What is Value Added Tax, VAT?
Tax Reform Brazil
Three Innovations of Brazil’s Value Added Tax Reform
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One of the defining features of Brazil’s tax system is the complexity of its indirect taxes. Notably, the system is marked by fragmented tax bases, the cumulative taxation at each stage of the production process (known as the cascading effect), and the administrative challenges posed by the jurisdiction to tax consumption of three levels of government— the Federal Union, 27 states, and 5,570 municipalities—each applying different tax bases and rates.
For decades, Brazil tried to reform this complex tax structure, with little success. However, the situation changed in 2023 when the country approved a landmark reform introducing three modern mechanisms that will likely be a model for the future of the value added tax (VAT). This tax is currently present in 175 countries around the world and is the main source of revenue for most developing countries.
In this post, we will discuss the findings of an upcoming study on three innovative VAT mechanisms of the Brazilian reform that can make this tax more effective, less regressive and adjusted to the country’s federal structure. We hope that the lessons from the Brazilian case will offer valuable insights for any government seeking to improve the design and application of this tax.
What is Value Added Tax?
Conceived by the German industrialist Siemens over a hundred years ago, the value added tax (VAT) is a tax on consumption levied on the value that businesses add at each stage of the production and distribution process. The VAT taxes consumption at destination with a broad base and a uniform rate, fulfilling three criteria of sound taxation.
First, it is a highly effective tool for revenue generation. Secondly, by not distorting the supplies among goods and services and by adopting the credit system, it does not influence the taxpayer’s choice, maximizing neutrality. Thirdly, its administrative simplicity lowers compliance costs for taxpayers and enforcement expenses for tax authorities.
The VAT was introduced in the mid-1950s in France, and Brazil was the third jurisdiction in the world to adopt it in 1964, albeit imperfectly. In Brazil, most indirect taxes are currently levied on the supplies of goods and services, in the form of four different taxes: PIS/COFINS by the federal government, ICMS by the states and ISS by the municipalities.
These four taxes are largely levied on origin (where the suppliers of goods and services are located) and represent the largest source of revenue in the country, with a 36.4% share of the total revenue of the three levels of government (Graph 1), and representing the main source of revenue for the states and most municipalities. Furthermore, Brazil has become the world’s biggest collector of this consumption tax.
Brazil’s Tax Reform Follows the Best International VAT Practices
Because of Brazil’s federative model, the reform adopted the Dual VAT model, with the creation of two separate taxes: the Contribution on Goods and Services (CBS), which is the responsibility of the federal government, and the Tax on Goods and Services (IBS), which is shared between states and municipalities.
In addition to the IBS and CBS, the reform also provides for the introduction of an excise tax on certain goods and services that are harmful to health and the environment, in line with the international excise tax model.
The model to be implemented solves three major problems with the current tax system:
- It creates two broad-based taxes. The two new taxes replace the four taxes with fragmented bases (PIS, COFINS, ICMS and ISS). CBS and IBS will be levied on all supplies of goods and services, in line with the best international VAT practices.
- It offers a constitutional guarantee of a VAT credit system. The reform constitutionally guarantees that VAT crediting will be broad, i.e. that all IBS and CBS paid on purchases of goods and services will give rise to tax credits, except for goods for personal use and consumption and other exceptions provided for in the Constitution, such as cases of exemption and immunity.
- It ends the “tax war” between states. The new system will adopt the destination principle, under which imports will be taxed and exports exempted. Internally, the rate to be applied will be the one used in the state or municipality of the destination of the supply of goods or services. The adoption of the destination principle in interstate transactions will eliminate the tax war among states under which, with the current model of ICMS and ISS partially levied at origin, is carried out by granting tax benefits to attract investment.
- Transition: The transition in the distribution of federal revenues from origin to destination will take place over 50 years. During this transition period, revenues will continue to be distributed according to the current origin-based system, with a gradual shift toward allocating the IBS based on the destination principle. This prolonged transition avoids an abrupt reduction in the revenues of sub-national entities benefiting from the current model, eliminating the need for direct compensation.
To ensure federative balance and regional competitiveness, four funds[2] were created under the responsibility of the federal government, aimed at fostering development, reducing regional inequalities, especially in the Amazon region, and compensating for the phasing out of the ICMS tax benefits. Although they reinforce federative equalization, they impose a significant financial burden on the federal government, requiring planning and strict fiscal management.
In addition, differentiated regimes were established as exceptions to the general IBS and CBS regimes for sectors such as health, education, basic food baskets and agriculture, through reduced rates and presumed credits. The favored regimes benefit specific regions and sectors, including the Manaus Free Trade Zone (ZFM), which maintained its free trade area tax incentives, and Simples Nacional, which preserved reduced and progressive rates for micro and small companies.
Implementing Three Innovative Mechanisms
The Brazilian tax reform brings three important innovations, including the creation of mechanisms for implementing and coordinating Dual VAT between the different federal entities and a split payment mechanism, which reduces tax evasion. A third innovation is the partial refund of VAT to low-income families to combat its regressivity (cashback).
1st Innovation: Dual VAT with the Creation of a Management Committee
As we mentioned earlier, the Dual VAT includes two taxes, one of federal responsibility and the other subnational, to be shared between states and municipalities.
The great novelty of the Brazilian tax reform compared to the dual VAT models of Canada and India is its institutional arrangement. A steering committee (Comitê Gestor) will be set up with representatives from the states and municipalities to administer the IBS, which will be responsible for collecting this tax on all transactions and distributing the proceeds according to federative transition rules and the place where the taxable supply occurs.
The Steering Committee represents an important simplification for taxpayers, as they will only need to register and remit the tax for a single entity instead of potentially for the 27 states and 5,570 municipalities. In addition, it will ensure that taxpayers can claim and receive credit refunds, since revenue collected on B2B supplies will not be transferred to the federative entities.
From the point of view of the sub-national entities, the Steering Committee (Comitê Gestor, as it is known in Portuguese) will have equal participation from representatives of the states and municipalities and will distribute the collection to the respective destination entity. Shared governance ensures the autonomy of sub-national entities in the administration of the tax, as the federal government will have no participation in Committee.
2nd Innovation: Collection of VAT on Financial Settlement
Another novelty of the Brazilian reform is the split payment model, or the collection of taxes when the payment is settled. This model has already been implemented in some European countries and was criticized for having a negative impact on business’ cash flow, since taxes were automatically remitted to tax authorities without considering any VAT credits of the suppliers. This meant that firms accumulated tax credits and had to wait to be refunded, which often took a long time, generating financial costs and cash flow problems.
The Brazilian model has solved this challenge by adopting an “intelligent split payment” model, in which there will be a prior consultation with the tax authorities to check whether the supplier has IBS and CBS credits before determining whether the split payment will be made.
If the supplier holds IBS and CBS credits, the split payment mechanism will not apply. Instead, the seller will receive the full transaction amount (i.e., price plus tax), ensuring that the firm’s cash flow remains unaffected (see Graph 2). If this consultation is not possible and the split payment is made, the tax administration must refund the amount of the taxes to the supplier within three days.
According to the graph above based on a hypothetical case, the supplier makes a sale to the buyer of $100 on which $26.5 of IBS and CBS are collected (1). The buyer then makes a payment of $126.5 through a financial institution (2). Before making the split payment, the financial institution checks with the tax administration to confirm if the supplier has IBS/CBS credits (3). If the supplier does not have enough IBS/CBS credits to settle the IBS/CBS on the transaction, the payment institution will make the split payment, remitting the amount of the taxes ($26.5) to the tax authorities (4) and the value of the item sold ($100) to the supplier (5). If the supplier has tax credits to settle the transaction, he will receive the full payment of the price and the IBS/CBS ($126.5) and no tax withholding applies.
The implementation of this model is possible because of the high level of digitization of VAT assessment and management. Brazil was one of the world’s pioneers in implementing electronic invoicing, digital accounting and has advanced instant payment systems such as PIX[1]. Split Payment is expected to reduce fraud conducted with false invoices and fictitious credits, paving the way for the reduction in the tax gap and, consequently, the standard rate too.
3rd Innovation: VAT Refund Mechanism (or Personalized VAT)
The main problem with VAT is vertical equity: in almost all jurisdictions the VAT is proven to be regressive when measured in relation to income. Lower-income taxpayers pay proportionally more tax than higher-income consumers on their consumption. To mitigate this impact, many countries reduce tax rates or exempt certain mass-consumption goods and services. However, this approach lowers revenue and can worsen inequality, as higher-income individuals tend to consume more in absolute terms.
The Brazilian reform adopted the Personalized VAT (P-VAT) or Cashback to solve this challenge. This solution consists of generalizing the tax base, adopting a single rate and returning what has been paid in IBS and CBS to low-income populations or disadvantaged groups. This maximizes collection and neutrality while reducing VAT’s regressivity. In short, P-VAT (Cashback) substitutes indiscriminate tax expenditures with focalized (expenses) tax refunds. Tax administrations can use electronic means (e.g. electronic invoices, especial card for beneficiaries, electronic payment, etc.) to improve the targeting of beneficiaries while combating fraud.
Families with a monthly per capita income of up to half of Brazil’s minimum wage will benefit from P-VAT. Cashback will correspond to 100% of the CBS and 20% of the IBS paid on the purchase of gas cylinders, electricity, water supply, sewage and piped gas and telecommunications, and 20% for other goods and services.
Conclusion about Brazil’s VAT Reform
Brazil’s reform of taxes on consumption aims to address two simultaneous challenges. First, it seeks to simplify the system, eliminate “cascading effects” and reduce the regressivity. To achieve this, it applies a broad base with low rates and full input tax crediting and introduces partial VAT refunds for lower-income individuals.
Secondly, it maintains the tax jurisdiction of all levels of government through the implementation of a dual VAT system (CBS and IBS). This system is overseen by a representative steering committee and ensures a fair and transparent distribution of tax revenues based on electronic invoicing.
The solutions implemented in the reform demonstrate that the adoption of good international tax practices combined with innovations in the design of institutional arrangements and the use of modern digital technologies for both tax management and financial transactions will be important allies for improving this century-old tax in the coming years.
