Will the U.S. Adopt the Value-Added Tax (VAT)? Roadblocks, Pros & Cons
Many Americans do not understand how an American VAT might affect them, or its possible economic consequences on GDP and the national debt. Congress is currently exploring tax reform in order to spur economic growth and protect American businesses. Their proposal includes a controversial Border Adjustment Tax that some claim is a VAT in disguise.
What will be its effects if adopted?
In a 2010 interview with the Atlantic Magazine, William Gale, Co-Director of the Brookings Tax Policy Center, proposed a federal Value-Added Tax (VAT) as a way to raise government revenues, eliminate deficits, and pay down the national debt without harming economic growth.
While Gale was speaking during the early recovery of the Great Recession (2007-2009), some tax and economic experts proposed that tax reform should include an American version of the VAT. Columbia Law Professor Michael Graetz, in a 2016 article in the Wall Street Journal, claims that a VAT would:
In many ways, a value-added tax is similar to a national sales tax. Ultimately, both are based on the consumption of a product and add to the final cost to the consumer. The primary difference between a sales tax and a VAT is that the former is collected on the final sale to the consumer, while the latter is paid during each stage of the supply chain. In other words, the latter is a combination of direct and indirect taxes.
Sales tax is added to the purchase price when the consumer purchases the goods. The retailer selling the product collects the tax and remits the proceeds to the taxing authority. The buyer is aware of the extra cost since it applies to the purchase price of the product. For example, a product selling for $100 subject to a 10% tax costs the consumer $110 – $10 in tax plus $100 to the retailer.
Currently, the U.S. does not have a federal sales tax, but 45 states now employ them as a revenue source. In addition to the state sales tax, many counties and cities tack on additional sales tax to the state charge. According to the Tax Foundation, combined sale tax rates range from a low of 1.76% in Alaska to 9.45% in Tennessee. JustFacts calculated that sales tax collections in the United States are about one-third of the taxes (over $600 billion) collected by state and local governments.
Since sales tax is regressive (a tax that takes a smaller proportion of total income as income rises), taxing authorities frequently exempt or reduce the tax rate on certain products and services deemed essential. Most states do not tax groceries, clothing, or utilities, for example. The decisions to exempt certain goods or services are extremely political as businesses seek to avoid extra out-of-pocket costs to the consumer that might limit their sales.
In 1998, Representatives Dan Schaefer (R-CO) and Billy Tauzin (R-LA) proposed legislation for a federal 15% sales tax (the Fair Tax) intended to replace personal and corporate income taxes, the estate tax, and some excise taxes. Subsequently, a nonpartisan tax reform group – Americans for Fair Taxation – proposed a federal sales tax of 23% that would apply to all consumption and investment purchases as well as goods and services sold by the government to households.
In a previous Fair Tax Act article on Money Crashers, we provided an extensive discussion of the issues surrounding the Fair Tax Act, introduced in the House of Representatives in January 2011. The Act included provisions to prohibit funding for the Internal Revenue Service and repeal the Sixteenth Amendment to Constitution (authorization for an income tax). The proposed Act died in a subcommittee of the House.
Each seller in the supply chain – supplier of raw materials, manufacturer, distributor/wholesaler, and retailer – collects the tax based on the value added to the product or service by each seller. Each seller would calculate, collect, and pay the value-added tax as the product moves from manufacture to sale. In other words, the seller would only pay tax on the value they added to the final product:
To sum up the transactions, the tax authorities have collected $400 in VAT totals ($100 from the supplier, $100 from the manufacturer, $100 from the wholesaler, and $100 from the retailer), equating to a 10% sales tax on the final sale to the consumer.
Advocates of a VAT claim that the tax calculation is much simpler than existing sales tax systems and less costly to administer. Gale, writing on behalf of the Brooking Institute, notes that producers will be incentivized to comply in order to receive offsetting tax credits and will be less likely to evade or game the system.
Recognizing that the VAT is regressive like a sales tax, proponents recommend offsetting the burden on low-income households by increasing cash transfers – direct payments from the government to those citizens who meet certain income and program requirements. Examples of cash transfers include unemployment assistance, Social Security, and worker’s compensation programs.
Despite its avant-garde name, value-added taxes in one form or another have existed for centuries. Stripped to its basics, a VAT is a consumption tax – those who consume or buy the product are liable for the tax – just like a sales tax, an excise tax, a Goods and Services Tax (Australia), or a Harmonized Sales Tax (Canada). Until the passage of the Sixteenth Amendment in 1913, which allowed income taxes, the United States government relied on consumption taxes for a significant portion of its revenues.
Many countries exclude VATs from investment income, limiting it to goods and services. They also typically allow a variety of exempted products for social or political reasons. Nevertheless, VATs accounted for about one-fifth of the world’s collected taxes in 2010, according to a report by TaxAnalysts.
The concept of a value-added tax was developed by Wilhelm Von Siemens in the wake of World War I. The former chairman of his family firm, Siemens, which is the largest industrial manufacturing company in Europe today, devised the tax to replace the “cascading turnover taxes,” or taxes on top of taxes. Some historians credit its development to American economist and tax expert Thomas S. Adams, who proposed it in a 1921 article in the Quarterly Journal of Economics as a substitute for corporate taxes.
While the two gentlemen may have devised the concept, Maurice Lauré, joint director of the French tax authorities, was the first to implement the tax in 1954. Slow to be adopted by industrialized countries, it spread throughout Europe as a condition to join the Economic Cooperation Union (now the European Union).
In the 1980s, large industrialized nations outside the EU – Australia, Canada, Japan, Switzerland – enacted their versions of VAT. According to a KPMG study, more than 140 countries around the globe today have value-added taxes with an average rate of 15% – the United States being the only Organisation for Economic Co-operation and Development (OECD) member without a VAT.
Enacting a value-added tax would be a significant change in U.S. tax policies. Today, the bulk of government revenues are progressive income taxes on corporations and individuals – the more you make, the more you pay. Since it applies to consumption, a value-added tax is regressive – the more you spend, the more you pay – and favors savings and investments. In the words of economist Sijbren Cnossen, the introduction of the value-added tax should be considered the most important event in the evolution of tax structure in the last half of the 20th century.
Value-added taxes foment intense feelings wherever and whenever they are considered. Many favor the tax due to its:
Others dispute the benefits of a value-added tax, claiming that it is:
With such hardened partisan positions, it’s hard to imagine the passage of a VAT today.
The CBO projects $1.7 trillion in individual income tax receipts and $320 billion in corporate income tax revenues in Budget Year 2017, with a GDP of $19.2 trillion. The country has failed to collect enough revenues to pay for its expenses for years, contributing to a national debt of $19.8 trillion as of June 1, 2017. This is especially troubling, considering the frequent warnings over the years that failure to lower the debt would have dire consequences for the country:
While senators and representatives on both sides of the aisle are increasingly pressured by their constituents to reduce the national debt, their solutions are ideologically antagonistic. Republicans advocate cutting the deficit by reducing spending, while Democrats would raise taxes, especially on corporations and the country’s wealthiest households.
Since any significant reform requires a bipartisan solution, a compromise (maintaining the status quo of taxes and expenditures) is the most likely outcome. But there may be an opportunity for both parties to further their long-range interests.
The president has publicly advocated a reduction or elimination of corporate taxes to stimulate economic growth. The CBO notes that the U.S. statutory corporate tax rate at 39.6% is the highest of the world’s 20 major economies (G20). According to economist and contributor Tyler Cowen of Bloomberg View, cutting the statutory rate to 15% “would spark investments that more than make up the cost.”
Barron’s claims that cutting the corporate tax rate would make American businesses more competitive in the global arena, reduce the massive amounts of time and energy now wasted on tax-avoidance maneuvers, and bring home trillions of dollars of profits earned by U.S. corporations overseas.
Republicans have traditionally opposed a federal VAT, fearing that, once in place, its efficiency and lack of transparency will encourage long-term government growth by “letting the camel’s nose under the tent.” At the same time, reducing the corporate tax rate would be hugely popular with their constituents.
Replacing the corporate tax with a revenue-neutral VAT may be an acceptable compromise for Republicans, since figures compiled by the Tax Foundation suggest a VAT of 2.86% would recover all of the revenues derived from corporate taxes today.
On the other hand, Democrats might agree to the substitution if sufficient exemptions or transfer payments are in place to moderate a VAT’s regressive impact on lower-earning households. An added long-term advantage is the possibility of higher VAT rates in the future. The Mercatus study showed the VAT rate had increased from the initial rate in nine of 10 major industrial countries, from an average of 9.88% to 15.97%.
House Republicans introduced a new Definition-Based Cash-Flow Tax (DBCFT) to replace the current corporate tax system. Though it has a new name, the DBCFT is essentially a VAT with an additional deduction for wages. Its net effect would be to shift from an “origin-based” tax (the corporate income tax) to a “destination-based” tax. Income tax applies to the production of goods and services, while DBCFT targets consumption of goods and services. According to the Tax Foundation, the Republican plan will:
The initial proposal calls for a 20% rate for corporations and 25% for incorporated businesses. Other aspects of the plan identified by RealClear Markets include:
As we enter into another attempt at tax reform, potentially including the adoption of a VAT-like tax, we should remember that previous efforts for a VAT have met stiff opposition. As Treasury Secretary Summers said, “When Conservatives realize that the VAT is regressive and Liberals recognize it is a money machine, there might be a chance of passage.”
The White House announced after publication of the plan that they were in the first stages of the tax reform process and were seeking input and considering several modifications. Any agreement must be bipartisan to garner the necessary vote. As a consequence, Roger Altman, a deputy Treasury Secretary in the Clinton administration, called the plan “likely dead” in a Bloomberg TV interview and estimated there was a “50-50 chance or less of a tax overhaul happening in 2017.”
If a value-added tax is passed in any form, it will undoubtedly extract more funds from American consumers, albeit indirectly. However, there is no certainty that the increased funds would be used to pay down national debt (a conservative goal) or expand government services (a conservative fear). It is also likely that the tax will supplement our tax system, rather than replace an existing tax. Calculating, reporting, and paying a value-added tax is less complicated than an income tax.
Would you favor a value-added tax? Should it replace an existing tax, such as the corporate income tax, or should it be an addition? Should any revenues from a VAT be used to reduce debt or increase social programs?
Categories: Economic Policy, Economy & Policy, Politics, Taxes
Michael R. Lewis is a retired corporate executive and entrepreneur. During his 40+ year career, Lewis created and sold ten different companies ranging from oil exploration to healthcare software. He has also been a Registered Investment Adviser with the SEC, a Principal of one of the larger management consulting firms in the country, and a Senior Vice President of the largest not-for-profit health insurer in the United States. Mike’s articles on personal investments, business management, and the economy are available on several online publications. He’s a father and grandfather, who also writes non-fiction and biographical pieces about growing up in the plains of West Texas – including The Storm.
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Will the U.S. Adopt the Value-Added Tax (VAT)? Roadblocks, Pros & Cons
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