Value Added Tax and Fiscal Federalism in Ethiopia

Crucial to the success of any federal state is the fiscal viability of the central government and component federal states. A feature common to most federal systems is the collection of greater revenues by the central government and reliance by states on transfers from the central government in addition to locally imposed taxes to fund budget expenditures. As is the case in many other federal jurisdictions, in Ethiopia the value added tax (VAT), a tax levied on business sales but ultimately borne by consumers, is an important source of central government revenue. As is also the case in many federal jurisdictions, an assignment of a portion of central government VAT revenues to states is one of the main sources of transfer payments by the central government to state governments in Ethiopia. However, the Ethiopian version of fiscal federalism differs significantly from that found in most other jurisdictions in three key design features – the division between the central and state governments of responsibilities to administer the VAT, the basis on which VAT revenues are divided between the central government and the state governments, and a peculiar design feature that results in tax collections by one state government to be offset by tax reductions suffered by another state government. All three features are cause for concern. The division of administrative responsibility undermines the goal of comprehensive uniform tax administration. The basis for division of tax revenues, a distinction built on the legal form of businesses, leads to assignments of VAT revenue unrelated to fiscal needs. And, most importantly, the odd design feature – the assignment of revenues from the VAT, intended to be a tax on consumers, to the state in which the seller is located rather than the state of the buyer – results in effective cross subsidies when businesses located in wealthier states sell goods and services to businesses operating in poorer states. This article provides a history of the Ethiopian regime and explores how the unique features of the Ethiopian fiscal federalism system arose. It suggests a system that divides revenue on the basis of a fiscal equalisation formula that divides VAT revenues on the basis of relative budget needs of states or a system that allocates revenue to the state in which the customer is located would yield a fairer outcome than the current system. It concludes with modernisation of the tax administration coupled with the adoption of a fiscal equalisation formula for distributing VAT revenues and a generous transitional system for transition to this regime would yield the optimal path going forward.