Zero-rating a better option than VAT exemption

The government’s recent decision to change the Value Added Tax (VAT) status of ordinary bread from exempt to zero-rated was received with jubilation by Kenyans.

However, despite this welcome move, the government has, based on the other proposed changes contained in the Finance Bill 2017, displayed a continued tendency to lean towards exemption as a means of incentivising various industries.

This trend can be traced back to the repeal of the Value Added Tax Act, Cap 476 (repealed VAT Act) with a less voluminous VAT Act, 2013 with effect from September 2, 2013. The VAT Act, 2013 significantly reduced the number of items that were either zero-rated or exempt as per the repealed VAT Act.

Further, the number of public bodies, privileged persons and institutions entitled to zero-rated supplies in the VAT Act, 2013 were significantly reduced.

Since the enactment of the new Act, the government has continued to exempt supplies, sometimes in response to lobbies for zero-rating, with the latest examples being the VAT exemption of liquefied petroleum gas (LPG), commonly used by households and the VAT exemption of inputs for the manufacture of pesticides.

In my view, exemption as an incentive, carries hidden costs which eventually undermine the noble intentions of the government in trying to grow industries which are integral to Kenya’s economy. Take for instance, the loaf of bread which is now zero-rated. An average-sized ordinary loaf of bread retails at Sh50. For purposes of this illustration, let us assume that it costs the bakery (am assuming the bakery is the retailer) Sh40 (exclusive of VAT) to bake one loaf of bread.

When ordinary bread was VAT-exempt, the bakery was not entitled to input tax credits in relation to VAT incurred on inputs acquired in the course of producing the bread. This meant that while the bakery was charged 16 per cent on Sh40 (Sh6.40) on purchase of its inputs, it was not able to offset the VAT incurred against VAT charged since the supply of ordinary bread was VAT exempt.

Therefore, the bakery would either absorb the VAT costs and suffer a corresponding decrease in its profit margins (which is often the case where contracts have already been negotiated) or recoup the tax cost by factoring it in its retail price such that the non-recoverable VAT burden is ultimately borne by the consumer (which is the sensible business decision to make). Therefore, the retail price of Sh50 has a cost component of Sh46.40, with Sh6.40 being the non-recoverable input tax.

Based on this illustration, it can be seen that neither the consumer nor the bakery benefits from VAT exemption because exemption of the final supply of good and/or services as an incentive ignores the cascading effect of non-recoverable VAT in the entire supply chain. On the flip side, zero-rating (as is now the case for bread) means the bakery is entitled to claim input tax credits in relation to the VAT incurred on the purchase of its inputs hence the Sh6.40 VAT in the illustration above would be recoverable by the bakery thereby eliminating the need to pass on the cost to the consumer.

Therefore, the bakery can reduce the retail price of bread while maintaining its profit margins which is the reasonable expectation of the government and its citizenry.

The government has acknowledged the futility of exemption as an incentive, which is why it has now overturned the exemption on ordinary bread in favour of zero-rating in order to obtain the desired effect of relieving the cost of living burden for the mwananchi (ordinary person).

Whilst the trimming down of the VAT legislation in enacting the VAT Act, 2013 simplified the law, it is my view that the current legislation should retain enough flexibility to allow for the provision of zero-rating as an incentive for the growth of key industries as the country aims to achieve its Vision 2030 aspirations.

I therefore urge the government to rethink its reliance on VAT exemption and consider adopting zero-rating, especially where the intention of granting VAT exemption is to alleviate cost for the citizenry or to stimulate growth in a specific sector.

To deal with refunds challenges arising out of zero-rating, the National Treasury should consider setting aside a portion of the VAT paid by taxpayers in a fund to finance refunds before allocating the tax collections to its many competing priorities.