Many Americans do not understand how an American VAT might affect them, or its possible economic consequences on GDP and the national debt. Congress is currently exploring tax reform in order to spur economic growth and protect American businesses. Their proposal includes a controversial Border Adjustment Tax that some claim is a VAT in disguise.
What will be its effects if adopted?
What Is a Value-Added Tax?
In a 2010 interview with the Atlantic Magazine, William Gale, Co-Director of the Brookings Tax Policy Center, proposed a federal Value-Added Tax (VAT) as a way to raise government revenues, eliminate deficits, and pay down the national debt without harming economic growth.
While Gale was speaking during the early recovery of the Great Recession (2007-2009), some tax and economic experts proposed that tax reform should include an American version of the VAT. Columbia Law Professor Michael Graetz, in a 2016 article in the Wall Street Journal, claims that a VAT would:
- free more than 150 million Americans from ever having to file tax returns or deal with the Internal Revenue Service;
- cut our corporate income-tax rate to compete with the lowest in the world without shifting the burden away from those who can most afford to pay;
- spur economic growth, increasing U.S. GDP by as much as 5% in the long run; and
- stimulate jobs and investments and induce companies to base their headquarters in the U.S. rather than abroad.
In many ways, a value-added tax is similar to a national sales tax. Ultimately, both are based on the consumption of a product and add to the final cost to the consumer. The primary difference between a sales tax and a VAT is that the former is collected on the final sale to the consumer, while the latter is paid during each stage of the supply chain. In other words, the latter is a combination of direct and indirect taxes.
What Is Sales Tax?
Sales tax is added to the purchase price when the consumer purchases the goods. The retailer selling the product collects the tax and remits the proceeds to the taxing authority. The buyer is aware of the extra cost since it applies to the purchase price of the product. For example, a product selling for $100 subject to a 10% tax costs the consumer $110 – $10 in tax plus $100 to the retailer.
Currently, the U.S. does not have a federal sales tax, but 45 states now employ them as a revenue source. In addition to the state sales tax, many counties and cities tack on additional sales tax to the state charge. According to the Tax Foundation, combined sale tax rates range from a low of 1.76% in Alaska to 9.45% in Tennessee. JustFacts calculated that sales tax collections in the United States are about one-third of the taxes (over $600 billion) collected by state and local governments.
Since sales tax is regressive (a tax that takes a smaller proportion of total income as income rises), taxing authorities frequently exempt or reduce the tax rate on certain products and services deemed essential. Most states do not tax groceries, clothing, or utilities, for example. The decisions to exempt certain goods or services are extremely political as businesses seek to avoid extra out-of-pocket costs to the consumer that might limit their sales.
In 1998, Representatives Dan Schaefer (R-CO) and Billy Tauzin (R-LA) proposed legislation for a federal 15% sales tax (the Fair Tax) intended to replace personal and corporate income taxes, the estate tax, and some excise taxes. Subsequently, a nonpartisan tax reform group – Americans for Fair Taxation – proposed a federal sales tax of 23% that would apply to all consumption and investment purchases as well as goods and services sold by the government to households.
In a previous Fair Tax Act article on Money Crashers, we provided an extensive discussion of the issues surrounding the Fair Tax Act, introduced in the House of Representatives in January 2011. The Act included provisions to prohibit funding for the Internal Revenue Service and repeal the Sixteenth Amendment to Constitution (authorization for an income tax). The proposed Act died in a subcommittee of the House.
What Is a Value-Added Tax?
Each seller in the supply chain – supplier of raw materials, manufacturer, distributor/wholesaler, and retailer – collects the tax based on the value added to the product or service by each seller. Each seller would calculate, collect, and pay the value-added tax as the product moves from manufacture to sale. In other words, the seller would only pay tax on the value they added to the final product:
- A manufacturer of cell phones buys raw materials for a single phone from a supplier for $1,000 plus a 10% VAT, or $1,100. The manufacturer then remits the $100 to the taxing authority.
- The manufacturer makes the cell phone and sells it to a distributor for $2,000 plus a 10% VAT, or $200. After receiving credit for the $100 VAT paid to the supplier, the manufacturer sends $100 to the tax authorities ($200 tax less $100 credit).
- The distributor sells the phone to a retailer for $3,000 plus an additional 10% VAT, or $300 ($3,300 total). They remit a VAT of $100 to the tax authorities after receiving the credit for the VAT on the previous transaction with the manufacturer ($300 tax less $200 credit).
- The retailer sells the phone to a customer for $4,000 plus an additional VAT of 10%, or $400 ($4,400 total cost to the consumer). The retailer offsets $300 of their tax with the credit from the wholesaler and sends $100 to the government.
To sum up the transactions, the tax authorities have collected $400 in VAT totals ($100 from the supplier, $100 from the manufacturer, $100 from the wholesaler, and $100 from the retailer), equating to a 10% sales tax on the final sale to the consumer.
Advocates of a VAT claim that the tax calculation is much simpler than existing sales tax systems and less costly to administer. Gale, writing on behalf of the Brooking Institute, notes that producers will be incentivized to comply in order to receive offsetting tax credits and will be less likely to evade or game the system.
Recognizing that the VAT is regressive like a sales tax, proponents recommend offsetting the burden on low-income households by increasing cash transfers – direct payments from the government to those citizens who meet certain income and program requirements. Examples of cash transfers include unemployment assistance, Social Security, and worker’s compensation programs.
History of the VAT
Despite its avant-garde name, value-added taxes in one form or another have existed for centuries. Stripped to its basics, a VAT is a consumption tax – those who consume or buy the product are liable for the tax – just like a sales tax, an excise tax, a Goods and Services Tax (Australia), or a Harmonized Sales Tax (Canada). Until the passage of the Sixteenth Amendment in 1913, which allowed income taxes, the United States government relied on consumption taxes for a significant portion of its revenues.
Many countries exclude VATs from investment income, limiting it to goods and services. They also typically allow a variety of exempted products for social or political reasons. Nevertheless, VATs accounted for about one-fifth of the world’s collected taxes in 2010, according to a report by TaxAnalysts.
The concept of a value-added tax was developed by Wilhelm Von Siemens in the wake of World War I. The former chairman of his family firm, Siemens, which is the largest industrial manufacturing company in Europe today, devised the tax to replace the “cascading turnover taxes,” or taxes on top of taxes. Some historians credit its development to American economist and tax expert Thomas S. Adams, who proposed it in a 1921 article in the Quarterly Journal of Economics as a substitute for corporate taxes.
While the two gentlemen may have devised the concept, Maurice Lauré, joint director of the French tax authorities, was the first to implement the tax in 1954. Slow to be adopted by industrialized countries, it spread throughout Europe as a condition to join the Economic Cooperation Union (now the European Union).
In the 1980s, large industrialized nations outside the EU – Australia, Canada, Japan, Switzerland – enacted their versions of VAT. According to a KPMG study, more than 140 countries around the globe today have value-added taxes with an average rate of 15% – the United States being the only Organisation for Economic Co-operation and Development (OECD) member without a VAT.
Advantages and Disadvantages of a VAT
Enacting a value-added tax would be a significant change in U.S. tax policies. Today, the bulk of government revenues are progressive income taxes on corporations and individuals – the more you make, the more you pay. Since it applies to consumption, a value-added tax is regressive – the more you spend, the more you pay – and favors savings and investments. In the words of economist Sijbren Cnossen, the introduction of the value-added tax should be considered the most important event in the evolution of tax structure in the last half of the 20th century.
Value-added taxes foment intense feelings wherever and whenever they are considered. Many favor the tax due to its:
- Efficiency: Sellers of products and services are incentivized to comply with regulations to receive credit for previously paid VAT and offset the tax for which they are liable. Consequently, U.S. News & World Report columnist Danielle Kurtleben claims, “The relatively simple tax [VAT], combined with a broad tax base (i.e., all consumers), can mean a large amount of revenue with little effort.”
- Economic Neutrality: Value-added taxes have little effect on economic behavior or the allocation of resources, according to the CBO. Conversely, a surtax or raising rates on the current income tax system will “exacerbate the misallocation of resources caused by tax preferences, multiple rates, and the problems of measuring income correctly under the [current] income tax [system].”
- Simplicity: Depending on the design of the tax, businesses would charge the VAT on the value of their sales to consumers and other businesses, but receive credit for the VAT they pay on purchases from other firms and remit the balance to the government. The net effect is to make business purchases free of tax. Consequently, much of the burden of collection and administration of VAT falls on the private sector, rather than the government. However, the potential savings are directly proportional to the design of the value-added tax – in particular, the exemptions, limits, and complexity of the tax. Administration cost savings may not be significant if the government must maintain administrative and collection systems for other taxes.
Others dispute the benefits of a value-added tax, claiming that it is:
- Regressive: Like all consumption taxes, the burden of payment falls more harshly on low-income earners than those with high incomes. Economists refer to this effect as the “marginal propensity to consume,” relating the income one has to the portions spent for consumptions and savings. A 2011 study by the U.K.’s Office for National Statistics indicated that the bottom 20% of income earners spent almost twice as much of their disposable income for VAT as the top 20% of earners. The gap might have been greater if certain necessary items were not exempted from the tax.
- Obscure: A 2010 study by the Mercatus Center of George Mason University claims that the impact of a value-added tax is hidden from consumers, even though the economic effect of a sales tax and a VAT are the same. Hidden taxes, according to the authors of the study, hide the real cost of government, making them more palatable. A 2010 Forbes article likened a value-added tax to the best way to pluck a chicken. Pulling one feather at a time means less squawk per feather so that more plumage can be taken without resistance. During the 2016 Republican Presidential Debates, candidate Marco Rubio, a senator from Florida, explained his resistance to a value-added tax by recalling that Ronald Reagan said that “a VAT was a way to blindfold the people.”
- Limitless: Lawrence Summers, former Chief Economist of the World Bank and U.S. Secretary of the Treasury, once quipped that a value-added tax could not be passed in the Congress because conservatives thought it was a “money machine.” Economics Professor David Henderson of the Naval Postgraduate School and formerly with the Council of Economic Advisers apparently thinks so, writing in the Wall Street Journal that “the evidence is strong that a VAT makes it easier for the government to tax more.” Fearing that coupling a value-added tax to big government would fuel greater growth of public programs, conservative organizations including the Heritage Foundation, Foundation for Economic Education, and the Cato Institute oppose any form of a VAT.
With such hardened partisan positions, it’s hard to imagine the passage of a VAT today.
Replace or Supplement?
The CBO projects $1.7 trillion in individual income tax receipts and $320 billion in corporate income tax revenues in Budget Year 2017, with a GDP of $19.2 trillion. The country has failed to collect enough revenues to pay for its expenses for years, contributing to a national debt of $19.8 trillion as of June 1, 2017. This is especially troubling, considering the frequent warnings over the years that failure to lower the debt would have dire consequences for the country:
- Boston University economist and former presidential candidate Laurence Kotlikoff testified to the Senate Budget Committee on February 25, 2015, “Our country is broke. It’s not broke in 75 years or 50 years or 25 years or 10 years. It’s broke today. Indeed, it may well be in worse fiscal shape than any developed country, including Greece.”
- Former Obama White House Budget Director Peter Orszag bluntly stated, “We are on an utterly unsustainable course.”
- Former Federal Reserve Chairman Ben Bernanke warned Congress in 2009, “Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.”
While senators and representatives on both sides of the aisle are increasingly pressured by their constituents to reduce the national debt, their solutions are ideologically antagonistic. Republicans advocate cutting the deficit by reducing spending, while Democrats would raise taxes, especially on corporations and the country’s wealthiest households.
Since any significant reform requires a bipartisan solution, a compromise (maintaining the status quo of taxes and expenditures) is the most likely outcome. But there may be an opportunity for both parties to further their long-range interests.
The president has publicly advocated a reduction or elimination of corporate taxes to stimulate economic growth. The CBO notes that the U.S. statutory corporate tax rate at 39.6% is the highest of the world’s 20 major economies (G20). According to economist and contributor Tyler Cowen of Bloomberg View, cutting the statutory rate to 15% “would spark investments that more than make up the cost.”
Barron’s claims that cutting the corporate tax rate would make American businesses more competitive in the global arena, reduce the massive amounts of time and energy now wasted on tax-avoidance maneuvers, and bring home trillions of dollars of profits earned by U.S. corporations overseas.
Republicans have traditionally opposed a federal VAT, fearing that, once in place, its efficiency and lack of transparency will encourage long-term government growth by “letting the camel’s nose under the tent.” At the same time, reducing the corporate tax rate would be hugely popular with their constituents.
Replacing the corporate tax with a revenue-neutral VAT may be an acceptable compromise for Republicans, since figures compiled by the Tax Foundation suggest a VAT of 2.86% would recover all of the revenues derived from corporate taxes today.
On the other hand, Democrats might agree to the substitution if sufficient exemptions or transfer payments are in place to moderate a VAT’s regressive impact on lower-earning households. An added long-term advantage is the possibility of higher VAT rates in the future. The Mercatus study showed the VAT rate had increased from the initial rate in nine of 10 major industrial countries, from an average of 9.88% to 15.97%.
The Destination-Based Cash-Flow Tax
House Republicans introduced a new Definition-Based Cash-Flow Tax (DBCFT) to replace the current corporate tax system. Though it has a new name, the DBCFT is essentially a VAT with an additional deduction for wages. Its net effect would be to shift from an “origin-based” tax (the corporate income tax) to a “destination-based” tax. Income tax applies to the production of goods and services, while DBCFT targets consumption of goods and services. According to the Tax Foundation, the Republican plan will:
- allow businesses to fully expense capital investments in the year of purchase rather than amortize the costs over years;
- eliminate the deduction of net interest expenses against taxable income; and
- exclude foreign profits from domestic taxation.
The initial proposal calls for a 20% rate for corporations and 25% for incorporated businesses. Other aspects of the plan identified by RealClear Markets include:
- Border Adjustment on Imports and Exports. Exports are exempted from the tax, but imported items are not. Many economists believe the effects on international trade will be limited, since the plan is likely to raise the value of the U.S. dollar relative to other countries’ currencies. This effect will also reduce the value of American foreign investments. However, if the exchange rate does not rise to the level of the tax, the country’s exports will increase, while imports and our trade deficit will fall. Consumer prices would rise, disproportionately affecting low-income households.
- Progressive Element Due to the Deduction of Wages. Companies that invest in automation, thereby reducing their U.S. headcount, will pay a higher tax than those with larger workforces. Proponents claim this will encourage investment in workers and higher wages. Allowing for the inclusion of wages makes the tax resemble an income tax and may cause problems with the World Trade Organization (WTO). The organization allows border adjustments for VATs, but not for income taxes.
- Poor Optics. Large, profitable exporters might generate negative net tax liabilities, thereby requiring the Treasury to compensate the companies for the paper losses. Since most Americans believe that profitable companies should pay more, not less, tax, political problems could arise.
- Decreased Government Revenues. Economists project that tax collections will fall an estimated $900 billion over the next decade under the proposed rate, adding to the deficit and national debt. Gale estimates that a 3% rate for all products would eliminate any revenue shortfall.
As we enter into another attempt at tax reform, potentially including the adoption of a VAT-like tax, we should remember that previous efforts for a VAT have met stiff opposition. As Treasury Secretary Summers said, “When Conservatives realize that the VAT is regressive and Liberals recognize it is a money machine, there might be a chance of passage.”
The White House announced after publication of the plan that they were in the first stages of the tax reform process and were seeking input and considering several modifications. Any agreement must be bipartisan to garner the necessary vote. As a consequence, Roger Altman, a deputy Treasury Secretary in the Clinton administration, called the plan “likely dead” in a Bloomberg TV interview and estimated there was a “50-50 chance or less of a tax overhaul happening in 2017.”
If a value-added tax is passed in any form, it will undoubtedly extract more funds from American consumers, albeit indirectly. However, there is no certainty that the increased funds would be used to pay down national debt (a conservative goal) or expand government services (a conservative fear). It is also likely that the tax will supplement our tax system, rather than replace an existing tax. Calculating, reporting, and paying a value-added tax is less complicated than an income tax.
Would you favor a value-added tax? Should it replace an existing tax, such as the corporate income tax, or should it be an addition? Should any revenues from a VAT be used to reduce debt or increase social programs?