The value-added tax (VAT) has been adopted by every developed country and most developing countries in the world. There is, however, one exception –The United States. That may be changing as there is currently discussion regarding its adoption in the U. S.
The value-added tax is a tax on goods and services and is collected at every step in the production chain. This is unlike the sales tax, which is paid only on retail sales. In a sense it is similar to sales taxes that are currently in place in 45 states as it is a consumption tax. VAT rates, obviously, vary from country, but in a survey of OECD countries, the rate varies from a low of five percent to a high of 24.5 percent.
How the VAT Works
As an example, assume that a 10% VAT is in place. The VAT will be added at each step in the production process. It starts when a manufacturer purchases raw materials and other items for $100. The 10% tax will be added so the purchase costs the manufacturer $110. Ten dollars is remitted to the government.
In the next step of the process the manufacturer completes its products and sells them to a retailer for $250. Again, the 10% VAT is added, bringing the amount of the transaction to $275. In this case, however, the manufacturer has already paid $10 in VAT, so the company takes a deduction for amounts already paid. Fifteen dollars ($25 – 10) will be remitted to the government by the manufacturer.
When the consumer purchases these items for $600, the VAT is added, bringing the cost to the consumer to $660. The retailer remits $35 ($60- 25) to the government. In the end, the entire tax is borne by the ultimate consumer.
There can be exceptions, deductions, and credits granted for certain types of products and services. As more exceptions are created, the system becomes less efficient and the amount of revenues raised decreases. One needs only to look at the current complexity of the income tax system to realize how these complicate the system. Most states have hundreds of exceptions in their sales tax systems, creating distortions.
First, the VAT is an efficient way to raise revenue. It is a broad-based tax, and somewhat self-enforcing. Businesses at any stage in the production chain can take a deduction for taxes paid only if they can show that their seller paid the tax before them. Thus businesses encourage each other to comply.
Related to this is a second advantage. Because the tax is collected at various stages in the production process, the government does not lose a large amount of tax revenue when a single business evades the tax.
Third, the VAT is considered less of a drag on the economy than income taxes. It has been shown that consumption taxes (such as the VAT or sales taxes) do not discourage savings as does the income tax. As consumers save more, capital becomes available to business for additional investment and expansion.
Some parties decry the fact that a VAT is a money machine, enabling additional government spending. Although this is a factor to consider, this argument is refuted by Bruce Bartlett (The VAT and the Money-Machine Argument) on two points. He first states that, contrary to popular belief, the trend in VAT rates is not upward. Many countries have never raised the rate from inception. Some have even lowered the initial VAT rate. His second point notes that higher taxes are anti-inflationary and reduce purchasing power. As purchasing power is reduced, consumers spend less and fewer taxes are collected. According to Bartlett, the money machine scenario just does not hold true.
A second issue with the VAT is that it is a regressive tax. Those in the lower income levels are disproportionately affected by such a tax. Two ways have been suggested to overcome this factor. First, similar to the situation with sales taxes, some goods can be exempted from the tax. Groceries, medications, and children’s clothing are three frequently-mentioned exceptions that could be made. A problem with this approach is that it gives companies an incentive to mislabel the products they sell in order to avoid the tax. An additional problem lies in the definition of an exempted product. For example, where is the distinction between groceries and food prepared in a restaurant? Many supermarkets offer, in addition to groceries, deli services with prepared food. Others even have sit-down areas where the food can be consumed. There is no bright line distinguishing one from the other.
A second approach to overcoming the regressive nature of a VAT is to implement it in conjunction with an overhaul of the income tax, making the income tax more progressive. Lower rates for lower income levels and higher rates for those in the upper income brackets would counteract some of the burden on the lower-income population.
A third problem with the VAT is how to tax services. How much value is added in the preparation of a tax return or in financial planning? One solution is to exempt such services, while another solution would define the value added would be determined.
There are hurdles to overcome before the VAT is implemented in the United States. The federal government is currently running large deficits and this tax presents an untapped (for the federal government) revenue source. This reason alone is sufficient to not dismiss the prospect of a VAT being implemented in the United States. A second factor is that the United States is in the distinct minority in terms of nations that have a value-added tax.
Ideally, implementation of a VAT in the United States would be revenue-neutral. Introducing a value-added tax, accompanied by a revamping of the income tax code, would seem to be the most palatable approach. This revision of the income tax code should be coupled with lower overall rates with the result that the tax burden is not increased significantly on any one population segment.
Subscribe to TaxConnections Blog
Enter your email address to subscribe to this blog and receive notifications of new posts by email.