Pepper Commentary: To VAT or Not to VAT

Pepper Commentary: To VAT or Not to VAT


That, indeed, is the question.
 
February brought the American Recovery and Reinvestment Act of 2009. Medicare and Medicaid costs are rising. Social Security is facing bankruptcy. Universal health care coverage is proposed. Trillion-dollar deficits are projected for the foreseeable future.
 
Taxes must increase to pay for all this. The debate revolves around who should pay what. The White House maintains that it will not raise taxes on those making less than $250,000 a year. Treasury Secretary Timothy Geithner believes, however, that "[w]e will not get this economy back on track, recovery will not be strong and sustained, unless we … can convince the American people that we’re going to have the will to bring these deficits down once recovery is firmly established."
 
Invoking the "American people" is a call for a broad-based tax. Based on the numbers, it may be the only way to pay the national debt. Imposing a national VAT, or value added tax, moreover, may be the most politically effective way to implement a broad-based tax because it will not raise income taxes on those making less than $250,000 year but still effectively will tax all.
 
What Is a VAT?
 
A VAT is a consumption tax. It is imposed on commercial activity involved in the process of producing goods and providing services. A VAT is levied on the value added by each business enterprise at every stage of production and distribution of goods and services.
 
For example, assume WidgetMaker assembles and sells $100,000 worth of Widgets and that the VAT rate is 10 percent. Further assume that, to make the Widgets, WidgetMaker purchased, in transactions subject to VAT, A Parts from Manufacturer A for $30,000 and B Parts from Supplier B for $40,000. In this case, Manufacturer A would have paid VAT of $30,000 x 10 percent, or $3,000, and Supplier B would have paid VAT of $40,000 x 10 percent, or $4,000. WidgetMaker’s VAT burden is $100,000 x 10 percent, or $10,000, less the $7,000 of VAT previously paid in respect of the final product for a total $3,000. This $3,000 reflects the value added to the product by WidgetMaker.
 
Technically, the method just described for calculating WidgetMaker’s VAT burden is known as the "credit-invoice VAT." It resembles a retail sales tax collected in stages. The VAT is the difference between the tax charged on taxable sales and the tax paid on inputs. The tax paid on the inputs is evidenced on invoices delivered (in this case, by Manufacturer A and Supplier B) to their purchaser (WidgetMaker) so the purchaser can perform the calculation.
 
The credit-invoice VAT is the most popular type of VAT in the world. Other types of VATs include the "credit-subtraction VAT," the "sales-subtraction VAT" and the "addition-method VAT." The credit-subtraction VAT is similar to the credit-invoice VAT, the most significant difference being that credit for tax paid on inputs is not determined by reference to VAT invoices (e.g., the invoices setting forth the $3,000 of VAT paid by Manufacturer A and the $4,000 of VAT paid by Supplier B) but rather is based on the tax-inclusive cost of an input (e.g., $33,000 in the case of the A Parts and $44,000 in the case of the B Parts) multiplied by a "tax fraction" reflective of the VAT rate. The sales-subtraction VAT calculates VAT liability by multiplying the VAT rate by the difference between total taxable sales and total taxable purchases for a given period. Liability under the addition-method VAT is determined by adding the cost of economic factors of production for a given period (wages, rent, etc.) and multiplying the total by the VAT rate.
 
The Devil’s in the Details
 
Once the method for calculating a VAT is chosen, it may (or may not) be designed to achieve particular economic, social or political goals. For example:
 
  • different VAT rates may be applied to different types of goods to create progressivity (e.g., higher VAT rate on luxury goods), discourage consumption (e.g., higher VAT rate on tobacco products) or encourage production of certain products or services (e.g., lower VAT rate on labor intensive industries to promote employment)
  • "zero rating" (not charging VAT) may be applied to necessities, such as food, water and medicine
  • entity exemption may be used to avoid imposing VAT in circumstances where the compliance burden is too great compared to the VAT at issue (e.g., small businesses with limited sales) or the entity is deemed to serve a purpose that deserves tax exemption (e.g., non-profit organizations)
  • transaction exemption may be applied to circumstances that are deemed not to warrant application of the VAT (e.g., isolated sales)
  • credit for VAT paid on inputs may be denied because their nature is considered unrelated to commercial activity (e.g., entertainment costs)
  • the timing of recovery of capital investments may be legislated to increase revenue (e.g., by requiring complete capitalization and therefore no credit for VAT paid on the input) or to seek to match cost recovery with production (e.g., by allowing VAT recovery on capital purchases through input credits over time)
  • excess credits from inputs (e.g., resulting from high inventory purchases but little sales) may be refunded or carried forward and, if carried forward, may be permitted to offset not only VAT but also income taxes, and
  • the determination of whether imports or exports should be subject to VAT may affect international trade.
 
As with any tax, the more nuances that are built into a VAT, the more complicated, costly and biased it may become.
 
Additionally, the imposition of a VAT requires a jurisdiction and its subdivisions to re-examine their other tax regimes. For example, if the United States were to impose a VAT, should it do so at a high rate and eliminate the federal income tax for certain groups or entities? Would the states replace their sales taxes with VATs to piggyback on federal law? Would their VAT codes be different?
 
Where Are We Now and Where Should We Go?
 
The U.S. government needs money. Taxes will go up. A VAT may be the most politically palatable way, if not only way, to raise the revenue needed. Discussion of a VAT is increasing in political circles, the press and public discourse.
 
VAT experts already have made initial recommendations on a U.S. VAT design. Earlier this year, the American Tax Policy Institute sponsored a conference in Washington, D.C. on "Structuring a Federal VAT: Design and Coordination Issues." Recommendations about VAT design (the credit-invoice VAT); international taxation (tax imports); and the application of VAT to the financial services, insurance and housing industries were given.
 
Now is the time to get involved in the debate over whether there should be a U.S. VAT and, if so, its design. Waiting until legislation is before Congress to lobby for particular treatment may be too late.
 
We welcome your thoughts.
 

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