CHAPTER – I

INTRODUCTION

1.1 Background of the study

Nepal has predominantly agricultural based country. The major portion of population live
in village and most of them are below the poverty line. Being one of the least developed
countries in the world, the role of government is still vital to build up infrastructure,
provide social services, and alleviate poverty. Wide spread poverty, repaid population
growth, low income level of people, unemployment, inadequate infrastructure, foreign
dependency, unutilized resource, inequitable distribution of wealth and income, lack of
adequate industries and adverse balance etc. are the main characteristics of Nepalese
economy. These are challenging problems, which demand increasing necessity of regular
expenditure in general and development expenditure in particular.

Nowadays, the major concern of every nation is to achieve repaid economic development.
Being one of the developing countries, Nepal also desired to achieve economic
development. In present day world, economic development has been one of the formidable
challenges for Nepal. Government revenues play a vital role in the repaid economic
development programmed to solve the above challenges. Revenue of the country may be
from external sources and internal sources. External sources of revenue are grants of
foreign government or agencies and loans. Such external sources are uncertain and not
good for healthy development of the country’s economy. Internal sources constitute tax
and non-tax revenue. It is better to mobilize internal resource rather than approaching to
foreign grants and loan.

Taxation is the most effective and powerful tools reserved in the hand of the government of
country. It is taxation, which invests paramount power in the government to hold over the
economy of country. The major objective of taxation is to make fund available for the
economic development and economic stability. Tax is the major part of government
revenue. It is better for development country to maximize revenue through domestic
sources, which is such much safer and fruitful as well. Taxation not only contributes in
economic development and stability but also helps in the equal distribution of national
income of the country.

Tax is means collect the revenue from the people, business, and other organization of the
country by the government. It is most important source of fund for government. It is used
to provide good governance and to develop infrastructures like electricity, transportation,
and other facilities to the people and its country.

Taxes are usually classified into two groups, direct taxes, and indirect taxes. There is a
predominant role in indirect taxes in Nepalese tax structure. Income tax and other indirect
taxes do not seem to play effective role in revenue mobilization due to their inefficient
operation. Sales tax however provides a considerable bulk of revenue but suffered from its
narrow base, cascading and pyramiding effects, which create distortions without
generating potential amount of revenue. That’s why, value added tax system has been
considered as an attractive alternative to exist as an indirect tax system, spreading around
the world at a speed which is unmatched by any of other tax in modern time. Although, it is
the youngest form of taxation innovated in the second half of the twentieth century, it has
been reform; VAT is now gaining the primary preference.

For collecting the revenues, VAT has been most essential sort of tax revenues of developing
countries because it is the most improved from of sales tax, which heads to revenue
enhancement and economic efficiency. It is an important instrument for the internal
resources mobilization. There is tremendous scope for increasing the revenue from VAT.
The sound implementation of vat will obviously increase its contribution coming days. The
tax reform with an adopting cats is one of the major elements of tax revenue source to
achieve goal of repaid economic development of developing countries.

1.2 Statement of Problem

Nepal is one of the poorest and least developed countries in the world. Nepal has been
suffering from resources constraints massive poverty, repaid population growth,
increasing unemployment, high dependency on agriculture, subsistence living standard
and poor infrastructures. Unfortunately, the problems instead of being solved are rather
deepening and worsening.

In Nepal, the resource mobilization is still poor that does not cover the growing
expenditure. Because of deficit financing and external loan, the economy has to face
resource gap, which is widening continuously.

The ever increasing government expenditures and limited resources of the revenues have
led the country to serve fiscal crisis over the years. Government expenditure is increasing
while there is no ‘equivalent’ increase in government revenue and such as unbalanced
growth in revenue and expenditure has resulted in massive revenue expenditure gap or
budgetary deficit in the economy.

The design of tax in Nepal is so poor and ineffective that as revenue relating investment it
always has very disappointing performance. The weak performance of tax in raising
revenue is clearly reflected in Nepal’s low tax GDP ratio.

Nepal’s lower revenue mobilization is due to the poorly designed and defective tax system
where the taxes are less productive and responsive. It is expected that VAT would be major
instrument to avoid deficit.

There have been arising various issues on design of VAT, its’ administrative operation and
applicability and its’ effect on different segments of society. A careful examination of this
issue imperative analysis is necessary to implement VAT successfully in coming days. To
evaluate the Nepalese VAT by identifying its present problems, not only from theoretical
aspect but also from the practical experience and to analyze the contribution of VAT in total
government revenue, this is the subject matter of this study. The study has tried to answer
the following questions.
 1. How to examine the importance and effectiveness of VAT revenue collection ?
2. How to identify current problems and prospects of VAT in Nepal ?
3. What is the contribution of VAT in total revenue in Nepal ?

1.3 Objectives of the study

The general framework of the study is to study the contribution of VAT in the total
government revenue of Nepal and identify various problems of VAT and suggest the
useful alternative solution to the wide range these problems. However, the main
objectives of this study are:
1. To examine the importance of VAT in revenue collection.
2. To study the contribution of VAT in total government revenue of Nepal.
3. To identify current problems and prospects of VAT.

1.4 Research Methodology

Research methodology is a process of arriving to the solution of a problem of a problem
through planned and systematic dealing with the collection, analysis, and interpretation of
the fact and figures. Research methodology refers to the various sequential steps to adopt
by a researcher in studying a problem with certain objectives in view (Kothari 1996: 19)

It tries to make clear view of method and process adopted in the entire aspect of the study.
It is known as a path from which we can systematically solve the research problems. The
research methodology includes Research Design, Nature, and Sources of Data, and Tools
Used.

Research Design
In this study Research Design will be more analytical in this sense that it was concentrate
on analyzing the contribution of VAT to government at each level such as whole, seller,
retailer etc. the present study has followed the descriptive as well as analytical approach to
achieve the objectives.
Sources of Data
In order to achieve the objectives of this study, secondary data will be use. Secondary data
will be taken mainly from the published from.

1.5 Significance of the study

There are various researchers on VAT conduct abroad as compared to Nepal. About more
than ten years have been passed since VAT came in operation but many Nepalese are
unknown of it. VAT, being itself a complicated and modern tax system more efforts should
be made on actual circumstances. Theoretical and practical knowledge are required to
implement VAT properly. So, this study analyze Nepalese VAT system with its contribution
in revenue collection and its problems. Because of this reason, the study will be directly
beneficial to policy maker, private sector, researcher, and other general people.
Policymaker will also be able to identify the areas requiring improvement and for the
proper implementation of VAT in Nepal it will also provide clear idea and knowledge to
those persons who are interested but confused about VAT system. Similarly, it will be
valuable reference to the future researcher. So, the study has great significance.

1.6 Limitations of the study

All the studies have their own limitations. No studies can be free from constraints such as
of resources time and money etc. this study is done for the partial fulfillment for master of
business studies. This is not far from several limitations, which weakens the heart of the
study, e.g. inadequate coverage of time period taken, reliability of financial and statistical
tools used and another variation. The study is conducted within certain limitations and
constraints.

The major limitations of the study are as follows:

1. The study is concentrated only on VAT.
2. The study is based mainly on secondary data but primary data is also gathered from
tax office tax experts, business men, tax payers, and consumers. So, the correctness
of the data depends up on the sources.,
 3. Field survey is done in Rupandehi (Butwal and Bhairahawa only).
4. The sample in small size in study may not fully represent as a whole of country.
5. This study covers the period only from fiscal year 2001/02 to 2008/09/

2.1.5.5 Subtraction Method

Under this method, value added is determined as net turnover. This net turnover is
obtained by subtracting the cost of materials from sale proceeds. Thus, VAT is levied on the
amount which is derived by subtracting purchases from sales. This method is duitable for
the consumption type of VAT.

2.1.5.3 Tax credit Method

It is also known as invoice method where the tax liability is derived by deducting tax paid
by the seller in purchasing from the total amount of tax collected from sales.

Within three methods of calculating VAT, the tax credit method has been widely used by
the most of countries in the world. Nepal also has adopted this tax credit method. The main
reason of adopting this method is its advantages. The first advantages of this method is the
easiness in finding out the amount of VAT collected, VAT paid and refund of tax. The second
advantages is its nature; it could be used for any time less than one financial year. The third
advantages is its catch up effect’ which avoids the problem of valuation. This is because any
understand of value at the domestic products and the import point in the case of imports;
would be correspondingly lower. It is an account based system so the tax system makes
more transparent. Thus the tax credit method is desirable for several reasons and has been
adopted by many countries of the world.

Let us see a case to make clear how VAT is charged at different stages suppose a
manufacturer buys raw materials from a farmer Rs. 100. He makes a finished good and
sells it to a wholesaler at. Rs. 160, the wholesaler sells it to a retailer at Rs. 200 and the
retailer also sells it to a consumer at Rs. 250. In such a case VAT is levied as follows:
 Table 2.1.2
Computation of VAT at different Stages under subtraction Method
Production/Distributio Purchase Price Sales Price Value Added Value Added
n Stages Tax @ 13%
Farmer - 100 100 13
Manufacturer 100 160 60 7.8
Wholesaler 160 200 40 5.2
Retailer 200 250 50 6.5
Total 460 710 250 32.5

Table 2.1.3
Computation of VAT at different Stages under Tax Credit Method
Production/Distributio Sales Price Value Tax Tax paid on VAT to
n Stages Added Collected on purchase @ be paid
sales @ 13% (b) to Govt.
13% (a) (a-b)
Farmer 100 100 13 - 13
Manufacturer 160 60 20.8 13 7.8
Wholesaler 200 40 26 20.8 5.2
Retailer 250 50 32.5 26 6.5
Total 710 250 92.3 59.8 32.5

2.1.6 Principle of VAT

There are two major principles for levying VAT they are:

2.1.6.1 Origin Principle

Under this principle, goods of services are taxed at the place where they are produced. This
implies that all exports are taxable and all imports are nontaxable. Where there is a border
and cross country trade, this principles gets importance to import goods of services over
domestic production. Countries with international boundaries do not prefer to have this
principle. But in European community (EC) where there is common border, this principle is
preferable. It discourages the exports either directly of indirectly as well as increase the
revenue loss.
2.1.6.2 Destination Principle
Destination Principle is a very popular principle adopted by a large number of countries.
Under this principle goods or services are taxed where they are consumed and not where
they are produced. This means all imports are taxed while all exports are free from tax. The
advantages of this principle is that it does not discriminate between imports and internal
production. This principle is in favor of promoting the export. Many countries have
followed this principle to boost export. Nepalese VAT system is also characterized by this
principle. Beside these major principles, other principles, which govern the VAT, are:

- Principle of making tax system more transparent.

- Principle of removing cascading effect
- Principle of increasing the tax base
- Principle of maintaining neutrality and
- Principle of encouraging the export

2.1.7 VAT as a Substitute of Sales Tax

VAT is an improved form of sales tax. It is a substitute for sales tax, hotel tax, contract tax
and entertainment tax. It is not a totally new form of taxation but only an improvised
version of sales tax. The price to be charged under VAT and sales tax do not differ. Under
the VAT but under the VAT system consumer know the amount they are paying in form of
VAT but under sales tax system, it was not shown separately in the bill. Through both taxes
are collected finally from the consumers, VAT is more transparent than sales tax. VAT is
levied at each stage from production to sales but sales tax is levied on only certain level of
sales.

The following example will clarify that the VAT does not increase the price of goods or
services but increases the amount of government revenue from different stages of sales.
Suppose an importer a certain article for Rs. 1000. This article is passed to wholesaler and
retailer charged 10% profit in their costs each. The total sales tax with cost price to
consumer and total VAT with cost price to consumer is shown in the following tables:

Table 2.1.4 (i)

Computation of Total Sales Tax and Cost Price to Consumers
Production/Distribution Cost Price Profit Selling Sales Tax @ Selling
Stages Price 13% Price Incl.
Sales Tax
Importer to Wholesaler 1000 100 1100 143 1243
Wholesaler to Retailer 1243 124.30 1367.30 - 1367.30
Retailer to Costumer 1367.30 136.73 1504.03 - 1504.03
Where, sales tax collected = Rs. 143
Cost Price to costumer = Rs. 1504.03

Table 2.1.4 (ii)

Computation of Total VAT and Cost Price to Costumer
Production/Distribut Cost Price Value Added Selling VAT @ 13% Selling Vat
ion Stages Price excl. Price Incl. Payable
VAT VAT to Govt.
Imported Goods 1000 - 1000 130 1130 130
Importer to 1000 100 1100 143 1243 13
Wholesaler
Wholesaler to 1100 110 1210 157.30 1367.30 14.30
Retailer
Retailer to Costumer 1210 121 1331 173.03 1504.03 15.73
Total 173.03

Where, VAT collected = Rs. 173.03 > Rs. 143 (i.e. sales tax)
Cost Price to costumer = Rs. 1504.03 (i.e. equal in both tax system)
2.1.8 The Procedures of VAT Implementation
The answer of how does VAT work is the procedures of VAT implementation in general.
The whole process of VAT implementation can be studied under the following three stages:

2.1.8.1 Registration Provision of Business Firms

The registration provision of business is also two types they are:
 i) Compulsory Registration: - Taxpayer whose annual turnover is more than Rs. 2
million is required to register in VAT compulsory. In addition to this, if the tax
payer falls under any one of the following proxy criteria, he/she is required to
register in VAT compulsorily:

- If the stock of tax payer exceeds the specified the specified amount when the tax
officers inspects the stock of if the monthly sale exceeds Rs. 2 Lakh or more during a
month.
- If the annual expenses of tax payer on the telephone and the rent exceeds Rs. 1 Lakh.
- If the premise of the taxpayer lies within the specified area of the market or the
street as specified by the department (IRD); of
- Those who import goods worth more than Rs. 10,000 at a time must register.

ii) Voluntarily Registration: - those vendors whose annual turnover is below (i.e.
Rs. 2 million) can, however, register voluntarily.

2.1.8.2 Implementation Process of VAT

After finishing the legal requirements and together of keeping required books and records
like a purchase book, a sales book and VAT accounts; a vendor can implement VAT in
practice. The difference between the VAT collected on sales and the VAT charged on
purchases determines the amount which a registrant must remit or the amount that may
be claimed as a refund. If the tax on sales than the tax on purchase, the vendor may carry
forward this credit to the next month.

2.1.8.3 Input Tax Credit

Registered businessmen are obliged to collect and remit VAT on their taxable transactions.
These registrants are entitled to recover the tax paid on their purchase. This recovery or
refund is known as input tax credit. Where VAT is paid or payable by a registrant on a
purchase except tax exempt made by the registrant in his commercial activities. Tax payers
whose export is more than 60% of total sales or those who are continuously on 6 months
credit may claim for refund. Refund shall be made within 30 days from the receipt of
refund claim.

2.1.9 Different Provision under VAT acts towards

i) Goods and Services: - VAT act divides all goods and services into two basic categories,
taxable and tax-exempt. Goods and services are either taxed at the standard rate of 13
percent or they are taxed at 0%. All goods and services except those which are specified as
taxed at 0% or tax exempt are known as the taxable goods or services. Tax exempt goods
and services as specified by the act are as follows:

- Goods and services of basic needs which include rice, pulses flour, fresh fish, meat,
egg, fruits, flower, edible oil, piped water, wood fuel.
- Basic agriculture products are also tax-exempt, for example, paddy, wheat, maize,
millet, cereals and vegetables.
- The expense of buying goods and services required to grow basic agriculture
products are tax-exempt. This includes live animals, agricultural inputs including
machinery, manure, fertilizer, seeds and pesticides.
- Social welfare services including medicine, medical services, veterinary services and
educational services.
- Goods made for the use of disabled persons.
- Air transport
- Educational and cultural goods and services such as books and other printed
materials, radio and television transmission, artistic goods, cultural programmers,
non-professional sporting events and admission to educational and cultural
facilities.
- Personal services are also tax-exempt. These services provided by the actors and
other entertainer sportsmen, writers, translators and manpower supplies agents.
- Exemption from VAT is also extended to the purchased and renting of land and
buildings.
- Financial and insurance services.
- Postage and revenue stamps, bank notes, cheque book.
Sources: (www.ird.gov.np)

The purchaser woll not pay any VAT on the above exempt goods and services and the
supplier is also not allowed input tax credit on purchase related to the above goods and
services.

iii) Import and Export : The VAT Act, schedule I list imports which are tax-exempt.
Some of these include prescription drugs, basic groceries, medical devices and
agriculture products. Most of imports however are fully taxable at customers
point. Thereafter these are treated on the same basis as domestically produced
goods. The VAT on imported goods is collected by custom. It is calculated on the
dutiable value of the goods. The value for the duty of the goods is determined in
accordance with the valuation provisions contained in the customs act.
Registrants may claim input tax credit for the VAT paid on imported goods used
in their commercial activities.

In context of exports, VAT is applicable only to the consumption of goods and services in
Nepal. However, supplies made in Nepal that are exported are taxable at 0%. Exporters are
allowed to claim input tax credits for VAT paid or payable on purchase of goods and
services relating to their commercial activities. Exports are taxed at 0% include exports of
both goods and services.

2.1.10 Reasons for growing popularity of VAT

VAT is definitely a modern tax system in comparison with order traditional taxes. Actually,
VAT is considered as the most important tax reform in the 20 th century. Even since its
adoption for the first time by France in 1954, Vat has gradually and convincingly earned
popularity and it is in vague at present in about 130 countries: big/small developed and
developing. For a simply example, any European country that want to be a member of E.C
(i.e. European Community) should have adopted VAT. Thus, the popularity of VAT is
increasing day to day. Besides this, there are number of reasons for growing the popularity
of VAT. They are:

- VAT minimizes the tax evasion due to its catch-up effect.

- It is simple to administer as compared to other indirect taxes.
- It is transparent and has minimum burden to costumer as it is collected in small
fragments at various stages of production and distribution. The effective use of VAT
makes the whole tax system transparent since VAT is account based tax system. If
VAT is implemented effectively income tax, property tax, customs becomes
transparent. Transparency in tax system certainly reduces tax evasion, which is the
most common phenomenon in Nepal.
- It is based on value added not on total price. So, price does not increase as a result of
VAT.
- There is mass participation of tax payers and it is a broad-based tax system which
increase the revenue mobilization. Thus, VAT has a revenue productivity
characteristic.
- VAT such a tax system which does not bring any unintended and undesirable effects
in the methods of production and distribution or in consumption. It means VAT is
neutral with respect the production and distribution.
- Equity is another feature of an ideal tax system. VAT is more equitable in the sense
that it falls equally on all goods that rather a different proportion of value added ar
various stages.
- Another reason for the growing popularity of VAT is that it helps to avoid the
problem of cascading or pyramiding.
In conclusion, VAT is a modern and transparent tax system. It is less distortive and more
revenue productivity that is why the VAT has become a popular means for tax reform and
has been spreading all over the world since in 1960s. above mentioned reasons make VAT
is the tax of present time.

2.2 Review of Related Studies

2.2.1 Review from Books
Shoup (1969) in his famous book “Public Finance” considers value added tax latest and
probably the final stage in a historical development general sales tax, which is imposed on
the ‘value-added’ by the business firms. VAT is the difference between sales proceeds and
the cost of material etc, purchased from other firms, which is the tax base of VAT. A firm
adds value added by processing or handing these purchased items with its labor force and
its own machinery, building or other capital goods (Shoup, 1969: 25-69)

Hyman (1972), in the book “The Economic of Government Activity” opines that the VAT is
simply multi-stage sales tax which exempts the purchase of capital goods and services from
the tax base. By exempting capital outlays at the time of purchase consumption type of VAT
provides a kind of investment tax credit incentive (Hyman, 1972: 250-269)

Goode (1986) in his book “Government Finance in Developing Countries” describes VAT as
the most important tax innovation of the second half of the 20 th century and it is classified
as a form of sales tax on consumption. The tax applies to the value added at production and
distribution that is to sales proceeds less purchase of material inputs and certain services
(Goode, 1986: 152-161)

Margaret Nicholson (1989) explains value added tax is a tax on the supply of goods and
services which is eventually borne the final costumers, but it is collected at each stage of
the production and distribution chain. Value added tax which is generally abbreviated to
VAT, charged on the supply both of goods and of services by firm who are registered and
taxable for VAT. VAT is an indirect tax charged as a percentage of the selling price on the
certain services and commodities. The percentage rate is set by the government and is
changed from time to time by the budget. Registration of VAT is compulsory for the
persons and firms whose turn over is in access of the “Threshold Limit” (Margaret
Nicholson, 1989: 123).

Khadka (1989), an expert of Nepalese tax system, in his book entitled VAT in Asia and the
Pacific Region” writes VAT is the most recent innovation in the field of taxation. It is levied
opn the value added to each commodity by a firm during all stage of production and
distribution.

This book has covered all aspects of VAT including the nature of VAT, reasons for the
growing popularity of VAT, department of VAT, etc. this apart the report examines the
structure and operation of VAT in the Asian Pacific countries, which also explores the
possibility of introducing VAT in Nepal. Probably, he is a person of observer of VAT aboard
and the first proposed VAT for Nepal with Micro-studied of Nepalese economy and system
(Khadka, 1989: 22)

Khadka, (1991), in his book, Nepalese Taxation: A Path for Reform”, he has reviewed the
development Nepalese tax system, analyzed its existing problems and studied feasibility
and possibility of tax reform. He lights on the domestic and international economic
scenario. Then, he states that in Nepal, tax reform has become necessary and possible due
to both internal and external factors. Further, economic reforms, including tax reforms,
have been taking place very rapidly in South Asian countries including India, Pakistan and
Bangladesh, and they expert pressure in other countries including Nepal. In context of
Nepal, he states “The Foreign clarity Indicates that the Nepalese Tax system does not
satisfy the criteria of a good tax system. Moreover, poor enforcement has only severed the
distortion the Nepalese tax system doesn’t satisfy the criteria of a good tax system.
Moreover, poor enforcement has only severed the distortion the Nepalese tax system to an
even greater extent. It is therefore, necessary to rationalize the structure and operation of
the Nepalese taxes and strength the tax administration (Khadka, 1991: 67-92).

Khadka, (2000), in his book “The Nepalese Tax System” points out the need to introduce
VAT in Nepal. One of the important reasons was to develop a stable source of revenue by
broadening the tax base. Moreover, Nepal will help to become less dependent on
international trade taxes for revenue in the future since it will not be in a position to levy
import duties on the trade that takes place within the South Asian Association for regional
co-operation (SAARC) region after the implementation of the South Asian Free Trade
Arrangements (SAFTA).
“A value added tax is a tax assessed at each steps of the production and distribution
process, levied on the difference between purchase cost of an asset and the price at which it
can be sold. Tax is added to tax product’s price each time it change hands until delivery to
the customer takes place, when the final tax is paid” (Encyclopedia of Management, 2002,
979).

Silwal, in his book “Value added Tax: A Nepalese Experience” (1999) has expressed his
practical experience about VAT. The book covers all aspects of VAT. In writer’s word “VAT
is an all stage no cascading tax system. It extends to all levels of production and
distribution. Similarly it covers all stages and services. Any discrimination in taxing goods
or services exempting any of them render VAT ineffective.

The book mostly concentrates on Nepalese tax system. The books clearly analyzes why the
government of Nepal introduced VAT. Recent government announced retail level sales tax
at the rate of ten percent covering a whole range of goods and services. There was not
procedural law to administer it. When RST introduce in Nepal, literacy level was meager
and billing and record keeping was fanciful. In this situation, required revenue cannot take
place, which is turn into the development expenditures so that a modern, efficient and
neutral tax like VAT, was therefore, preferred to get rid of past anomalies.

The writer expresses a version by borrowing government declaration that “the government
of Nepal does not in order not have the option of doing nothing. Major changes must be
made in order to make tax administration fair, efficient and effective. The hostility,
harassment and co-operation that currently exist between the tax office and the business
community must end if Nepal is to have a modern tax system. The business wants the
system changed and willing to pay a reasonable tax but they want the system transparent
and fair.”

Silwal suggests that factor affecting VAT design take also into consideration. A poorly
designed VAT accompanied by week administration would just drain the treasury. So,
utmost care is necessary while designing a VAT . According to him, the following facts were
considered while designing a VAT in Nepal (i) tax base issue (ii) rate structure issue (iii)
exemption issues and (iv) threshold issues.

Finally, Mr. Silwal has reached a conclusion that the introduction of VAT provides an
opportunity to sweep away to cobwebs and revamp a substantial part of the tax
administration. In every country where it has been implemented properly the VAT has
proven itself as a revenue productivity tax. However, benefit from