A Value Added Tax inherently fails – Fraud and exemptions guarantee revenue expectations fall short – A lack of transparency and conflict with state policies ensures opposition

Abstract: In the context of unprecedented U.S. budget deficits, some proponents of the value-added tax (VAT) are calling for the U.S. to levy a VAT to close the federal deficit. They are seriously mistaken. While a VAT has some advantages to the current U.S. tax code, adding the VAT to current federal taxes—as proponents propose—would realize none of these benefits and would instead depress the economy. The real cause of the massive federal deficit is Congress’s overspending, not a lack of taxation. The value-added tax (VAT) is a major source of tax revenue for every industrialized country in the world except the United States. The Domenici–Rivlin Debt Reduction Task Force has issued the latest call for the U.S. to adopt a VAT to solve its growing debt problem.[1] Some argue that a large tax increase is necessary because Congress cannot reduce spending enough to cut the deficit to more sustainable levels.[2] On this flawed line of reasoning, the VAT is the logical choice because it can raise large amounts of revenue and because the United States is the only developed country without a VAT. Proponents often cite the economic virtues of the VAT as an additional reason for the United States to adopt it. While the VAT has some economic advantages compared to other tax systems, these theoretical advantages would apply only if it replaces all other federal taxes. If Congress simply added a VAT on top of other federal taxes, its comparative advantages would disappear. It would substantially raise taxes, perpetuate the current tax system’s many problems, and create a host of new complications. Even as a total replacement for the current tax code, a VAT would pose several challenges for the nation. What Is the VAT? The VAT is a consumption tax that taxes the value added by businesses at each point in the production chain. It can apply to both manufactured goods and services. This contrasts with the more familiar income tax, which taxes salaries, wages, and the returns to savings, but does not tax purchases. Because the VAT is a consumption tax, it would closely mirror the sales taxes that most Americans pay at the state and local levels. In fact, consumers would experience no difference between a national sales tax and a VAT. A sales tax and a VAT designed to raise equal amounts of revenue would raise the final price of purchases by roughly the same amount. Credit-Invoice VAT. In the credit-invoice method, the most common form of the VAT, a business pays VAT on its purchase of inputs and collect it on its sales whether those sales are to another business or the final consumer. The business then submits the invoices that it receives from its suppliers to the government’s revenue agency. The invoices detail the amount of VAT that the business paid to its suppliers. Once the revenue agency verifies that the business remitted the proper amount of tax on its sales and that the submitted invoices match the suppliers’ filings, the agency refunds the business for VAT paid. The filings by businesses give the revenue agency a simple way to ensure that businesses pay the required amount of VAT. As long as the business can pass the tax on to its customers, which is typically the case, the business ultimately pays no tax. It acts solely as a collection agent for the government, collecting VAT on its sales and remitting to the government the difference between the VAT it collects and the VAT it paid on inputs. The burden of the tax moves up the production chain until the consumer bears the full burden, just like under the sales tax. Chart 1 shows how a credit-invoice method VAT could apply in the production of a shirt. How the Value-Added Tax Works A credit-invoice VAT is generally easier for revenue agencies to enforce than sales taxes and therefore enables more efficient revenue collection. The method of revenue collection makes it more efficient. A sales tax is collected only when the final user of the product makes a purchase. For instance, customers buying a new pair of shoes or a new television pay the price of the item plus the sales tax, which is an additional percentage of the sales prices, at the point of purchase. However, businesses do not pay sales taxes on the items they purchase so that the sales tax does not “pyramid” inside the cost of goods and raise their prices surreptitiously. In practice, businesses end up paying sales taxes in many cases, but they should be completely exempt from paying sales taxes according to sound tax policy. Because a sales tax is collected at only one point in the production process, customers and sellers can work together more easily to evade it. The only check to make sure the seller collects the tax is an audit by a revenue authority. A credit-invoice VAT is more resistant to tax evasion because businesses collect and remit the tax at every stage of the production process. Subtraction-Method VAT. Another viable approach to levying VAT is the subtraction-method VAT, which is economically equivalent to the credit-invoice VAT. Each method has positives and negatives, but almost every country that levies a VAT has chosen the credit-invoice method as the best way to apply the VAT in practice. Of the approximately 150 countries that levy a VAT, only Japan uses the subtraction method.[3] The subtraction-method VAT is similar in practice to the business income tax that the United States and most other countries levy. Businesses calculate their taxable base by subtracting their expenses from their sales (gross income). The major difference between the subtraction-method VAT and the business income tax is that the cost of labor is not deductible under the subtraction-method VAT. Labor’s contribution to output is an integral part of the value added by the business. Among other key differences, all purchases from other businesses are deducted immediately under the subtraction-method VAT, including purchases of long-lived assets (no depreciation system), but interest expense is not deductible. The most important difference between the credit-invoice VAT and the subtraction-method VAT is how they are collected. Instead of collecting the VAT each time a transaction occurs, under the subtraction-method VAT businesses would pay VAT on their taxable base, which is calculated by totaling their gross receipts and subtracting the cost of inputs purchased from other firms. A subtraction-method VAT would have the same economic effects as a credit-invoice VAT because businesses still pay the tax on the difference between the sales of their goods and costs of their inputs. However, the subtraction-method VAT effectively prevents showing the tax embedded in the prices of goods and services. While most countries that levy a credit-invoice VAT do not require— and in some cases even prohibit—displaying the tax on sales receipts, displaying the tax in a subtraction-method VAT is impracticable, making the tax opaque to taxpayers. That most countries’ choose the credit-invoice method over the subtraction method reflects the economic circumstances and the consequences of past tax policy decisions. For example, because the subtraction-method VAT bears a strong resemblance to a traditional income tax, it could be a better, although still problematic, tax system than an income tax, but it would be a poor choice as an additional new tax. Many countries that have adopted a credit-invoice VAT already had some kind of national consumption tax. In searching for extra revenue, replacing a confusing array of minor sales taxes with a comprehensive, operational national retail sales tax in the form of a VAT would make good sense. Further, all countries have problems with tax evasion. Tax evasion is still a problem under a credit-invoice VAT, but the tax is far less susceptible to evasion than most taxes because of the credit-invoice paper trail. The relative difficulty of evading a VAT is particularly important when governments impose high tax rates. Addition-Method VAT. The addition-method VAT is not used anywhere in the world. As its name implies, the addition method is the opposite of the subtraction method. Like the subtraction method, it is applied only once in the production process, and its cost is entirely hidden from individual taxpayers. Yet unlike the subtraction method, businesses add the costs of their inputs, instead of subtracting them from their sales to calculate their tax base subject to the VAT. Inputs could include labor costs, costs of goods and services purchased, and even profits in some cases.[4] The addition method is more of a theoretical application of the VAT and is not used in practice. Even though it is no different in theory from the other types of VAT, when actually applied, the addition method creates problems that the other methods do not. Some businesses, such as businesses with labor-intensive production processes, would pay higher tax bills because their unique circumstances require them to add more to their taxable base. Unsurprisingly, such businesses would seek relief from the government in the form of carve-outs for their specific industry. However, when the government grants relief to one industry, the pressure to offer similar exemptions to other industries soon builds. Special treatment of particular industries quickly spreads and destroys the VAT’s advantage of exerting minimal influence on the market. As a result of these exemptions, the addition-method VAT would create a substantial drag on the economy, unlike the other types of VAT.[5] VAT Strengths The VAT has some key meritorious features. The most important is that it excludes saving and investment from the tax base. Saving and investing are vital for economic growth because businesses use capital to expand their operations. Entrepreneurs use them to begin businesses. Both activities create jobs and grow the economy. Taxing savings and investment reduces their attractiveness to individuals and increases the cost of raising capital for businesses. This reduces the amount of saving and investing and therefore the number of jobs created. Because the VAT taxes only consumption, not returns from saving and investing, it is a better alternative than other taxes that tax saving and investing. Another positive feature of the VAT is its “border adjustability.” All countries that employ a VAT either exempt exports from the VAT or rebate the entire VAT paid on exports. Similarly, all countries that levy a VAT also levy the VAT on their imports. This has two positive effects. Domestically, all goods sold in a country with a border-adjusted VAT pay the same amount of tax regardless of country of origin. Second, in the global market, a border-adjusted VAT places exports on an equal footing with products from other countries because they will all face the same amount of tax regardless of where they are sold. In contrast, a business income tax raises the relative price of exported goods because it is not rebated like a VAT. Similarly, the individual income tax is rolled into the prices of goods produced by businesses that pay individual income tax instead of business income tax. There is no practical way to rebate the portion of the higher price due to either income tax from the good’s total cost. When a business exports that product it must therefore sell at a higher price, making its product less competitive in global markets. All taxes create distortions in the market because all taxes change the behavior of individuals and businesses. The best taxes affect the behavior of individuals and businesses the least. A structurally sound VAT measures up well against other taxes because it exerts relatively little influence on the decisions of businesses and individuals. Yet this feature holds true only if it applies uniformly to all goods and services in an economy because it raises the prices of everything proportionally. In this way, no product or service gains an artificial comparative advantage over another. The moment one good or industry secures an exemption for its goods or services, this relative advantage of a VAT dissipates rapidly. Border adjustments support the neutrality of the VAT because it ensures that all goods face the same level of tax regardless of where they are manufactured. The final strength of the VAT is its relatively low cost of enforcement. Because calculating the VAT is straightforward and businesses need to produce invoices to receive their refunds, enforcing the VAT costs revenue agencies less than enforcing other types of taxes. VAT Flaws While the VAT has some advantages over other taxes, it is far from trouble free. The VAT has several inherent problems. Hidden Tax. The VAT’s biggest flaw is that, unless mandated otherwise, the amount of VAT paid by taxpayers is hidden. (See Chart 1.) In this example, the consumer knows only that the price of the shirt is $22.00. Because the VAT is typically not printed on the sales receipt, the consumer does not know that the price includes a 10 percent ($2.00) VAT. One fundamental principle of sound taxation is transparency, and most nations’ VATs flagrantly violate this principle. State and local sales taxes are explicitly shown on sales receipts so consumers know the cost of the good before and after the tax. Even though a VAT would raise the final cost of goods and services in the same way, the VAT is typically not shown on sales receipts because politicians hide the steep price of the VAT and their policies from taxpayers. Even if the VAT is shown on receipts, taxpayers are highly unlikely to keep their receipts and total their VAT for the year. Politicians especially like the VAT because it obscures the tax burden and the true cost of government services from taxpayers. This can lead taxpayers to demand more government services because they wrongly perceive that the prices of such services are lower than they are. In a democratic state, the cost of taxes and government should be as explicit as possible so that taxpayers and voters can make fully informed decisions about the size of government. Taxing Services. The U.S. economy is becoming increasingly service-based, but the VAT has difficulty taxing services. In fact, all consumption taxes, including state and local sales taxes, struggle to tax services because tax authorities have difficulty determining actual sales when no physical property changes hands. Many state and local governments in the United States often forgo levying sales tax on most services because of this difficulty. Compared to the cost of their services, service providers generally purchase low-cost inputs from suppliers. For example, doctors provide relatively high-cost services for patients, but have low input costs compared to automotive manufacturers. Auto manufacturers must purchase costly inputs such as steel to produce each car. Doctors need equip an office only once to provide their services. The same applies to other service providers, such as attorneys, accountants, and financial service providers. This means the value added (the price of the service minus the cost of inputs) is high for service providers and the VAT they owe as a share of gross receipts is also high compared to traditional manufacturing businesses. This creates a strong incentive for service providers and their customers to collude to evade the VAT by transacting in cash. Alternatively, the service provider can underreport sales to capture all the benefit of evading the tax. In both cases, authorities would have difficulty proving tax evasion without on-site monitoring and inspections. Because services are a large and growing portion of the economy, exempting them from a VAT would necessitate raising the VAT rate considerably higher to collect the expected amount of revenue, another major problem of the VAT. State Sales Taxes. Forty-six states levy a sales tax. A VAT at the federal level would be similar to state sales taxes. States would likely strongly resist any federal attempt to usurp their sales tax authority because they rely on sales tax revenue. A VAT at the federal level would likely force states to apply their sales taxes to a uniform set of goods and services. This would take from the states their ability to tailor their sales taxes to their desires and each state’s unique economy. States would also be forced to keep their rates within a narrow range. Because the VAT rate would likely begin relatively high, it would leave states little room to lower their sales tax rate to increase their competitiveness compared to other states. Further, a federal VAT would increase sales tax evasion, thus reducing state tax receipts, possibly significantly. Underground Economy. No tax is 100 percent enforceable, and the VAT is no exception. The VAT’s ease of enforcement is not an absolute designation. The VAT is easier to enforce than other taxes that do not generate an easily auditable paper trail. Yet some would undoubtedly find ways to evade a VAT. In fact, a VAT would encourage development of a large underground economy. Saving up to 20 percent or more on every transaction would be a powerful incentive for consumers and businesses to work together to evade the VAT. They could evade the VAT by conducting transactions in cash or by bartering goods and services. Neither tactic would leave a paper trail, making it difficult for authorities to prove abuse. Europe’s experience with the underground economy confirms this. Informal transactions and buying and selling on the black market are common in Europe. Avoiding the VAT is part of the culture. In many cases, citizens evading the VAT are not even aware that they are escaping taxation because their evasion methods have become part of their everyday lives.[6] Similar behavior would quickly become endemic in the United States if it adopts a VAT. Fraud. A credit-invoice VAT has an inherent self-enforcement mechanism because of the trail of paperwork required, but even then fraud would still be prevalent. Fraud is different from the underground economy. It consists of businesses engaging in schemes to secure larger refunds than those to which they are entitled, rather than evading it outright like in an underground economy. No matter how well constructed, VATs are always susceptible to scams that allow businesses to claim larger refunds than they are entitled. VAT fraud can take the form of false claims of taxes paid, refunds claimed for nonrefundable purchases, businesses set up only to issue false invoices of taxes paid, and hidden sales.[7] European countries have a long history of administering the VAT, but they still experience considerable VAT fraud. Countries in the European Union (EU) lose approximately $107 billion annually in uncollected VAT. This amounts to a tax gap— the percentage of tax revenues that a tax should collect—of 12 percent,[8] which is a high rate of noncompliance for a consumption tax. Tax authorities will always struggle to gain the upper hand on criminals that game the VAT to their advantage. The monetary gains that the criminals can enjoy by abusing the VAT are a strong incentive to stay one step ahead of law enforcement. For instance, the EU is working to thwart VAT-related fraud and abuse in carbon dioxide emission permits, which are the staple of the EU’s cap-and-trade program. For example, in “carousel fraud,” criminals set up a fake company that purchases the carbon-emitting permit from a company in another country. The fake company then quickly trades the permit to another company in its country, pockets the VAT that it collects from the company purchasing the permit, and quickly disappears with the VAT proceeds. This scheme can use any easily moved good. The fraud involving carbon emission permits alone cost EU countries $7.4 billion over a recent 18-month span.[9] The carbon emitting permits are the latest trend in VAT fraud, but certainly not be the last. Tax evaders will quickly move on to a new scheme once authorities clamp down on this type of fraud.