0.21 Taxation and development  (Page 4/4)

Operation of the vat

Except for very small firms, all sales at all LEVELS ARE TAXABLE. Suppose the VAT rate is a uniform 19%, as in Peru. A retail clothing store collects 19% tax on all its monthly sales. Does the firm send all this 19% to the government? NO . From taxes due on its sales, the firm gets to subtract all VAT it paid on its purchases , say from clothing manufacturers or wholesalers. The firm taxes a tax credit for taxes it paid on purchases, and then remits the difference to the government. Neither the firm nor the government has to actually compute value added: tax credit mechanism works to tax only the value added by the firm. This is illustrated in the numerical example below.

To begin with, recall value added is the difference between firm’s sales and the purchases the firm made during each taxpaying period (purchases from suppliers). Under the tax credit type of VAT, the retail firm in our example does not need to actually compute value-added.

The firm merely applies the VAT it paid on its purchases from other firms against VAT due on its sales. Consider:

• T = VAT to be paid to government by the firm
• t = VAT tax rate
• S = Total sales of the retailer
• P = Purchases from suppliers
• To compute T, the firm merely uses the following relation:
• T = S(t) – P(t)
• If the VAT rate is 20%, and sales = 100 and purchases equal 60, then T = 20 – 12 = 8 TOTAL VAT due to government

Because firms would never attempt to maximize value-added, we expect lower efficiency losses from VAT. On the other hand, firms do try to maximize profits, so taxing profits can lead to adverse changes in firm’s behavior.

Again, the basic reasons that the VAT has become the predominant form of sales tax worldwide are fourfold. First, the widespread perception that a properly designed VAT can raise more revenue with lower administrative and compliance costs, than other broadly-based consumption taxes, and can do so in highly neutral fashion. And the VAT can also be more effectively enforced than other forms of indirect general consumption taxes.

The retail VAT is more neutral in its impact on private sector decision-making relative to wholesale and manufacturers level sales taxes or income taxes because it does not influence the forms or methods of doing business. Under a retail VAT, the taxes paid on any product or service is the same for one produced in the corporate or non-corporate sector, whether by capital or labor intensive methods. And the VAT, unlike the income tax has no effect on firm’s leverage.

The VAT is also clearly superior in its treatment of international trade: only under a VAT is it, in practice, possible to free all exports from tax, through zero rating of exports, and rebates on VAT previously paid on materials and capital equipment used for export items.

Finally, the VAT is best suited for implementing one of the basic aims of switching to consumption taxation: the encouragement of capital formation. This is because of the marked superiority of the VAT in freeing capital (producer) goods and exports from tax (relative to other consumer taxes).

In sum, a flat-rate VAT is perhaps one of the cleanest, most effective fiscal tools ever devised. But it is very unlikely the U.S. will adopt a VAT in the near future, for three reasons:

• Partisan groups talking past each other.

Poorly informed Conservatives believe that VAT is merely a money machine. They think that it will allow government to grow steadily larger as a percentage of GDP. This belief was widespread in 1986 in U.S. It is still found in 2014 (see WSJ article “Dangers”, Oct. 15, 2009). [MG GET REFERENCE]

In 1984 the author was a consultant to Treasury on what was called Treasury I – the study that led to the 1986 tax reform in U.S. – the so-called Reagan Reforms. My assignment was the VAT, contained in Volume 3 of Treasury 1. I was told, “Depict in detail a good workable VAT. Do it for history . We know we cannot adopt it now because of the “money machine” reputation of the VAT.”

Poorly informed Liberals distrust VAT. They mistakenly believe all consumption taxes are very regressive. They fail to understand this is not necessarily so. A properly constructed VAT can easily avoid regressivity by zero rating (i.e. exemptive) food and taxing income elastic consumption of personal services and providing rebates to low income taxpayers.

A final reason 46 states operate retail sales taxes, when consumption is the tax base. States fear federal encroachment on their most important tax base. There has been very strong opposition from this source.

Consider that on 160 other nations have adopted VAT including all European nations. They don’t believe the VAT inherently hurts poor people. They understand that it is a good clean revenue source.