Thursday, December 7, 2017

How a Value-Added Tax (VAT) Works, and Why Governments—Except for the USA—Love It

We continue to mine T. R. Reid’s wonderful book studying tax systems in use around the world: A Fine Mess: A Global Quest for a Simpler, Fairer, and More Efficient Tax System.  The subject here will be the value-added tax or VAT with which most of us only become familiar when we travel overseas.  It seems the United States is one of the few countries that has chosen to not implement one.  Reid quotes a Professor Richard Bird of the University of Toronto to provide some perspective.

“Professor Bird, who has helped design tax regimes for numerous countries, told me that ‘a VAT, or its twin a GST [Goods and Services Tax], is an absolutely essential element of any tax structure today.  To set up a tax structure anywhere that didn’t include a VAT would be malpractice; it would be like creating a health-care system without hospitals.  That’s why every responsible Finance Ministry has used it.”

The VAT was created mainly to solve the problem of tax dodging by French businesses.  Is this something that the US should be concerned about?  You bet!  Kenneth Rogoff, in his book The Curse of Cash, provides us with some startling data.   One realizes that the tax authorities will target suspicious tax returns for an audit.  However, they can also target tax returns for an audit randomly in order to poll the economy to estimate the extent to which tax avoidance activities affect revenue.

“The IRS has used these extensive audits, combined with an array of other information (e.g., investigations into high-income-earner tax shelters) to arrive at an overall estimate of unpaid taxes.  For 2006, the most recent year reported, the IRS found that the ‘tax gap’—the difference between taxes voluntarily paid and taxes due—was $450 billion.  This comprises tax evasion in many different sectors, including underreporting of business income, wage income, and rental income.”

“Of the $450 billion, the IRS expected to recover $65 billion, leaving a net tax gap of $385 billion.  Put differently, roughly 14% of estimated 2006 federal taxes, or 2.7% of 2006 GDP, will never be paid.”

One might suspect that this activity goes on at levels where cash is not the logical means of transaction, but that would be wrong.  It seems a staggering number of small businesses use cash transactions as a means of hiding income.

“By far the most important area of tax noncompliance comes from underreporting of business income by individuals who conduct a significant share of their transactions in cash.  The problem extends to individuals operating as partnerships or small corporations.  Overall, small business owners report less than half their income and account for 52% of the tax gap.”

And the problem is even worse when state and local taxes are included.  Rogoff states that state and local taxes provide revenue at a level of about two thirds of federal revenue.

“Most states have income taxes (where noncompliance is presumably similar to that for the federal income tax), as well as sales taxes, where the scale for noncompliance in cash transactions is enormous.”

Rogoff was focused on cash as a vehicle for committing crime, but the real problem is that there is no mechanism in place for providing tax collectors with a record off what transactions actually took place.

It was the Frenchman, Maurice Lauré, who took up the task of inventing a system whereby records would be generated and business participants would willingly report all of their transactions.  The beauty of the system he developed was that it created the incentive for businesses to obey the tax laws.

Before explaining how a VAT works, we must compare it with a standard “sales tax” as applied across the US.  The sales tax is only applied at the end of a sequence of transactions involved in producing a product.  Consider a chair purchased for $200 by a consumer where the sales tax is 10%.  That person pays $220 for the chair and leaves unconcerned about whether or not the $20 she paid in taxes actually gets transferred to the government.  As Rogoff’s data shows, much of it doesn’t.

Lauré’s approach would break down that transaction and apply the 10% tax at each step in the production of that chair, but credit each participant for taxes already paid before moving forward. 

Let’s use the chair as an example of how value-added taxes work.  Company A buys wood from a supplier valued at $50.  He adds the tax and pays the supplier $55.  The supplier owes the government $5.  Company A fabricates the chair and sells it company B who will stain and finish it for $100 plus $10 in tax.  Company A is responsible for tax of $10 minus a credit for the $5 it paid in tax for the wood.  It transfers $5 to the government.  Company B then sells the finished chair to company C who will sell it to a consumer for $150 plus $15 in tax.  Company B transfers $15 minus its $10 credit to the government.  When the product is sold to a consumer for $200 plus $20 in tax, Company C owes the government $20 minus its credit of $15.  The net result is that the tax collector receives $20 on a $200 purchase, just as in a sales-tax transaction.  The price of the chair to the consumer would have increased to $220along the way to cover the cost of the tax, but the consumer would not explicitly be paying the tax.  The difference with a value-added tax is that each business participating in the chair’s production has the incentive to make sure all other participants record their taxable transactions so that each can claim their credit for taxes already paid.  If someone chooses to try to cheat, there will be a record that will allow the tax collector to detect it.

“….Lauré’s new tax on commercial transactions worked so well that it began to spread to other countries; Europe’s nascent Common Market (which became the European Union) made the value-added tax mandatory for all its member nations in 1967, on the theory that a unified market should have a unified tax structure.  Fairly quickly, the idea was taken up in South America and Africa, in the fast-growing ‘Tiger economies’ of East Asia, and then, somewhat later, in former British colonies like Australia, New Zealand and Canada.  By 2016, some 175 of the planet’s 200 countries had a value-added tax or a goods and services tax, which is another name for the same thing.”

The VAT is an important source of revenue for nations and it allows them to lower income and other taxes that taxpayers dislike and economists view as providing economic distortions (incentives for economic inefficiencies).

“This form of taxation brings in about 20% of all government revenue in the world; among the members of the OECD, the club of rich nations, VAT payments constitute 33% of all tax revenue.  For many countries, the VAT has become the most important single tax; in France, Lauré’s invention generates about 40% of revenues.”

The VAT is usually buried in the price of the item purchased where it is easily forgotten about rather than tacked on at the end where it is a constant reminder to the taxpayer.  Countries can also choose to provide VAT-free prices on goods that are exported, a benefit that is familiar to aggressive shoppers in other countries.  This also provides an advantage when competing with the United States in international markets.

The VAT has some disadvantages which probably contribute to the lack of interest exhibited by the United States.  Since the tax is generally applied to all purchases, it is regressive in nature because the lower income individuals will have it applied to a higher portion of their income.  This can dealt with in a number of ways, but the simplest approach is to remove the undesirable aspect of regressiveness with tax credits for those with low incomes through the income tax.  The implementation also requires some initial investment, but that is soon more than paid for by the increased efficiency of collection.  For a federal system with state and local sales taxes, some effort is required for a federal tax to be included, but other countries such as Canada, New Zealand, Australia, and Great Britain have already figured out ways to do it.

Liberals in the US have demonstrated a lack of interest in a VAT because it is intrinsically regressive in nature.  Conservatives in the US have opposed it because it is too efficient at collecting taxes (Reid chose to title his chapter on VATS “The money Machine”).  Since it is not applied explicitly at the time of purchase, taxpayers tend to forget about it.  Also, since prices vary continuously from market factors and overall inflation, small changes in the tax rate could generate a lot of government revenue without even being noticed by the public.  Conservatives would find such a tax to be exceedingly dangerous in the wrong hands.  However, the price conservatives pay in avoiding a VAT is higher income taxes.

The most recent study of a US Vat was generated by a study group formed by George W. Bush in 2005 tasked with making the tax code “fairer, simpler, and more efficient.”

“In an earlier version of its report, the advisory panel had proposed a revamped federal income tax, with a progressive rate structure of 15% for the lowest brackets and then additional brackets 25%, 28%, and 33% for people at higher incomes.  But if the United States adopted a 15% VAT on purchases, the income tax could be slashed to two brackets: 5% for lower income families and 15% for taxpayers above the median income.  With a top rate of 15%, few taxpayers would find it necessary or productive to invest in complicated tax avoidance schemes, so compliance would go up and IRS administrative costs would go down.”

Reid points out that by 2005 we had already embarked on a path of irreconcilable partisanship and the study group was, in the end, unable to come up with a consensus on whether to recommend a VAT.

Is there any chance for positive changes in the US tax code aimed at fairness and efficiency?  Not any time soon, but perhaps there is hope that a VAT might be reconsidered in the future.  It would only require that both conservatives and liberals pause, step back, and reconsider the advantages of a VAT.  Reid provides us with this take on the situation from Lawrence Summers.

“The former Treasury secretary Lawrence Summers offered a tongue-in-cheek prediction of when that would happen.  ‘Liberals think the VAT is regressive,’ Summers said, ‘and conservatives think it’s a money machine.  If they reverse their positions, the VAT may happen’.”

The interested reader might find the following articles informative:

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