What's in a VAT?
I got a note indirectly from Peter asking for clarification of the VAT that Mitch Daniels mentioned. I'll just try to clarify kinds of taxes, and will not venture into the wisdom of Daniels' flirtation with VAT save for my very last sentence.
One can tax income, or tax consumption, or some other tax base. VAT is considered by many to be a consumption tax. A true VAT taxes the value added (the VA in the name) by producers at each stage of production. Because that tends to be cumbersome administratively, we tend to use it a tax on final sales of goods and services.*
(*There are flaws with this shortcut, when for example businesses buy products on which sales tax is collected and then put them into some other product which is taxed again. This 'pyramiding' can be a big issue for a few goods, but largely is considered a secondary effect by most public finance economists. A proper VAT would avoid pyramiding.)
A pure consumption tax tries as best it can to not tax earnings on capital. That would mean a zero tax on capital gains, interest and dividends. You could instead make all contributions to savings accounts tax free, then tax withdrawals. If you tax all income including capital income, you have punished the thrifty to the benefit of the profligate -- the former will pay both taxes on labor income and on what they save, higher taxes than the fellow earning an identical labor income who never saves.
To anticipate a question, the FairTax is a form of a consumption tax; the flat tax (suggested by Peter's colleagues Robert Hall and Alvin Rabushka) is an income tax. The Fair Tax requires a higher tax rate to generate the same tax revenue than a flat tax (the latter is stated to be 19%, the former to be a rate of 23%, though some dispute that figure. Let me quickly add I am not an expert on Fair Tax, and have no interest in discussing it. Just saying it's considered a kin of the sales tax. It is not identical to VAT, nor a pure national sales tax.)
I'll close with an anecdote. VAT has been a long-standing flirtation going back at least to the 1970s. I wrote a paper on it in college. While in grad school at Claremont we had a conference on Reaganomics and Jerry Jordan, then a member of Reagan's Council of Economic Advisors, was a speaker. I drove him back to the airport and asked about VAT. He replied he liked it, but the only condition under which the administration would consider it would be if you could completely swap VAT for the income tax. He reasonably concluded that would not happen politically (remember this is when the first of the deficits after the Reagan tax cut were beginning,) so the Administration would not speak in favor of it. I read that Daniels thinks you could have VAT and a flat income tax.
Here's a nice dictionary entry on consumption taxes from which I drew some guidance.
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Dec '10
Re: What's in a VAT?
Economists are notorious for forgetting political realities.
I think that Keynes' pathetic naivete in thinking that politicians would run surpluses in good economic times is yet more evidence that his intellect is wildly overrated.
Forget the economic arguments, politicians cannot be trusted with a VAT, especially a VAT on top of an income tax.
Now, I have an idea for a tax increase that would result in, say, 15% economic growth the instant it's implemented and raise revenue to stratospheric levels:
A progressive surtax on legal fees.
Feb '10
Re: What's in a VAT?
I'm in favor of the FairTax but consider it a long shot politically. Like you mentioned, I'd only support it if it replaces the income tax permanently (as in, by a constitutional amendment). Of course, the FairTax would itself require a constitutional amendment, so I suppose the two could be combined.
There are many criticisms of it, but most are superficial and are addressed in great detail by the proponents. However, it still lends itself to easy demagoguery ("Candidate X, my opponent, supports slapping you with a 23% sales tax!" with no context of course).
My main qualm with it is the idea of the government sending a rebate check to everyone. That makes me uneasy, but I understand it is considered necessary to avoid hitting the poor too hard with the changes.
The rest, I like. Given our national lack of saving, I like that it encourages saving. I like that it encourages the re-use and re-sale of goods rather than the disposable buy-and-toss culture we have today. I like that it does not penalize capital growth, and that in spite of the scary-sounding 23%, most would end up paying less.
Feb '10
Re: What's in a VAT?
Ah-- one other thing I like about the FairTax is that it serves as a daily reminder of the cost of government. And any increase would be immediately visible to people and thus probably harder to pass. Since it's a sales tax, it's much harder or almost impossible to make it steeper on the rich, taking one of the key class-envy weapons out of the hands of the socialists.
May '10
Re: What's in a VAT?
Professor Banaian, could you discuss your view on the various administrative merits of VAT v. income tax. I've heard various people suggest VAT as harder to cheat on and/or easier to administer. I find both propositions dubious. You?
Jul '10
Re: What's in a VAT?
What I like about VAT is that it encourages saving rather than consuming. That will fit in well with reduced Social Security and Medicare entitlements.
It's not just government that has lived beyond its means in this country. Any tax reform that increases the incentive to save would be a boon.
Re: What's in a VAT?
In most VAT systems businesses have to keep every invoice (they apply tax to sales, but net out tax they pay on inputs.) Can be cumbersome; they also have refunds to be received, and processing this can lead to delays. If you had just VAT, probably no worse than the current complex income tax system. But compared to a flat tax, I think VAT would be more complicated.
On cheating, yes, that's why after the USSR broke up all those successor states wanted VAT. The problem was administration -- there, it was very very difficult to get refunds back on schedule. So it almost ended up taxing all business inputs at the VAT rate, which is highly inefficient and destroys industries that rely on two or more layers of production.
Dec '10
Re: What's in a VAT?
So it almost ended up taxing all business inputs at the VAT rate, which is highly inefficient and destroys industries that rely on two or more layers of production.
That's the killer for VAT. It punishes the production of any sufficiently complex product.
To use a standard economics analogy, consider the pencil...
Jan '11
Re: What's in a VAT?
AmishDude: So it almost ended up taxing all business inputs at the VAT rate, which is highly inefficient and destroys industries that rely on two or more layers of production.
That's the killer for VAT. It punishes the production of any sufficiently complex product.
How are the VAT rates decided? That seems to me to be the key factor in whether or not an industry or business is going to get whacked or not.
Dec '10
Re: What's in a VAT?
I start from the position that the best tax is one that everyone pays, everyone pays every purchase and everyone hates for that reason. It disabuses the population of the notion that someone else can pay for it all.
So from that point of view, a VAT is probably the best.The downside is that the party that implements it will be out of power for a generation.
In Canada we have had a VAT since the eighties. The GST started at 7%, and was lowered to 5% a few years ago. Some provinces have harmonized their provincial sales taxes with the GST. BC did it last year, and we have a 12% VAT.
It works like this: every business pays the VAT on every purchase they make, and they charge VAT on every sale they make. There are a few exceptions such as groceries and some services. The amount they pay is a credit against the amount they collect. So if you purchase something for $100, you pay $5 VAT. You process it in some way and sell it for $200, and collect $10. You then remit $10 - $5 to the government. The end consumer pays the full amount.
Dec '10
Re: What's in a VAT?
The advantages accrue to business. As a business you don't pay any VAT on anything. BC recently replaced the provincial sales tax of 7% with the HST. It is far simpler to administer than a sales tax. Now all items are taxed on purchase, and taxed on sale, the difference remitted. Any business purchase is not taxed under this scheme. Collection from other businesses is simple, since they don't pay it in the end.
The disadvantages are the cost of administration. The tracking of credits is tedious. And if your market is the end users, you are collecting an unpopular tax for the government.
To collect any substantial amount of tax requires a high rate. The 7% rate collected a bit north of $40 billion in Canada. 1/10th of the US economy. So say $400 billion collected if that rate was applied to the US. Not trivial, but considering the cost of compliance in the economy, not a huge amount. One benefit is the enhanced ability of the tax collector to collect. Although the stakes are higher for the businesses at the end of the line to not pay.
Nov '10
Re: What's in a VAT?
There is a simple definition of a VAT. It is a gigantic tape worm that lives hidden in the bowls of the national economy gradually consuming so much of what comes its way that the economy eventually dies of malnutrition. Meanwhile, government grows and grows into a hideous mutation of anything ever envisioned by the founding fathers.
May '10
Re: What's in a VAT?
The key, as Mr Jordan says, is to have one tax or the other, not all of the above. Europe is a great example of the toxicity of mixing. Here in the UK we have a top income tax rate of 50% ($240K), a 20% VAT, a gazzilion more hidden taxes (petrol is amazing!) - and yet the UK still has the dubious distinction of, up until today, beating even the USA in the fiscal irresponsibility race.
From a consumer standpoint, until recently, computers, cameras - pretty much everything cost about the same in GBP here as it does in $ there. The difference has narrowed somewhat with the crash but is moving back. End result is higher cost of living resulting (my opinion) in a lower standard of living.
Having run businesses in Spain & UK, both of which have VAT, I can say that the administrative burden of a VAT is no big deal once you set up for it.
Re: What's in a VAT?
Economically, the VAT makes sense. In effect, it is a tax on consumption -- which would encourage frugality on our part (a virtue in which we are sorely lacking). Politically, I fear that it would be a disaster -- for it is to the general public invisible, and it could be raised and raised without stirring great anger. I fear that it would be a step towards the full Europeanization of this country.
May '10
Re: What's in a VAT?
King Banaian, Guest Contributor
So it almost ended up taxing all business inputs at the VAT rate, which is highly inefficient and destroys industries that rely on two or more layers of production. · Feb 14 at 8:42pm
As a small businessman, I most fear this aspect of the VAT--it represents a huge advantage for big business over small business.
To build a room addition, say, I might pay for outside inputs from an electrician, an HVAC guy, truss builders, a cabinet maker, a plumber, an accountant--VAT charges for which, after much hassle, I may or may not get reimbursed for. A large home builder, which employs all these people directly, would have none of this VAT-related hassle and expense, giving it a competitive advantage.
A VAT would be one more juicy bone thrown by government to big business cronies.
Sep '10
Re: What's in a VAT?
I would agree that we need to strive for transpanrency so that the public has an intuitive and real feel for the level of taxation. The VAT has problems there. It sounds complex, but I can appreciate Mr. MacDonald's view above that it is not as bad as it might seem to the uninitiated. I guess I don't see the advantage of the VAT over what I consider the simpler national sales tax.
Oct '10
Re: What's in a VAT?
Is there a politician alive who would support a simple system of taxation, regardless of what basis it had? To reward your friends and punish your enemies could just as simply be expressed as reward your contributors and punish the other guys.
But... for academic argument:
The simple sales tax, consumption tax, is by far the least complicated of all. As for the so-called heavy-on-the-poor aspect, the exemption from sales tax of basics, such as anything currently covered by food stamps, plus perhaps medications, and no tax on services, makes the process simple. I have just described the sales tax of Pennsylvania in the 1950s. Simple and to the point, and it provided almost the entire income basis for that state at that time.
Constitutionally, prior to the 16th amendment, revenue sources authorized for the feral government were customs duties and excise taxes, that is, a sales tax. And, yes business can cheat the system, but a simple audit system, consuming far less resources than the IRS does, will keep all but the actually dishonest from cheating.
And, it goes without saying that nothing will ever work as long as the 16th amendment remains.
Jan '11
Re: What's in a VAT?
Under this model, I don't see how this is different than a national sales tax. The government collects $5 on $100 of sales. Then you collect $10 on the $200 sold to someone, but send $5 of that to the government, presumably for the $100 of value added. This is no different than a 5% sales tax on the final product, except that the taxes are collected from multiple levels, rather than one, and the tax is completely transparent to the consumer. This seems unavoidably more complicated, thus more expensive.
I don't get it.
Oct '10
Re: What's in a VAT?
fullfrontal
Under this model, I don't see how this is different than a national sales tax. The government collects $5 on $100 of sales. Then you collect $10 on the $200 sold to someone, but send $5 of that to the government, presumably for the $100 of value added. This is no different than a 5% sales tax on the final product, except that the taxes are collected from multiple levels, rather than one, and the tax is completely transparent to the consumer. This seems unavoidably more complicated, thus more expensive.
I don't get it. · Feb 15 at 6:19am
It's simple... it provides for a giant bureaucracy and unending paperwork. See my post above. And one other thing. The VAT is opaque, 'cant find the pea under the walnuts. The sales tax is in-your-face. You are reminded constantly what this whole scam is costing you. What other system offers that!
Dec '10
Re: What's in a VAT?
@ TeeJaw
Tapeworm? Really? Tell that to Germany, only recently narrowly surpassed by China as the biggest exporter in the world.
@ AmishDude
Your concerns do make some sense, but mostly for manufacturing operations that consolidate components they purchase into finished products. This is low-margin manufacturing that is almost completely departed overseas.
The real action for manufacturing high-margin items is the creation of those individual components that go into iPods, TVs, and even toasters. For stuff like this your concern is, I think, less acute. Although I am talking out my a$$ a little on that.
Jul '10
Re: What's in a VAT?
I see absolutely no reason to support a VAT/ national sales tax unless the 16th Amendment goes bye-bye. Otherwise it's just one more way for the National Government to wet its beak.
Repeal should happen about five minutes after Sarah Palin is elected President... of NOW. Why pitch tax proposals that require a supermajority to be an improvement?