Value-added tax (VAT) became infamous upon introduction in the UAE at the start of 2018. Many — from consumers to business owners — blamed the tax for its supposedly destructive economic consequences, while others endorsed the VAT as one logical step away from reliance on hydrocarbons for revenues and towards a more diversified economy.

The debate prior to introducing the tax circled around the rate at which the VAT should be fixed at, and whether or not to refund it back to tourists similar to countries like the UK, Singapore, and Japan. The alternative was a model similar to that of the US, where no VAT is given back upon your flight home.

The UAE set the rate at 5 per cent, with other much higher taxes on selected items imposed earlier. Levies included 50 per cent on soda drinks and 100 per cent for tobacco and energy drinks. Conventional wisdom states that VAT is good for the economy as well as the country’s fiscal position. If so, then what are the downfalls of VAT?

Two words: reduced consumption. When VAT is introduced for the first time, or even if it is increased from one rate to another, the subsequent result is that it reduces one’s consumption. This, however, does not need to be taken at par and applied across the board.

For instance, a VAT of 5 per cent does not affect individuals equally, and a reduction in consumption will be subject to price sensitivity of individuals to the new pricing regime by merchants.

What usually goes unnoticed here is that a VAT does not necessarily need to be passed on from producers and merchants to consumers. That is, producers of items or merchants could decide to absorb the impact of a VAT by reducing their own profit margin, retaining sales volume or even increasing it if a higher market share is attained through the provision of a tax-free privilege to their customers.

Such a possibility, however, could be exclusive to producers and merchants with fat profit margins that could afford the 5 per cent VAT. Examples include building contractors and car dealers, especially of luxury ones.

Another downfall for VAT is its impact on an economy that is relying on tourism as a key pillar in its economic diversification. VAT, regardless of how low it is set, would have some sort of impact on attractiveness as a destination for tourists. Refunding VAT is debatable depending on the VAT level.

A very low rate of VAT may not be worth the bureaucratic and administrative hassle, unlike a much higher one that could drastically undermine a country’s tourism sector. The UAE’s Federal Tax Authority reports on its website that it will soon share how tourists can get their VAT back. I do hope here that the queue-less, tax-refund mechanism in Japan will be adopted.

When shopping in Japan, one’s passport must be presented at the time of purchase to ensure that VAT is refunded. VAT refunds can be done in two different ways. For large department stores, VAT is refunded immediately as cash or is credited back to the card used.

Otherwise, the VAT amount is subtracted from the item’s price and a receipt is given. In other words, amount paid is net of VAT. Upon flying out of Japan, all VAT refund receipts are handed over after checking-in, without the need to show the items purchased as the case is in Singapore.

The net result of a VAT, if done right, should be positive for any economy, and even better for one that wishes to diversify away from revenues generated by natural resources. In my opinion, the taxes on soda, tobacco, and energy drinks are especially important due to the possible health benefits they could result in, not only for individuals who are directly impacted by the taxes, but for an overall healthier population.

Though VAT could result in reduced individuals’ consumption, such consumption could be compensated by government consumption, or spending, such as Abu Dhabi’s Dh50 billion stimulus, Dubai’s incentives for investors, and Sharjah’s salary increases. As long as a balance is maintained between both consumption types, VAT’s impact on an economy should be a net positive.

What’s also noteworthy about VAT’s introduction is that the UAE in an ideal position to collect and analyse economic data including consumption, which could prove beneficial for future impact analysis of government policies.

The last question that I want to leave you with: how to manage VAT’s reduced consumption with rising bank lending rates?

Abdulnasser Alshaali is a UAE-based analyst.