Tax Expenditures and Complexity in a VAT System: The Case of Brazil

Despite its known regressivity, the value-added tax (VAT) has been considered a robust tool for development, especially if integrated into a well-implemented tax-and-benefit system. VAT is often considered a neutral tax that minimizes distortions and is particularly relevant to low- and middle-income countries due to its simplicity to administer and potential to effectively reduce tax evasion.

In general, VAT is also a relatively simple tax to administer. However, several design issues might make a VAT complex and inefficient. The sustained use of tax expenditures either to promote social goals or to attract investments is a case in point.

It is widely recognized that a VAT system should be broad-based, with a single rate and minimal tax exemptions. Exemptions in VAT create significant distortions for both consumers and businesses. In addition, VAT exemptions, for example, on essential goods and services might have limited or even negative distributional consequences on the poor. Redistribution is usually most effectively achieved by considering the entire tax-and-benefit system, e.g. via welfare transfers.

Brazil’s Consumption Tax System

There are several reasons why consumption taxation is problematic in Brazil. First, Brazil has at least five different taxes on consumption, although only one can be conceptually considered a VAT: the Goods and Services Tax (Imposto sobre Operações com Circulação de Mercadorias e Serviços – ICMS). It is a tax levied by states on the supply of goods and, despite its name, on the supply of only two types of services (communications and intra- and interstate transportation). Other consumption taxes include the municipal Services Tax (Imposto sob Serviços de Qualquer Natureza – ISS), the federal Industrialized Goods Tax (Imposto sobre Produtos Industrializados – IPI), and the federal taxes called PIS (Programas de Integração Social) and COFINS (Contribuição para o Financiamento da Seguridade Social).

As expected, the co-existence of several consumption taxes levied by different tiers of government creates numerous conflicts. The most critical problems regard those between states to determine which one is entitled to tax certain transactions (especially when it comes to online sales or supply of digital goods); between municipalities (when a service is supplied in one municipality by a provider located in another) and between a state and a municipality (when it is unclear whether what is being supplied is a good or a service – e.g. it is debatable whether an application software should be considered a good (thus taxable by the state ICMS) or a service (therefore taxable by the municipal ISS).

Moreover, besides conflicts between jurisdictions, one of the main problems results from the impressive number of tax expenditures in the tax system. In addition to a ‘standard’ exemption, Brazil’s state legislations adopt several forms of tax expenditures, such as reduced tax rates, tax deductions, tax credits, tax deferrals (which can be partial or total) and accelerated depreciation allowances, but also other ‘creative’ forms of tax incentives, mostly disguised as financial subsidies.

Tax Expenditures and Complexity in Brazil’s VAT System

When it comes to Brazil’s VAT system, most of tax expenditures granted in the context of interstate transactions, are not targeted at helping poor individuals but rather employed as a harmful tax competition instrument. Brazil’s VAT is an origin-based tax with differentiated tax rates for interstate transactions. Whereas the rate on exports from southern to northern states is 7 percent, the rate on exports from north to south is 12 percent. This differentiated rate creates incentives for northern states to offer financial subsidies or tax incentives to attract a business to set up, for example, a warehouse in its territory so that it imports goods from a southern state (at a 7-percent rate) and exports them back to the same southern state (at a 12-percent rate). Under such a scenario, tax competition results in the erosion of the southern state’s tax base (and tax revenue). Indeed, the tax competition game ends-up in a race to the bottom that significantly reduces overall tax revenue collection and provides costly windfall gains for beneficiary companies.

Economic distortions apart, one critical consequence of tax competition that is often neglected regards the costs resulting from legal complexity. To avoid retaliation or legal litigation, states often provide tax incentives that are usually highly opaque. Moreover, the use of different forms of tax expenditures results in a significant increase in the complexity of the tax system. For instance, by definition, one of the legal consequences of a standard VAT exemption is that input tax is not recoverable by the taxpayer. One of the problems with other forms of tax expenditures is that it is unclear whether and in which cases a similar rule applies. Where more than one type of tax expenditure applies in the same supply chain, complexity is even more significant, both from the legal and economic perspectives.

The lack of a consolidated and conceptual understanding of tax expenditures in Brazil’s VAT, both among tax specialists and in the academic literature, creates considerable uncertainty for taxpayers. Against this backdrop, in the recently published book “Benefícios Fiscais do ICMS” (in Portuguese), I clarify many of the legal issues and interpretation questions triggered by the magnitude and lack of uniformity of tax expenditures in Brazil’s VAT system.

Major tax reform is under way in Brazil to merge the five taxes mentioned above into one single destination-based VAT, with a single reference rate and no tax expenditures allowed. The new tax is expected to incorporate most of the features of an ideal VAT. That said, considering the unsuccessful attempts to overhaul Brazil’s tax system over the years and the conflicting political interests at stake, the outcome of the reform is still uncertain.