The main determinants of VAT revenue productivity in Ethiopia. A research

TABLE OF CONTENTS

DEDICATION

ACKNOWLEDGEMENT

LIST OF ABRREVIATIONS

LIST OF ACRONYMS

TABLE OF CONTENTS

LIST OF TABLES

LIST OF FIGURES

LIST OF TABLES IN THE APPENDIX

LIST OF FIGURES IN THE APPENDIX

ABSTRACT

CHAPTER ONE
1. Introduction
1.1. Background of the Study
1.2. Statement of the Problem
1.3. Objective of the Study
1.3.1. General objective
1.3.2. Specific objectives
1.4. Research Questions
1.5. Significance of the Study
1.6. Scope of the Study
1.7. Limitations of the Study

CHAPTER TWO
2. Literature Review
2.1. Theoretical Literatures
2.2. Empirical Literature

CHAPTER THREE
3. Research Methodology and Model specification
3.1. Research Method of Analysis
3.2. Data Collection and Source
3.3. Model Specification
3.3.1. Unit Root Test
3.3.2. Estimation procedure

CHAPTER FOUR
4. Data Presentation and Analysis
4.1. Descriptive Analysis
4.1.1. VAT revenue collection productivity in Ethiopia over (2003-2016)
4.1.2. Corruption in Ethiopia over (2003-2016)
4.1.3. Economic growth in Ethiopia over (2003-2016)
4.1.4. Gross VAT collection in Ethiopia over (2003-2016)
4.1.5. Import expenditure of Ethiopia over (1977-2016)
4.1.6. Inflation in Ethiopia over (2003-2016)
4.1.7. Population in Ethiopia over (1960-2016)
4.1.8. Total consumption expenditure in Ethiopia over (2003-2016)
4.2. Econometric Analysis
4.2.1. Test analysis
4.2.2. Estimation procedure
4.2.3. Stability of the model and coefficients

CHAPTER FIVE
5. Summary, Conclusion and Recommendation
5.1. Summary
5.2. Conclusion
5.3. Recommendations

6. REFERENCES

7. APPENDICES

DEDICATION

I dedicate this thesis for my families, advisor, teachers, and friends.

ACKNOWLEDGEMENT

First of all, I would like to thank my God to his lead in my way and accomplishments. Thus, Glory to him. Then to Saint and Virgin Marry (Mother of Jesus Christ), Angels and Saints with their respectful honors.

Second, I thank my parents all.

Third, I would like to forward honorable and respectful thank my sponsor Ministry of Education.

Fourth, I have great thank to my patient, friendly and industrious advisor Taddele Tafese (Ass prof.).

LIST OF ABRREVIATIONS

CON Consumption

INF Inflation

LIST OF ACRONYMS

ADF Augumented Dickey Fuller

AIC Akaike Information Criteria

ARDL Autoregressive Distributed Lag

CPI Corruption Perception Index

ERCA Ethiopian Revenue and Custom Agency

ETB Ethiopian Birr

ETR Electronic Tax Register Machine

FER Foreign Exchange Rate

GDP Gross Domestic Product

GoE Government of Ethiopia

IMF International Monetary Fund

LDCs Least Developed Countries

MoFED Ministry of Finance and Economic Development

n.d not dated

OECD Organization for Economic Cooperation and Development

OLS Ordinary Least Square

UN-OHRLLS United Nations Office of the High Representative for the Least Developed Countries, Landlocked Developing Countries and the Small Island Developing States

VAT Value Added Tax

WB World Bank

LIST OF TABLES

Table 1: Unit root test with intercept and linear trend

Table 2: Residual diagnostics test (correlogram-q-statistics)

Table 3: Coefficient diagnostic test (ARDL bound test)

Table 4: Model selection summary

Table 5: The chosen ARDL model estimation result

Table 6: Short run error correction model regression result

Table 7: Long run coefficient form

LIST OF FIGURES

Figure 1: VAT revenue productivity in Ethiopia (C-efficiency ratio) over (2003-2016)

Figure 2: Trends of corruption in Ethiopia (corruption perception index) (2003-2016)

Figure 3: Trends of Economic growth in Ethiopia (2003-2016)

Figure 4: Trends of Gross VAT collection in Ethiopia (in Birr) (2003-2016)

Figure 5: Trends of Import expenditure in Ethiopia (in millions dollar) (1977-2016)

Figure 6: Trends of inflation rate in Ethiopia (consumer price index) (2003-2016)

Figure 7: population in Ethiopia from (1960 -2016)

Figure 8: Total consumption expenditure in Ethiopia over (2003-2016)

Figure 9: Plot of Cumulative sum of Recursive Residual

Figure 10: Plot of Cumulative sum of Recursive Residuals Square

LIST OF TABLES IN THE APPENDIX

Table A. 1: Thesis data

Table A. 2: Unit root test result

Table A. 3: Correlogram of Residual Squared

Table A. 4: Heteroscedasticity test

Table A. 5: multicollinearity test

LIST OF FIGURES IN THE APPENDIX

Figure A. 1: Residual graph

Figure A. 2: Histogram normality test

Figure A. 3: Model selection graph

DETERMINANTS OF PRODUCTIVITY OF VAT REVENUE IN ETHIOPIA

ABSTRACT

VAT is one of the indirect taxes levied on consumption where the value of goods and services increases as they charge hands in course of production, distribution and final sales to the consumer. Ethiopia has implemented the Value Added Tax in January, 2003 primarily to raise more revenue, modernizing its tax administration and encourage investment and trades. The Ethiopian Customs and Revenue Authority (ERCA takes the responsibility), and is facing with a substantial problem of VAT revenue collections efficiency. So in this study, the efficiency of VAT over time and determinants of productivity of VAT in Ethiopia at macro level from 2003-2016 has been given focus. To achieve this objective, the researcher used quantitative research designs using secondary data from the data sources (i.e. ERCA, NBE, and WB). Some statistical graphs, tables and percent are used, and also Autoregressive Distributed Lag (ARDL) Approach model is applied in order to investigate the long-run effect of determinants of productivity of VAT revenue. The study concludes that productivity of VAT in Ethiopia is less efficient over time which is 18% on average and, very responsive to changes in its determinants (specifically GDPcG, inflation, import, population, and corruption). So this investigation provides decision makers with an analytical framework which can be used to estimate the associated VAT revenues productivities in Ethiopia.

CHAPTER ONE

1. Introduction

1.1. Background of the Study

VAT is an indirect tax on the consumption of goods and services. Compared with single-stage sales taxes, which are levied on the actual value of output at each stage of the productive process, VAT relates to the value added to the goods or services at each individual stage, and amounts to the difference between output tax and input tax. Output tax is the VAT that is chargeable at the appropriate rate on the sale of taxable commodities by a taxable person. An entrepreneur has to be registered for VAT, and calculate the output tax when his taxable turnover has exceeded the threshold for compulsory VAT registration. Meanwhile the input tax is the VAT added to the price of commodities liable to VAT, which are purchased by the entrepreneur. It can be deducted (Zolotukhina, 2017).

A value-added tax (VAT) is a form of consumption tax. From the perspective of the buyer, it is a tax on the purchase price. From that of the seller, it is a tax only on the “value added” to a product, material or service, from an accounting point of view, by this stage of its manufacture or distribution. The manufacturer remits to the government the difference between these two amounts, and retains the rest for themselves to offset the taxes they had previously paid on the inputs. The “value added” to a product by a business is the sale price charged to its customer, minus the cost of materials and other taxable inputs. A VAT is like a sales tax in that ultimately only the end consumer is taxed. It differs from the sales tax in that, with the latter, the tax is collected and remitted to the government only once, at the point of purchase by the end consumer. With the VAT, collections, remittances to the government, and credits for taxes already paid occur each time a business in the supply chain purchases products (P. Sivasakkaravarthi and D. Ganesan, n.d).

In an expansive piece of creating and change nations VAT performs fundamentally financial capacity, being the primary wellspring of spending income (for instance in 2014 in Ukraine the income acquired from VAT was 51% of aggregate assessment income, in Moldova it accomplished 58.2%). In the meantime the shadow economy especially in type of debasement and tax avoidance that exists in these nations prompts an extensive duty hole which in turns diminishes VAT proficiency (sokolovyska and sokolvskyi, 2015).

Most nations managed the new difficulties by receiving new assessments, including the Value Included Tax [VAT]. Today, the VAT is a noteworthy piece of the expense framework in more than 136 nations, raising around one-fourth of the world's duty income. The open deliberation in regards to the welfare picks up related with changing from exchange charges to the VAT isn't finished. The welfare picks up from a change to the VAT are sketchy within the sight of a huge casual division (Emran and Stiglitz, 2005). The center pay nation’s income recuperation following exchange progression has been around 50 pennies for every dollar of lost exchange charge income, and the income recuperation has been exceptionally powerless in low-pay nations. Nor is there much confirmation that the negligible nearness of a value added imposes has made it less demanding to adapt to the income impacts of exchange progression (Baunsgaard and Keen, 2005).

Among the real incomes, the VAT has turned into an essential and developing source of income to government. Different measures on VAT organization and implementation, development of the expense to extra items, and the presentation of electronic money enlisting machines expanded incomes lately. The offer of VAT (both residential what's more, import) income achieved five percent of gross domestic product in 2012/13, which was double the offer of 2007/08, and the VAT profitability and proficiency were enhanced too. The efficiency of VAT found the middle value of to 0.26 percent in nine years, going from as low as 0.17 percent in 2007/08 to as high as 0.33 percent in 2012/13 (WB, 2016).

A 2017 International Labor Organization study of 187 countries reported consumption tax increases from 2010-2015 in 93 developing countries and 45 high-income countries. Among developing countries 27 are in Sub-Saharan Africa, 18 in East Asia and the Pacific, 18 in Latin America and the Caribbean, 14 in Eastern Europe and Central Asia, nine in the Middle East and North Africa and seven in South Asia (Oriz et.al. 2017 cited in Buenaventura and Miranda 2017). Egypt is the latest country to have adopted VAT. In August 2016, Parliament passed the Egyptian VAT Act of 2016 and thereafter approved a 13 per cent VAT rate. This change to the Egyptian tax system sought to unlock the first $1 billion tranche of a $3 billion loan from the World Bank. Welcoming the move and other austerity measures as steps in the right direction, the IMF expressed support through a $12 billion loan commitment in 2017 to Egypt over the next three years (IMF, 2016).

Ethiopia presented value added tax (VAT) in the year 2003 as a substitution to deals assesses (sales tax). VAT is the chief wellspring of income for the Ethiopian government. For instance, in the 2006– 07 financial years, government VAT income (on residential exchanges) represented around 41 for each penny of aggregate government incomes from residential sources (EFIRA, 2007). Further, since its presentation, VAT has been more income beneficial than deals assess (sales tax) (Teferra, 2004). To maintain VAT's income part in the administration's back, guarantee that the income produced by this assessment is raised as productively as could reasonably be expected. Be that as it may, in Ethiopia incomes raised by VAT are more often than not collected to the detriment of disintegration in its striking highlights. This might be caused by factors counting poor VAT organization, i.e., the insufficiency of expense experts to actualize the qualities of the expense by and by. A decent duty organization is basic in completely executing the plan highlights of VAT and accomplishing government's arrangement destinations on the loose.

To alleviate the issue of VAT rebelliousness and increment income the government of Ethiopia (GoE) presented VAT withholding plan in 2009. This plan requires chose government organizations and open endeavors to withhold 100% of the VAT on their buys what's more, transmit the sum to assess specialists inside 30 days from the finish of the month in which the VAT was withheld. Citizens are permitted to balance VAT withholding against VAT payable in a period. In the event that the withholding VAT and the information VAT surpass the VAT payable on deals, the abundance is claimable as discount (Wollela, 2016).

In Ethiopia, VAT is connected to all organizations with a turnover of more than 500,000 Birr. For firms with not exactly the turnover limit of 500,000 Birr, a much lower 2% level rate is connected. The law requires any firm with sufficiently high turnover to enlist for VAT. Turnover charge is imposed on administrations rendered locally. It is expected to be proportionate to VAT for non-VAT-enlisted substances. Obviously, a firm can downplay its turnover. Notwithstanding, on the off chance that, after survey by the assessment specialist, it gives the idea that a man has downplayed its turnover, the expert will issue an extra appraisal. In the event that the books of record are regarded unsatisfactory by the expense specialist, the charge specialist might evaluate the expense on the premise of data accessible or on the premise of market cost of such great or administration in the market. Consequently firms will measure the advantages of underreporting turnover against the expenses of identification (Mesa and Sow, 2015).

VAT boosts the general economic growth of Ethiopia but the issue of regressively resembling to sales tax still continues. During the periods 2003 to 2012, the growth rate of VAT was 66.27% on average. In the same periods the average growth rates of GDP were only 2.53% from sales tax. However after executions of VAT, such growth rate reached about 21.9% on average. VAT to GDP becomes 2.95% on the same period. However, to be effective, it requires strong administrations and cooperation’s of the tax payers with taxing authority and the government in general (Dessalegn, 2014). In the year 2013 Ethiopia collected ETB 62.2billion tax revenue, which undermined by ETB 12.3billion compared to plan. Total VAT collection was ETB 25.23billion in the quarter, which shares 40.53% of total tax revenue in the country (wondwosen, 2016).

VAT has been introduced in Ethiopia to maximize the revenue that the government collects out of tax. Identification and registration of the taxable persons, filling and payments, VAT invoicing, refunding, auditing and penalties for non-compliance partly attributes to the salient features of VAT to be different. This may help to be VAT less vulnerable to evasion and fraud compared to other taxes (Marishet and Fikre, 2017). But if not well implemented; non-compliance, evasion, tax avoidance and fraud will ensue affecting the entire tax system, the revenue generated, disturb smooth market operation and entail unnecessary administrative costs. Failure to register, failure to file tax return, underreporting tax liability, illicit claim of refunds and issuing improper invoices are among the major challenges. Thus, given the significance of the revenue for the national economy and ultimately the role of VAT system to ensure smooth, uniform and competitive business environment throughout the country, this research investigated the major determinants of productivity of VAT in Ethiopia.

1.2. Statement of the Problem

A VAT is a critical revenue stream for industrialized countries. Among non-U.S. OECD members in 2009, the VAT raised 6.4 percent of GDP in revenue and accounted for 19.2 percent of revenue raised at all levels of government. As with any tax, revenue from a VAT depends on the rate structure and the base. The standard VAT rate, the rate charged on most goods and services, has remained relatively steady in recent years in non-U.S. OECD countries. In 2012, it ranged from a low of 5 percent in Japan to a high of 27 percent in Hungary. The average rate was 18.7 percent (Birhan, 2014).

VAT revenue performance appears to be declining and is low compared to that in neighboring countries. For instance, VAT and other indirect taxes accounted for about 27 percent of total tax revenue in the year 2013 in Ethiopia, while these taxes contributed about 51 percent in Rwanda and 56 percent in Uganda (IMF, 2016).

The introduction of the VAT in Ethiopia disrupted the functioning of an existing tax administration because of inadequate preparation, lack of uniformity in application, lack of awareness by the side of the taxpayer, application contrary to the law and problems related with institutional capacity, lack of institutional capacity in mobilizing the tax payer, loose partnership and cooperation between VAT Payers and employees of ERCA, lack of commitment by the side of the ERCA employees towards VAT implementation, delay in decision making for complaints raised by VAT payers, tendency of ERCA towards penalizing the defaulting VAT Payers instead of creating common understanding (Bizualem, 2015).

The major problems that hinder the smooth implementation of VAT in Ethiopia are the absence of efficient VAT administration system, existence of eligible business entities that have not yet registered for VAT, existence of some VAT registered business enterprises that have collected the tax with illegal invoice and retain the tax for themselves, the presence of taxpayers that did not declare the tax they collected as per the law, low level of tax awareness of the community, existence of VAT registered business enterprises that offers customers an opinion to pay or not to pay VAT for the purchases they made in the market and provisions of forgery VAT invoices as well as the lower level of the purchasing power of the community which increases the needs of searching goods and services that excludes VAT value from its prices (Hailemariam, 2011).

Different research works has been undertaken on the issue of VAT in Ethiopia. Wondwesen (2016) studied on the challenges of VAT efficiency in south Ethiopia and identified audit problem, administration limitation, customer non awareness and others. Birhan (2016) also got the same result studying VAT efficiency factors in Gondar.

Masalu (2013), in the study of factors affecting VAT revenue performance in Tanzania identified internal factors ( like administrative capability, manpower, taxpayer identification, taxpayer assessment, taxpayer sensitization, corruption & embezzlements ) and external factors ( like VAT Law & regulations, threshold level, VAT exemptions, VAT refunds) using a multiple regression analysis.

Though these researches are undertaken they are at micro level and not sufficient in methodology to address the problem of VAT productivity in Ethiopia. They used only simple statistical methods in their research. But VAT has potential for further increasing tax revenues in many LDCs and needs a critical look in to it (UN-OHRLLS, 2017). So this research takes this issue as a basic and important stand, and then tries to investigate using appropriate econometric model incorporating how much significant the relationship is between VAT revenue productivity and its factors. But major factors which are at macro level are incorporated depending on theories and empirical review.

Since time series analysis is used the variables may not be stationary. So OLS model can’t be used. Co integration is used when the variables are at the same order. But the variables could have different order. So in this study ARDL model is used. ARDL is good because we can have different orders and the case of non stationarity. The other thing is the past values of the dependent variable could affect the dependent variable (Kahil et.al 2016).

The ARDL model is the more statistically significant approach to determine the co integration relation in small samples. The other is both long run and short run parameters are determined simultaneously. We can obtain efficient and unbiased estimators (Narayan, 2004 cited in Tewedros, 2014).

1.3. Objective of the Study

1.3.1. General objective

The prime objective of this study is to investigate the main determinants of VAT revenue productivity in Ethiopia. In order to address this main objective we focused on the following specific objectives.

1.3.2. Specific objectives

a) To assess the VAT revenue productivity over the period 2003/2004 till 2016/2017 in Ethiopia
b) To assess the major factors affecting VAT revenue productivity in Ethiopia.

1.4. Research Questions

The paper took the advantage of the availability of recently collected nationally representative time series data and answered the following questions:

a) How much VAT revenue productivity varies across the period 2003/2004 till 2016/2017 in Ethiopia?
b) What are the major determinants which affect VAT revenue productivity in Ethiopia?

1.5. Significance of the Study

This research is important for policy makers to know the critical determinants that could robust or decelerate the VAT productivity in Ethiopia. As my research is targeted on identifying determinants which have significant impact on VAT productivity, the findings of this thesis significantly benefits the stakeholders to drive and implement appropriate policies for enhancing VAT productivity and improve the tax system as a whole. It is also important as an addition in the existing literatures and researches and for future researchers as a reference and leading light for more exploration.

1.6. Scope of the Study

This stud only focused on VAT productivity among tax (indirect) categories. In addition it is limited to only the time series secondary source of data from 2003/2004 till 2016.

1.7. Limitations of the Study

The study only focuses on the macro level of the economy in the country. Due to this some difference may be present in the productivity of VAT in different regions of the country. There was some data problem due to time and recording problem in different offices. Some offices record data up to a certain period and they leave the other period. I used the recorded data of this period its similarity (consistency) with those offices which record the whole period. This was alleviated by using complementary sources data like World Bank from international offices and others national offices like national bank of Ethiopia.

CHAPTER TWO

2. Literature Review

2.1. Theoretical Literatures

A tax is a compulsory levy made by public authorities for which nothing is received directly in return. Taxes are, therefore, transfers of money to the public sector, but they exclude loan transactions and direct payments for publicly produced goods and services. The classification by nominal source of taxation meaning by the way of collecting taxes can be direct and indirect taxes. Direct tax is assessed and collected directly from the individuals who are intended to bear it. It is usually collected through an intermediary and the most popular intermediary is the employer (income tax) of the tax payer. In this aspect the tax payer may not have contact with tax authorities but can depend on individual circumstances. The average tax rate could be changed according to conditions. The indirect tax is not collected directly from the individuals who are intended to bear it. It is paid by one person but collected from another. Mostly the tax is included in the price but not always visible on a bill. The amount of tax paid depends on the object one buys but not on the individual circumstances (James and Nobes, 1997).

A VAT taxes the value-added in production through the various stages of production. Value added is simply the difference between the value of the goods and services sold and the value of goods and services purchased as intermediate inputs. Under a VAT, the sum of purchases and value added by the firm itself equals (by definition) the value of the inputs (which have a full tax credit attached to them) of the next firm in the production distribution process. As a result, the same value-added is never taxed twice; that is, cumulative effects do not occur. Moreover, at the final retail stage the sum of all values added throughout the process and, by the same token, the sum of all the differences between sales and pure has equal the consumer price, excluding tax. The final price, that is the price paid by consumers, has therefore to cover all the values added at the successive stages. VAT thus provides a systematic mechanism for taxing final consumption while relieving transactions in intermediate goods. In comparison, the retail sale tax is levied only at the time of sale to the consumer. The total tax collected piecemeal under the V AT from all stages of production and distribution is equal to a tax collected on the sale from retailer to the final consumer or user, that is, a retailer-sales-tax. This equivalence has sometimes led to a VAT being term a national sales tax (Metcalf, 1995:123 cited in Bergen, 1995).

Value-added tax is collected after the final consumer prices are imposed, but does not affect the production or distribution (Dilius and Kareivaitė, 2010). On the other hand, VAT is a regressive tax, because in terms of the same consumption, people with lower income spend a larger part of their income rather than those with higher income (Jenkins et al., 2006).

There are three alternative methods of VAT computation. These are the addition method, the invoice-based credit method and subtraction method. By the addition, the tax liability is equal to the tax rate multiplied by the value added defined as the sum of wages and profits. By the subtraction method, the tax liability at any stage is equal to the tax rate multiplied by the tax base or value added measured as the difference between the values of outputs and inputs. The final one is the invoice-based credit method. Under the invoice based credit method, a firm at any stage of the production-distribution chain charges its customers the VAT on its output, submits the tax to the treasury, and then claims for the VAT already paid on its input purchase. Generally the invoice-based credit VAT is most common and apparently has advantages over both addition and subtraction methods. The addition method relies on accurate information on wages and profits which are hard to obtain in developing countries, and thereby runs into the same problems faced in income taxation. The subtraction method, on the other hand, requires an explicit estimation of the tax base—this would be fine for a VAT with a single rate structure but would result in serious problems for a multiple-rate VAT regime (Minh Le, 2003).

There are three related measures of VAT productivity in theory: (a) the VAT efficiency ratio; (b) the C-efficiency measure; and (c) VAT gross collection measure. All three measures calculate efficiency as the ratio of actual VAT collections in the country to the potential revenues that would be derived from applying the standard VAT rate to, respectively, three potential tax bases: GDP, total consumption expenditure, and private consumption expenditure. The formulas for these three measures are as follows:

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In principle, a VAT with no exemptions, a single rate, and full compliance should result in efficiency ratios of close to 100 percent (IMF 2010). In practice, of course, many VATs are very far from this possible goal. In fact, none of these measures gets close to the actual tax base on which the VAT falls, even though given the exclusion of investment and most public consumption from the VAT base in most countries, the VAT gross collection measure should be closer than the C-efficiency ratio and definitely closer than the VAT efficiency ratio, based as it is on GDP. In addition the use of the standard VAT rate to compute potential revenues ignores the existence of multiple rates, some lower than the standard rate and some higher; exemptions and zero rating provisions are also ignored. The potential revenue of a VAT in any country thus depends to a considerable extent on political decisions made in determining the VAT base. The actual revenues then depend further upon how fully that potential base is actually reached, which in turns depends upon two interrelated factors ( the level of tax compliance (tax morale) and the effectiveness of the tax administration) (Vequez M.Bird, 2010).

It is often said that general consumption taxes are better for economic growth than income taxes because of their effect on savings and on labor supply. Since general consumption taxes do not impose on savings while income taxes impose on savings and on the income from savings (interest), general consumption taxes can encourage savings, leading to increased investment and growth. Also, general consumption taxes do not affect people’s decisions about whether or not to work, improve competitiveness. The argument that general consumption taxes promote international competitiveness on which the VAT is refunded on exports and so has no effect on the ability of domestic firms to export. So, general consumption taxes are better for domestic economic growth than income taxes or corporate taxes. But general consumption taxes increase inequality between the rich and the poor compared to income taxes. A change from income taxes to consumption taxes, which improves the incentive to save and reduces the taxation of capital income, would lead to increased inequality (Miki, 2011).

Consumption taxes can be categorized as general consumption taxes, typically VAT or sales tax (which is applied on a broad range of goods and services) and specific consumption taxes, such as excises and import duties, which are applied on a limited number of goods and services. In general, consumption taxes and particularly VAT are often thought to have a less adverse influence on the decisions of households and firms and thus on GDP per capita than income taxes. However, these advantages have to be balanced against equity concerns that arise from their lack of progressivity. Consumption taxes are neutral to saving since consumption taxes apply the same tax rate on current and future consumption (provided that tax rates are constant over time) they do not influence the rate of return on savings and individual’s savings choices as income taxes do. Hence, consumption taxation is often seen as favoring private savings relative to income taxation (Johansson et.al, 2008).

The VAT is generally believed to be non-distortionary, provided there are few exemptions and little zero-rating. However, it is increasingly accepted that zero-rating is necessary to achieve social justice and security in harsh economic conditions. When the VAT on investment is fully credited, it is an improvement over older taxes on capital goods. The VAT generally replaces inefficient, distortionary, and badly administered taxes that cascade liabilities, use many tax rates, tax capital goods and exports, favor imported goods, reduce the base, and frequently involve an antiquated and corrupt administration. With the introduction of the VAT, the economic costs and risks of collecting revenue will decline as the entire production and distribution chain becomes involved in collecting this tax, because this spreads the costs and risks of collection over a much larger number of transactions. The VAT has also helped to facilitate trade by exempting exports, removing hidden subsidies, and placing the taxation of imports and domestic production on the same level playing field. On the whole, the VAT’s effects on trade have been considered to be largely beneficial, with economists applauding the level playing field for imports and governments generally paying more attention to the removal of barriers to exports (Kayaga, 2007).

The success of the VAT cannot be taken for granted; it requires good design and implementation. In many developing countries, VAT suffers from being incomplete in one aspect or another, leading to less revenue being collected. VAT is often thought to be an intrinsically complicated tax, cumbersome for both taxpayers and authorities. In developing countries, where even basic record-keeping abilities may be limited, it can be especially difficult to implement a VAT. The effectiveness of the VAT is further undermined by the difficulty of implementing workable self-assessment systems, under which taxpayers declare and pay taxes on the basis of their own calculations, subject to the possibility of later audit by tax authorities. Government’s inability to give prompt refunds of excess credits to certain taxpayers, particularly exporters, reduces the effectiveness of VAT because exports are zero-rated; exporters have no output tax liability, and are entitled to a refund of the tax paid on their purchases. Failure to provide prompt refunds detracts from the merits of the tax. Increasing consumption taxes definitely fosters the expansion of the hidden economy if the labor intensity of the production in that sector is greater than in the formal sector. The right way to implement VAT is through self-assessment. However, potential taxpayers have many ways to escape being taxed. They may flee abroad; they may remain hidden in the informal economy; or they may secure some form of favorable treatment by exerting influence to have changes made in law. This has resulted in the erosion of the base of the VAT through concessions at many levels as well as through general administrative weakness (Ebrill, 2002).

The collection efficiency of the VAT is the ratio of the VAT revenue to aggregate consumption divided by the standard VAT rate. It is impacted by political economy considerations _ greater polarization and political instability would reduce the efficiency of the tax collection. In addition, collection is impacted by structural factors affecting the ease of tax evasion, like the urbanization level, the share of agriculture, and trade openness (Aizenman and Jinjarak, 2005).

The sources of inadequacy of revenue from taxation include tax structure that is not buoyant or income-elastic, a long time lag between government revenue collection and spending, lack of fiscal discipline, and reluctance of the government to control its expenditures, and lack of information about the behavior of tax revenue functions (Wawire, 2011).

The potential revenue which can be raised from the VAT depends on a number of factors, such as the standard tax rate, the number of taxes, the range between the highest and the lowest nonzero rates, the age of VAT, foreign exchange and inflation rates, how broad the tax base will be and the degree of tax compliance. In estimating a VAT’s revenue yield, economists use the operating assumption that a VAT would be fully shifted to final consumers in the form of higher prices of goods (Bickley, 2011).

2.2. Empirical Literature

Were Wawire (2011), studied the determinants of VAT revenue and assess the response of VAT structure to changes in its tax bases using Paul Samuelson's (1955) fundamental general equilibrium analysis. The study finds that growth elasticities for VAT are all greater than one. The estimation results show that total GDP elasticity of VAT revenues is less than the elasticities with respect to monetary GDP, suggesting the existence of an underground economy in Kenya over the period of analysis. It is found that VAT revenues respond with substantial lags to changes in its determinants and that VAT revenues are sensitive to unusual circumstances. The study concludes that Kenya’s VAT revenue is very responsive to changes in their determinants especially international trade. There is therefore the challenge of creating a stable VAT system so that tax revenues can increase rapidly as the economy grows.

Bikas and Andruskaite (2013), an article examined the concept of value added tax, the notion of the tax, the EU directives governing the tax rate base as well as the change of standard rate in European Union countries. The paper also analyses the relationship between the VAT revenue and macroeconomic indicators: gross domestic product, gross domestic product per capita, consumption expenditure, household consumption expenditure, government consumption expenditure, export, import and unemployment in the country in an attempt to construct a model that describes the significance of VAT revenue collected. To designate factors, influencing VAT income, correlation coefficient between established VAT regulations (standard VAT ratio, margin between highest and lowest, except zero, VAT ratios and period of VAT institution), ratios, characterizing economic conditions (GDP, GDP per capita, consumption, household’ consumption, governments’ consumption, import, export and unemployment rate), that positively influence VAT income, was calculated. The obtained results show that reliable and strongest relations exist between ratios, characterizing economic conditions (GDP, GDP per capita, consumption, household’ consumption, import and export), that positively influence VAT income. VAT income tollage is more influenced by households’ consumption than governments’. Though it is impossible to conclude that the relationship does not exists with decisions made by government in the field of VAT or unemployment rate as they can indirectly influence VAT income. However VAT income model, which exactly enough characterizes VAT income (deviations between calculated and concrete tollage VAT income is below 0.5 per year) relies only on factors containing the strongest and reliable meaning.

Diana (2011), in Kenya study evaluates VAT revenue productivity for the period 1995/96 to 2009/10. The study evaluated the determinants of VAT revenue and come up with a model for predicting VAT revenue in future. The analysis showed that the determinants of VAT revenue have a significant effect on the responsiveness of VAT revenue. This implies that the growth in VAT revenue during the period of study was accounted for by changes in its determinants. In the VAT revenue equation, the positive intercept effect is counteracted by negative effects that are greater the higher are standard tax rate, inflation rate and foreign exchange rate. This study also finds that multiple rates, higher range between highest and lowest non-zero VAT rates, and the longer the VAT has been in operation (age of the VAT) are associated with higher revenues. This study concludes that foreign exchange rate, number of rates, range, and age directly or indirectly influence VAT revenue. This was observed from the increase in VAT collections over the study period, given changes in the determinants. The study also concludes that Kenya’s VAT productivity is normal, comparing it with worldwide results.

Sokolovska and Sokolovskyi (2015), an article estimated the efficiency of value-added tax (VAT) collection in the countries worldwide. In a large part of developing and transition countries VAT performs primarily fiscal function, being the main source of budget revenue (for example in 2014 in Ukraine the revenue obtained from VAT was 51% of total tax revenue, in Moldova it achieved 58,2%). At the same time the shadow economy particularly in form of corruption and tax evasion that exists in these countries leads to a considerable tax gap which in turns reduces VAT efficiency. The study found the negative correlation between the VAT efficiency ratio and shadow sector and CPI as well, which could be explained by the fact that for transparent economies the share of the unpaid taxes is small, and the estimation of VAT revenue is sufficiently precise, and vice versa is true for non-transparent economies.

Vazquez and M.Bird (2010), examined about value added tax productivity over countries in the world. From this the general trend in productivity is towards a consistent improvement over time, particularly for Eastern Europe and North Africa and the Middle East. The most striking exception is Sub-Saharan Africa, where a significant drop in VAT efficiency (however measured) in the first half of the 1990s has not since been reversed. With respect to the average VAT efficiency, for example, it is between 35 and 40 percent in most regions with the striking exceptions of Eastern Europe at 45 percent and Sub Saharan Africa at 25 percent. While the ratios are generally higher for the C-efficiency ratio (about 5 percentage points higher) and the VAT gross collection ratio (about 10 percentage points higher), the pattern is the same in all cases. For the VAT gross collection ratio the average figure for most regions of the world is between 60 and 65 percent, with the outliers being again Eastern Europe at over 70 percent and Sub-Saharan Africa at 40 percent.

Erfani et.al (2013), studied the factors that affect value added system performance in Iran. According to the study Tax culture, Inflation, Adoptive accounting system with VAT, Underground economy, and Informing and training are identified. Tax culture designing and explain the value added tax as a new born tax base increased the satisfactory level of the actors and cult rising. Inflation affects VAT by Creating multiple ratios in value added tax of consuming goods and investments, Taking complementary policies of absorbing cash and decreasing money supply, Taking control policy and issuing needed laws in this field, Dedicating offish tax to the economics segments with traditional works, and Supplementary policies after fixing and regulation of the price. Adoptive accounting system with VAT: the existence of homogeny and unity between organization acceptable tax accounting system and financial accounting cause to simplifying and fasting in calculation affairs besides transparency. Underground economy is a part of the economy that is not transparent, doesn’t pay the tax but use the government equipments. Because of this reason that actors like tax escaping, so organization should spend more costs for identifying auditing and receiving tax to control the amount of tax escaping. Informing and training is the most complete factor and the element of operating value added tax. Modern nature of short term courses, the process of self represents and receiving and maximum of the number of actors’ professional jobs and related workers and economical firms is necessary.

Keen and Lockwood (2007), paper explored the causes and consequences of the remarkable rise of the VAT. The paper used on a panel of 143 countries for 25 years, of a system of equations describing both the probability of VAT adoption and the revenue impact of the VAT. The presence of a VAT does indeed have a significant impact, but also a complex one, with a negative intercept effect counteracted by positive effects that are greater the higher are per capita income and, more tentatively, openness. While the sign of the revenue impact of the VAT is thus in general ambiguous, most countries that have adopted a VAT seem to have gained a more effective tax instrument in doing so (though this is less apparent in sub- Saharan Africa), and most without it seem likely to gain from its adoption. Adoption of the VAT is associated with a long run increase in the overall revenue-to-GDP ratio of about 4.5 percent but its impact is complex. The shift effect of the VAT now becomes negative, but acting in the opposite direction are gains that tend to be greater in higher income and in more open economies.

Dakito (2011), discussed some critical literatures on value-added tax (VAT) in Ethiopia relating to its contributions for economic development and its impact on the Social Spending in Ethiopia employing quantitative empirical analysis technique and multiple regression models as abstractions and descriptive statistics. The study considered a vector of economic development indicators as dependent variables and regressed each on VAT revenue proceeds and other income (loan, donation, grant, taxes excluding VAT revenue, and others) of Ethiopia State for the study period (1995-2002 E.C. or 2003/04 – 2009/10 G.C.). The analysis showed that, except education sector, VAT revenue contributed positively for the development of the respective sectors. On the aggregate the analysis showed that VAT revenue had a considerable contribution for the development of the economy during the period under study. However, the contributions are statistically significant only to health and agricultural and natural resource development sectors. Therefore, it can be said that, the VAT tax revenue was unable to neutralize the regressivity of VAT tax levy in Ethiopia because its unsystematic exemptions, tax structure, and tax system. Thus, the study concludes that various sectors of the economy of Ethiopia are yet to benefit significantly from VAT revenue expenditure of the state government. Consequently, the paper calls for equity in sectorial spending of VAT proceeds in Ethiopia State in order to ensure balanced development and sustainability of the emerging mega city status of the state.

Hamdu and Zinash (2017), conducted an assessment on the Problems faced by traders during using Electronics Tax register Machine ( ETR) the Case of Addis Ababa City. The paper used random sampling method 363 tax payers were selected from the total population of 6794 with 85% return rate. The paper has identified problems related to the use of ETRs from the perspective of tax payers. The major finding is that use of ETRs improved timely filling of the monthly VAT returns, significantly improved the collection of value added tax and has increased government income, businesses prepare and file their VAT returns in good time to beat the ERCA deadlines without the involvement of tax agent’s services in filling tax returns and also the . The major problems faced by the tax payers are unallowable expenses due to the problem of ETRs suppliers and the lack of consistency and transparency in imposing penalty for tax personnel. Maintenance cost and time, higher compliance costs are also fund to be among the major problem of the tax payers.

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