What is Value-Added Tax (VAT)? Should the U.S. Implement a VAT?

Whether you are a Republican or a Democrat, one of the biggest concerns in today’s U.S. economy is our $19.4 trillion deficit. Both parties have a variety of ideas and theories regarding a solution to reduce the United States deficit. One of the most common theories, however, is the consideration of a Value-Added Tax (VAT).

In order to make an educated decision as to whether a VAT is right for the United States, we must first understand the definition of a VAT as well as its strengths and its weaknesses.

What is a Value-Added Tax (VAT)?

A value-added tax (VAT) is considered a consumption tax rather than an income tax and is very similar to retail sales tax / state sales tax. VAT taxes the value added by a business at each production stage and can apply to both manufactured goods and services. One of the major differences between VAT and state sales tax is the manner and timing of collection of the tax. VAT is collected in stages as the goods and/or services are produced and sold, whereas state sales tax is collected in total upon the final sale of a product.

There are two common forms of the VAT: the Credit-Invoice VAT and the Subtraction-Method VAT. For purposes of this article, we will discuss the Credit-Invoice VAT as this is the most common form of the VAT and is used by all countries worldwide that levy a VAT, except for Japan who uses the Subtraction-Method VAT.

Under the Credit-Invoice VAT, a business pays VAT on its purchases and collects a VAT on its sales. The business then remits the invoices evidencing the amount of VAT paid to its supplier to the property revenue agency, who in turn verifies that the correct amount of VAT was paid. Once verified, the revenue agency sends a refund to the business that paid the VAT to the supplier. If done correctly, the business ultimately does not pay any tax and the VAT is pushed through the production chain and levied to the consumer just like state sales tax. The business basically acts as a collections agent for the revenue agency in that it collects a VAT on its sales and remits to the revenue agency the difference between the VAT it collected on sales and the VAT it paid on purchases.

Below is an illustration of how a 10% VAT is levied and collected throughout the various stages of production.

Step 1

Step 2 Step 3 Step 4

Total

Farmer grows trees and sells to wood processors for

Wood processors debark, cut and sell the wood to lumber yards for

Lumber yards store, dry and sell wood to retailers for

Retailers price wood for

Sale Price

$1.00 $5.00 $10.00 $20.00

VAT Collected by Seller

$0.10 $0.50 $1.00 $2.00

Credit from Previous Stage

$0.00 ($0.10) ($0.50) ($1.00)

Net VAT Collected

$0.10 $0.40 $0.50 $1.00 $2.00
** Effectively the customer pays the total 10% VAT as the $2.00 VAT is added to the final sales price of $22.00.

 

Strengths of a VAT

A few of the main strengths of implementing a VAT in the U.S. include but are not limited to the following: stimulate economic growth; efficiency of revenue collections for the government; “Border Adjustability” and excludes tax on investments and savings.

Stimulate Economic Growth

According to an article in The Wall Street Journal, Michael J. Graetz, a professor of law at Columbia Law School, who strongly supports VAT, states that a VAT would stimulate economic growth and increase U.S. GDP by as much as 5% in the long run.

Mr. Graetz also states in this article that if the U.S. was to shift taxes from production to consumption, as a VAT would do, this would stimulate jobs and investments as companies would be induced to base their center of operations in the U.S. rather than overseas. In addition, if the U.S. was to tax imports and exempt exports, this would result in hundreds of billions of dollars for the U.S. Treasury over the next 10 years.

Efficiency of Revenue Collections / Government Growth

As discussed above, VAT is collected by businesses at every stage of production and sent directly to the government. This concept makes the collection process more streamlined and efficient for governments, therefore allowing governments to enhance their revenue collection process.

Governments tend to like VAT better than income taxes as VAT brings in more revenue, since businesses play a bigger role in the collection process. This is incentivized by the fact that businesses receive credits for the VAT they pay throughout the production chain. As a result, the more money in government, the faster government can grow and flourish.

“Border Adjustability”

Border adjustability is the process of either exempting exports from the VAT or rebating the entire VAT paid on exports. All countries that levy a VAT handle exports this way and levy the VAT on their imports. This process has two distinct advantages: (1) It puts exports on an equal playing field with products from other countries as they all get taxed at the same rate regardless of where they are sold and (2) all goods sold domestically are taxed at the same rate regardless of where the products where made.

Excludes Tax on Investments and Savings

VAT taking the position of a consumption tax rather than an income tax allows the U.S. to exclude tax on investments and savings, which are taxed under the current U.S. tax code. Investments and savings are an essential part of economic growth as businesses rely on capital to grow their operations and start-up businesses rely on capital to start new businesses. Both business growth and new start-up businesses create new jobs and in turn help with economic growth.

Under the current U.S. tax code, we tax the income generated from these investments and savings, which makes it more difficult and expensive to raise capital. In the end, this makes investing less attractive and more expensive.

Weaknesses of a VAT

To counter some of the strengths of a VAT, we must also discuss some of the weaknesses. These included but are not limited to the following: burden of tax is disproportionate to individuals with lower incomes; encourages wasteful government spending; and the Creation of an Underground Economy.

Burden of Tax is Disproportionate to Individuals with Lower Incomes

The idea behind VAT is that everyone pays the same amount of tax on the consumption of products. Opponents of a VAT argue that a VAT would take significantly higher percentages of income from lower-income individuals than the U.S.’s tax system currently does.

Proponents of a VAT say the way around the disproportionate tax burden is to offset the tax of lower-income individuals by either sending them a refund check, other means of welfare, exempting certain categories of products like necessities, and/or charge a luxury tax on certain products that are more commonly purchased by high-income individuals.

Encourages Wasteful Government Spending

If levied, a VAT can generate billions of dollars of revenue for the government at what appears to be a relatively low rate. The problem is once the VAT is implemented it is very easy for the government to increase the rate to generate even higher revenues. It is very common practice around the world to implement a VAT at one rate and slowly increase this rate over time which allows the government to spend even more money.

Once in place, a VAT could be increased by Congress anytime they feel the need to raise more money and/or start and pay for new programs that they feel are important. This puts a significant amount of power in the hands of the government which is a big concern for many Americans.

Creation of an Underground Economy

Since a VAT is taxed at every stage of production and reported on the various invoices, it generally leaves a better paper trail than our current income tax system. Even with this paper trail in place there would still be individuals who find ways to elude the VAT. One of the most common ways of doing this is by creating what is known as an underground economy. This is very common around the world with countries that currently levy a VAT. Individuals and businesses could easily elude a VAT by simply conducting transactions in cash and/or by bartering goods and services. Both of these instances would leave very little to no paper trail and make it hard for the government to regulate.

Conclusion

As mentioned above, there are both strengths and weaknesses to implementing a VAT in the United States. This is a very common practice around the world. In fact, the United States is the only industrialized country not to levy a VAT. With that said, just because every other industrialized country levies a VAT, that does not necessarily mean it is right for the U.S.

A VAT certainly has some attractive features, however, to work correctly it would have to completely replace the current federal income tax system and even then there are many flaws in levying a VAT. Many opponents of the VAT think that if the U.S. was to levy a VAT it would be on top of the current federal income tax and it would actually hold back the U.S. economy, not help it. Many think if the U.S. adopted a VAT and implemented it on top of the current federal income tax, it could permanently increase the size of government, reduce the U.S. standard of living and slow economic growth. These are all the opposite of what the U.S. currently needs.

Finding ways to increase tax revenue may help with our current deficit, however, Congress should be finding ways to reduce government spending as well, as the real cause of our current $19.4 trillion deficit is overspending and not necessarily lack of taxation.

There are many aspects of implementing a VAT that were not covered in this article, however, hopefully after reading this article you have a solid basis to start your own research into this hot topic. Armed with this knowledge, you will be to get involved in political discussions regarding the various alternatives being considered by Congress to help reduce our current deficit.

 

References

The Wall Street Journal. “Should the U.S. Adopt a Value-Added Tax?” (Posted February 28, 2016) Dow Jones & Company, Inc.

Furchtgott-Roth, Diana. “Resist the Value-Added Tax: Opposing View.” (Posted February 3, 2016) USA Today.

Dubay, Curtis S. “The Value-Added Tax is Wrong for the United States.” (Posted December 21, 2010) The Heritage Foundation

United States Chamber of Commerce. “An Introduction to the Value Added Tax (VAT)” (April 25, 2010) First in Series of White Papers by the U.S. Chamber of Commerce.

Accurate Tax.com. “Could a National VAT Work in the United States?” AccurateTax.com. (accessed August 26, 2016)

 

Photo: https://www.flickr.com/photos/teegardin/5537894072

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