VAT in the UAE - Impact on the SMEs

UAE resident alert: 5% VAT is officially coming by Jan 1, 2018, reads a headline in Khaleej Times (12 Feb 2018)

VAT is added on each layer of supply chain and is ultimately reflected in the final price. For example a 5% VAT on a good of cost AED 100 will cost the buyer AED 105, the seller will collect AED 5 and deposit with the government in their tax filings. Hence, businesses will have to become the tax collection arm for the government.

Impact of VAT on businesses

Profitability
VAT is borne by the end user, hence the gross profit of a business remains the same. The impact is shifted to the final customer of a good or service.

Prior to VAT, for example, a mobile retailer buys a mobile from the wholesaler for AED 100 and sells for AED 110, making a gross profit of 10% on the sale.
After VAT is introduced, the same mobile will cost the retailer AED 105 (input tax) and sell for AED 115.5 collecting AED 5.5 (output tax) from the end-customer. The difference between output and input tax AED 0.5 is the tax income for the government.

Source: Ministry of Finance, Government of Dubai website

The above example is applicable to businesses who will register for tax filings. For unregistered companies, VAT will be paid on purchases, but no output tax will be collected, hence tax expense will become part of the cost of sales and this will affect the gross profits.

In summary, registered companies will not take a hit on their gross profits but unregistered companies will.

VAT will potentially increase the operating and admin expenses for the SMEs affecting their net profit margins. Cost of collecting taxes and compliance costs will add to the admin expenses. However, if these processes are electronic (quite possible) and training is made available, these costs can be kept on the lower side.

Pricing Strategies
A lot of the businesses who face intense competition and a 5% increase in their prices will affect the demand for their goods and services may decide to further lower the prices to remain competitive post-VAT. However, it can be argued that a VAT of as low as 5% may not have a significant impact on demand for certain consumer goods.

Liquidity
VAT will definitely affect the working capital of the SMEs. The timing difference between output and input tax will affect the liquidity of businesses. Businesses with poor credit control will be affected the most.

For businesses paying suppliers upfront and offering credit to customers should plan in advance on how to manage cash flows. On the contrary, businesses buying on credit and selling on cash basis will benefit.

ERP & Process flows
Businesses will have to bear costs in improving their financial reporting systems and hire/outsource accounting needs of the business.

Wages and Salaries
In the current economic conditions, payroll seems to be least affected as the labor supply exceeds demand for manpower.

Conclusively, VAT will create opportunities for government to switch to non-Oil sources of income. In the short run, jobs will be created in finance departments and a lot of audit and consultancy firms will start providing tax services to their existing clientele.

Information Available so far:
Rate: 5%
Implementation date: 1 Jan 2018
Minimum Turnover: AED 3.75 million per annum
Frequency of filing: Quarterly (3 months)
Registration opens: last quarter of 2017
Will tourists pay VAT: Yes

Businesses can only benefit out of VAT, by preparing towards it!

A great mind: Ibn Khaldun

One article on this great personality will be considered as a disservice and I  shall try my best, within my capacity, to read and research more and write about the great works of the historian Ibn Khaldun who was born in 1332 in Tunis. He was educated in the religious studies of Qur'an, Hadith, jurisprudence, and law, as well as sciences such as physics, mathematics, philosophy and logic. His strong base in a wide variety of disciplines helped him to analyze the worldly affairs, specially governments, in greater depth.

Ronald Reagan, 40th president of the United States, commented on Ibn Khaldun by saying: 

“May I offer you the advice of the 14th century Arab historian Ibn Khaldun, who said: “At the beginning of the empire, the tax rates were low and the revenues were high. At the end of the empire, the tax rates were high and the revenues were low.”

And, no, I did not personally know Ibn Khaldun, although we may have had some friends in common!”[1]

His economic ideas which he analyzed during the 14th century became part of the governments’ fiscal policies around the globe. Very correctly, a co-relation has been established between the tenor of the governments and the tax rates. As per the guidelines of Islam, the Zakat (philanthropy/charity tax) is 2.5% of accumulated wealth. Other taxes like land tax, inheritance tax and tax on spending have not been popular in the Muslim World. It is quite comprehensible from the above that if the tax rates are low, the public is encouraged to pay tax and the governments end up collecting greater tax revenues. Furthermore, Ibn Khaldun stated:

“The reason for this is that when the dynasty follows the ways (sunan) of the religion, it imposes only such taxes as are stipulated by the religious law, such as charity taxes, the land tax, and the poll tax. They mean small assessments, because, as everyone knows, the charity tax on property is low.”[2]

And then he added:

“At the beginning of the dynasty, the revenues are distributed among the tribe and the people who share in the ruler’s group feeling, in accordance with their usefulness and group feeling and because they are needed to establish the dynasty, as we have stated before. Under these circumstances, their leader refrains in their favor from (claiming) the revenues which they would like to have.”

Ibn Khaldun studied government’s behavior in great depth and it seems the same behavioral trends exist till date.  Governments prefer using public finances for the welfare of the tribes and societies and to establish a strong liking or aptitude towards their rule. In contrast, when governments sway from the path and corruption becomes the culture, the tax revenues are siphoned off to non-productive areas bearing nil or negative results.

Accountability, Self-checks and balances

Umar Bin Al Khattab, the second caliph of Islam, was known to have two lamps that he would use to light his house. One lamp was funded by the tax payer’s money and he would use that only during his work, in his official capacity, as the leader of the vast empire. The second lamp was personally funded by the caliph and he would use that when engaged in personal affairs, and not of the government. It was Umar bin Al Khattab’s accountability which contributed to the strong foundations of a successfully run and contolled empire.

Ibn Khaldun opposed high levels of taxation

“The result [of high taxation] is that the interest of the subjects in cultural enterprises disappears, since when they compare expenditures and taxes with their income and gain and see the little profit they make, they lose all hope. Therefore, many of them refrain from all cultural activity. The result is that the total tax revenue goes down, as (the number of) the individual assessments go down.”

Governments tend to increase taxes excessively to finance public debt and extravagant ventures within the boundary and overseas. This negatively impacts the willingness of the public to contribute or participate in the economics of the country. Excessive taxes have discouraged investments and consumerism and this has had further effects on poverty, employment and crime rates. The words of Ibn Khaldun can be very rightly analyzed in the form of the Laffer curve as below.

The Laffer Curve, named after the American economist  Arthur Laffer, credited his work to the great Ibn Khaldun

Ibn Khaldun’s ideas have actually been known to us in the form of the Laffer curve (advocates supply-side economics). The Laffer Curve helps the economists to ascertain the optimum tax rates which maximizes the tax revenue, without the need of increasing the tax rates in proportion. The basis of setting an optimum tax rate is to encourage businesses to re-invest their profits in expanding their businesses which creates opportunities. As purchasing power increases, businesses earn more, and more jobs are created a greater number of individuals and corporations tend to fall in the tax bracket. 

I prefer to refer to the graph above as Khaldun's curve and his immense contribution to the economics of the world is extraordinarily remarkable.

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[1] Ronald, Reagan. “There They Go Again.” New York Times February 18 1993, n. pag. Web. 1 Dec. 2012

[2] Ibn Khaldūn. The Muqaddimah, An Introduction To History.

Does debt really matter?

A lot of people believe or rather assume that debt does not matter as governments around the world owe money to the public, and not the aliens.

However, it matters for two main reasons. Firstly, if the debt grows at a faster rate than the economic output, it implies higher interference of the government in the price mechanism/free market economy. This results in higher taxes being levied (strict fiscal policy) to finance the deficits and we all know that taxes are bad in the current scenario as they discourage spending.

Secondly, the issues faced by current and succeeding governments. No sane government would like to lay an impression on the public that the debt per citizen is on an increasing trend. This comes with political repercussions.

This is indeed a vicious cycle and I am still figuring out the start and end points of the cycle. Kindly, assist!