Why a decentralized VAT collection model could do more harm than good

“The Federal Inland Revenue Service (FIRS) and the Rivers state government are locked in a legal dispute over the latter’s claim that it is constitutionally empowered to collect Value Added Tax (VAT) revenue within its jurisdiction, a responsibility hitherto reserved for the FIRS. Rivers state appears to have won the opening salvo with two favourable court judgements, but it is early days yet as the case is destined for the supreme court. I have keenly followed the debate and found two major arguments in favour of Rivers state: i) that decentralization of VAT collection will deny the inefficient Federal Government more revenue to waste, and ii) this will encourage states to engage in a healthy competition to attract businesses.

I like to play in an area I am comfortable with, so I will not be making any commentary on the legality of state’s claim. Rather, I am more interested in the consequences of the court judgement and what I consider to be the optimal solution. For a start, Abuja has nothing to lose directly like most people think. In fact, the FGN could potentially end up with more than 3x its current VAT revenue if collection becomes decentralized. Currently, the federal government gets approximately 15% of total VAT receipt (which amounted to N204bn in 2020 or 6% of FGN revenue), while states and local governments share the remaining 85%. If VAT collection becomes decentralized, one can imagine that the FG will retain import VAT and leave the non-import VAT component to state governments. However, up to 50% of Nigeria’s VAT revenue is from imports, implying that state governments could end up with lower share of the pie compared to the current model.

Nigeria’s current VAT structure is by no means perfect, but there is already an element of fiscal federalism in the sharing structure, which one can even argue is superior to the sharing formula for oil.  There is a 20% derivation principle in the sharing of VAT revenue (i.e. states keep 20% of their contributions) compared to 13% for oil. The derivation principle explains why Lagos took 18% of total VAT revenue shared amongst states in 2020, while Kano and Oyo were distant second with only 4% share in the same year. If my mathematics is correct, the distribution structure implies Lagos is contributing no less than 50% to total federation VAT revenue, and could easily become a clear winner in a decentralized structure. However, Lagos has other advantages working in its favour that may no longer be permissible in a more decentralised structure, particularly after adjusting for import VAT which the FGN will lay claim to.

The second argument which says that states will suddenly begin to engage in a healthy competition if VAT is decentralised, is a very odd one that doesn’t hold water, considering that VAT is a consumption tax that hardly informs business decisions because it is passed to consumers. As a Lagos resident, I will not shift my consumption of Nestle’s products to Ogun state because of VAT rate, except I live in a border town in which case I can take advantage of the differential. In the same way, Chicken republic will not close its outlets in Lagos in favour of Oyo state because of a VAT rate differential. If the aim is to drive competition, there are much better tax tools to achieve this purpose than a consumption tax, and that has not even happened under the existing structure.

PAYE tax is by far a more superior tax incentive that states can offer, but none (that I am aware of) has ever offered tax rebate to any company as an incentive, so we might be overstating the willingness of states to compete or even the capacity to effectively collect this revenue. States are in full control of PAYE tax collection but only four states (Delta, Lagos, Rovers and FCT) earn more revenue from PAYE relative to VAT. Evidently, these same states will thrive in a decentralized model but even if this is just, the potential fiscal consequences on the other 33 states would be too severe. Ekiti state’s N4bn PAYE revenue in 2020 is barely one-fifth of its VAT revenue of N24bn. How would Ekiti state not go completely bankrupt within a year if this policy goes through? Except of course the state government shakes down every visible large corporate in sight to plug the huge fiscal drain. Many seem to have the perception that the only acceptable form of fiscal federalism is one that is comprised of federating units that are completely independent. This may sound fair, but could also be inefficient. More importantly, a federal system without some measures of fiscal equalization will cave under the weight of income inequality and social strife.

The biggest losers by far will be businesses who would have to navigate government bureaucracy across 36 states. At best, many companies will run rings around state governments that have weak capacity to collect such a complex indirect tax, thus worsening income inequality. At worst, we will end up with a multiple tax structure that will worsen the ease of doing business environment.  Some developing countries like India used to operate a decentralized indirect tax model but this soon became a major impediment to business, as effective tax rates in some cases exceeded 20% after accounting for multiple sales tax. Also, you had situations where goods could not enter some states for days because local tax authorities want to do compute taxes. India had to abandon this system and adopted a hybrid model in 2017 with a more centralized General Sales Tax (GST), which is now regarded as a major reform victory.

Advocates of fiscal federalism have jumped on this issue to press home their point. One can understand the sentiment at play here, but the country will be better served by focusing on areas of maximum effect, rather than engage in a needless over-reaction that will cause more harm to businesses. Inter-state travel in Nigeria is already a nightmare for manufacturers and traders dealing with multiple local authorities. Granting state governments the power to charge VAT takes this to a whole new level. We had a taste of this during the Right of Way controversy, when state governments imposed exorbitant right of way charges on telecom firms, which ended up setting the entire nation back on broadband penetration. Multiple this by a factor of 41 million SMEs and what we will end up with a chaos in the administration of indirect taxes.

Nigeria can draw lessons from India’s latest hybrid structure, which centralizes the majority of taxable goods and services and excludes some items to allow for peculiarities of each state. Controversial items such as alcohol, petroleum products and agriculture are best left to each state to determine based on its norms and culture. Aggrieved states could also argue for a more just sharing structure, which can easily happen with a higher derivation – say 30%. What we should, however, avoid is a completely decentralized model…”