What You Should Know About a VAT
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Dr. Martin Regalia
Senior Vice President and Chief Economist
U.S. Chamber of Commerce
Lately, you can’t open a newspaper without seeing a story on the value added tax (VAT). Newspapers write, “Will the VAT Lady Sing?” and “Value Added Tax: Will It Solve Our Budget Woes?”
What Is a VAT?
A VAT, used in approximately 150 countries, is a tax imposed and collected on the value added at each stage in the production and distribution of a good or service. It is levied on the difference between the sales and production inputs of a business.
The VAT is a consumption tax, like a retail sales tax. One important difference is that the VAT is collected in stages as the goods and services are produced and sold, whereas the retail sales tax is collected once upon final sale.
How Is a VAT Calculated?
The two most prevalent methods of calculating a VAT are the credit-invoice method and the subtraction method.
Under the credit-invoice method, which is most commonly used, a tax is imposed on the business for all of its sales. The VAT applies the tax rate to the sales price of the good or service (output), and the tax is disclosed on the sales invoice. A business credit is provided for all VAT on purchases of taxable goods and services (inputs) used in the business. Thus, the net tax paid at a stage of production or distribution is computed on the value added by that business at that particular stage.
Here’s an example assuming a 10% VAT rate. Assume Farmer sells wheat to Miller for $50, paying a $5 VAT (10% x $50 sales price). Miller processes wheat into flour and sells it to Baker for $150, paying a $10 VAT [(10% x $150 sales price=$15) minus credit of $5 paid on previous business input by Farmer, as reflected on the invoice]. Baker bakes wheat into bread and sells it to Retailer for $300, paying a $15 VAT [(10% x $300 sales price=$30) minus inputs credit of $15 paid on previous business inputs paid by Farmer and Miller]. Retailer sells bread to consumers for $500, paying a $20 VAT [(10% x $500 sales price=$50) minus inputs credit of $30 paid on previous business inputs paid by Farmer, Miller, and Baker]. A total $50 VAT has been paid in four stages.
Under the subtraction method, the tax base is computed as the difference between the business’ taxable sales and its purchases of taxable goods and services. At the end of the reporting period, the tax rate is applied to the difference.
For example, assuming a 10% VAT, Farmer sells wheat to Miller for $50, paying a $5 VAT [10% x ($50 sales price-$0 purchases)]. Miller makes flour from wheat and sells it to Baker for $150, paying a $10 VAT [10% x ($150 sales price-$50 purchases)]. Baker makes bread from flour and sells it to Retailer for $300, paying a $15 VAT [10% x ($300 sales price-$150 purchases)]. Retailer sells bread to consumers for $500, paying a $20 VAT [10% x ($500 sales price-$300 purchases)]. Here, a $50 VAT has been paid to the government in four stages by the businesses, but it has been calculated based on total transactions for the period, rather than individually on single transactions as under the credit-invoice method.
Generally, the credit-invoice method is the preferred method. It provides detailed records and documentation and is simpler to calculate and verify because the tax is applied to individual transactions.
Further, this method is more easily “border-adjustable,” meaning that it is better calibrated to make our goods and services more competitive around the world. When a VAT is “border adjusted,” the tax is removed from exports and imposed on imports, thus taxing them at the same rate as goods produced in the country of destination and making them more competitive with each other. A credit-invoice method VAT has been accepted as border-adjustable under the General Agreement on Tariffs and Trade (GATT) because it does not discriminate against imports or provide overrebates on exports.
General Pros and Cons of a VAT
So is a VAT a knight in shining armor or a Trojan horse that will wreak even greater havoc on our economy?
Proponents of a VAT point to how effectively it can raise revenue. Further, they note that the VAT is easily administered for services such as public utilities, legal, consulting, and engineering. Additionally, they contend that a VAT is simple and convenient for consumers, computed at the time of sale and paid as part of the purchase price, and is a simpler computation than an income tax for businesses.
VAT supporters also point to its ability to function effectively on a global scale. It can be used to allocate tax to the country of destination, where the goods or services are consumed, whether here or abroad. This is done by “border adjustments,” as discussed above.
VAT supporters often say that because a VAT taxes consumption rather than income, it tends not to distort an individual’s decision to work, consume, or save, thereby enhancing economic efficiency. Moreover, they suggest that a VAT is fair, taxing similarly situated consumers in a like manner.
VAT opponents rebut a number of these arguments. Many contend that it is such an effective revenue raiser that it promotes less spending discipline on the part of government because revenues are easily boosted with a simple rate increase. Also, they say that while the VAT is easily administered for some industries, it is hard to measure and assess for others, such as banking and insurance.
Opponents also point out that deviations to the VAT are frequently introduced—including multiple rates of tax, exemptions, or preferences. Since many VATS exclude various goods and services, or classes of taxpayers for economic, social, or political reasons, neutrality and efficiency are adversely impacted.
Further, whoever bears the incidence of a VAT invokes much ire among its opponents. They say that it is inherently regressive, as poorer individuals tend to spend a higher percentage of their income on purchases than wealthier individuals, resulting in taxation of a higher percentage of their income. Opponents also say that the elderly are adversely impacted by a VAT, having already paid taxes on wages then placed in savings; as they retire, they will now be taxed when they spend their savings.
If a VAT is adopted as a replacement for the U.S. corporate income tax system, extensive transition rules would have to be implemented. If adopted as an add-on tax, the VAT would entail significant costs and efforts in setting up an additional governmental structure to accommodate and administer it in parallel to the income tax, including hiring more personnel to enforce it.
As the United States faces ballooning budget deficits, discussions of a VAT will likely continue. We hope that this article has provided you with a basic understanding of almost everything you wanted to know about a VAT but were afraid to ask.
Caroline Harris, chief tax counsel at the U.S. Chamber of Commerce, contributed extensively to this article.