries. Price discrimination, by subsidizing buyers with low creditworthiness. A less efficient collection of bad debts, as trade with bad debts is made extremely expensive. The finance literature presents several good arguments in favor of trade credits, e.g. transaction costs and asymmetric information. In contrast RVAT is an economically bad argument for trade credit. It is a subsidy that leads to inefficiently high use of trade credit. 1 The authors thank Richard Sweeney for very useful comments and suggestions. 3 Reimbursement of VAT on written-off Receivables In many OECD countries sellers have a right to reimbursement of the VAT (value added tax) they have paid on goods sold, that is on receivables, but for which they have not yet received payment on written-off receivables. In this article we argue that a right to reimbursement of VAT on written-off receivables (RVAT) is economically inefficient: RVAT distorts credit markets. Suppliers get a competitive advantage vis a vis financial institutions in providing loans. RVAT helps firms to price discriminate between buyers. Buyers of low creditworthiness both private persons and firms are subsidized. RVAT lowers, at least in some countries, the attractiveness of selling bad debt to more efficient debt collectors. This leads to a less efficient collection of bad debts. The rest of the article is organized as follows: Section 1 presents the legal situation of RVAT. Section 2 refers arguments for existence of trade credits in a non-rvat world. Section 3-5 analyses the distorting effects of RVAT as regards competitiveness of bank loan compared with trade credits, facilitating implementation of price discrimination as well as regards to reducing the efficiency of the market for risky debt. Section 6 discusses the argument that abolition of RVAT lower the attractiveness for employees to be entrepreneur. Section 7 concludes. Reimbursement of VAT: The legal situation today The economic importance of VAT in the OECD-area has increased over the last 25 years. VAT taxes 2 is now found in all OECD countries except US and they accounted for 18 per cent of total tax revenues and 60 per cent of consumption tax revenues in 2000, OECD (2002). Reimbursement of VAT means that a supplier who has sold a good subject to VAT and paid VAT on the sale, can receive refund of paid taxes if the buyer does not pay for the good in question. Although reimbursement of paid taxes on 2 By VAT we mean general consumption taxes based on the value-added principle, that is also some Goods and Services Taxes (GST). Jørgensen and Owens (1995) describes value-added taxes compared with retail taxes:.. under a VAT system tax is levied at each stage and can be reclaimed in the next link in the trading chain until the final consumer is reached; all traders are treated on an equal footing. In general, VAT thus has little or no distortionary economic effects. Under a tax on retail sales, by contrast, the end-user of a product or a service has to be identified, since that is the stage at which the tax has to be levied. Under a VAT system with tax being levied at each stage, it is of course in the trader s own interest to reclaim it. In this way the tax will automatically be paid by the final consumer. They argue that in theory and under ideal circumstances a VAT tax and a retail sales tax should be economic identical, but that VAT in fact often is considered to be more difficult to evade. 3 written-off receivables is not restricted to VAT, presumably, RVAT is one of the most important. In Denmark, for example, the VAT is 20% of the price inclusive of VAT (or 25% of the price exclusive of VAT). Thus a supplier, who has sold a TV on credit at 1,000 euro, VAT included, can receive reimbursement of 200 euro VAT if the buyer does not pay for the TV. The Danish RVAT is due to pure coincidence. RVAT exists because the VAT law originally as originally drafted gave firms a choice between settling VAT using the payment method or the invoice method. A free choice presumes reimbursement of VAT because a corporation that chooses the payment method automatically will have the right to reimbursement of VAT. If the customer does not pay for the delivered good no turnover will be registered according to the payment method, and consequently there will be no VAT to pay. When parliament decided to allow only the invoice method it apparently forgot to remove the right to reimburse VAT. Also, a fairness argument ( why should people pay taxes on income they haven t received? ) could have played quite a large role. Many other OECD countries operate with reimbursement of VAT as table 1 shows 3. This is also the rule for Australia, which as the last but one OECD country introduced a federal VAT with effect from 1 July Outside the OECD area almost all the central and eastern European countries introduced VATs during the 1990s. For these countries RVAT is not the predominant rule. OECD (1998) reports 4 that Contrary to practice in EU countries, however, most Central and Eastern European VATs (except the Romanian VAT) do not have an allowance for bad debts and this is not violated by a free choice of accounting basis as In nearly all countries, the law prescribes the invoice basis of accounting. 3 For the EU countries the relevant EU directive Sixth Council Directive of 17 May 1977 on the harmonization of the laws of the Member States relating to turn-over taxes Common system of value added taxes: uniform basis of assessment states that it is up to the individual states to decide on whether or not to admit tax credits for VAT paid on written-off receivables. It says (article 7): In the case of cancellation, refusal or total or partial nonpayment, or where the price is reduced after the supply takes place, the taxable amount shall be reduced accordingly under conditions which shall be determined by the Member States. However, in the case of total or partial non-payment, Member States may derogate from this rule. 4 OECD (1998), p. 38 and p The OECD study cover Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia. 4 Table 1: VAT systems in selected OECD countries (2002) Country Australia Austria Belgium Canada a) Denmark Finland France Germany Great Britain Greece Iceland Ireland Italy Luxembourg Netherlands New Zealand Norway Portugal Spain Sweden Switzerland Turkey Introduction Duty rate (%) year Normal Special / /1/6/ /8/ / / / /4.3/10/ / /6/ / / / /6/ / /8/26/40 Possibility of reimbursement No No a) The federal component is 7.0%. In addition, for some provinces a provencial component of 8.0% applies. Note 1: OECD (1995) and IBFD might differ on which year a VAT system was introduced. In these cases OECD (1995) applies. Note 2: For some countries (e.g.germany, Great Britain, Luxembourg, Netherlands and Norway) special rates apply to farmers, fishermen or forestry undertakings among others. Sources: Australian Government (Australian Taxation Office). Canadian Department of Justice (Excise Tax Act). International Bureau of Fiscal Documentation (IBFD), Guides to European Taxation, Volume IV: Value Added Taxation in Europe (Binder *, **, *** and ****), Amsterdam, Updated version: OECD (1995, 2002). New Zealand Government (Inland Revenue). 5 US is the only OECD country without a federal VAT. The US sales tax is a state 5 tax imposed on retail sales, some services and other items. Compared to VATs a difference is that the risk of loss of paid taxes on written-off receivables by and large is delimited to retailers. Reimbursement of sales taxes, however, gives the same incentives as RVAT. Most states operates with reimbursement, although exceptions exist 6. The literature of VAT mentions that neutrality of VAT to the financial sector among other features includes neutral treatment between banks and non-financial suppliers of trade credit 7. The rest of this article discusses the distortionary effects of RVAT in relation to risky debt. We begin with a description of why imperfections in some cases might establish trade credits dominating bank loans as a market solution and then we discuss in which ways the RVAT distorts that outcome. Why trade credit in a no-rvat world? RVAT is by definition only relevant when companies do not sell for cash, i.e. when they provide some kind of credit. Now it is obvious that cash payment is not possible, or at least not practical, in all circumstances. When a painter paints a flat or an office, delivery is continuous and unless cash is paid continuously, there will be some element of credit. For many companies, it is more appropriate to send out bills once a month rather than continuously. Even if bills are written every day, there is still some element of credit, as the bill has to be sent and the customer needs a couple of days to pay. Because payment does not take place when the item is handed over risk of non-payment is inevitable. 5 Because of local sales taxes the total tax rate might vary dependent on city and county. 6 For instance, The Texas Administrative Code, The Sales and Use Tax Regulations issued by The California State, Board of Equalization, The Indiana Administrative Code and The South Carolina Code of Laws allow a deduction for sales taxes paid on bad debts. On the other side The Pennsylvania Code does not permit to take a sales tax credit for amounts representing bad debts or uncollectible accounts. 7 For instance, Malcolm Gillis (1990) discuss VAT and Financial Services. As one of four principal features for neutral tax treatment of Financial Services under a VAT Gillis (1990) mentions: Neutral treatment between firms that specialize in financial services (bank, insurance companies) and other firms that do not specialize in finance but that offer financial services as complements to their principal activities (trade credit offered by wholesale houses and manufacturers, factoring and leasing firms, and the like), p One can easily overestimate the volume of unavoidable credit risk. It should be remembered that we are only interested in risky credit. An obvious way to avoid risky debt would be to let risky customers pay in advance 8. Of course, this would in some cases lead to another kind of risk, as the seller also might default, but the point is that the total risk can be diminished. Furthermore, technological development increases the possibility of instant payment: when bills can be sent electronically and payment can be made the same way, the unavoidable credit period is shortened. Therefore, much trade credit is voluntary; the seller has chosen not only to be a seller, but also to provide credit. Many companies give their customers the choice between cash payment (with a rebate for cash payment) or payment within a month. Some companies accept even longer credit periods, demanding interest for the credit. Sale on credit is also common in many consumer sales; cars, furniture, televisions etc. are sold on credit. In some of these cases the company is not the real creditor, however, but only a middleman. That is often the case with cars; the car sales company has an agreement with a finance company that gives the loan directly to the buyer. Nevertheless, many sellers are also providers of credit. What determines whether credit from the seller or a loan from a financial intermediary is optimal? One might think that banks and other financial intermediaries have a comparative advantage in credit evaluation and debt collection and thus should dominate completely. As trade credit is widespread, however, this is apparently not the case. There might be several explanations as to why companies in some areas have a comparative advantage vis à vis banks: Transaction costs: It may be simpler to do everything in one transaction (sell and give credit) instead of the buyer having to go to two different places to make the transaction. A seller can stop supplies and, therefore, he has better opportunities than a bank has to force borrower to comply with credit terms. Also, some companies are very dependent on their supplier (a seller of the expensive TV brand B&O cannot change to selling other televisions if B&O stops delivering). A bank has only one and rather drastic way of enforcement, namely to declare the buyer bankrupt. Furthermore, bankruptcy costs typically are of such a huge size that banks often have no immediate advantage by a petition for bankruptcy. Information: Suppliers might have a comparative advantage with regards to evaluation of creditworthiness. Through sale to a certain type of customers (i.e. 8 Little information is available on the size of losses companies incur on their credit sales, but there is no doubt that the amounts are considerable. 7 garment shops) sellers build up an expertise in credit evaluation of this type of business. Knowledge about the specific market as well as about the customers is established through continuous business relationships over a long period. This asymmetric information in favor of the seller provides him with an advantage compared to the banks. These explanations are good reasons for the existence of trade credits. As we will argue, however, there are also bad reasons, one of them being RVAT, another that supplier credit enhances the possibility of credit discrimination. RVAT and trade credit RVAT seems natural and fair. The seller has not received his money. The authors of OECD (1998) stress the opinion, that VAT should be collected only on the net consideration received by the seller and If a debt becomes irrecoverable, taxable persons should be allowed to claim an input tax credit for the tax included in the debt. Any part of the debt subsequently recovered should be included in taxable receipts 9. Why should a seller pay VAT on a sale where he hasn t received payment? Would this not add insult to injury? Fairness is an elusive concept, however. Let us therefore instead concentrate on economic efficiency: a system without RVAT is more efficient than a system with RVAT. The easiest way to understand the negative efficiency effects of RVAT is to look at the sale decision and the credit decision as two independent decisions. There is no reason for the seller to provide credit to the borrower, except maybe for a very short time period for practical reasons, as mentioned above. An obvious alternative to sales on credit is for buyers to borrow from banks and other financial institutions. If a third party financed the purchase, the seller would pay VAT whether the buyer was able to repay the loan or not. RVAT givers providers of trade credits an unfair advantage in lending, compared to financial intermediaries. This advantage increases with the risk of loss on the loan and with the maturity of the loan. 9 OECD (1998), p. 38 and p. 40. The foreword of the publication stresses that the views and opinions expressed are those of the author, which don t necessarily represent those of the OECD or the European Commission, which is joint editor. 8 Rules differ between countries and can be rather complicated, depending on who the buyer is and how the sales price is defined (are interest payments separated out when selling on credit? etc). Problems become even more complicated when income tax is included. We concentrate on the RVAT problem. Let us analyse a situation where a household buys a television for 1000 euro, of which 200 euro is VAT. The purchaser has no money and needs a loan. The choice is between two types of loan: The seller grants the buyer credit A bank gives the buyer a loan Let us assume that seller and bank have exactly the same expertise in judging credit risk and exactly the same costs, which for convenience are set equal to zero. Under these assumptions one would expect banks and sellers to be able to offer loans at exactly the same terms. We make the following simplifying assumptions: The loan/credit is to be repaid in one year. The risk-free interest rate is 4%. The probability that the customer does not repay the loan is x, where x is a number between 0 and 1 (x=0.10 corresponds to 10% probability that the loan will not be repaid). The borrower is not charged any fixed fee, only interest. Both bank and seller are risk neutral. To grant such a loan a bank will require a minimum interest r, which can be calculated from the equation (1A). This interest rate r secures that the bank has a return of 4% after expected losses. More generally, equation (1B) specifies r as a function of the risk free interest rate r rf and x. (1A) (1,000) (1+r) (1-x) = (1,000) (1+0.04)= 1,040 r (1B) r = rf + x 1 x Table 2 shows the minimum interest rate for the bank, depending of the size of the credit risk x. An increasing risk (x) leads to an increasing rate of interest. The example can easily be extended to take account of internal loan costs in the bank. Table 2: Creditor s minimum interest rate etc. depending on risk of default Risk of Bank Supplier Bank s default Minimum interest rate Expected rate of interest Minimum interest rate Expected rate of interest additional interest rate 0% 1% 5% 10% 5.05% 9.47% 15.56% 4.85% 8.42% 13.33% 0.00% 0.20% 1.05% 2.22% 9 How does the calculation look if the seller of the television provides credit and he also requires an expected return of 4%? We assume that the credit does not increase the probability of sale. The purpose is solely to analyse to what extent RVAT gives the seller an advantage compared to the bank as a creditor, independent of who is the best (most efficient) to grant credit. The question is whether RVAT causes distortion between different suppliers of the same financial services. A seller that grants a 1,000 euro credit would require an expected payment of 1,040 euro in one year. With an interest rate of r and a risk of default at x the expected payment of the credit in one year is calculated from (2A). The first part of the expression is the expected payment from the buyer and the second part is the expected VAT reimbursement. Equation (2B) is the more general specification of r. (2A) (1,000) (1+r) (1-x) x (2B) r x r = rf x Table 2 shows the interest rates required by the supplier and the bank. With the above assumptions the supplier s required interest rate will be 0.20 percentage points less than the bank s at a 1% risk of default, and 2.22 percentage points less at a 10% risk of default. In other words, RVAT gives the supplier a competitive edge in giving credit. Without RVAT we would have a level playing field. The reason for this result is obvious. If a customer borrows money in the bank, the state gets the VAT whether the customers pays or not. If, however, the customer gets credit from the seller, the state gets money only if the customer pays. If we look at buyers that are companies themselves, we get the
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