by T. R. Reid
Acme Furniture sells the table to Mrs. Buyer for $600, plus the 8% tax, for a total of $648. Acme is required to remit this $48 in tax to the government, but it gets a credit for tax it paid—that is, $36—to the wholesaler. So Acme actually pays the government $12.
With the credits for taxes already paid, each link in this chain of production and merchandising ends up paying tax only on its contribution to the product along the way. That is, the value-added tax does what its name suggests: it taxes each link in the chain only on the amount of value it added toward the final product.
If you add up all the tax payments—$12 from the forest company, $8 from the wood products company, $12 from the furniture maker, $4 from the wholesaler, and $12 from the retail store—the government collects a total of $48 from the sale of this table. That’s precisely the same amount it would receive from an 8% tax applied only on the retail sale. But the chain of payments that take place under a VAT makes the VAT system work better—from the government’s standpoint, at least.
With a retail sales tax, Mrs. Buyer paid Acme Furniture $48 in tax, which the store is supposed to remit to the government. For the tax collector, an important aspect of this common transaction is that Mrs. Buyer has no incentive to find out whether the retailer actually forwarded this $48 to the department of revenue. It’s all the same to her whether the owner of Acme Furniture pays the tax or pockets the money. To economists, this is a fundamental flaw with a retail sales tax: nobody has an incentive to see that the tax is actually paid. And this was Maurice Lauré’s great gift to tax collectors all over the world; in his VAT system, everybody has an incentive to report the taxes that are due.
With a VAT, each buyer along the chain gets a credit for the sales tax it already paid. And thus each buyer has an incentive to report that tax payment to the government. In the example we just considered, Distinguished Tables reports that it paid a tax of $20 to Elite Wood Products; Distinguished reports that $20 so it can get the credit against the tax it owes. As a result, the tax agency knows that Elite received $20 in tax and should have remitted that $20; if Elite failed to pay the tax, the government will know about it and start collection procedures. Because every buyer along the chain has an incentive to report the tax he paid to his supplier, no supplier can get away with ducking the tax. In essence, the VAT is self-policing, which makes it a much harder tax to evade than a simple retail sales tax.
Beyond that, the VAT provides a more even flow of tax revenue to government coffers than a retail sales tax. Some products can take months or years to move from raw material to final retail sale. Under the retail sales tax, the government won’t get a penny of revenue until the retail customer makes that final purchase. With a VAT, in contrast, each step along the way from forest to furniture store triggers a tax payment.
Economists, too, think the VAT is a “good” form of taxation—or at least one that has fewer negative side effects than a tax on personal or corporate income. Because (almost) every government has to collect tax, economists want to see it done in a way that minimizes economic distortion. The VAT meets that test in several ways:
It’s a tax on spending, not on labor or savings or investment. As we’ve seen throughout this book, it’s a basic economic principle that if you tax something, you get less of it. A payroll tax penalizes work; in theory, people will work less if their earnings are taxed. A tax on dividends or interest penalizes saving; a tax on capital gains penalizes investment. So if a nation can use VAT revenues to reduce the burden of other taxes, the undesirable side effects of other types of taxes will be reduced.
The amount of consumption in an economy tends to be more constant than the amount of labor. When recessions hit, and people lose their jobs, they no longer have wages and salaries to be taxed. But to some extent, people keep buying things. So a consumption tax like the VAT is less variable and thus more dependable as a source of revenue, particularly when the overall economy slows.
Because everybody buys stuff, everybody pays a tax on purchases. This is appealing to those who worry about the so-called 47% problem—that is, the significant number of people who don’t pay income tax. In the United States in recent years, the number of households exempt from the federal income tax—because their income is below the basic threshold where the tax kicks in—has run about 47%, as Mitt Romney famously complained during the 2012 presidential campaign. (Of course, the 47-percenters still have to pay Social Security tax, Medicaid tax, gasoline tax, and so on.) A consumption tax like the VAT is paid by everybody, including those who pay no income tax and those who are in the country illegally.
With a VAT, particularly if imposed at the national level, it is no problem to apply the tax to online purchases. This eliminates the disadvantage the brick-and-mortar stores face when they have to pay a local sales tax while the distant Internet seller can price the same product without including local tax.
Most VAT systems do not charge a tax on the final sale of an item that is exported. This means the seller can quote a tax-free price to his export customer. For a trading country that has no VAT—that is, the United States—that creates a competitive disadvantage for domestic companies, which are already facing a corporate income tax higher than that of most of their foreign competitors. If VAT revenues were used to reduce the corporate income tax rate, the combination should enhance exports and thus improve the national balance of payments.
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ON THE OTHER HAND, there are also economic problems associated with a value-added tax—problems that prompt furious opposition whenever somebody proposes a VAT for the United States.
The VAT often works as an “invisible” tax. That is, the amount of tax is included in the retail price of the item, so the purchaser isn’t reminded that she’s paying a tax every time she buys something.
If you buy a book for $25.00 in the United States, you actually have to pay more; if the sales tax is 7%, the total price of that book will be $26.75. Because the price tag said $25.00, the buyer knows with every purchase that she’s paying a tax. But if you buy a book for €25.00 in France, you’ll pay only €25.00. The book was actually priced at €20.83; the 20% VAT, €4.16, is included in the retail price. So the buyer thinks she’s paying for a €25.00 book, as if there were no tax.
This system makes it easier for countries to raise their taxes; because the tax is invisible, consumers don’t know when taxes have gone up. If the VAT on that book goes from €4.16 to €4.66, the purchaser will now be charged €25.50. The customer may not be pleased about it, but she’s likely to blame the publisher or the bookstore for this increase.
Governments use this ploy all the time. Britain’s Conservative Party has always held itself out as the small-government, low-tax party. But after the Great Recession slashed government revenues, the Conservative government raised the national VAT rate from 17.5% to 20%. This increased the cost of almost everything Brits went to buy, but the tax increase was hidden in the retail price of each item. At the next election, in 2015, British voters told pollsters they still considered the Conservatives the low-tax party—a major reason the Tories won a big electoral victory that year.
To the economists, an invisible tax is a bad idea. People should know how much they’re paying—whether they are buying books or governmental services. I asked the policy director of the Netherlands’ national tax bureau about this aspect of the Dutch VAT, which is folded into the retail price and thus hidden from consumers. “As an economist, of course I deplore an invisible tax,” Michiel Sweers told me. “As a tax collector, I’m all for it.”
Of course, the VAT need not be invisible. Canada’s GST is applied like an American sales tax; there’s a pretax retail price for the product, and the sales clerk then adds the tax to the total due at time of purchase. So Canadian consumers are reminded of the tax with every ca-ching of the cash register. But Canada is the only country so far to reject tax-inclusive pricing.
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nbsp; Because it tends to make raising taxes so easy—and so free from consequences for the party responsible—champions of lower taxes consider the value-added tax anathema. Conservatives argue that the VAT is a “money machine” designed to churn out increasing revenue to pay for more and more government. The Wall Street Journal neatly set forth the anti-VAT line of argument in an editorial:
It’s the hottest trend among tax collectors, raising a gusher of revenue for spendthrift governments worldwide. We refer to the value-added tax (VAT). . . . Americans, be warned.
The VAT is a sort of turbo-charged national sales tax on goods and services that is applied at each stage of production, not merely on retail transactions. Politicians love it because it is the most efficient revenue-raiser known to man, and its rates can be raised gradually to finance new entitlements or fill budget holes. The VAT is typically introduced with a low rate but then moves up over time until it swallows huge chunks of national economies. . . .
Because VATs are embedded in the price of products, they can often rise unnoticed by the consumer, which is why liberals love them as a vehicle for periodic stealth tax hikes. . . .
[T]he VAT . . . makes every business an aggressive tax collector. . . . The businesses get a rebate on the portion they paid when they remit to the government the sums they collected, so the system motivates all companies to ensure taxes are paid in full.
The U.S. is a rare industrial nation that doesn’t have a VAT, though don’t think it can’t happen here. Liberals campaign on soaking the rich, but they know there’re only so many rich to soak. . . . [T]hey need a new broad-based tax that hits the middle class, where the big money is.3
The Journal’s observation about who ends up paying a value-added tax—that is, everybody who buys things, rich or poor—points to another downside of the value-added tax. It can be regressive; that is, it can have a bigger impact on low-income people than on the wealthy. People in the lower brackets spend a higher share of what they earn on basic consumption than the wealthy do, which means the VAT is proportionally a heavier tax on those least able to pay.
There are different approaches to dealing with the regressive nature of a VAT. One is to make certain items tax-free—items that are essential for life and make up a major share of purchases by lower-income consumers. Typically, countries will exempt groceries, medicine, and school supplies from the tax. Some places say that work clothes or cleaning supplies or pet food should be taxed at a lower rate than less essential items. But this becomes another instance of a problem we’ve seen throughout this book: equity in taxation often comes at the price of simplicity. Once you start varying the rates, or exempting certain purchases completely, the tax regime gets complicated fairly quickly. Many countries apply the full VAT to restaurant meals—on the theory that the rich are more likely to dine out—but do not tax groceries that are to be consumed at home. That means a clerk should not collect tax on the sale of eight ounces of ham, but she should on three ounces; in the eyes of the law, the former is a grocery sale and the latter is lunch. Canada’s VAT applies to one to five doughnuts—that’s considered “immediate consumption”—but not to six, which are classified as “basic groceries” to be taken home.4 It becomes a complicated mess for some guy who’s just trying to make a living selling doughnuts.
A simpler way to deal with this problem—the method recommended by the International Monetary Fund and other tax-advisory organizations—is to charge the same VAT for everything but then to give a credit to low-income people through the income tax. This, too, can get complicated. But because most developed countries already have special income tax provisions for low-income families—such as the earned income tax credit in the United States—it’s something tax authorities know how to do. New Zealand has chosen to deal with the problem of regression this way: Its 15% GST applies to virtually everything, including the goods and/or services provided in a brothel. But it has mechanisms to refund the GST payments for people in the lowest brackets.
The system of tax collections and credits for every link in the production chain is not simple. There’s a definite cost involved in setting up a VAT regime, and there are compliance costs for those who have to pay the tax. Once the system is in place, though, it should be cheaper and easier than what we’ve got today. The economists Joel Slemrod and Jon Bakija reviewed several studies on administrative costs of different tax regimes. They concluded that “a broad-based, single-rate VAT could involve considerably lower enforcement and compliance costs than the current income tax in the United States.”5
Beyond that, imposing a VAT raises prices, which is likely to deter consumption and stifle economic growth. The Japanese learned that the hard way. After the burst of the “bubble economy” of the 1980s, business activity and tax revenues fell sharply. The Japanese government began running up huge annual deficits. More revenues were needed, so the government implemented a VAT in 1989 and raised it in 1997. This made the recession worse. The price of everything went up. People stopped shopping. The economy slumped even further. It took years before economic activity returned to pre-VAT levels. To avoid a repeat of that disaster, Japan’s prime minister decided in 2016 to cancel a scheduled increase in the VAT rate.
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ALTHOUGH THE BASIC STRUCTURE of VAT/GST all over the world is essentially the same thing that Maurice Lauré implemented in France in the 1950s, there is a broad range of tax rates and regulations governing this consumption tax. In the European Union, member nations are required to have a VAT of at least 15% so that no member tries to lure shoppers into its stores with a sharply lower sales tax. (The EU also allows countries to set reduced rates on items like food, medicine, and books.) Most EU members impose a tax higher than that; in 2016, the average rate in Europe was 21%. As we’ve seen earlier, the current world champion at gouging shoppers is Hungary, with a standard rate of 27%.
Hungary offsets this severe tax bite with lower rates for certain basic commodities, like food and medicine. Many other countries do the same. Going in the other direction, some nations impose a higher VAT for luxury goods like perfume and jewelry; the luxury VAT can run as high as 85% (in Chile), which the buyers of diamond-encrusted watches and pearl necklaces can presumably afford.
Here’s a list of various countries and their standard VAT rate, as of 2016:6
Nation
Standard VAT/GST rate
Argentina
21%
Australia
10%
Belgium
21%
Canada
9.975% to 15%
Chile
19%
China
17%
Denmark
25%
Egypt
10%
Finland
24%
France
20%
Germany
19%
Hungary
27%
Ireland
23%
Italy
22%
Japan
8%
Malaysia
6%
Mexico
16%
New Zealand
15%
Norway
25%
Russia
18%
South Africa
14%
Sweden
25%
U.K.
20%
United States
0%
Because the VAT is such a ubiquitous aspect of daily life, the consumption tax has predictably become the focus of furious political battles. Moviemakers in Japan, arguing that the nation’s once great film industry was dying, lobbied for years to get movie tickets exempt from the VAT (and won). Under similar lobbying pressure, France sharply cut the VAT on restaurant meals in 2009, and Germany cut the tax on hotel rooms in 2010; in both cases, subsequent studies showed that only a small fraction of the savings was passed on to consumers through lower prices.7 Poland applied a zero rating (that is, no VAT) on disinfectants and had to fight the Brussels bureaucracy all the way to the European Court of Justice (in essence, the EU’s Supreme Court) to defend it. All over Europe, women’s groups have launched prolonged battles against applying the VAT to tampons, calling this a tax on women. Results to date are mixed: women have won a zero rating for tampons in Ireland and reduced tax rates in Britain, France, the Netherlands, and Spain. But most European countries still tax tampons at the full rate, which means Hungarian women get to pay 27% over the retail price every time they stock up.
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STUDY AFTER STUDY and blue-ribbon panel after blue-ribbon panel have concluded that a VAT would work in the United States. If the revenues were used to eliminate, or at least reduce, the tax on interest, dividends, and capital gains, the consumption tax might encourage savings and investment. There would be a definite start-up effect, both in administrative costs and in higher retail prices, but over time these impacts should disappear. For this reason, presidents from Nixon to Obama have thought out loud about establishing a VAT.
