A Value-Added Tax: Who is the Joke on?

by Henry Young February 23 2010, 14:42

It has been said that a value added tax (VAT) will not pass because liberals fear it is regressive and conservatives fear it will increase the size of the federal government.  “However, the joke continues, a VAT will be passed when liberals recognize that it could be a money machine and conservatives recognize that it is regressive.”  But are the terms of the joke accurate?  Would enacting a vat be trading a regressive tax for more government?

I. What Is a VAT

There is more than one way to implement a VAT and the intricacies of such implementation are beyond the scope of this article.  Suffice it to say, a VAT imposes taxes at every level of production so that all taxes have been paid by the time the good reaches the consumer.  This method of taxation gives each producer a tax credit equal to the tax levied on his portion of the production.  Because the taxes are built into the price of the final good purchased by a consumer, the consumer pays no additional tax at the cash register and receives no corresponding credit.  Though it sounds complicated, a VAT is actually quite simple and better explained with an example. 

Alan owns a wheat farm and buys seeds for ten dollars.  When Alan harvests his wheat and sells it to Bob for 110 dollars the government imposes taxes on the 100 value Alan added (110 - 10) but gives him a corresponding deduction for that tax; that is, at the end of the process Alan will not pay taxes.  Bob takes the wheat and makes beer which he sells to Carl for 1000 dollars.  Bob is taxed on the 900 dollar value he added, but like Alan, Bob is given a credit to offset this tax burden.  When Carl buys the beer form Bob he pays 1000 dollars and is not charged any additional tax at the register – because the tax is built into the price of the beer – and Carl gets no tax credit.

Essentially, a VAT imposes taxes on the value the business adds to the good or service he sells.  Notably, when the consumer purchases the good he will pay the price on the good, not the price of the good plus an additional tax.

II. Effects of a VAT

It is difficult, if not impossible, to divide the effects of a VAT into categories of advantages and disadvantages because, as illustrated by the joke above, one person’s advantage is another’s disadvantage.  Increasing government revenue or equality may be seen as an advantage to some while they may be viewed as a disadvantage to others.  However, it might be possible to conclude whether a VAT would be a tradeoff between a more regressive tax system and more government intervention.

A. Would a VAT be Regressive?

At first glance, a VAT appears regressive.  Wealthier people consume proportionately less of their income while less wealthy people may consume all or almost all of their income.  However, people tend to consume about how much they earn so over a lifetime a VAT tends to be a lot less regressive than one might think.  More importantly, one should start an analysis of whether a VAT would be regressive by asking: to what are we comparing a VAT?  In the United Sates corporate and personal income taxes are progressive while payroll and excise taxes are regressive.

A second integral part of analyzing how regressive a VAT would be is defining what would be subject to the VAT.  It is likely that if Congress passed a VAT, it would create a zero tax designation for a number of goods frequently purchased by low-income people.  It is also possible that Congress would create a flat exemption for the VAT which might be aimed at alleviating a certain level of spending from the VAT thus insulating low-income Americans from the effects of a VAT.

Additionally, Congress might target small business for exemption from a VAT (partially due to high administrative costs).  While the point of taxation is to raise revenue for the government, exempting small businesses, which are the “engine of job growth in America,” would be politically popular while the specter of raising taxes on small business might be considered a political nonstarter, so this is a likely possibility.  Importantly, exempting small business might relieve them from compliance cost which would make a VAT less regressive.

Finally, changing from our current system to a VAT would change incentives for saving.  The current system in the United States taxes a person’s savings twice: once when he earns money and a second time when his savings earns interest. Clearly this double taxation dissuades Americans from saving.  However, a VAT would create an incentive to save.  Recently, the personal savings rates of Americans has been cause for concern as the personal saving rate dipped into the negative for the first time ever in 2006.  However, while it might have been wise to remove disincentives to personal savings in the past, it might be unwise to create incentives to save during a recession when the government needs people to spend their money.  In terms of how regressive a VAT would be, it would create an incentive to save but that incentive could only be acted upon by individuals wealthy enough to have disposable income.  At the same time, and mentioned above, in the long run individuals tend to spend the money they earn so the effect on savings might be overstated. 

Simply put, whether a VAT would be regressive is a bit more complicated than one might think.

B. Would a VAT Increase the Size of Government?

Whether a VAT would increase the size of government, at least partially, depends on if the VAT increases revenue, which in turn depends on the rate of the VAT, the spending habits of consumers, and the exemptions provided for by Congress.  These variables are difficult to assess but two consequences for government of a implementing a VAT are noteworthy.

A VAT will decrease a consumer’s association between taxes and increased costs because taxes are built in to the price of the good.  When a consumer takes a good to a cash register he will only see the price he pays for, essentially eliminating the ability to take into account the cost of the good added by taxes.  This disassociation will make it easier for government to raise taxes in the future because consumers will be less likely to notice the increase or if they notice the increase consumers will be less likely to blame government.  Shrouding government taxes through a VAT makes it less likely that people will notice or oppose tax increases which might make it easier for government to grow.

This change in how consumer will assess the role of taxes in the price of a good has a corresponding upside: it makes collecting taxes less politically contentious (a problem noted by above) which might in turn help the government avoid a situations like California’s current budget crises in which revenue cannot be raised without a referendum.  Clearly, for proponents of smaller government the way to avoid government growth would be to cut expenditures but a VAT might still help avoid a political stalemate.

Second, and related, consumers are better able to assess the cost of goods and therefore better able to make good decisions.  That is to say, not having taxes add at the register and removing the possibility of owing the government taxes at the end of the year better equip a consumer to make smart choices.

III. Conclusion

Like most tax issues the VAT is complex.  VATs are difficult to assess in the abstract because the “devil is in the details.”  However, two conclusions are worth making.  First, VATs might not be as regressive as one might think because of life-time spending habits and thus the difference between our current tax system and a VAT might be “less than commonly imagined.”   Additionally, there are ways to implement a VAT that would minimize how regressive it might be in the short-term.  Second, while a VAT hides taxes within the cost of a good and thus might make it easier to raise taxes, it also makes a consumer’s choice better informed and therefore more efficient.

If liberals choose to oppose a VAT it should not be because it is necessarily regressive and if conservatives choose to oppose a VAT it should not be because it necessarily will grow government.

Endnotes:

[1] Gilbert E. Metcalf, Value-Added Taxation: A Tax Whose Time has Come? 9 Journal of Economic Perspectives 121, 123 (1995).

 

[2] Two common types of VATs are the subtraction method and the credit method.  “Under a subtraction method VAT, a business deducts business purchases, including capital outlays, from sales and pays tax on the difference. A subtraction method VAT, sometimes called a business activities tax (BAT), differs from a single-rate credit method VAT only in computation procedure, and the two taxes produce the same revenue if imposed at the same rate.”  J. Clifton Fleming, Jr., Sorting out the Uncertain Simplification (Complication?) Effects of VATs, BATs and Consumed Income Taxes 2 Fla. Tax Rev. 390 (1995).

 

[3] Id.

 

[4] John K. McNulty, Flat Tax, Consumption Tax, Consumption-Type Income Tax Proposals in the United States: A Tax Policy Discussion of Fundamental Tax Reform 88 Calif. L. Rev. 2095, 2147 (2000).

 

[5] Id at 2148; see also, Gilbert E. Metcalf, supra note 1; see also, Joseph Bankman and Barbara H. Fried, Winners and Loser in the Shift to a Consumption Tax 86 Geo. L.J. 539, 546-47 (1998).

 

[6] John K. McNulty, supra note 4.

 

[7] Sean Raft, Imagining a Progressive and Comprehensive Consumption Tax 86 Or. L. Rev. 161, 177 (2007).

 

[8] Gary Chartier, A Progressive Case for a Universal Transaction Tax 58 Me. L. Rev 1, 7 (2006).

 

[9] Gilbert E. Metcalf, supra note 1.

 

[10] Jesse Lee, “The Engine of Job Growth in America” White House Blog, available at http://www.whitehouse.gov/blog/2010/02/02/jumpstarting-small-businesses-engine-job-growth-america.

 

[11] Barry M. Freiman, The Japanese Consumption Tax: Value-Added Model or Administrative Nightmare? 40 Am. U.L. Rev. 1265, 1299 (1991).

 

[12] Michael J. Graetz, Taxes that Work: A Simple American Plan 58 Fla. L. Rev. 1043, 1054 (2006).

 

[13] Gilbert E. Metcalf, supra note 1 at 131.

 

[14] Bureau of Economic Analysis, Comparison of Personal Saving in the NIPAs with Personal Saving in the FFAs, http://www.bea.gov/national/nipaweb/Nipa-Frb.asp.

 

[15] Sean Raft, supra note 7 at 198.

 

[16] Joseph Bankman and Barbara H. Fried, supra note 5 at 546.

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