A value-added tax (VAT) is a fee assessed against businesses at each step of the production and distribution process, usually whenever a product is resold or value is added to it. A VAT is levied on the difference between the purchase cost of an asset and the price at which it can be sold (i.e., the amount of value added to it). Producers and distributors typically pass the cost of the VAT on to the final consumer in the form of price increases. Tax is added to a product's price each time it changes hands until delivery to the customer takes place, when the final tax is paid.
Value-added tax falls under the general category of a consumption tax, meaning taxes on what people buy rather than on their earnings, savings, or investments. VAT has also been referred to as a sort of national sales tax, though it functions very differently. Sales tax is imposed on the total retail price of the item sold, while VAT tax is imposed on the value added at each stage of production and distribution. And though more complicated than sales tax, value-added tax systems have more checks against tax fraud because the tax is assessed at more than one point in the distribution process.
The process of assessing value-added tax occurs roughly as follows:
Value-added tax is a primary source of tax revenue in many European and other developed countries. With the exception of the United States, all countries of the Organization for Economic Cooperation and Development (OECD) use a VAT or similar tax on consumer expenditures. Though a value-added tax system has not been extensively used in United States, some presidents have examined the idea.
Value-added tax was first suggested in Germany during the post–World War I period as a replacement to the country's turnover tax. The turnover tax was similar to the value-added tax system but did not provide rebates for the taxes paid at each stage. Other proponents of VAT suggested that the United States adopt it as a substitute for excise taxes imposed after the War. However, it was not until 1953 that the value-added tax system was put in place in the United States or Europe. That year, Michigan adopted a modified VAT, termed a Business Activities Tax, and used the system for 14 years. France was the first country to begin using value-added tax to partially replace its own turnover tax system.
In 1967 the Council of European Economic Community (EEC) issued directives for widespread adoption of value-added tax to replace existing turnover taxes and link EEC members with a common tax system. The Council also hoped the new system would increase foreign trade, which was hindered by the complex regulatory practices of the turnover tax system. After the directive, countries outside the EEC such as Austria, Sweden, Brazil, Greece, and Peru also adopted some variation of the VAT, either in addition to or as a replacement for their own national tax structures.
A 1983 U.S. News & World Report article titled "What's Wrong with the System?" examined alternatives to the current tax system in the United States, citing problems such as complexity of tax laws, the expense of hiring professionals to prepare tax documents, and IRS backlog. One of the cited alternatives was value-added tax, by then widely used across Europe and other developed countries.
From 1987 to 1997, value-added tax was introduced in many eastern European countries, the former Soviet republics, and Asia. China, Thailand, the Philippines, and Bangladesh all implemented the policy during the mid-1990s. By the early 2000s, VAT had become the a key component of the tax systems in more than 120 countries, with tax rates varying from 5 to 25 percent. Writing in Finance and Development, Liam Ebrill claimed that "the rapid rise of the value-added tax was the most dramatic-and probably most important-development in taxation in the latter part of the twentieth century, and it still continues."
There are three types of value-added tax used around the world, each different in the ways that taxes on investment (capital) expenditures are handled. The most common is the consumption method, which allows businesses to immediately deduct the full value of taxes paid on capital purchases. The second is the net income method, which allows gradual deduction of VAT paid on capital purchases over a number of years, much like depreciation. The third type, gross national product method of value-added tax, provides no allowance for taxes paid on capital purchases. The name of this type of tax is derived from the fact that the tax base is approximately equal to private GNP. The consumption method is most favored among general populations because it most equally taxes income from labor and capital and promotes capital formation.
In theory, value-added tax systems with a uniform rate are neutral to all forms of productive input. However, countries across the world have had to modify the VAT system with multiple rates and exemptions to meet political, economic, and social needs. Most nations do not assess any tax on necessities such as food, medicine, and shelter. And because of the difficulty in computing value added, professional services such as banking, accounting, and insurance are often exempt. The largest variation from uniform tax rates is the zero tax rate on exports. Since taxes will likely be assessed at a product's destination, many do not impose a tax on the final selling price of exports. To compensate, the VAT is applied to imported products. Working together, countries seek more balanced trade.
Financial services have traditionally been exempt from value-added tax because no one has found a systematic, easy way to tax these services, partially because of the difficulty in determining the nature of services provided. Also, some wonder if it is fair to charge a tax on services often related to saving and investment.
Though some services are exempt from value-added tax, they must still pay the VAT on expenses such as office equipment; additionally, these business are ineligible for rebates on the VAT they pay. Therefore, exempt business sectors pay the total VAT on any good and service purchased. Often the cost of paying value-added tax is rolled into fees charged for the services offered. As a result of this imbalance, competition becomes greater, as companies can import services tax free, instead of buying services from a company whose price probably is inflated to absorb some or all of the hidden VAT taxes paid.
To remove such distortions in the economic effect of a value-added tax, a new method of taxing financial services would need to be devised. If these services were no longer exempt from value-added tax, they could reclaim prepaid VATs on equipment, etc., but they would also be required to charge VAT on any services offered. What complicates the matter further is categorizing which services are performed specifically on a customer's behalf and which are performed on the institution's behalf. Additionally, services performed for the institution as a whole still indirectly benefit consumers. These issues make for murky ground when computing the value a service provider should be taxed upon.
The benefit of staying with the current system is that people are used to it. The option of charging VAT to financial services means added resources must be committed to changing existing VAT coverage and finding a way to measure value added for financial institutions. A third option is to look for a distinct way of taxing services while remaining under the value-added tax system. As an example, the European Commission was exploring the idea of taxing services on a cash-flow basis, taxing cash movement.
One of the best reasons for instituting a value-added tax, according to VAT proponents, is that the system encourages personal savings and investment—principal elements of a healthy economy—by taxing only consumption. In the current United States tax structure, citizens pay taxes twice on money they save—once when income tax is withdrawn from their paycheck, and again when they pay taxes on the interest earned from savings and gains from investments. Similarly, the tax system in place in the United States encourages corporations to use debt financing, in which interest payments made by the company are tax deductible. Any dividends earned are subject to double taxation. And because taxes on capital purchases cannot be immediately deducted (only later as depreciation expense), the costs of capital investment increase. If a company does have a large asset base, it must generate more income to increase investor returns, subjecting itself again to higher tax payments.
Another benefit touted by VAT supporters is a more constant revenue flow. Tax revenues under the current U.S. structure rise and fall as a result of changing economic conditions, decreasing during recessions and growing during an economic boom. During recessionary periods, revenues may fall enough that government financial requirements utilize all available funds, and economic recovery becomes further delayed. Proponents of value-added tax believe it results in more financial stability and revenue flow.
Supporters of VAT for the United States view the system as a supplementary tax that could help make up for revenue lost due to personal income taxes, and believe imposition of a VAT may also result in general lowering of income-tax rates. They also assert that items such as food, medicine, and shelter should be exempt (as they are in other countries with a value-added tax structure) in order to maintain fair practices for those who must expend the majority of their income on basic necessities. It would also mean people who save and invest money realize benefits. Finally, VAT advocates maintain that the current tax system in the United States cannot raise sufficient revenue to support minimal government expenses.
A value-added tax would in theory eliminate the need for federal tax expenditures, which are largely responsible for depletion of federal revenues and increases in the national debt. Also, since the VAT is a consumption tax, people will be more motivated to save and invest disposable income. Additionally, a VAT would in some way reduce bias toward those who earn higher incomes. Tax write-offs can usually be taken advantage of only by those who itemize—meaning that they are available only to a small percentage of U.S. citizens, usually those with the highest incomes.
Dropping the current tax system in the United States in order to adopt a VAT would require additional taxes on state and local services and products as well. Because value-added tax is similar to implementing a national sales tax, it impinges on territory currently occupied by states and local governments, and could add to the expenses incurred by cities and states by making them responsible for collection and enforcing compliance to the VAT system. It would require that every state rewrite its tax code, and could also add another tax layer for cities already charging state and local sales taxes. And while some cities could benefit from nontaxable export sales, others that depend primarily on domestic industry could face large losses in sales, resulting in declining revenues and lost jobs.
The prospect of a value-added tax also raises questions such as: Which goods and services purchased by cities would be federally taxed? Which provided by cities would be federally taxed? There would be no provisions for tax-exempt municipal bonds, which could mean an increase of up to thirty percent of finance costs for some municipalities. Deductions for state and local taxes, mortgage interest, investment in enterprise zones, housing, and jobs would also be eliminated. And cities with citizens who have less disposable income could stand to lose significant revenues with a consumption tax, revenues that would affect the public infrastructure and its investment in schools, roads, and utilities. VAT critics feel a de facto national sales tax will also reduce the amount of local funding states can expect from the local sales tax.
Because those with higher incomes spend a lesser proportion of their total wealth on consumption, households with lower income would still realize disadvantages and pay more tax proportionately than those who make more. However, adjustments can be made to value-added taxes so that taxation of food, housing, clothing, and medicine are given a zero or low tax rate. Also affecting citizens with lower incomes would be the fact that charitable contributions would no longer be deductible expenses.
Adding to the drawbacks, some economists feel that instituting a value-added tax would result in increasing prices and, as a result, inflation. U.S. economists have estimated the net effect of a VAT implementation as a five percent price increase. Also, assumptions that administrative costs would decrease with a value-added tax system may be erroneous. VAT-compliance costs to business would be higher, especially with special exemptions and multiple rate levels to consider. And the VAT would not eliminate income or payroll taxes completely, meaning the VAT would only add to administrative costs incurred.
A fairly recent complication in the administration of VAT systems involves electronic commerce. Though the sales of online retailers accounted for an ever-increasing percentage of overall sales of software, videos, and music, such sales were not subject to VAT. Governments in the EU and elsewhere planned to implement a VAT for electronic commerce in order to protect traditional retailers from unfair competition and create a new source of revenues. "New technologies are steadily drawing VAT into the realms of competition between tax regimes and presenting its architects with the problem of how legislation can be redesigned to reflect previously unimagined transactions, while preserving neutrality with the existing ones," Graeme Ross wrote in International Tax Review.
Though the concept of value-added tax has met with considerable success outside the United States, U.S. policy makers have not yet warmed to the idea. The topic has been debated by economists since the post–World War I period but attracts only mild, sporadic support. The suggestion to adopt a VAT policy in the United States has been formally proposed at least five times since the early 1970s. Supporters are firmly convinced problems with the existing tax structure could be corrected with its adoption through the generation of revenues and subsequent stimulation of production.
VAT would replace individual and corporate in-come tax, as well as the Internal Revenue Service (IRS) and the almost $500 billion in related annual federal tax expenditures. However, deductions for mortgage interest, state and local taxes, earned income credit, and so on would no longer apply. Establishment of a value-added tax structure would directly change how state and local revenues are taxed. A VAT would require a determination of whether any taxable base includes state and local taxes, i.e., whether the price of a good or service had been calculated before or after any state and local income, property, or other taxes were applied.
On the import/export front, the United States loses by its lack of participation in a VAT system. With such a system, the country's large trade deficit could be improved. As provided by the General Agreement on Tariffs and Trade (GATT), prices for export goods can be discounted for some taxes, but not for income and social security taxes. But countries that use the VAT system can reduce prices by the total amount of VAT paid, giving them an economic advantage over the corporate and payroll taxes U.S. firms must pay. By adopting a VAT system and reducing the level of corporate, income, and payroll taxes, the United States could increase its export volume and U.S. firms would not be forced to lower prices to compete with other countries.
Wendy H. Mason
Revised by Laurie Collier Hillstrom
Ebrill, Liam, et al. "The Allure of the Value-Added Tax." Finance and Development, June 2002.
"Get the VAT Out: Tax Refund." U.S. News & World Report, 28 April 1997.
Hooper, Paul, and Karen A. Smith. "A Value-Added Tax in the U.S.: An Argument in Favor." Business Horizons, May-June 1997.
"Introduce VAT to Halt Sales Tax War Among States." Business Line, 19 May 1999.
Ogley, Adrian. Principles of Value-Added Tax—A European Perspective. International Information Services, Inc., 1998.
Ross, Graeme. "Indirect Taxation—Designing Its Future." International Tax Revenue, October 2004.
Scott, Andrew. "Taxing Financial Services: A Future with Options." OECD Observer, January 1999.
"What's Wrong with the System?" U.S. News & World Report, 18 April 1983.