# Presentation: 661374

## Presentation to the President's Advisory Panel on Federal Tax Reform:The Value Added Tax (VAT)

- May 11, 2005

- Charles McLure
- Senior Fellow
- Hoover Institution
- Stanford University

## Overview

- Overview of Credit-Method Value Added Tax (“VAT”)
- Comparison of Credit-Method VAT, Subtraction-Method Business Transfer Tax (“BTT”), and Retail Sales Tax (“RST”)
- Exempting and Zero-Rating under VAT, BTT, and RST
- Taxation of Financial Services under a Credit-Method VAT
- International Issues
- Subtraction-Method BTT:  Additional Considerations
- What Liberals and Conservatives Fear – or Like – about the VAT

## Overview

- Appendix
- Implications of three ways of implementing indirect consumption taxes
- Extended evaluation of direct and indirect forms of consumption taxes
- Subtraction-Method BTT:  Additional considerations
- Coordinating state and local RSTs with a federal VAT

## Credit-Method Value Added Tax (“VAT”)

- Credit-Method VAT is an indirect tax on consumption
- Indirect taxes cannot be personalized for circumstances of purchasers
- Flat Tax and Consumed Income Tax are direct consumption taxes
- They can be personalized via exemptions, deductions, and graduated rates

## Credit-Method Value Added Tax (“VAT”)

- Credit-Method VAT is the most commonly used tax on consumption
- Levied by approximately 150 countries worldwide, including all 25 members of the European Union (“EU”)
- VAT has administrative and political advantages over other indirect consumption taxes, such as:
- Subtraction-Method VAT
- Business Transfer Tax (“Subtraction-Method BTT”)
- Japan is only OECD country to use Subtraction-Method VAT
- Retail Sales Tax (“RST”)
- Levied by 46 U.S. states, including the District of Columbia, and 9 Canadian provinces
- Not levied in any other major developed country

## Three Forms of Indirect Tax on Consumption:An Illustration

- (Tax rate = 10%)

| Economic activity | Farmer | Miller | Baker | Total |
| --- | --- | --- | --- | --- |
| Basic transactions |  |  |  |  |
| 1.  Sales | $ 300 | $ 700 | $ 1,000 |  |
| 2. Purchases | $ 0 | $ 300 | $ 700 |  |
| 3. Value added (sales - purchases) | $ 300  | $ 400 | $ 300  | $ 1,000 |
| Subtraction-Method Business Transfer Tax (BTT) |  |  |  |  |
| 4. Business Transfer Tax 
    (10% of line 3) | $ 30 | $ 40 | $ 30 | $ 100 |
| Credit-Method VAT (VAT) |  |  |  |  |
| 5. Tax on sales (10% of line 1) | $ 30 | $ 70 | $ 100 |  |
| 6. Less:  input tax on purchases | $ 0 | $ 30 | $ 70 |  |
| 7. Net VAT liability | $ 30 | $ 40 | $ 30 | $ 100 |
| Retail Sales Tax (RST) |  |  |  |  |
| 8. Retail Sales Tax | Exempt | Exempt | $ 100 | $ 100  |

## Three Forms of Indirect Tax on Consumption:An Illustration

- (Tax rate = 10%)

| Economic activity | Farmer | Miller | Baker | Total |
| --- | --- | --- | --- | --- |
| Basic transactions |  |  |  |  |
| 1.  Sales | $ 300 | $ 700 | $ 1,000 |  |
| 2. Purchases | $ 0 | $ 300 | $ 700 |  |
| 3. Value added (sales - purchases) | $ 300  | $ 400 | $ 300  | $ 1,000 |
| Subtraction-Method Business Transfer Tax (BTT) |  |  |  |  |
| 4. Business Transfer Tax 
    (10% of line 3) | $ 30 | $ 40 | $ 30 | $ 100 |
| Credit-Method VAT (VAT) |  |  |  |  |
| 5. Tax on sales (10% of line 1) | $ 30 | $ 70 | $ 100 |  |
| 6. Less:  input tax on purchases | $ 0 | $ 30 | $ 70 |  |
| 7. Net VAT liability | $ 30 | $ 40 | $ 30 | $ 100 |
| Retail Sales Tax (RST) |  |  |  |  |
| 8. Retail Sales Tax | Exempt | Exempt | $ 100 | $ 100  |

- In their pure forms, BTT, VAT, and RST have identical effect:  taxation of consumption
- VAT and RST are “transactions-based” taxes:  they are levied on each sale
- BTT is an “accounts-based” tax:  it is not/cannot be levied on each sale
- BTT taxes “slices” of value added (sales minus purchases)
- Under RST, tax collector gets only “one bite at the apple,” at the last stage
- Under BTT and VAT much of tax is collected before the last stage
- Under VAT invoices showing tax paid must support input credits

- See appendix slide 21 for further discussion.

## Three Features of the Standard VAT

- Credit-Method
- Businesses are allowed ***input credits*** for VAT shown on invoices
***Immediate credit*** for all tax on business purchases, including capital goods
- Required for consumption tax
- Simpler (no need for complicated “timing” rules for depreciation, etc.)
- “Destination” treatment of foreign trade, due to ***“border tax adjustments”***
- Imports are subject to VAT (with input credit for registered businesses)
- Imports are treated like domestic production
- Exports are zero-rated
- Exports enter world markets tax-free

## Credit-Method VAT: Exempting and Zero-Rating of Last Stage

- (Tax Rate = 10%)

- Input credits are allowed for zero-rated sales, but not for exempt sales
- Exemption of last stage eliminates tax only on value added at that stage
- Zero-rating of last stage eliminates tax on entire value of sales at all stages through credits at last stage
- Zero-rating is common for **exports**

| Economic activity | Farmer | Miller | Baker | Total |
| --- | --- | --- | --- | --- |
| Basic transactions |  |  |  |  |
| 1. Sales | $ 300 | $ 700 | $ 1,000 |  |
| 2. Purchases | $ 0 | $ 300 | $ 700 |  |
| 3. Value added  (sales – purchases) | $ 300  | $ 400 | $ 300  |  $ 1,000 |
| Exemption of Last Stage (Baker) |  |  |  |  |
| 4. Tax on sales (10% of line 1) | $ 30 | $ 70 | Exempt |  |
| 5. Less: input tax on purchases | $ 0 | $ 30 | $ 0 |  |
| 6. Net VAT liability | $ 30 | $ 40 | $ 0 | $ 70 |
| Zero-Rating of Last Stage |  |  |  |  |
| 7. Tax on sales (10% of line 1) | $ 30 | $ 70 | $ 0 |  |
| 8. Less: input tax on purchases | $ 0 | $ 30 | $ 70 |  |
| 9. Net VAT liability | $ 30 | $ 40 | - $ 70  | $ 0 |

## Credit-Method VAT: Exempting and Zero-Rating of Intermediate Stage

| Economic activity | Farmer | Miller | Baker | Total |
| --- | --- | --- | --- | --- |
| Basic transactions |  |  |  |  |
| 1. Sales | $ 300 | $ 700 | $ 1,000 |  |
| 2. Purchases | $ 0 | $ 300 | $ 700 |  |
| 3. Value added  (sales – purchases) | $ 300  | $ 400 | $ 300  |  $ 1,000 |
| Exemption of Intermediate Stage  |  |  |  |  |
| 4. Tax on sales (10% of line 1) | $ 30 | Exempt | $100 |  |
| 5. Less: input tax on purchases | $ 0 | $ 0 | $ 0 |  |
| 6. Net VAT liability | $ 30 | $ 0 | $ 100 | $ 130 |
| Zero-Rating of Intermediate Stage |  |  |  |  |
| 7. Tax on sales (10% of line 1) | $ 30 | $ 0 | $ 100 |  |
| 8. Less: input tax on purchases | $ 0 | $ 30 | $ 0 |  |
| 9. Net VAT liability | $ 30 | -$ 30 |  $ 100  | $ 100 |

- (Tax Rate = 10%)

- Zero-rating of intermediate stage has no effect on ultimate tax liability (Zero-rating produces lower input credits)
- Exemption of intermediate stage breaks chain of credits and ***increases*** tax (Neither exempt seller nor customer is allowed input credit for VAT paid by exempt seller)
- Exemption creates “cascading” of tax, incentives for self-supply, and other economic distortions; zero-rating does not
- Producers of intermediate stage goods and services do not want to be exempt; this is politically important

## Credit-Method VAT: Summary of Effects of Exemption and Zero-Rating

|  | Stage of production/distribution process |  |
| --- | --- | --- |
|  | Intermediate stage | Last stage |
| Exemption | Breaks chain of input credits; increases tax

Cascading tax and distortions
 | Only value added at final
stage is untaxed |
| Zero-rating | No effect | Entire value of sale is
untaxed |

## Choosing between Exemption and Zero-rating

- Administrative differences
- Exemption requires allocation of input taxes; zero-rating does not
- Depends on the purpose
- Zero-rating selected final sales eliminates tax; exemption does not
- Exempting intermediate sales increases tax; zero-rating does not
- Exports:  only zero-rating eliminates tax at pre-export stages
- Reducing regressivity (not an optimal way to do this, given EITC, etc.)
- Avoiding taxation of (non-commercial) activities of non-profit organizations
- Small business (for administrative business; probably not needed in US)
- Zero-rating does not eliminate administrative burden; exemption does
- Exemption increases taxation, except at final stage
- Make registration and normal treatment optional
- Financial institutions:  discussed in detail later

## Exemption and Zero-Rating of Last Stage Under BTT, VAT, and RST

| Economic activity | Farmer | Miller | Baker | Total |
| --- | --- | --- | --- | --- |
| 1. Sales | $ 300 | $ 700 | $ 1,000 |  |
| 2. Purchases | $ 0 | $ 300 | $ 700 |  |
| 3. Value added  (sales – purchases) | $ 300  | $ 400 | $ 300  |  $ 1,000 |
| Subtraction-Method Business Transfer Tax (BTT) |  |  |  |  |
| 4. Business Transfer Tax    
 (10% of value added in line 3) | $ 30 | $ 40 | Exempt | $ 70 |
| Credit-Method VAT:  Exemption |  |  |  |  |
| 5. Tax on sales (10% of in line 1) | $ 30 | $ 70 | Exempt |  |
| 6. Less: input tax on purchases | $ 0 |  $30 | $ 0 |  |
| 7. Net VAT liability | $ 30 |  $40 | $ 0 | $ 70 |
| Credit-Method VAT:  Zero-Rating |  |  |  |  |
| 8. Tax on sales (10% of line 1) | $ 30 | $ 70 | $ 0 |  |
| 9. Less: input tax on purchases | $ 0 | $ 30 | $ 70 |  |
| 10. Net VAT liability | $ 30 | $ 40 | - $ 70  | $ 0 |
| Retail Sales Tax |  |  |  |  |
| 11. Retail Sales Tax | Exempt | Exempt | Exempt | $ 0  |

- Exemption of last stage under VAT or BTT eliminates tax only on value added at last stage
- Zero-rating of last stage under VAT eliminates tax on entire sales price, like a retail sales tax exemption

- (Tax Rate = 10%)

## Effects of Exemption of Intermediate Stage under VAT and BTT

| Economic activity | Farmer | Miller | Baker | Total |
| --- | --- | --- | --- | --- |
| 1. Sales | $ 300 | $ 700 | $ 1,000 |  |
| 2. Purchases | $ 0 | $ 300 | $ 700 |  |
| 3. Value added (sales – purchases) | $ 300  | $ 400 | $ 300  |  $ 1,000 |
| Subtraction-Method Business Transfer Tax (BTT) |  |  |  |  |
| Business Transfer Tax
  (10% of value added in line 3) | $ 30 | Exempt | $ 30 | $ 60 |
| Credit-Method VAT |  |  |  |  |
| Tax on sales (10% of line 1) | $ 30 | Exempt | $100 |  |
| Less: input tax on purchases | $ 0 | $ 0 | $ 0 |  |
| Net VAT liability | $ 30 | $ 0 | $ 100 | $ 130 |

- (Tax Rate = 10%)

- Subtraction-Method BTT:  exemption of intermediate stage ***reduces ***tax
- politically vulnerable to requests for exemptions
- Credit-Method VAT:  exemption of intermediate stage *** increases***** **tax
- much less vulnerable:  intermediate stages do not want to be exempt

## Taxation of Financial Services under a Credit-Method VAT

|  | Business Customers | Households |
| --- | --- | --- |
| Conceptually correct tax treatment | Taxation or zero-rating 
(Tax would not ultimately matter) | Taxation |
| Other Alternatives |  |  |
| Normal taxation | Infeasible:  There are no transactions to tax |  |
| Exemption | Break in chain of credits, producing
       Over-taxation
       Cascading
       Incentive for self-supply | Under-taxation
No taxation of value added by financial institutions |
|  | Relatively simple:  Requires only allocation of input credits between exempt financial services and taxable non-financial services |  |
| Zero-rating | Conceptually correct tax treatment | Greater under-taxation
No taxation of financial services |
|  | Simplest:  Requires no allocation of input credits |  |
| HYBRID:
Business services zero-rated;
Consumer services exempt | Conceptually correct tax treatment | Under-taxation
No taxation of value added by financial institutions |
|  | More complicated:  Requires allocation of input credits between zero-rated financial services provided to businesses and exempt financial services provided to households, as well as between financial services and taxable non-financial services |  |

## International Issues

- Border Tax Adjustments are relatively simple under VAT
- Verify exports; valuation is not required (because zero-rated)
- Valuation of imports is important only for purchases by households
- Undervaluation of business imports yields lower credits
- Using a VAT to *lower* income tax rates would have international repercussions
- Destination-based VAT would, per se, be neutral
- More excess foreign tax credits:
- US income tax would have effects more like territorial tax
- Investment in US might be encouraged
- Pressures on foreign countries to lower income tax rates
- Using a VAT (or a BTT or an RST) to *replace* the corporate income tax would cause massive international disruptions

## Evaluation:  Direct and Indirect Forms of Consumption Taxes 

| 

Form of consumption tax | 
Total replacement for federal income taxes | Partial replacement for federal income taxes/additional source of federal revenue |
| --- | --- | --- |
| Direct tax
    Consumed Income Tax
    Flat Tax | Possibly | No |
| Transactions-based indirect taxes
    Credit-Method VAT
    Retail Sales Tax  | 

No
No | 

Possibly 
Probably not |
| Accounts-based indirect tax
   Subtraction-Method BTT | No | No |

- See appendix slide 22 for further discussion.

## Subtraction-Method BTT:  Summary of Additional Considerations

- Difficult to allow deductions only for purchases that have been subject to BTT
- Accurate Border Tax Adjustments (BTAs) are not simple if not all pre-export stages are taxed
- BTT does not – or should not – accommodate multiple rates

- See appendix slides 23 and 24 for further discussion.

## What Liberals and Conservatives Fear – or Like – about the VAT

- “The VAT is regressive” (burdening the poor relatively more than the affluent)
- Exemption (or zero-rating) of necessities is not the solution
- Exemptions do not have much effect on the distribution of income
- Higher VAT rate would be required
- Exemptions complicate administration and distort choices
- There are other ways to reduce the burden on the poor (e.g., EITC)
- Everyone should help pay for government in a democracy
- “The VAT is a ‘money machine’” (that leads to bigger government)
- Governments in the European Union spend more than those in the US
- But they spent more before the switch from inferior sales taxes to VAT
- Not clear whether there is an upward trend in the size of governments because of a VAT
- Less constraint on spending if necessities are exempt or zero-rated
- Indexing (of Social Security, EITC, welfare, etc.) to reflect VAT would reduce restraint

## Appendix

## Implications of Three Ways of Implementing Indirect Consumption Taxes

| Subtraction-Method BTT | Credit-method VAT | Retail Sales Tax |
| --- | --- | --- |
| Key Feature |  |  |
| Business purchases are
deductible | Taxes on business purchases are creditable | Business purchases are
exempt |
| Revenue Implications |  |  |
| Benefits of paying no tax
on any slice of value added
   Exemptions (base erosion)
   Evasion | No benefit to not paying tax before the last stage
Exemption (or evasion) at last stage loses only tax on value added at that stage
Only zero-rating at retail level eliminates tax
Exemption at prior stage raises total tax | Benefits of paying no tax
   Exemptions (base erosion)
   Evasion |
| Key Effect |  |  |
| Taxes “slices” of value added | Most revenue collected before the last stage
Taxes paid before the last stage “wash out” in credits
Only tax at last stage matters | One “bite at the apple” (at the
retail stage) |
| Political Implications |  |  |
| Highly vulnerable to base erosion | Relatively invulnerable to base erosion | Highly vulnerable to base
erosion |

## Extended Evaluation:  Direct and Indirect Forms of Consumption Taxes

| Form of consumption tax | Total replacement for federal income taxes | Partial replacement of federal income taxes/additional source of revenue |
| --- | --- | --- |
| Direct consumption-based tax
   Consumed Income Tax
   Flat tax | Possibly
More friendly to saving
Possibly simpler
Raises international issues
Transition rules | No
Two sets of rules for “income” taxes |
| Transactions-based indirect tax
   Credit-method  VAT
   Retail Sales Tax | No
Tax rates so high (30-40+%) RST would not be administrable; VAT might not be
No simplification: State income taxes would remain
Tax rates even higher (well above 40%) with no state income taxes
Massive international disruptions
EITC eliminated.  Would it be replaced elsewhere? | Possibly
Would allow lower income tax rates
Would reduce some (not all) distortions
Would leave income tax, with its complexity, in place
VAT/RST compliance is not simple
Could facilitate improvement of state and local sales taxes
Would “poach” on state and local fiscal preserve |
| Accounts-based indirect tax
   Subtraction-
   Method BTT | No
No simplification: State income taxes would remain
EITC eliminated.  Would it be replaced elsewhere?
Highly vulnerable to base erosion | No
Would leave income tax, with its complexity, in place 
Two sets of rules for similar taxes
Would allow lower income tax rates
Vulnerable to base erosion and thus distortion
Would not facilitate improvement of state and local sales taxes
Would (less obviously) “poach” on state and local fiscal preserve |

## Subtraction-Method BTT:  Additional Considerations

- Border Tax Adjustments (BTAs) are not simple
- Incentive to overvalue imports
- Treatment of exports
- Exempt only value added at export stage?
- Incentive to shift activities to “export” stage
- Incentive to undervalue exports
- Would not eliminate BTT on exports
- Eliminate all BTT on exports (as under Credit-Method VAT)
- Calculation of tax base: zero minus purchases
- What if not all pre-export activity has been taxed?

## Subtraction-Method BTT:  Additional Considerations

- BTT does not – or should not – accommodate multiple rates
- Invitation for lobbyists to gain low rates
- Manipulation of transfer prices to shift income to low-tax activities
- Accurate BTAs (eliminating all tax) are impossible
- How much tax has been paid before the export stage?
- How much tax has been paid on competing domestic products?
- Deductions could, in theory, be allowed only for purchases from suppliers subject to BTT
- Difficult to implement under accounts-based BTT
- To be effective it would need to mimic credit-method VAT
- Invitation for lobbyists to gain exceptions
- Problems of multiple rates and BTAs remain

## Coordinating State and Local RSTs with a Federal VAT

- Four defects of state and local (S&L) RSTs
- Many products (especially services) are untaxed
- Many business purchases are taxed
- Incredible complexity, due in part to lack of uniformity
- Many interstate sales to households are untaxed
- US Supreme Court’s decision in *Quill*, based on complexity
- Potential benefits of coordinating S&L RSTs with federal VAT
- More likely to tax services (taxed under VAT)
- More likely to exempt business purchases (input credits under VAT)
- Coordination could reduce complexity (greater uniformity of tax base and administration)
- Federal legislation could override *Quill* (not needed with uniformity)

## Coordinating State and Local RSTs with a Federal VAT

- S&L counter-arguments
- 	Federal VAT would “pre-empt” traditional S&L tax base
- 	Coordination reduces state sovereignty over tax base and administration
- S&L governments would retain sovereignty over tax rates
- Sovereignty over base and administrative details is much less important
- States have not acted responsibly:  lack of uniformity