Value-Added Tax
Explain the concept of value-added tax (“VAT”)
A value-added tax (“VAT”) or goods and services tax (“GST”) is an indirect form of taxation targeted at consumption – measured by spending on goods and services. “Value added” denotes that the payable tax equals the difference between the sale price a firm charges the buyer of a good or service, and the costs of materials and other taxable inputs. As an illustrative example, in the European Union, where much of the taxation is based on VAT principles, each time a consumer good is manufactured, the manufacturer must pay a value-added tax on all materials used in the production of the consumer good. Once the product reaches a retailer, the consumer must then pay a value-added tax at the point-of-sale that reflects his role in the final sale.
Generally, a VAT is discussed in the context of a sales tax, its consumption tax counterpart. For example, a VAT is comparable to a sales tax in that both are payable on transactions involving end consumers. However, unlike a sales tax, a VAT only encompasses the difference between the seller-purchased price and the resale price. The implementing mechanism for this process involves levying a tax on all sales, but refunding the tax difference to the sellers in the supply chain.
In practice, there are two primary ways of collecting a VAT: either through an accounts-based or invoice-based method. Under the invoice-based approach, each seller in the supply chain assigns a value-added rate on his output and gives each buyer a unique invoice which details the amount of tax payable. If buyers are liable for a VAT on subsequent sales (output tax), they are able to ease their tax burden by expensing taxes paid on purchase invoices as input taxes. The difference between output and input taxes establishes a tax liability that is owed to the government. Alternatively, the government issues a VAT refund in the case of negative liability. For purposes of the accounts based method, purchaser invoices are not involved in the collection process; rather, tax liabilities are calculated on the basis of deducting allowable purchases from revenues.
A VAT is widely considered superior to a traditional sales tax in at least one fundamental way. For instance, under a sales tax system, a business selling consumer goods is required to make imperfect assumptions about the motivations of buyers. These assumptions should inform decisions on whether or not to collect a tax at the point of sale. As an illustrative example, assume that a buyer is the intended end consumer of a purchased good. If so, the seller is required to levy a tax on the purchase price. If instead the buyer is hoping to resell good at profit after adding value to it, then the seller should not collect tax. And so, sellers have a perverse incentive to under-collect taxes. Meanwhile, under a VAT, this incentive does not exist because accurate tax collection is way to get tax refund in the case of negative liability.
The most convincing argument against a VAT is that it is a regressive form of taxation that is disproportionately passed on to the working poor. For example, empirical studies show that the poorest consumers spend a significantly higher proportion of both their gross income and disposable income on the VAT than those higher up on the economic ladder.
Another noteworthy limitation of the VAT is the criticism that, unlike the traditional sales tax, it can create a cascading effect of administration costs that are passed down by way of greater prices throughout the production chain. Whereas under a traditional sales tax, tax liability only attaches to transactions involving end users, under a VAT, manufacturers and wholesalers are also involved in the tax collection process, adding an additional layer of administration and paperwork costs that track higher overhead costs.
The merits of imposing VAT in the United States
Amid increasing structural deficits in the federal budget and a broad bipartisan consensus that the current system of taxation in the United States is irretrievably broken, a VAT has emerged as the leading alternative system of taxation that can address both issues. Indeed, most industrialized nations employ a VAT as the primary source of funding government services. From this perspective, the advantage of a VAT is two-fold: its simplicity together with its broad tax base means that it will be the most efficient means of generating the revenue levels needed to close the budget deficit while at the same time generating enough money to cover the rising costs of entitlement programs; and it can overcome the well-documented failings of the income tax. For example, because a VAT has a broad tax base (all sales), even a comparatively low rate can generate income at a much faster rate than alternate revenue streams. Plus, proponents of a VAT rightly point to its chain of taxpayers as establishing a built-in enforcement mechanism, since there is a “paper trail” of tax liability at each stage of production. As a consequence, enforcement costs are appreciably lower.
What’s more modifying the VAT doesn’t entail the same sort of disadvantages associated with modifying the income tax rate to generate additional revenue. For example, increasing the income tax rate could depress economic activity due to the fact that many economics think the main problem with the income tax is that it creates double taxation on savings and investment: tax liability is assigned both to ordinary income earn and on income generated from investments (carried-interest or dividends).
Of course the VAT is not without its own perfections. For example, many experts rightly point out that under a VAT the poor shoulders a higher tax burden than the rich because they spend a much higher proportion of their income on consumption, and basic necessities cost considerable more than under a traditional sales tax. Even so, combining a VAT with a progressive income tax could offset these unintended consequences. Besides, both experience and theory indicate that properly implemented VATS are capable of creating appreciable economic benefits. From this perspective, a VAT is less damaging to an economy because it taxes consumption, and when combined with a modified income tax system, savings and investments are taxed at much lower rate.
Should the U.S. adopt a VAT
Although a VAT has many advantages over the current system of taxation in the U.S. it is unlikely that it would be a good fit as a replacement or supplement to current system. From this perspective, the U.S. economy, in particular, is becoming increasingly service-based. Yet both experience and theory suggest that the VAT has an unproven track record relative to its ability to tax services. In truth, consumption tax systems have a hard time taxing services precisely because tax authorities are unable to accurately assign tax liability to sales of intangible goods.
As an illustrative example, relative to the cost of their services, service providers (doctors, lawyers, psychologists, accountants, to name a few) generally purchase low-cost inputs from suppliers. For example, lawyers provide relatively high cost services for clients, but have low input costs relative to automobile or computer manufacturers. Consequently, the value added (the price of service minus the cost of taxable inputs) is higher for service-providers than their counterparts operating in the manufacturing sector. Not surprisingly, this incentivizes service providers and their clients to transact in cash for purposes of evading VAT liability. Alternatively, a VAT has no way of ensuring that service providers don’t underreport their sales, and thus reaping favorable tax treatment for avoidance.
References
Bodin, J., Ebril, L. P., & Summers, V. P. (2001). The Modern VAT. International Monetary Fund.
Rampell, C. (2009, December 11). Many See the VAT Option as a Cure for Deficits. New York Times. Retrieved from http://www.nytimes.com/2009/12/11/business/11vat.html
