The Department of Finance has correctly denied the proposal to grant value-added tax (VAT) exemptions to oil and petroleum products both on the basis of its negative effects on revenue collection efforts and its minimal social impacts and trade-offs on poverty alleviation. Their arguments are valid. Beyond those, we likewise feel that the granting of exemptions on critical inputs along a value chain could well lead to higher costs and subsequently higher prices.

It was long after legislators conspired to cover a self-inflicted deficit with a cocktail of anemic sin taxes, a controversial attrition law and an even more controversial expanded value-added tax (E-Vat) law that debate on exemptions began.

Ironically, despite overwhelming sponsorship, the same lawmakers who voted for expanded VAT coverage eventually pandered to populism and political expediency when the public bucked the tax. A few however, stood on principle and they continue to stand their ground.

These opposing perspectives compel an examination shorn of rhetoric and politics. Fortunately, the exemption debate centers on petroleum and oil tariffs. These are not simply common costs but economic multipliers where exemptions impact, negatively or positively, along the value chain.

One of the intrinsic benefits of a VAT is its ability to prevent the cascading of tax burdens as they occur along a value chain. Because the VAT is applied only on values added at specific levels where inputs and outputs are delineated, once applied, there should be no taxes on taxes that cascade.

These are, however, dependent on the consistency of a VAT application on all stages of the chain where a taxable commodity is an intermediate input such as petroleum and oil products.

Many consumers imagine that VAT exemptions might alleviate price increases and VATs harsh effects. But do they?

To analyze, let us take the example of VAT exemptions for medication enjoyed by senior citizens against the proposed across-the-board VAT exemption on oil products.

Senior citizens are final consumers. If VAT-exempt, they do not pay VAT. Here, indeed VAT exemptions alleviate harshness.

Unfortunately, the tax burden creeps up the value chain to the drugstore that purchased the medicines but was not VAT-exempt. As nothing previously inputted as costs might be VAT exempt other than the senior citizen at the end of the value chain, taxes remain for all other levels and for all other inputs that went into the medicine. For these taxes, the drugstore, unable to pass these on will have to bear the full tax burden.

Costs then bloat at the drugstore level where they effectively subsidize the tax that the senior citizens should have borne.

For oil products, when these are raw materials or intermediate inputs such as fuel burned in power plants or those used to transport food, vegetables and other final products whose prices carry fuel, transportation and other costs as inputs, when exemptions are imposed the tax burden is effectively applied one level up where costs inordinately bloat as VAT credits cannot be reclaimed.

Note that oil is an imported commodity and upon its importation a VAT was applied. The VAT chain on oil starts at the very top. If exemptions are applied down the line, some entity within the chain will have bloated costs.

Simply put, if oil products were VAT-exempt, sellers, including bulk fuel dealers cannot levy a VAT on it and the VAT chain is broken. However, VAT on any other input remains.

For instance, the VAT on services, electricity, transport, insurance, etc, remains as costs subject to VAT and thus comprises the total product’s tariff at the pump level. As delineations vanish, these taxes become part of the cost of goods sold because of the unrecoverable tax at the seller level.

Should the supplier take advantage of the exemptions in a broken VAT chain to charge VAT-inclusive prices, they reap additional profits at the intermediate levels of a value chain and create the same cascading effect that VAT sought to avoid.

It makes better business sense for suppliers to pay the VAT and claim input credits rather than have exemptions that bloat either costs of goods sold or expenses when credits cannot be reclaimed and are instead tucked into the price of a commodity. As cascading begins where VAT is applied down the line, it leads to higher prices. Do the simulations to validate the price bloating postulate. Studies show cascading can result in increased prices from 12% to as much as 30%.

Exemptions break the VAT chain and cause an inflated costs of goods sold to cascade where down the line VAT is necessarily applied on an inordinately larger amount than would have been included had a VAT credits been reclaimable and thus theoretically taken out of the equation.

For politicians who pander to populism, beware what you wish for.