November 25, 2015

A Primer on the Value-Added Tax

As concern about long-term federal deficits and debt mounts, some policy experts in Washington have been discussing the possibility of a value-added tax, or “VAT.” Some envision it as a replacement for current taxes while others favor it as an add-on to raise additional revenue. Although Congress is not actively considering a VAT and The Concord Coalition has not taken a position on it, Concord maintains that all policy options should remain on the table. Thus this article offers a brief look at the value-added tax.

I. What Is the Value-Added Tax and How Does It Work?

The VAT is similar to other consumption taxes such as the sales tax. Consumption taxes generate revenue by taxing purchases of goods and services—in contrast to taxes on income or wealth, for example. Although Americans are well acquainted with the retail sales tax because it is often used at the state and local level, the VAT is an unfamiliar concept for most. Among developed countries, the United States is unusual for not using a value-added tax.

Despite some fundamental similarities with the sales tax, the VAT has a substantially different collection process. Businesses collect a retail sales tax when a consumer purchases a good or service. The value-added tax, however, is collected on the value a business adds to a product at each stage of the production process.

For example, a 10 percent retail sales tax on a new computer priced at $1,000 would generate $100 in revenues when the consumer purchases the computer. In contrast, a 10 percent value-added tax would partly be collected before the consumer’s purchase.

Assume a simple three-stage production process. Each of the three companies involved in that process would remit 10 percent of the value that it adds to the product. If the three companies include (1) a computer chip manufacturer; (2) an assembly plant; and (3) a retail computer store, the process would look something like this:

1. The computer chip manufacturer produces a $100 chip.

  • The value added is $100. The company pays 10 percent ($10) in taxes to the government.

2. The assembly plant manufactures the computer and sells it to the retailer for $500.

  • The value-added is $400 ($500 minus the $100 already added). The assembly plant remits 10 percent of $400 ($40) in taxes to the government.

3. The retailer sells the computer to the consumer for $1,000.

  • The value-added by the retailer is $500 ($1,000 minus the $500 in value added previously). The retailer pays 10 percent of $500 ($50) in taxes. The consumer pays the same amount as under a retail sales tax ($1,000).

II. Pros and Cons of a Value-Added Tax

Why do some governments use a VAT if the end results are the same as with a retail sales tax?

First, the VAT is a more efficient way to raise revenues than a retail sales tax. Because tax revenue is collected in many stages under the VAT, less revenue is lost from tax evasion. Companies involved in the production process have an incentive to ensure they are dealing with companies that abide by the rules. Otherwise, some companies could end up paying taxes that should have been paid by others earlier in the production process.

Second, a value-added tax gives people an incentive to save. Consumption taxes increase the cost of goods and services, and thus encourage personal savings and investment — which in the long run can encourage growth and benefit the economy.

Several caveats should be noted about a value-added tax, however.

Consumption-based taxes raise concerns about regressivity. Because low-income households consume a larger proportion of their incomes than high-income households do, taxing consumption is often considered “regressive” and unfair. Taxing income or wealth, on the other hand, is considered “progressive” because tax rates can be adjusted according to a household’s income. Apprehension about the fairness of a VAT means Congress would likely exempt certain goods and services that are deemed to be necessities. But defining what a “necessity” is can be tricky, and exempting some items from the tax diminishes the tax base.

The broader the tax base, the lower the overall tax rate needed to generate a certain amount of revenue. The opposite is also true: The more exemptions and deductions, the higher the overall tax rate will need to be. Some advocates of the VAT suppose that it would tax all consumption, making it appear very attractive in comparison to the federal income tax system with its litany of exemptions, deductions, and credits.

But just as they do now with the income tax, special interest groups would pressure lawmakers to approve questionable exemptions to a VAT. Judging from their past performance, lawmakers would be likely to approve many such exemptions, substantially narrowing the tax base – and reducing tax revenues.

The administrative costs of implementing a VAT also raise concerns. Although a VAT is efficient from the government’s perspective, many businesses would face extra record-keeping and potential audits by tax officials. Because businesses in the United States are unfamiliar with administering the VAT, it would be initially more difficult to implement than a federal sales tax.

While liberals worry about regressivity, many conservatives object to any new taxes and fear that the VAT would be so successful at generating new revenues that it would facilitate dramatic increases in government spending. They also note there is no guarantee that VAT revenue would be used for deficit and debt reduction.

Finally, a national value-added tax would probably face opposition from states and local governments that rely on consumption taxes as their major source of revenue. A national VAT could increase public resistance to state and local sales taxes, or at least to increasing them.

In short, although a federal value-added tax could have some fiscal and economic benefits, it would also carry risks, and the political feasibility of such a tax is uncertain.