Avoidable Tension over Proposed VAT Formula

Postscript BY Waziri Adio

All sides have mismanaged the discussion around the proposed change to the formula for sharing value added tax (VAT) among states. We are now smack in the middle of an ego-driven, political and polarising battle that could have been avoided or moderated if those involved had exercised good faith and put greater store in negotiation and consensus-building. It is not too late to step back, bring down the heat, and find common ground.   

To be sure, the Federal Government (FG), represented by the presidency, has the right to take the lead in developing fiscal policy for the country. But it also has the responsibility to pro-actively seek inputs from and actively facilitate discussion among and with the states especially on matters that will, for ill or good, directly impact states’ finances. However, the FG (perhaps fancying that the centre and the states exist in a master-subordinate relationship) chose to dictate how states’ portion of VAT should be shared. This is a haughty, paternalistic approach that is at odds with the principles and practice of the federal system that we operate. The president was once a governor, and it is unlikely he would have put up with such a treatment as a governor.

The Northern Governors’ Forum was wrong in outrightly framing the tax bills as being anti-north and urging legislators from the north to reject all the bills. This introduced a sectional dimension, fuelled conspiracy theories and awakened a toxic north-south divide. There is enough tension in the country. We don’t need to crank things up.

Then, the National Economic Council (NEC) was equally impolitic for openly asking the president to withdraw the bills from the National Assembly to allow for more consultations. NEC could have raised a team of six governors (representing the six geo-political zones and led by its chairman, the vice president) to share its concerns with the president and leave it to him to decide the next steps. But by going public first, the governors under the auspices of NEC threw down the gauntlet, and it is easy to see how the president and his handlers would have perceived that as an affront to the person and office of the president.

A major chunk of reform is political. Any reform that touches on revenue allocation among and within tiers of government in a federation will always be contentious and will be doubly political. The political actors have a plethora of official and unofficial channels for resolving such frictions or at least for moderating them. The politicians failed to play the good politics. In this instance, good politics will mean not trying to win every argument and at all costs.

It is not too late for those for and against the proposed VAT formula to put the obvious missteps behind them and to, with respect and open mind, listen to and hear each other, and to work out a compromise that may not be perfect but will not leave either party with a sense of losing out or losing face. Even when such one-sided victory is possible by fair or foul means (and there are aides and followers that will be pushing for such), it is not politically and strategically sustainable. Neither is it worth the current and future costs.

For a start, both sides will need to take it easy on the hyperboles and the misrepresentations. It is neither true that only northern states will be negatively affected by the proposed change in the formula for sharing VAT among states nor is it accurate that only Lagos and three other states will be worse off under the proposed order. Available data and simulations indicate that there will be winners and losers across the country, to different degrees. It is also not useful to offhandedly dismiss the concerns of the other party as motivated by hidden agenda, malice, politics or ignorance.

Agora Policy undertook a review of FAAC documents for all the months for which revenues have been shared this year to tease out the details of what the 36 states contributed to and received from the VAT pool. The think tank put the outcome in tables, charts and maps, which were shared in a series of threaded posts on social media. The data and analysis put a lot of things in perspective for me, including showing the strength and the flaws of the current formula.

So much has been made of the undue advantage that accrues to Lagos State based on how VAT is currently attributed. According to computations made by Agora Policy from the FAAC documents, the total non-import VAT in 10 months was N4.15 trillion, out of which N2.21 trillion or 53% was attributed to Lagos. It stands to reason that Lagos alone could not have been responsible for the consumption of more than half of the goods and services that attracted local VAT in the country within 10 months. Clearly, this is ‘Headquarters Effect,’ which arose simply because most of the big companies operating in the country have their head offices in Lagos and paid their  VAT from there.

This surely needs to be corrected because it unduly advantages Lagos, Rivers, Oyo, Delta, and Bayelsa at the expense of the other states. But this attribution advantage can be corrected without the current upheaval. We will return to this shortly. However, the special advantage that Lagos and the four other states enjoy in attribution is not proportionately reflected in what they received from the VAT pool. Lagos for instance did not receive 53% of what was available to the states. It received N371.09 billion in the period, clearly the highest, but that translates to only 16.76% of its contributions of N2.21 trillion, 14.6% of the N2.53 trillion shared by the states, and only 6.82% of the total of N5.07 trillion shared by the three tiers of government.

It is the same pattern for the four other states with possible headquarters effect. Interestingly, only four of the 36 states received less than what they contributed to the VAT pool. You guessed right. These are the states advantaged by the current way of attributing contribution to VAT: as stated earlier, Lagos received only 16.76% of what was attributed to it, while Rivers got 22.45%, Oyo received 42.7% and Bayelsa got 94.69% of their contributions.

However, 32 other states got much more than they put in the pot. Of these, 17 states received 101-300% of their contributions;11 states got 301-500% of what they put in; and four states received over 500% of their contributions—Kebbi, 723.77%; Cross River, 725.27%; Abia, 793.13%; and Imo, a whopping 1,715.98%. While data on contributions by states shows wide disparity (from N3.33b by Imo to N2.21 trillion by Lagos), the distribution is more evenly spread with 34 states receiving between N47.07 billion and N94.37 billion, while only two states received above N100 billion (Lagos, N371.09 billion and Rivers, N150.76 billion).

Distribution is more evenly spread between states and across zones and regions not only because almost all the states collected more than they put in, but also because the gap in what states received is very narrow. Also, the myth of one region benefiting more or less is not supported by the data for 10 months in 2024. Whatever most states lost in wrong attribution is compensated for by the current sharing formula, which allocated 50% to equality, 30% to population and 20% to derivation. This means that for equality alone each of the 36 states (irrespective of their contributions or attributions) received N35.19 billion from 50% of the N2.53 trillion available for states to share from the VAT pool. This evens things out to a large extent. The subsisting formula is thus not as thoughtless or as unfair as it is projected.

But the analysis by Agora Policy also reveals that current formula is not without challenges. An obvious one is that a high percentage assigned to equality of states creates a form of perverse incentive: irrespective of contributions, all states will always get a steady and hefty inflow from the VAT pool. There is no consequence for states not charging and remitting VAT on contracts they give out. This allows for freeloading and unfairly raises the cost of procurement for compliant states. Also, states with high populations have inbuilt advantage because of the 30% of the VAT pool assigned to population. So, a populous state is guaranteed a tidy sum from 80% of the VAT pool for states even if it contributes very little. Apart from providing incentives for some states to cheat others, this will also reduce the amount of revenues that can be generated from VAT and negatively impacts Nigeria’s total tax revenues and tax-to-GDP ratio.

A few examples will suffice, and by the way this is across the country. Imo State contributed N3.33 billion in 10 months to the VAT pool but received N57.22 billion within the same period, the clear outlier in terms of contribution against receipt. But within the same period, Ebonyi State contributed N21.98 billion which was 96% of the total of the N22.83 billion that Abia, Enugu and Imo states combined pitched in for the same period.

Meanwhile, each of these states received higher than the N49.97 billion that Ebonyi got during the same period. In the North West, the contribution by Zamfara (N14.30 billion) was almost double the N7.46 billion by Kebbi but the two states received about the same amount from the pool. In the North East, Bauchi’s contribution (N16.31 billion) was the lowest in the zone, yet what the state received (N62.80 billion) was the highest in its geo-political zone.

In the South South, Cross River contributed just N7.17 billion, which is a mere 13% of what Bayelsa put in but what Cross River received (N51.97 billion) was slightly higher than what Bayelsa got (N51.69 billion). In the South West, it is interesting that the contribution by Ekiti State (N25.40 billion) was higher than the total of what was put in by both Ondo (N11.92 billion) and Osun (N13.09 billion). Yet what the states received was as follows: Osun, N55.72 billion; Ondo, N55.62 billion; Ekiti, N51.59 billion. This means that despite that Ekiti contributed more than both Ondo and Osun combined, Ekiti received less than each of these two states. Clearly, there are issues with the formula, which need to be addressed.

But taking the derivation from 20% to 60% in one fell swoop (while allocating 20% apiece to equality and population) is not going to be as painless for most states as the proponents have made it to look. Saying that only Lagos and a few states will lose out is not exactly accurate. Re-allocating revenues is a zero-sum game: there will be losers and winners. VAT constitutes the bulk of the revenues that states get from FAAC, and not giving states that will be dislocated enough time to plan, not discussing how potential and sudden losses will be compensated in a federation, asking those who will lose a major source of revenues for the budgets that they have already proposed to just get on with it or be more creative is not only insensitive but a bit provocative.

So, how do we balance the necessity to stop some states (across the zones) from gaming the formula and the imperative of ramping up revenues with the need to address the potential losses to some states without unnecessarily heating up the system or laying the foundation for a future crisis? This is where technical sagacity should have a handshake with deft political management. The two sides in this dispute need to make their case to each other, devoid of emotion or threats. They will need to understand where each side is coming from and be ready to make concessions.

Without a doubt, certain things have to change but maybe not in the way or in the order they are proposed. For instance, the current VAT law did not specify how derivation should be attributed. It is most likely that, for administrative convenience, FIRS and the major companies decided that VAT should be paid from their headquarters and attributed to where the tax is paid. This can be corrected administratively by FIRS, without immediately changing the formula for sharing VAT due to states. This will also be easier to sell as a majority of the states will benefit from the change in attribution. For sure, there will be losses, but these will mainly be to states like Lagos and Rivers, states that depend the least on FAAC allocations. This change in attribution can commence soon without much hoopla.

The second option will be to change the percentage allocated to derivation, but not immediately, and not from 20% to 60% at once, and not without showing compelling evidence of how states will be impacted and how those that will incur major losses will be assisted to cope. Devoting 60% to derivation will definitely advantage not just states with high population and high disposable incomes but also states that have high economic activities that attract VAT. Food is excluded from VAT. So, agrarian states will lose out. Same with smaller states and even big states with mass of poor people. The states likely to be disadvantaged by shrinking equality and stretching derivation are likely to spread across all the zones.

In Section 40, the current VAT law says that “provided that the principle of derivation of not less than 20% shall be reflected in the distribution of the allocation amongst States and Local Governments as specified in paragraphs (b) and (c) of this section.” The current law mentioned only derivation and does not say that derivation should be only 20%. There is plenty room for manoeuvre here. Derivation can be more than 20% within the existing law, say 30% or 35% to start with. Other parameters not specified in the law can also be adjusted. But there will be a need for a proper discussion between the FG and the governors on one hand, and among the governors on the other, including how to ensure that all states pay VAT on the contracts they give.

Credible and compelling data will be necessary to drive this discussion. It will help if FIRS has actual data on consumption of VAT-able goods and services by location for all the states. If it does not have the actual data, FIRS can explore two options: request for change in attribution for some months and make the case or use proxy data to build a case. A good proxy will be the consumption expenditure pattern report by the NBS. According to the 2019 report, Lagos had the highest total consumption expenditure of 12.60% in the country while Taraba had the lowest with 0.74%.

This presents a fairer picture than the current VAT attribution pattern but it needs to be disaggregated along food and non-food expenditure (as food doesn’t attract VAT, and food constituted 56% of consumption expenditure). NBS recently released the Living Standard Survey for 2023/2024 where most recent consumption expenditure can be extrapolated. The proxy data can be used to model different scenarios and arrive at an agreeable adjustment of the derivation component of the formula.

There will be need for a phased transition and agreed transfers to those that will lose out. The changes to VAT and CIT rates are phased, all the way 2030. So, why is FG in a hurry to change how VAT is shared among states and especially to change derivation for the states from 20% to 60% by 2025? And why is FG carrying on as if this is the only thing in the tax bills or an area it is not ready to yield an inch of ground on? What is really at stake here beyond ego and powerplay? Finally, it will be unreasonable to expect states to easily plug sudden gaps of N10-30 billion in annual VAT revenues without some hand-holding. We need reasonableness and cool heads on all sides. The needless muscle-flexing and sabre-rattling should stop.