# **1. Introduction**

In September 1991, South Africa replaced its general sales tax (GST) with a consumption-type value added tax (VAT). The original statutory rate was 10 percent, which was subsequently raised to 14 percent in 1993. The South Africa VAT is levied on the domestic supply and imports of goods and services, while exported goods (such as gold) and services<sup>1</sup> are zero-rated. With a rebate for intermediates and investment purchases, the VAT is generally seen as a consumption tax as the consumer pays it at the final stage of production.<sup>2</sup> The advantage of a VAT is that, unlike other indirect taxes, it eliminates the cascading effects of taxes on intermediate inputs and, as such, it removes distortions affecting input choices in production.

Initially, there were concerns about the regressiveness of the VAT. To assist the poor, selected foods (such as brown bread, maize meal, milk and milk powder, rice, unprocessed vegetables and fruits) and paraffin were zero rated. There were also concerns that it would be difficult to administer and that it would place a burden on small businesses. There were doubts that a VAT could replace the GST as a source of government revenue.

Some of these initial concerns about a VAT have not materialized. For example, small firms were excluded for social reasons as well as to simplify the system. The VAT has proven to be a stable and broad-based source of government revenue. The tax collection method of a VAT encourages “self-policing”—producers are more likely to purchase intermediates from sellers who can verify that they have paid the value added taxes due.<sup>3</sup> However, the VAT is mildly regressive (see Fourie and Owen (1993) and Figure 1 in section 2.1), despite efforts to zero rate commodities important to low-income households.<sup>4</sup> In this paper, we analyze the welfare and income distribution effects of possible reforms to South Africa’s value added tax in order to improve its equity impact while maintaining its strong revenue features. We use a computable general equilibrium (CGE) model of South Africa, with data for 2001.<sup>5</sup> We extend the model to include VAT payments with rebates on intermediate inputs. There are 10 households according to income deciles. We allow for unemployment in the semi-skilled and unskilled labor categories.

First, we describe the incidence of the VAT. Following Devarajan and Hossain (1995) we remove the VAT from the price system and replace it with a proportional increase in the income tax. With this approach, we maintain public expenditure levels because government revenue does not change and, because we use a direct tax to restore government revenue, we do not distort the

> 1 Exports do not attract VAT – an important feature of all VAT systems. There are some definitional and administrative problems with regard to international traded services that are under review.

> 2 Go and Mitra (1999) use a CGE model that incorporate a similar VAT for India.  For the history and issues about VAT as a tax instrument, see Baker and Elliott (1997) and Ebill et al. (2001) for example. 3 See Kearney (2004).

> 4 This does not mean that the whole tax system is regressive—see tax structure in section 2.

> 5 In this paper we expand upon the tax specification in the CGE model originally programmed by Marna Kearney (see Go and Kearney, 2003) and which uses the standard CGE model code developed by Lofgren et al. (2001). The Social Account Matrix in that model was commissioned by the World Bank and constructed by Quantec of South Africa.

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