The Value-Added Tax (VAT)

What is the VAT?

Negative Consequences of the VAT

VAT Scenarios

Possible Effects on COGD

What is the VAT?

A value-added tax, or goods and services tax (GST) is a tax levied on a firm’s added value, at each stage of production and was first introduced, although in a different form, in France in 1954. On a larger scale it was adopted by the European Communities in 1967. At that time, before introducing the VAT, European countries and the U.S. confiscated about $0.27 out of every dollar of national income. In the beginning European VAT rates averaged around 5 percent, but since then the rates have gone up significantly, averaging 18 percent. Because of the VAT European governments now seize about 41 percent of national income in taxes.

The “value added” of a company is the difference between its sales and purchases of inputs from other companies. In simpler words, the “added value” is the amount a firm contributes to a good or service by applying its factors of production.46

According to the European Commission the VAT, as applied in the European Union countries, is “a general tax that applies to all commercial activities involving the production and distribution of goods and the provision of services, [and it is] a consumption tax because it is borne by the final consumer.”47

There are three types of value-added taxes – a consumption VAT, an income VAT and a gross product VAT. Under the most widely used consumption VAT (adopted by all 29 OECD nations with a VAT), the purchase price is deducted at the time of purchase, which makes it simpler to compute the tax.

Three alternative ways of imposing a VAT exist:

credit-invoice method: “typically administered by taxing the total value of sales of all businesses, but allowing businesses to claim a credit for taxes paid on their purchases of raw material, intermediate materials, and capital goods from other businesses;”48
subtraction method: the company calculates the value added by subtracting its cost of taxed inputs from its sales, and later multiplies it by the VAT rate to get the tax liability;
addition method: a firm calculates its value added by adding all payments for untaxed inputs, and then multiplies the result by the VAT rate.

The credit-invoice VAT is also known as a European-style VAT and is the version that has been adopted by 28 out of 29 OECD countries that have a VAT. If the tax were ever to be implemented in the U.S. it would most certainly have that form.

Negative Consequences of the VAT:

There are many disadvantages and adverse effects of implementing a VAT in the U.S. First of all, taxing consumption is regressive, which means that the burden of the tax as a share of income is greater for families with lower income. The VAT is consequently one of the most regressive tax schemes, as lower-income families spend more on necessities as percentage of their income. This tax would impose a significant new tax burden on the poor.

Adding a tax on consumption would also be costly both in terms of compliance and management, as no federal general consumption tax currently exists in the U.S. New agencies or bureaus within existing agencies would have to be set up, raising the cost of an already expanding government. Companies would have to bear compliance costs of transitioning into the new tax system, as accountants would have to be re-trained. Further, firms themselves would serve as tax collectors for the government, which means that every company would have to keep records of every transaction, segregating them according to policy-makers’ instructions. A 1992 CBO report estimated that “administering the VAT would (…) cost the federal government about $750 million to $1.5 billion annually, and complying with it would (…) cost U.S. businesses about $4 billion to $7 billion annually.”49

Looking at a broader perspective, if implemented in the U.S., the VAT would expand the general cost of government significantly. Evidence from around the world shows that a VAT is likely to add to the aggregate burden. A study conducted by the Tax Policy division of the U.S. Chamber of Commerce in the 1980s found that government spending grew 45 percent faster in nations that had adopted a VAT than in those that had not. What is more, the tax burden grew almost 34 percent faster in VAT countries.50

In a theoretical world where the government acts logically and looks at the long-term effects of its actions, the VAT could replace much more economically damaging corporate and personal income taxes. However, real world evidence from VAT nations shows that when such a tax replacement or reduction was cited as an argument to switch to a VAT, not only were corporate and income taxes not eliminated, but they were in fact raised.

By taking money out of the private sector and transferring it to the government the VAT slows down the economy and destroys jobs. Furthermore, the VAT “drives a larger wedge between pre-tax income and post-tax consumption, therefore reducing incentives to engage in productive behavior.”51

What makes a VAT politically appealing for proponents of bigger government is the fact that it is essentially a hidden tax. Unlike state sales taxes in the United States, the VAT is embedded in the price of a good and most people are unaware of the tax or how high it is. This lack of awareness is also the main reason why it is easy for the governments to raise the rates.

The experience of VAT nations, especially in Europe, should teach us that introducing a VAT, equals bigger government and a slower economy, American policymakers should steer clear of the VAT fallacy.

VAT Scenarios:

In May 2009 the Washington Post reported that a VAT trial balloon was being floated by Kenneth Baer, spokesperson for Peter Orszag, the President’s Budget Director. Democrats and the White House are exploring the feasibility of using a VAT to pay for their government-controlled national health insurance scheme. Despite President’s Obama campaign promise not to raise taxes on families making less than $250,000, Mr. Baer stated: “While we do not want to rule any credible idea in or out as we discuss the way forward with Congress, the VAT tax, in particular, is popular with academics but highly controversial with policymakers.”52

This is not the first time the idea of a value-added tax has been contemplated in the U.S. However all past VAT trial balloons met with strong opposition. Such attempts, to name a few, were made in 1979, 1984, 1985, 1989, and most recently in 1993, when newly elected President Clinton explored ways to pay for a government health care plan. In 2005 President Bush’s Advisory Panel on Federal Tax Reform analyzed tax reform options, including a VAT. While not recommending a VAT alternative, it “viewed this option as worthy of further discussion.”53

In order to understand fully the effects imposition of a VAT would have, one has to look at the actual numbers. To reflect the impact of a VAT, we calculated the rates at which a VAT would have to be
set to implement certain policies.

VAT Rates Scenarios

Policies	VAT Base as percentage of GDPVIII
	40% EU Average	60% mid-point	80% academic average
Healthcare reform (~$300 billion annually)	5.34%	3.56%	2.67%
Replacement of all federal taxes (2009)	39.02%	26.01%	19.51%
Replacement of payroll tax (2009)	16.02%	10.68%	8.01%
Replacement of corporate income tax (2009)	3.24%	2.16%	1.62%
Replacement of personal income tax (2009)	17.57%	11.71%	8.79%
Fund the unfunded liabilities of Social Security and Medicare (2009-2085 average)	7.72%	5.15%	3.86%

For example, assuming the VAT was implemented to finance the Congressional Democrat healthcare reform, the minimum tax rate (with the highly unlikely 80 percent VAT base) would stand at 2.67 percent, and the maximum rate (with the most probable European style 40 percent base) would amount to 5.34 percent.

To illustrate how the VAT rate would have to rise through 2085 in order to fund the unfunded liabilities of Social Security and Medicare, we made a conservative projection, based on the data from the “2009 OASDI Trustees Report.” In these estimates we assumed the European Union average VAT base rate of 40 percent.

	Unfunded liabilities billion of $	VAT rate
2009	11.27	.20%
201	10.21	.18%
2011	4.63	.08%
2012	1.64	.03%
2013	13.88	.20%
2014	42.15	.58%
2015	53.95	.70%
2016	84.69	1.05%
2017	120.31	1.43%
2018	163.44	1.85%
2019	207.90	2.25%
2020	258.49	2.68%
2021	310.75	3.08%
2022	367.24	3.48%
2023	428.28	3.88%
2024	491.25	4.25%
2025	559.11	4.63%
2030	945.45	6.25%
2035	1,404.08	7.40%
2040	1,924.47	8.08%
2045	2,528.27	8.45%
2050	3,298.35	8.80%
2055	4,323.98	9.23%
2060	5,715.33	9.75%
2065	7,584.31	10.35%
2070	10,072.22	11.00%
2075	13,320.70	11.65%
2080	17,432.39	12.23%
2085	22,658.48	12.75%

Possible Effects on COGD:

Assuming the European-style 40 percent tax base rate, if a value added tax were imposed in order to finance healthcare reform, the 2009 COGD would move by nine days, to August 21.

If the government decided to fund the unfunded liabilities of Social Security and Medicare through a VAT, assuming the 40 percent tax base rate and the 2009-2085 average cost, the 2009 COGD would be thirteen days later and would fall on August 25.

VIII The VAT base is the portion of GDP that is liable to this taxation, which could be expressed as percentage of GDP. European Union countries VAT base averages around 40 percent. The academic average is the maximum percentage of GDP that can be reasonably taxed (e.g. excluding government expenditures), which amounts to around 80 percent. The hypothetical 60 percent VAT base is used to show a middle ground between those two.

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