re 

Volume 3 Value-Added Tax 

Office of- the Secretary 

Department of the Treasury November '1984 
TABLE OF CONTENTS 

Volume Three 

Chapter 1: INTRODUCTION 

Chapter 2: THE NATURE OF THE VALUE-ADDED TAX 

I. Introduction 

TI. Alternative Forms of Tax 

A. Gross Product Type 

B. Income Type 

C. Consumption Type 

111. Alternative Methods of Calculation: Subtraction, 

IV. 

V. 

VI. 

Chapter 

I. 

11. 

Credit, Addition 

A. Subtraction Method 

8. Credit Method 

C. Addition Method 

D. Analysis and Summary 

Border Tax Adjustments 

Value-Added Tax versus Retail Sales Tax 

Summary 

- 3: EVALUATION OF A VALUE-ADDED TAX 

Introduction 

Economic Effects 

A. Neutrality 

B. saving 

C. Equity 

D. Prices 

E. Balance of Trade 

A. Growth of Government 

B. Impact on Income Tax 

C. State-Local Tax Base 

III. Political Concerns 

Iv. European Adoption and Experience 

Chapter 4: ALTERNATIVE TYPES OF SALES TAXATION 

I. Introduction 

11. Analytic Framework 

A. Consumption Neutrality 

E. Production and Distribution Neutrality 

111. Value-Added Tax 

IV. Retail Sales Tax 

VI. Personal Exemption Value-Added Tax 

V. Manufacturers and Other Pre-retail Taxes 

VII. Summary 

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Chapter 5: MAJOR DESIGN ISSUES 

A. Commodities 

B. Transactions 

C. Firms 

D. Consequences of zero Rating or Exemption 

E. Tax Credit versus Subtraction Method 

A. Adjustment of Government Transfer Payments 

B. Zero Rating of Food and Other Necessities 

C. Provision of a Refundable Credit 

D. Personal Exemption Value-Added Tax 

I. Introduction 

11. Zero Rating versus Exemption 

111. The Issue of Regressivity 

IV. Single versus Multiple Rates 

V. Foreign Transactions 

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Chapter 

I. 

11. 

111. 

IV. 

V. 

VI. 

VII. 

- 6: IMPLEMENTATING A VALUE-ADDED TAX IN 

CERTAIN INDUSTRIES AND ACTIVITIES 

Introduction 

Taxation of Services 

A. Services Clearly Suitable for Taxation 

B. Financial Services 

C. Governmental Activities for Which No Charge is Ma 

D. Services that Cannot Effectively Be Taxed for 

E. Problems in the Transportation Field 

F. Services Involving Significant Social Policy 

G. Summary 

Taxation of Small Enterprises and Farmers 

A. Small Businesses 

B. Farmers and Value-Added Taxes 

Governments and Not-for-Profit Institutions 

A. Governmental Units 

B. Taxation of Nonprofit Institutions 

Housing and Construction 

A. Housing: Homeowner versus Tenant 

B. Commercial (Nonhousing) Construction 

c. European Experience 

D. Summary 

Taxation of Used Durable Goods 

A. Consumption Goods 

B. Sales of Used Business Assets 

Tax Treatment of Fringe Benefits 

A. Forms of Fringe Benefits 

B. summary 

iv 

Administrative Reasons 

Considerations 

.de 

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Chapter 7: VALUE-ADDED TAX BASE 

Chapter 8: DISTRIBUTIONAL EFFECTS OF THE VALUE-ADDED TAX 

I. Introduction 

11. Some Underlying Assumptions 

111. The Alternative Solutions 

A. Adjustments in Transfer Payments 

B. Zero Rating of "Necessities" 

C. Reimbursement for Value-Added Tax 

D. Personal Exemption Value-Added Tax 

IV. Summary 

Chapter 9: ADMINISTRATION OF A VALUE-ADDED TAX 

I. Introduction 

11. 

111. 

IV. 

V. 

VI. 

VII. 

VIII. 

IX. 

X. 

General Information 

Recordkeeping 

Filing of Returns and Payment of Taxes 

Imports 

Enforcement 

A. Examination 

B. Collection 

C. Criminal Investigation 

D. Appeals Procedures 

Pub1 i c Education St rategy 

Returns Processing 

Data Processing Activities 

Cost Estimates 

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XI. Summary 124 

Appendix 9-A: Form 6400 Federal Value-Added Tax (VAT) Return 125 

Appendix 9-B: Estimated Staffing and Annual Cost ,128 

V 
Page 

TABLES 

2-1 

2-2 

3-1 

3-2 

6-1 

6-2 

6-3 

6-4 

7-1 

8-1 

8-2 

8-3 

8-4 

9-1 

9-2 

Comparison of Three Methods of Calculating 

Value-Added Tax Liability 9 

Comparison of Value-Added and Retail Sales Tax 15 

Federal, State, and Local Tax Revenue for Selected 

Countries as Percent of Gross Domestic Product, by 

Taxes on Goods and Services as a Percentage of Total 

Taxes and Value-Added Taxes as a Percentage of Total 

Taxes, 1967-1982 25 

Exemptions of Small Firms from Sales Taxes, Based on 

Sales Volume 59 

Distribution of 1979 Nonfarm Sole Proprietorship Returns, 

1980 Partnership Returns, and Amounts of Business Income 

by Gross Business Receipts Class 60 

Farm Enterprises: Proprietorships, Partnerships, and 

Corporations. Number and Business Receipts by Size of 

Receipts 63 

Illustrative Treatment of Farmers Under a 10 percent 

Value-Added Tax 66 

Estimate of Value-Added Tax Base 86 

Distribution of Value-Added Tax Burden: Broad-Based Tax 

Type of Tax, 1982 24 

and the Effect of Indexing Transfer Payments 93 

Distribution of Value-Added Tax Burden: Broad-Based Tax 

and the Effect of Zero Rating Food and Other Expenditures 96 

Distribution of Value-Added Tax Burden: Broad-Based Tax 

and the Effect of Income-Based Credits 107 

Distribution of Value-Added Tax Alternatives as a 

Fraction of Economic Income by Income Class 111 

Taxpayer Compliance Levels: Individual and Corporate 

Selected Years, 1976-1981 118 

Audit Coverage and Staffing for Value-Added Tax 

by Categories of Taxpayers 120 
Page 

FIGURES 

8-1 Effect of Indexing Transfer Payments on the 

8-2 Effect of Zero Rating Food and Other Expenditures 

8-3 Comparison of Tax Burden Resulting from 

8-4 Effect of Income Based Credits on the 

Distribution of Value-Added Tax Burden 

on the Distribution of Value-Added Tax Burden 

Broad- and Narrow-Based Value-Added Taxes 

Distribution of Value-Added Tax Burden 

94 

97 

101 

108 

ix 
Chapter 1 

INTRODUCTION 

Many observers of the American fiscal scene believe that the 

Federal government should introduce a national sales tax. At the very 

least, a national sales tax could be used to take pressure off the 

income tax; that is, it would allow lower income tax rates and these, 

in turn, would cause less disincentives to work, save, invest productively, and innovate. In addition, a shift in the mix of taxation 

toward more reliance on taxes on consumption, rather than income, 

would reduce further the discrimination against saving found in 

current law. Some advocates of a national sales tax see it as a means 

of reducing the Federal deficit and its drain on the supply of 

national saving. 

Despite the potential advantages of a national sales tax, the 

Treasury Department does not recommend that such a tax be adopted at 

this time. A national sales tax has disadvantages, as well as advantages; though these are not previewed here, they are discussed at 

length in Chapter 3. The most compelling reason for not proposing a 

national sales tax results from the context in which the Treasury 

Department conducted its review of the tax system. 

As noted in Chapter 2 of Volume 1, Overview, the Treasury 

Department proposals are revenue neutral. This implies that any 

revenue obtained from a national sales tax would be used solely to 

reduce the income tax. Thus one must ask whether reducing pressure on 

the income tax would justify introduction of a whole new source of 

Federal revenue. The Treasury Department estimates that the process 

of introducing a Federal value-added tax would take roughly 18 months 

from the date of enactment. Thus, for example, even if a value-added 

tax were passed by Congress in mid 1986, it could not have an effective date before January 1, 1988. When fully'in force, a value-added 

tax would require 20,000 additional personnel and cost about $700 

million to enforce. The Treasury Department has concluded that the 

advantages of a national sales tax are not sufficient to justify this 

level of expenditure merely to reduce reliance on the income tax. 

This volume considers in greater detail the issues involved in 

deciding whether or not the United States should adopt a national 

sales tax. A value-added tax is the type of sales tax that would be 

most appropriate for use at the Federal level, if a decision were ever 

made in favor of a national sales tax. This volume therefore concentrates on the description and evaluation of a value-added tax from an 

economic and administrative perspective. But it also discusses 

briefly other types of sales taxes. 

Value added can be conveniently thought of as the difference between a 

firm's sales and its purchases from other firms. A value-added tax is 

Chapter 2 provides a basic description of a value-added tax. 
-2- 

a multistage sales tax levied at each point or stage in the 

production-distribution process. The retail value or price of a 

product is equal to the total of the values added at each of these 

stages. Thus, a value-added tax that includes the retail level would 

have the same aggregate tax base and raise the same amount of revenue 

as a retail sales tax, assuming the two taxes apply to the same goods 

and services and are imposed at the same rate of tax. 

methods for calculating tax liability, the only form suitable for the 

United States would be a consumption-type value-added tax with tax 

liability determined under the credit method. This means that purchases of capital equipment would, in effect, be deductible in full in 

the year they are made and that a firm would calculate its tax liability by subtracting value-added tax paid on its purchases from other 

firms from the tax due on its sales. 

Chapter 3 evaluates the economic effects and political concerns 

that would be associated with a value-added tax. A value-added tax 

would have several advantages, including neutrality toward saving, 

capital formation, production techniques, and consumption decisions. 

But it also would have several disadvantages: regressivity, a onetime increase in prices, Federal intrusion into the sales tax area, 

significant administration and compliance costs, and the possibility 

of greater public expenditures. 

Chapter 4 evaluates several alternatives to a value-added tax: a 

retail sales tax, manufacturers and wholesale sales taxes, and a personal exemption value-added tax. Only a value-added tax or a retail 

sales tax would be basically neutral with respect to consumption and 

production decisions. That is, a properly designed tax of either type 

would riot seriously distort the consumption behavior of individuals 

nor the production techniques and methods of business firms. In 

contrast, any pre-retail tax, such as a manufacturers or wholesale 

sales tax, would badly distort both consumption and production 

behavior. The result would be reduced consumer satisfaction and less 

tax revenue at a given rate. Pre-retail taxes also create substantial 

administrative problems that would not be present with either a retail 

sales or value-added tax. Though a retail sales tax and a value-added 

tax are similar, there may be both administrative and economic reasons 

for favoring a value-added tax, if a national sales tax is desired. 

have to be resolved before a value-added tax could be implemented. 

These include: the distinction and choice between zero rating and 

exemption, which are two alternatives for providing differential tax 

treatment to selected commodities, transactions, or firms; the methods 

for reducing regressivity and the absolute burden of the tax on the 

poor; the choice between single or multiple rates of tax; and the tax 

treatment of exports and imports. 

While there are different forms of value-added tax and alternative 

Chapter 5 discusses a number of specific design issues that would 
-3- 

A fundamental characteristic of a value-added tax is that it 

functions most effectively if it is applied uniformly throughout the 

entire economy. Yet, implementation of this rule may not be possible 

for some forms of activity. Chapter 6 discusses a number of problem 

areas in which strict application of a value-added tax may be either 

difficult or inadvisable. These include some services, small business, farming, governmental entities and nonprofit organizations, 

housing, used goods, and fringe benefits. 

Chapter 7 discusses the likely value-added tax base and the 

revenue that would be generated by a tax on that base. The projected 

1988 level of personal consumption expenditures is about $3.1 

trillion; each percentage point of a value-added tax levied on this 

total would yield about $31 billion. But a realistic base would be 

well below this figure. Rents, on both tenant and owner-occupied 

housing, would probably not be taxed. It is also likely that medical 

care, education, and religious and welfare activities would not be 

taxed, either for distributional reasons or to encourage certain 

activities. Banking and insurance may be excluded from the tax base 

because of the difficulty of properly defining value added in these 

sectors. These exclusions would result in a value-added tax base of 

about $2.4 trillion. Exclusions for food and medicine would reduce 

the base further. 

A general sales tax is often criticized as unfair to lower income 

individuals and families. Two aspects to this equity argument can be 

distinguished: (1) the absolute burden of the tax on the lowest 

income groups, and (2) the regressivity of the tax or the relatively 

higher burden of the tax, as a percentage of income, at the lower 

income levels than at the middle or upper levels. Chapter 8 discusses 

four alternatives for reducing the burden of the tax on the poor: 

excluding certain goods and services from the tax base; providing a 

reimbursement for value-added tax paid on an average amount of essential consumption; adjusting transfer payments; and using a personal 

exemption type of value-added tax. 

form of tax. The Internal Revenue Service would need substantial 

additional resources to administer a value-added tax properly. 

Chapter 9 provides the first publicly available appraisal of these 

additional resource needs. 

At the Federal level, a value-added tax would be an entirely new 
-5- 

Chapter 2 

THE NATURE OF THE VALUE-ADDED TAX 

I. Introduction 

each stage or point in the production and distribution process. ~n a 

typical business operation, a firm purchases raw materials from its 

suppliers and produces a product or service by processing, manufacturing, distributing, or otherwise "adding value" to its initial purchases of goods and materials from other firms. While value added may 

be calculated in various ways, it is easiest to think of it simply as 

the difference between a firm's sales and its (non-labor) purchases of 

produced goods. If a firm buys $60 worth of raw materials from other 

firms and produces a product that sells for $100, its value added is 

said to be $40. With a tax rate of 10 percent, its value-added tax 

liability would be $4. Normally, of course, many different firms and 

activities are involved in producing a product and distributing it to 

the consumer. Consider the case of a loaf of bread. The farmer, 

miller, baker, trucker, and grocer are all involved in growing the 

ingredients, producing the bread, and delivering it to the consumer. 

In this example, a value-added tax would apply to the value added by 

each firm that is involved in the production and distribution of the 

bread. 

A value-added tax is a multistage sales tax that is collected at 

Since many firms are usually involved in producing a good for the 

market, it is convenient to think of the retail price or value of a 

product (or service) as being equal to the total of the values added 

in the production and distribution process. The loaf of bread, in 

other words, will sell for the total of the value added by the farmer, 

miller, baker, trucker, grocer, and anyone else involved in getting it 

to the consumer. Thus, a value-added tax that extends through the 

retail level would collect essentially the same amount of tax on a 

product as would a retail sales tax levied at the same rate of tax. A 

value-added tax, however, differs from a retail sales tax in that the 

tax is collected piecemeal, in several stages, rather than exclusively 

on the retail sale. 

11. alternative Forms of Tax 

There are three separate types of value-added tax: gross product, 

income, and consumption. They differ in their treatment of capital 

equipment that has been purchased from other firms. This difference 

may be illustrated by assuming that a firm calculates its value added 

by subtracting its purchases from other firms from its sales and then 

applying the tax rate to the resulting value added to determine its 

tax liability, even though this is not the method normally used to 

calculate tax liability under a value-added tax. For the sake of 
-6- 

simplicity and clarity of explanation, this illustration will also not 

consider the question of whether exports or government purchases would 

be subject to the tax. 

A. Gross Product Type 

In determining its tax liability under a gross product value-added 

tax, a firm would be allowed to deduct its purchases of raw materials 

from its sales, but it would not be allowed to deduct the cost of its 

purchases of capital equipment, or even the depreciation on that 

capital equipment. Since gross investment purchases (including depreciation) are subject to taxation, the economic base of a gross product 

value-added tax is similar to gross national product. Capital investment is, in effect, taxed twice under the gross product tax. Capital 

goods are taxed at the time they are purchased and also when the 

products they produce are sold to consumers. In contrast, raw materials and other non-capital items that are purchased from other firms 

(that is, purchases on current account) may be deducted from sales 

under a gross product tax. Output generated by these purchases is, of 

course, taxed at the time of sale. 

administrative difficulties in those borderline cases where it is 

difficult to distinguish expenditures for capital goods from those for 

items that are exhausted currently in production or for repair and 

maintenance purposes. Since capital purchases are not deductible in 

determining tax liability, there would be an incentive to classify 

them as current expenditures. The difficulties would be more pronounced than under the income tax where capital expenditures are 

eligible for a depreciation allowance and perhaps an investment tax 

credit. There also would be an incentive for self-construction of 

capital goods. 

version places the heaviest tax burden on capital goods. It would 

discourage saving, discriminate against capital intensive methods of 

production, and cause firms to delay modernization and upgrading of 

plant and equipment by minimizing expenditures on capital assets. The 

gross product tax is best relegated to the realm of conceptual curiosities and should not receive serious consideration in public policy 

discussions. 

A gross produce type of value-added tax would create significant 

Of the three different types of value-added tax, the gross product 

8. Income Type 

Under the income variant of the value--added tax, both purchases of 

raw materials and depreciation on capital goods would be deducted from 

sales in computing a firm’s value added. Since net investment purchases (gross investment less depreciation) are subject to taxation, 

the economic base of this tax is similar to net national income. By 

taxing net investment, this tax would impose a tax burden on net purchases of capital goods. Because this type of value-added tax 

requires the calculation of depreciation allowances, it would have 

some of the same administrative problems that arise under an income 
-7- 

tax. Asset lives and depreciation paths would have to be specified. 

A given depreciation stream may not be correct if the rate of inflation changes markedly. There would be an incentive to classify purchases as current expenditures, which are deductible, rather than 

capital expenditures, which must be depreciated. This is not to 

criticize the income tax, but to point out that many of the same 

difficulties would arise under either an income tax or an income type 

value-added tax. As long as the United States has an income tax there 

is no reason to adopt an income-type value-added tax. 

C. Consumption Type 

Under the consumption-type value-added tax, all business purchases, including those for capital assets, would be deductible in 

calculating a firm's value added. Since a full deduction is allowed 

for gross investment, this alternative would result in a tax base 

equivalent to total private consumption. A consumption value-added 

tax avoids the need to distinguish between capital and current expenditures or to specify asset lives and depreciation allowances for 

capital assets. As noted above, both the gross product and income 

versions of the value-added tax would penalize capital investment by 

placing an additional tax burden on capital equipment purchases; the 

tax would be imposed on the capital good itself and on the output 

produced by the capital good. In contrast, a consumption-type valueadded tax would be neutral between methods of production since substituting capital for labor (or vice versa) would not affect a firm's 

total taxes; it also would be neutral between the decision to save or 

consume. Because of these characteristics, the consumption version is 

the type of'value-added tax used in Europe and the only type that 

should receive consideration in the United States. 

1x1. Alternative Methods of Calculation: Subtraction, Credit, 

Addition 

Though value added is often thought of as the difference between a 

firm's sales and its purchases, value-added tax liability may be calculated by three different methods: by subtraction, credit, or 

addition. These three alternatives are illustrated by the example in 

Table 2-1. That example assumes an economy with only three firms (one 

each in manufacturing, wholesaling, and retailing) and in which the 

manufacturing sector sells all of its output to the wholesale sector; 

the wholesale sector buys only from the manufacturing sector and sells 

all of its output to the retail sector. The rate of tax is 10 percent 

A. Subtraction Method 

Under this method, illustrated in the top part of Table 2-1, a 

firm calculates its value-added tax liability by subtracting its purchases from other firms from its sales and applying the tax rate to 

the difference. With a consumption value-added tax, the deduction for 

purchases would include any capital equipment bought during the period. In contrast, only depreciation on capital equipment would be 

deductible under the income version of value-added tax. In either 
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instance, purchases of raw materials and other intermediate goods 

would be deductible in determining a firm's value added. 

El. Credit Method 

The credit, or invoice, method is used by all of the member countries in the European Economic Community (EEC) and by most other countries that have a value-added tax. Under the credit method, a firm's 

tax liability is determined by allowing the firm to subtract valueadded tax paid on purchases from tax due on its sales. This method is 

illustrated in the middle panel of Table 2-1. The amount of deductible tax paid on purchases would include the full amount of tax paid 

on any capital equipment purchases in the case of a consumption-type 

value-added tax. Alternatively, for the income version of value-added 

tax, the tax paid on capital equipment would be amortized or depreciated over the life of the asset, rather than being deducted entirely 

in the year when the capital asset was purchased. 

An important characteristic of the credit method is that except in 

the case of outright exemption of intermediate stages of production 

the tax on a product depends on the tax rate that prevails at the 

final taxable stage; this would be the rate levied at the retail stage 

in the case of a value-added tax that extends through the retail 

level. Thus, any value-added tax evaded by firms prior to the retail 

level would result in higher taxes at the retail level; lower tax 

rates at pre-retail stages would be offset by full collection of the 

tax at the retail level. This can be seen from a slight modification 

of the Table 2-1 illustration of the credit method. If no tax is paid 

by either the manufacturer or wholesaler, the total tax on the $1,100 

in (pre-tax) retail sales would still be $110, the same as when the 

tax is distributed among the three sectors. (The example in Table 2-1 

does not explicitly show the $10 in tax on the $100 in purchases made 

by Firm A, the manufacturer. In this instance, the full tax liability would be collected at the retail level, the same as under a 

retail sales tax, since the etailer would have no credit for tax paid 

on purchases. 

C. Addition Method 

Though value added is equal to the difference between a firm's 

sales and its purchases, it also is equal to the payments for the 

labor and capital that generate the value added. Under the addition 

method, a firm's value-added tax liability is calculated by adding 

together the components of value added, wages, rent, interest, and net 

profit, and then applying the tax rate to that sum. It is illustrated 

in the lower panel of Table 2-1. Since net profit normally reflects a 

capital depreciation allowance, the addition method is usually associated with an income type of value-added tax. A consumption method 

value-added tax could be implemented by the addition method only if 

net profit was based on the expensing or full immediate deductibility 

of capital equipment purchases. If the objective is a consumption 

value-added tax, this can be achieved more easily under the credit 

method than by calculating net profit (with capital expensing) and 
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Table 2-1 

Comparison of Three Methods of Calculating 

Value-Added Tax Liability 

(10 percent value-added tax) 

STAGE OF PRODUCTION 

Firm A : Firm B : Firm C : Total 

Manufacturer: Wholesaler: Retailer: Economy 

1. SUBTRACTION METHOD: 

Sales $350 $850 $1,100 $2,300 

pi1 r chases 100 350 850 1,300 

value added 250 500 250 I, 000 

(sales minus 

pur cha s e s ) 

value-added tax 25 50 25 100 

2. CREDIT METHOD: 

Sales 350 850 1,100 2,300 

Tax on sales 35 85 110 230 

Purchases 100 350 850 1,300 

Tax on purchases - 35 - 85 2 

value-added tax 25 50 25 IO0 

10 - 

(tax on sales less 

tax on purchases) 

- 3. ADDITION METHOD: 

Factor payments plus net profit 

Wages 150 300 200 650 

Rent 50 100 20 170 

Interest 25 15 20 I 2 0 

Profit - 25 - 

Total 250 500 250 I, 000 

Value-added tax 25 50 25 100 

25 - 10 I_ 

60 
adding it to the other factor payments. The calculation of net profit 

involves all of the problems that plague the current income tax. 

D. Analysis and Summary 

The subtraction, credit, and addition methods should be viewed as 

equivalent only in the case of a single rate of tax applying to nearly 

all goods and services. In such a situation, the three methods would 

work equally well and would generate the same amount of total tax 

revenue. A more realistic situation is one in which policymakers may 

prefer a single-rate value-added tax for administrative and efficiency 

reasons, but in which it will be necessary to tax some goods and 

services at special rates. In a world in which all goods and services 

are not taxed at the same rate, the credit method is superior to 

either the subtraction or addition alternatives. 

Under the subtraction approach, virtually every sector of the 

economy would exert political pressure for special treatment. This is 

because ultimate tax liability on a given product would depend on two 

factors: value added in each sector or industry and the tax rate 

applied to that value added. Assuming that firms do not incorrectly 

overstate purchases or understate sales, they would have relatively 

little control over their value added subject to tax. But they would 

try to minimize their value-added tax liability by seeking preferential, or perhaps even zero, rates of value-added tax on their own 

sector or industry. 

consumption depends on the tax rate imposed at the final or retail 

stage, the mining, agricultural, manufacturing, and other non-retail 

sectors would have less incentive to seek special treatment and be 

less likely to do so. Because any tax charged on their sales may be 

credited by their (non-retail) customers, it should (recordkeeping 

considerations aside) be a matter of indifference to firms making nonretail sales as to whether or not they are subject to the tax. 

Indeed, as shown below, exemption from tax would actually be adverse 

to the exempt firm's non-retail customers. 

Special rates, which would be more likely under the subtraction or 

addition method than under the credit alternative, would have a number 

of adverse economic consequences. They would unfairly favor those 

consumers with strong preferences for lightly-taxed goods and penalize 

those preferring to buy more heavily-taxed items. To the extent that 

the nonuniform rates induced changes in buying habits, consumer satisfaction would decline and the government would collect less revenue. 

As explained in section IV, a so-called indirect tax, such as a valueadded tax, may be rebated on exports under international trading 

rules. With differential rates for various sectors or products, it 

would be virtually impossible under the subtraction method to calculate the correct amount of tax that would be permitted as a rebate on 

exports and collected on imports. Differential rates would make the 

tax more complex, both for taxpayers and tax administrators, thus 

increasing compliance and administration costs. 

With the credit method, in contrast, since tax liability on final 
- 11 - 

Though multiple rates are far less satisfactory than a single rate 

of value-added tax, the experience of other countries demonstrates 

that it may not be possible to avoid them. The credit method is 

attractive not only because it makes the tax base less vulnerable to 

erosion from pleas of special interest groups for tax relief, but 

because it is superior to the subtraction method in accommodating the 

demands that will be made for tax relief for some goods or services. 

Under the credit method, goods and services can be freed of tax by 

simply applying a rate of "zero" at the retail stage and allowing a 

full credit for pre-retail taxes. In similar fashion, the accurate 

rebate of tax on exports occurs automatically. The same result could 

only be achieved under the subtraction method by applying a rate of 

zero at each and every stage of production or distribution through 

which the tax favored good or service passes. 

that may assist the Internal Revenue Service (IRS) in the administration and enforcement of both the value-added tax and the income tax. 

Under the subtraction method, Firm A in Table 2-1 may have an incentive to understate its sales, for either value-added or income tax 

purposes. But its business customer, Firm B, has an offsetting incentive to have its purchases from A properly specified on the sales 

invoice so that Firm B gets a full deduction for those purchases. A 

similar "cross checking" situation exists under the credit method. 

Since Firm B may credit taxes it is charged by Firm A, it will wish to 

insure that Firm A'S invoice properly identifies the tax on those 

sales. Thus, either the credit or subtraction method provides tax 

administrators with a record of sales and purchase information which 

may be useful for enforcement purposes. Analysis of the records of 

Firm B can be used in auditing the supplier (Firm A), or, the records 

of Firm A can be used to assist in an audit of Firm B (the customer). 

The addition approach would have some of the same problems as the 

subtraction method in avoiding pleas for differential rates and in 

determining accurate border tax adjustments if the tax were not 

imposed at a uniform rate on all goods and services. It would probably not provide tax administrators with any more enforcement information than they now receive under the income tax. 

Both the subtraction and credit methods contain incentive features 

IV. Border Tax Adjustments 

In 1983, U.S. exports of goods and services were equal to about 10 

percent of the economy's output. In the United States, as in other 

countries, the design of a value-added tax must take into account the 

fact that the movement of goods and services across national borders 

is commonplace. 

either of two principles. A product can be taxed in either the country where it is produced or where it is consumed. If a product is 

taxed where it is produced, it is said to be taxed on the basis of its 

origin or place of production. Alternatively, if a product is taxed 

where it is consumed, it is taxed on the basis of its destination or 

Taxes on commodities entering international trade can be levied on 
location of consumption. In principle, a value-added tax can be imposed on either of these bases, origin (production) or destination 

(consumption), but virtually all countries using the value-added tax 

rely on the destination principle so that imports and domesticallyproduced goods compete on an equal tax footing. 

Suppose, referring again to Table 2-1, that the manufacturing 

activity took place in one country and the wholesaling and retailing 

activities in another country. A value-added tax could be implemented 

on an origin basis merely by allowing each country to tax (at whatever 

rate it chooses) value-added generated within its borders. The country of manufacture would tax $250 in value added, while the country in 

which the wholesaling and retailing activities occurred would tax the 

remaining $750 in value added. The origin principle could be implemented naturally by the subtraction method, since it provides a direct 

measure of value added. An important consequence of the origin principle is that a good traded internationally may bear a different 

amount of value-added tax than that of a competitive good produced 

exclusively in a single country. Only in the unusual case in which 

the exporting and importing countries have the same rate of valueadded tax would the taxes on the traded and domestically-produced 

goods be the same. 

be implemented on a destination basis. In this case, value-added tax 

is imposed only where the good is consumed, riot where it is produced. 

This necessitates a rebate of any tax imposed in the exporting country 

and a compensatory tax in the importing country to equalize the tax 

burden with a good that is domestically produced and consumed. The 

export rebate and import tax, designed to place traded and domestically-produced goods on an equal tax footing in the country where they 

are consumed, are known as border tax adjustments. State retail sales 

taxes are levied under the destination principle. A state retail 

sales tax is not imposed on goods destined for export out of the 

taxing state, but is levied on any imports sold to consumers in the 

taxing state. 

The credit method of determining value-added tax liability is 

superior to either the addition or subtraction approaches for implementing the destination principle. The rebate of tax on exports is I 

accomplished by simply applying a tax rate of zero at the export stage 

and giving the exporter full credit for any tax paid on inputs purchased to produce the export good. This procedure frees the export 

from all value-added tax imposed in the exporting country. Consider 

again the example in Table 2-1 in which manufacturing occurs in the 

exporting country and wholesaling and retailing in the importing country. The exporting country implements the destination principle by 

applying a rate of zero, rather than 10 percent, to the $350 in export 

sales and allowing a full credit or refund for the $10 in tax paid on 

purchases related to the export sales. In this way, those exports 

enter the importing country free of any value-added tax from the 

exporting country. 

As an alternative to the origin principle, a value-added tax may 
unless the import good is purchased directly by the final consumer, rather than from a taxable firm, it is not even necessary for the 

importing country to explicitly levy the value-added tax at the import 

stage to implement the destination principle. tlnder the credit 

method, the tax on a product depends on the rate applied on the final 

sale to the consumer. As long as the retailer, in the Table 2-1 

example, charges a tax rate of 10 percent on its $1,100 in sales, the 

full value-added tax of $110 will be collected. Even if the wholesaler was the importer, it would not be necessary for a tax to be 

levied on the wholesaler's import purchases. If value-added tax was 

imposed, the retailer would be allowed a credit, but if no tax is 

charged, there would be no credit. In either case, provided there is 

at least one taxable firm between the import stage and final consumer, 

the credit method will insure that consumption of imports and domestically-produced goods takes place on an equal tax footing, as required 

by the destination principle. 

In contrast to a credit method value-added tax, there are substantial complexities to implementing the destination principle under 

either the subtraction or addition methods. Under the credit method, 

prior-stage tax is revealed directly by the amount of credit available 

with respect to a firm's purchases. Thus, the border tax adjustment 

on exports can be determined precisely. But, under the addition and 

subtraction methods, if the value-added tax rate at each of these preexport stages is not the same, it would be very difficult for the exporting country to know the correct amount of value-added tax to allow 

as an export rebate. To determine the current amount of border tax 

adjustment it would be necessary to know the number of previous 

stages, the value added at each of those stages, and the tax applied 

at each of those stages. 

On the import side of the ledger, any tax not imposed at the 

import stage under the addition method would be lost completely. 

Under the subtraction method, the destination principle would be 

implemented by denying a firm a deduction for purchases of inputs on 

which no tax had been paid. This should probably occur at the import 

stage. Still, it will be difficult to treat imports and domesticallyproduced goods the same if different rates of tax have been applied at 

pre-retail stages to the domestic goods. In contrast to the credit 

method, both the addition and subtraction alternatives would place 

pressure on tax administrators to ensure that value-added tax was 

collected at the import, as well as at all subsequent taxable stages. 

v. Value-Added Tax versus Retail Sales Tax 

A consumption-type value-added tax that extends through the retail 

stage is similar to a retail sales tax in that the two taxes will collect the same amount of revenue, assuming they are imposed at the same 

rate of tax and have equal coverage. This is illustrated in Table 2-2 

which compares a consumption-type value-added tax with a retail sales 

tax, each levied at 10 percent. Value-added tax liability is calculated under the credit method. In each case, the product sells at 
- 14 - 

retail for $1,000, before tax. Under the retail sales tax, illustrated on the right-hand side of Table 2-2, the retailer charges the 

customer a tax of $100 and sells the product for $1,100, including 

tax. Neither the manufacturer nor wholesaler charge retail sales tax 

since neither makes retail sales. This same total amount of tax of 

$100 is collected under the value-added tax, but it is collected 

piecemeal from the manufacturer ($25), wholesaler ($50), and retailer 

($25), rather than being collected entirely at the retail level. 

Thus, a value-added tax can be viewed as a multistage tax equivalent 

to a retail sales tax. With equal coverage and tax rates, the two 

taxes will raise equivalent amounts of revenue. 

Administrative differences between the two taxes create some 

important economic differences. They are mentioned here and discussed 

more fully in Chapter 4. The number of firms involved may be smaller 

under a retail sales tax, but the difference may not be as significant 

as first appears since noriretail firms may make some (taxable) retail 

sales. It also is necessary for tax administrators to check that taxexempt purchases by nonretail firms have been made for legitimate taxfree purposes. A value-added tax may be more successful than a retail 

sales tax in freeing capital equipment and other business purchases 

from tax. Reportedly, this was the reason that Sweden replaced its 

retail sales tax with a value-added tax in 1969. If capital equipment 

and business purchases are taxed, the multiple taxation that arises 

discriminates against those goods produced with business equipment 

that has been taxed and makes it difficult to calculate the proper 

border tax adjustments on exports sales. Imports would receive 

preferential treatment compared to domestically-produced goods since 

the border tax adjustment would apply to the import itself, but not to 

the capital equipment used to produce the import. 

in collecting some revenue on those transactions escaping taxation 

through the "underground economy," which consists of informal economic 

activity not reported for tax purposes and illegal activities associated with narcotics, gambling, and prostitution. Because value-added 

tax is collected at each of the links in the production and distribution process, some tax will be collected even if no tax is charged 

on the actual retail sale. Even if an enterprise does not pay tax on 

its retail sales, it would, the argument goes, at least pay tax on its 

purchases. This assumes, however, that the firm is not able to 

successfully claim a credit or refund for tax paid on those purchases 

related to the sales on which it does not charge tax. 

tax might even be successful in reducing the "tax gap," which IRS 

estimated to be about $90 billion annually in 1981 (before being 

reduced by subsequent tax rate reductions and changes in enforcement 

procedures). The tax gap relates to income taxes, not to sales or 

value-added taxes, and is defined as the difference between the total 

amount of income tax (corporate and individual) voluntarily paid for a 

given year and the correct tax liability for that year. According to 

recent IRS estimates, the underground economy, accounts for only 15 

A value-added tax will be more successful than a retail sales tax 

To the extent that it substitutes for an income tax, a value-added 
- 15 - 

Table 2-2 

Comparison of Value-Added and Retail Sales Tax 

VALUE-ADDED TAX RETAIL SALES TAX 

PRODUCT STAGE (10 Percent) (10 Percent) 

Before After Before After 

Tax - TELX ___ TBX Tax - Tax Tax 

HANUFACTURE: 

Sales 

Pur chases 

Net Tax 

WHOLESALE: 

Sales 

Purchases 

Net Tax 

RETAIL : 

Sales 

Purchases 

Net Tax 

TOTAL TAX 

$250 $25 $275 $250 $ 0 $250 

- - 0 - 0 0 

25 0 

750 75 825 750 0 750 

250 - 25 275 250 - 0 250 

50 0 

1000 100 1100 1000 LOO 1100 

750 - 75 825 750 - 0 750 

25 100 
- 16 - 

percent of the total income tax gap. The remainder of the tax gap 

reflects many forms of noncompliance unrelated to the underground 

economy, such as: the failure to properly report income from unincorporated businesses, dividends, interest, and capital gains; overstating deductions and business expense; failure to file income tax 

returns; and failure to pay acknowledged liabilities. To the extent 

that any of this unreported income stemming from noncompliance is used 

to purchase taxable goods and services, a value-added tax would reach 

this portion of the tax gap, regardless of whether the income was from 

unreported activities or from the-Gllega-1 sector. 

Forty-five states have a retail sales tax, but none has a 

consumption-type value-added tax. (Michigan has an additive-type, 

income-based value-added tax which replaced its state corporate income 

tax, but has corporate profits in its base.) If the Federal government were to adopt a national sales tax,' it might be possible to 

piggyback the state sales taxes with a national retail sales tax. 

This kind of Federal-state coordination would be more difficult to 

achieve with a value-added tax. This factor, however, should not be 

overemphasized. While there are statutory provisions for piggybacking 

state and Federal income taxes, no state has chosen to do so. 

r,; -I 

VI. summary 

A value-added tax may be imposed on different tax bases, and tax 

liability may be calculated in various ways. Not all forms would be 

suitable for the United States. If the policy debate in the United 

States ever focuses on choosing a form of value-added tax, it should 

concentrate on a value-added tax with the following characteristics: 

1. consumption type; 

2. credit method of determining tax liability; and 

3. destination principle of border tax adjustments. 

As explained in Chapter 3, the tax should also have a broad base, with 

only minimal and well justified exclusions, and it should be imposed 

at a single, uniform rate. 
- 17 - 

Chapter 3 

EVALUATION OF A VALUE-ADDED TAX 

I. Introduction 

liability calculated under the crredit method from an economic and 

political perspective. This is the form of tax that has been adopted 

by the member countries in the European Economic Community (EEC) and 

would be the most likely candidate for the United States, if a policy 

decision were made to adopt a value-added tax. 

Some of this discussion necessarily involves comparing a valueadded tax with other taxes, such as the personal and corporate income 

taxes and the social security or payroll tax. This is because revenue 

generated by a value-added tax could also be raised by one of these 

other levies, or could permit these other taxes to be reduced. A more 

detailed discussion and evaluation of the individual and corporate 

income taxes appears in Volumes 1 and 2 of the Treasury Department 

Report. 

11. Economic Effects 

This chapter evaluates a consumption-type value-added tax with tax 

This section appraises a value-added tax with respect to its 

economic neutrality, impact on saving, distributional equity, and 

effects on prices and international trade. As noted in Chapter 2, a 

consumption-type value-added tax is similar to a retail sales in terms 

of its economic effects. Thus, the reader may find it easier to think 

of a retail sales tax, rather than a value-added tax, in evaluating 

these effects. 

A. Neutrality 

A neutral tax is one that does not interfere with the economic 

behavior of individuals or firms. Compared .to the situation that 

would exist if no tax is imposed, a neutral tax would not interfere 

with the decisions of individuals to work or not work, to save or 

consume, or to consume one good or another; or with the decisions of 

firms on what to produce and what production methods to use. A 

cigarette tax, for example, is not neutral because it may discourage 

consumers from buying cigarettes. While some taxes are intended to 

change consumer behavior, neutrality is generally viewed as a 

desirable objective of tax policy because it is assumed that both the 

value of economic production and consumer satisfaction will decline if 

a tax forces either firms or individuals to change their behavior. 

1. Production neutrality. In a market-oriented economy, business 

firms are motivated by competitive forces to use the most efficient 

production techniques. In this way, the goods and services demanded 

by consumers are produced, and at the lowest possible cost. If a tax 
interferes with these production decisions, resources are used less 

efficiently and less output is available to satisfy consumer demand. 

neutrality. By allowing a full deduction for the tax paid on purchases of capital equipment it would not distort production or investment decisions. Compared to a no-tax situation, the tax would not 

encourage firms to favor the use of either labor or capital in the 

production process. The total tax liability incurred by a firm, consisting of both the tax on its purchases and the tax on its sales 

(after allowing for the tax on purchases) would be the same regardless 

of the precise capital-labor mix. The corporate income tax has many 

distortions, it favors debt over equity finance, noncorporate over 

corporate products, labor over capital, and consumption over saving. 

As explained in the next section, a value-added tax would be neutral 

between consumption and saving. Since purchased consumption goods are 

subject to taxation, a value-added tax may discourage work effort by 

those who have the alternative of using leisure time to produce goods 

and services that would be taxed if purchased. An example of this 

result would be an individual using leisure time to paint a house or 

tend a garden. In contrast to a value-added tax, the individual 

income tax, because it is progressive and applies to both income that 

is saved as well as the return on saving, may discourage saving and 

risk taking, as well as work effort. Even though the payroll tax 

applies to most forms of labor, it probably is not neutral. ~t may 

discourage work effort, and the pay-as-you-go financing of social 

security may reduce saving. 

viduals "vote" for the goods and services they want to buy by signaling the prices they are willing to pay. These price signals are 

received by business firms, who produce those goods and services 

valued most highly by consumers. If a tax changes the structure of 

relative prices determined in the market place, consumers respond by 

buying more of some goods and less of others. The end result is 

reduced consumer satisfaction and a less efficient use of the 

economy's resources. A broad-based value-added tax, imposed at a 

single rate, would constitute a relatively uniform percentage of all 

consumer expenditures. Thus, it would be a reasonably neutral tax. 

The corporate income tax, in contrast, to the extent that it is 

reflected in higher prices, changes the structure of prices in the 

market place and interferes with consumption choices. 

As explained in Chapter 7, it is unlikely that a Federal valueadded tax would apply to all forms of consumption. Either for social, 

distributional, or administrative reasons, the tax would probably not 

apply in full to housing, medical care, insurance and finance, education, and religious and welfare activities. At most, the tax would 

apply to about 77 percent of total personal consumption expenditures. 

Exclusions from the tax base would make the tax less neutral and distort consumption and production decisions in favor of the 

preferentially-taxed items. The experience of other countries indicates that nonuniform coverage and rate differentiation are the prime 

A consumption-type value-added tax would score high in production 

2. Consumption neutrality. In a market-oriented economy, indi- 
- 19 - 

sources of nonneutrality in the value-added tax. It is for this 

reason, as well as to avoid administrative complexity, that departures 

from a broad base should be minimized and that rate differentiation 

should be avoided, particularly if alternatives exist for alleviating 

the burden of the tax on lower income groups. 

E. Saving 

unlike an income tax, a value-added tax would be neutral toward 

the saving-consumption choice. Suppose that in an economy without 

taxes the interest rate is 10 percent. An individual with $100 of 

income could either purchase $100 of consumption goods this year or 

could save the $100 and purchase $110 of consumption goods next year. 

This individual could consume 10 percent more next year by not consuming (by saving) the $100 now. A value-added tax would not alter 

the basis for this choice between consumption and saving. Consider a 

value-added tax rate of 20 percent, levied on the tax-inclusive value 

of goods and services. Now the choice is between consuming $80 this 

year and paying $20 in tax or saving the $100 this year, allowing it 

to grow to $110, and consuming $88 next year and paying the remaining 

$22 in tax. Note that the net rate of return on saving is not 

affected by the value-added tax; it is still 10 percent. By postponing $80 of consumption this year, the individual can consume $88 or 

10 percent more next year. 

In contrast, a tax on income from capital, such as the corporate 

income tax or the individual income tax on interest or dividends, is 

not neutral between consumption and saving. (Of course, the unintegrated taxation of corporate income and dividends causes distortions 

beyond these.) Continuing the same example, an individual subject to 

a 20 percent income tax could, after paying the tax, purchase $80 of 

consumption goods this year or save the $80 in order to consume $86.40 

next year, after paying a 20 percent tax on the $8 in interest earned 

on the $80 in savings. In the income tax case, the net return to 

saving is now only 8, rather than 10, percent. It is 20 percent less 

than it is with a value-added tax since both the amount saved and the 

interest earned on that amount are subject to the income tax. 

regard to the choice of whether to consume now or save for future consumption; the value-added tax does not discourage saving the way an 

income tax does. Assuming any increased saving is absorbed by higher 

real investment spending, a value-added tax may be superior to an 

income tax in fostering capital formation and economic growth. The 

amount of the increase in saving would depend on the responsiveness of 

saving to higher after-tax rates of return. 

This example demonstrates that a value-added tax is neutral with 

c. equity 

Consumption expenditures, as a percentage of income, fall as 

income rises. Individuals and families at the middle and upper income 

levels consume a smaller proportion of their income than those at the 

lower income levels. Thus, a broad-based value-added tax imposed at a 
- 20 - 

uniform rate would absorb a larger percentage of the income of those 

at the lower income levels than those at the middle and upper income 

levels. In other words, a value-added tax would be regressive, 

assuming no exemptions or differential rates for "necessities" or 

"luxuries". The individual income tax, in contrast, is progressive, 

since it allows for personal exemptions and a zero bracket amount and 

because tax rates rise with income. The distributional pattern of the 

corporate income tax is less clear. If it is reflected in lower 

returns to capital, it may be progressive, but if it is reflected in 

higher prices it is more like a nonuniform sales tax. The payroll tax 

also is regressive because of the earnings limit and because wage 

income falls, as a percentage of total income, as income rises. 

Several observations can be made about the regressive nature of 

the value-added tax. As explained further in Chapters 5 and 8, 

regressivity has two facets: the absolute burden of the tax on those 

below the poverty level and the regressive effect on those above the 

poverty level. For those with income above the poverty level and 

subject to the income tax, the regressivity of the value-added tax can 

be offset by adjusting the income tax rates. But for those who are 

below the poverty level and not subject to the income tax, this 

approach is not helpful; the value-added tax could, however, be offset 

by a refundable tax credit administered through the income tax system 

or by increased transfer payments. 

Generally speaking, reduced rates for purchases of certain 

commodities and exemptions from the tax base are not a desirable means 

of alleviating regressivity. They create administrative problems in 

distinguishing between taxed and tax-favored items. Should orange 

juice and orange soda, for example, be accorded the same tax treatment under a food exemption? If food purchases by everyone are tax 

free, the revenue cost may become excessive, and excluding everyone's 

food purchases from the tax base is not necessary in order to lessen 

the burden of the tax on low income individuals and families. If food 

is not taxed, the smaller tax base must be offset by higher rates on 

the items subject to taxation in order to raise an equivalent amount 

of revenue. 

A value-added tax may also shift tax burdens within an income 

class because it may weigh more heavily on recently-formed families 

facing significant expenditures on consumer and household durables 

than on more established families who have already made these expenditures. Compared to an income or payroll tax, it may shift the burden 

of the tax from the working to the nonworking and the aged. 

D. Prices 

A value-added tax accompanied by an accommodating monetary policy 

and no offsetting reduction in other taxes would probably lead to a 

one-time increase in consumer prices in direct relation to the coverage and rate of tax. According to the discussion in Chapter 7, a 

broad, but realistic, tax base would cover about 77 percent of total 
consumption expenditures. If a 10-percent value-added tax were 

applied to this base, consumer prices would rise by nearly 8 percent. 

By and large, this would be a one-time increase in the consumer 

price level, not an annual occurrence. There may be some secondary 

price increases because of wage payments and other business contracts 

that are indexed to the general price level, but these would be modest 

by comparison with the initial increase. 

were reduced. Consider, for example, a reduction in corporate taxes. 

Economists continue to differ on the shifting pattern of the corporate 

income tax. Some contend that it is treated like a business cost and 

reflected in higher product prices. Others argue that it reduces the 

after-tax return to capital. If the former observation is more accurate, the impact of reducing the corporate income tax would offset the 

price-increasing effect of the value-added tax. If the payroll tax 

(at least the employer portion) is reflected as a cost element in output prices, any reduction in this tax would also offset the priceincreasing influence of the value-added tax. 

The experience of those countries which have adopted a value-added 

tax confirms the view that it may generate a one-shot increase in the 

price level, but not an annual inflationary spiral. A staff study by 

the International Monetary Fund, "Is the Introduction of a Value-Added 

Tax Inflationary?," analyzed the impact of the introduction of the 

value-added tax on consumer prices in 31 countries. In some cases, 

the value-added tax was a revenue-neutral substitute for other taxes; 

in others the level of taxation was increased when the value-added tax 

was introduced. According to this study, in 21 of the 31 countries 

that were analyzed, the introduction of a value-added tax had no major 

impact on the price level. In four countries, the introduction of the 

value-added tax may have contributed to inflationary forces that were 

primarily the result of expansionary economic policies. In five 

countries, there was a one-time increase in the price level, but no 

subsequent effect on the rate of increase of prices. Only in Norway, 

according to the study, could a rate of increase in the price level be 

identified that could not be associated with other economic factors. 

The study concludes that introduction of a value-added tax is not I' i nh e rent 1 y " in f 1 a t i ona r y . 

The price-level impact could be offset to the extent other taxes 

E. ealance of Trade 

It is frequently argued chat a value-added tax would improve the 

u.S. trade balance by making iJ.5'. goods more competitive in world 

markets. This argument is based primarily on the realization that the 

value-added tax can be rebated on exports and levied on imports. 

Though there may be some validity to the argument, it is important to 

specify clearly the circumstances under which it would prevail. 

nation principle border tax adjustments for indirect taxes such as 

The General Agreement on Tariffs and Trade (GATT) permits desti- 
- 22 - 

sales or value-added taxes, but not for direct taxes such as the corporate or individual income tax or social security taxes. That is, 

indirect taxes, like the value-added tax, can be rebated on exports 

and imposed on imports, but no corresponding adjustments can be made 

for direct taxes. 

Imposing a value-added tax without any reduction in the income 

tax, or some other direct tax, would not directly improve the U.S. 

balance of trade. Export subsidies and import taxes could, in a 

system of fixed exchange rates, increase a country's exports and 

reduce its imports. But, the export rebate and import tax allowed for 

the value-added tax are merely border tax adjustments required to put 

the value added tax on a destination basis. The export rebate merely 

allows exports to enter world markets free of value-added tax, not at 

a subsidized price below the pre-tax price. Similarly, imposing a 

value-added tax on imports merely places imports on an equal footing 

with domestically produced goods; it does not penalize imports. A 

comparison with state retail sales tax is illustrative; in any particular state, charging retail sales tax on a Toyota does not make a 

Chevrolet more competitive in that state, because the same sales tax 

applies to both automobiles. Nor would the Chevrolet be more 

competitive abroad just because it could be exported free of sales 

tax. As with a retail sales tax, the imposition of a value-added tax, 

with no offsetting change in any other taxes, would not directly 

improve the U.S. trade balance. 

The analysis is somewhat different if a value-added tax is part of 

a revenue-neutral substitution for an existing direct tax, such as the 

corporate income tax or payroll tax. As noted above, under GATT 

neither the corporate income nor payroll tax may be rebated on exports 

and imposed on imports. Under traditional assumptions that these 

taxes are borne by share-holders or by labor, respectively, reducing 

them would have no effect on prices, and partially replacing them with 

a value-added tax would have no effect on the competitiveness of U.S. 

industry. The substitution of a value-added tax for either of these 

direct taxes could improve the U.S. trade balance only if the domestic 

price level remains unchanged, or at least increases by less than the 

full amount of the value-added tax. This would occur if one of these 

taxes is shifted to consumers and would be "unshifted" if reduced. 

Under these circumstances, the export rebate would reduce the price of 

U.S. exports, and the import tax would increase the price of imports 

relative to those of domestically-produced goods. In this instance, 

there would be a tendency for the U.S. trade balance to improve. Even 

this conclusion, however, requires some important qualifications. 

not allowed to adjust fully over time. Exchange rates, of course, 

have been allowed to adjust since 1971. Thus, any expansion in net 

exports resulting from the substitution of the value-added tax for the 

corporate income tax would be dampened by an appreciation of the 

dollar relative to other currencies. Second, other countries also 

have payroll and social security taxes. Thus, they could act to offset any expected improvement in the United States trade balance by 

First, it assumes that exchange rates are fixed, or at least are 
substituting increases in their (already existing) value-added taxes 

for these other taxes. Third, even if the partial replacement of the 

corporate income or payroll tax would improve the U.S. trade balance, 

the choice of whether to adopt a value-added tax is much too important 

to be driven by this consideration. 

A value-added tax may be associated with an improved U.S. trade 

balance in a different way. To the extent that it allowed the corporate income tax to be reduced, U.S. industry may become more vigorous 

and better able to compete in world markets. 

ZIT- Political Concerns 

This section evaluates the impact a value-added tax would likely 

have on the growth of government, the income tax, and the state and 

local tax base. 

A, Growth of Government 

A value-added tax would be an entirely new tax at the Federal 

level. It would raise substantial amounts of revenue. At 1988 levels 

of income and expenditure, a broad-based value-added tax would raise 

about $24 billion per percentage point of tax. Revenue from a valueadded tax could be used to reduce the deficit, to reduce or replace 

other taxes, or to finance increased government spending for defense 

or social programs. 

Policy makers, therefore, are likely to view the value-added tax 

as a mixed blessing. Some may applaud its economic neutrality and its 

anticipated favorable impact on economic growth and productivity, but 

be concerned over its potential for funding a permanently higher level 

of government spending. Others may attempt to balance its regressive 

aspects with its ability to generate funding for new or expanded 

government programs. 

taxes tend to be high tax, and presumably high government spending, 

countries. Table 3-1 shows taxes as a percent of national output 

(gross domestic product) for the United States and twelve other countries for 1982. According to the table, Canada, Japan, Switzerland, 

and the United States are relatively low tax countries. None of these 

four countries has a national value-added or retail sales tax. (Canada 

has a manufacturer's sales tax at the Federal level and Switzerland a 

wholesale level sales tax.) Over a longer time span, for nearly all 

European countries with a value-added tax, total taxes have increased 

as a percentage of national output since the introduction of the 

value-added tax. While value-added tax countries appear to have high 

taxes, generally, the causal relation, if any, is less clear. As 

shown in Table 3-1, some of the high tax countries also have high 

income and other direct taxes. The value-added tax is not the sole 

reason for the high level of taxation in these countries. Table 3-2 

shows taxes on goods and services (in the first line) and value-added 

taxes (in the second line) as a percentage of total tax revenue for 

Foreign experience indicates that those countries with value-added 

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- 26 - 

many of the same countries for a number of years. Since the table 

identifies value-added taxes separately, it is possible to compare the 

situation both before and after the adoption of the value-added tax. 

In most of these countries, the proportion of tax revenue raised 

through indirect taxation (sales, excise, and value-added taxes), has 

fallen since the adoption of the value-added tax. This reflects the 

growing importance of income and social security taxes, not a reduction in value-added taxes. Even though value-added taxes have 

generally increased as a percentage of gross domestic product over the 

period, they have not been as important as income and social security 

taxes in financing the growth in government in these countries, 

Still, according to Table 3-2, the absence of a value-added tax in 

Canada, Japan, Switzerland, and the United States, helps explain the 

relative unimportance of indirect taxation in those countries. 

B. Impact on Income Tax 

As noted, the revenue generated by a value-added tax could be used 

to finance a reduction in other taxes, such as the individual income 

tax. Thus, a value-added tax would permit further reductions in marginal tax rates, which would strengthen the incentives to work, save, 

and innovate, relieve the pressure on the definition of taxable 

income, and reduce the incentive to shelter income. To the extent 

that tax avoidance and evasion are motivated by high income tax rates, 

a value-added tax would also alleviate these problems and improve the 

administration and enforcement of the income tax and therefore its 

image. 

C. State-Local Tax Base 

A Federal value-added tax or retail sales tax might be viewed as 

an unwarranted intrusion by the Federal government into the fiscal 

domain of state and local governments. Forty-five states and the 

District of Columbia, as well as many local jurisdictions, impose 

general sales and use taxes, a revenue source which they may view as 

exclusively their own. Sales and gross receipts taxes account for 

about 35 percent of overall state and local tax revenue. In contrast, 

excises on goods and services, exclusive of the windfall profit tax, 

generate only about 4 percent of Federal tax receipts. 

While the Federal government should be sensitive to the impact a 

national sales or value-added tax would have on state and local governments, it is not clear that this should preclude Federal adoption 

of such a tax. Experience with the income tax, of course, demonstrates that there can be Federal, state, and local government 

taxation of the same tax base. Forty-five states and the District of 

Columbia impose a corporate income tax, as does the Federal government. Similarly, forty-four states and many local governments have 

joined the Federal government in imposing an individual income tax. 

offer the states an opportunity to improve the coverage and enforcement of their retail sales taxes. At present, many state taxes fall 

A Federal retail sales tax (more so than a value-added tax) would 
- 27 - 

considerably short of the objective of taxing a broad range of consumption goods at a uniform rate. Exemptions for food, clothing, and 

services are typical. On the other side of the coin, very few states 

exclude all capital goods and other business purchases from taxation. 

A comprehensive Federal sales tax would offer the states an opportunity to "piggyback" the state taxes on the Federal base. States 

would enjoy the advantage of the broadly-defined Federal base, but 

would be free to set their own state tax rates depending on state fiscal needs. This would avoid any acrimonious intergovernmental disputes over the proper amount of sales tax revenue to be shared with 

the states. Federal-state piggybacking in this area would be easier 

under a Federal retail sales tax than under a Federal value-added tax. 

While they are economically equivalent taxes, it would be administratively difficult to piggyback state retail sales taxes on a Federal 

value-added tax. The latter, for example, would not distinguish B 

between retail and nonretail sales. Thus, state retail sales taxes 

would not apply to all transactions incurring a Federal value-added 

tax, but only to retail sales. Both taxpayers and state tax administrators would have to grapple with the definition of a retail sale, as 

they do now. Any piggybacking of state retail sales taxes on a 

Federal value-added tax thus would be limited to the retail portion of 

the Federal tax. 

IV. European Adoption and Experience 

This section reviews the relevance for the tJnited States of 

European experience with the value-added tax. The initial proposal 

for a value-added tax can be traced back to 1919. In 1949, the Shoup 

Mission to Japan proposed a value-added tax for the prefectures which 

was initially adopted, but then repealed. It was not until 1955 that 

France adopted a wholesale level value-added tax as a replacement for 

its multistage production tax. The more recent popularity of the 

value-added tax dates from the formation of the European Economic 

Community (EEC) in 1957 and the Community's interest in tax 

harmonization. Subsequently, the value-added tax was adopted by 

Denmark (1967), Germany (1968), the Netherlands (1968), Luxembourg 

(1970), Belgium (1971), Ireland (1972), and Italy and the United Kingdom (1973). (Greece is scheduled to adopt the value-added tax by 1986 

as a condition of its membership in the Community.) The non-EEC European countries of Austria, Norway, and Sweden also have value-added 

taxes, as do many developing countries. 

The purpose behind the formation of the EEC was to move Western 

Europe toward economic union, that is, to establish a single, integrated market for the movement of goods, services, people, and capital. When the Community was formed in 1957, all Member States with 

the exception of France (that is, Belgium, Germany, Italy, the Netherlands, and Luxembourg) imposed cascade-type turnover taxes. A tax was 

levied on each sale of an item as it passed through the production and 

distribution process. Because no relief was given for prior-stage 

taxes, the total tax on a product increased with each sale, hence, the 

name cascade turnover tax. 
- 28 - 

This type of tax gave rise to four problems: (1) It discriminated 

against multistage production processes and distorted business operations by creating an incentive to vertically integrate the production 

and distribution processes into a single firm to minimize tax liability. (2) It distorted international trade because it was impossible to 

accurately calculate the allowable border tax adjustments on exports 

and imports. (3) The effects of the cascade tax on income distribution were unknown. (4) The tax became very difficult to administer as 

further exemptions and rate differentials were adopted in ad hoc 

attempts to alleviate the adverse impact of the tax on production and 

investment decisions. 

lems. It does not distort production methods and the credit method of 

calculation results in exact border tax adjustments. Its effect on 

income distribution was easier to determine arid, as long as exclusions 

and rate differentiation are minimized, it is much easier to administer. Thus, beginning in 1967, the European Economic Commission issued 

a set of Directives requiring EEC Member Countries to replace their 

turnover taxes with a value-added tax and specifying some of the 

details of the new tax. 

The consumption-type value-added tax answered all of these probThe European decision to adopt a value-added tax had three salient 

features: (1) It was a clear improvement of the European fiscal 

structure. The value-added tax corrected all of the faults of the 

cascade turnover tax. (2) It enabled the Member States to substitute 

one indirect tax for another and leave the balance between direct and 

indirect taxes relatively undisturbed. As shown in Table 3-2, income 

and other direct taxes have actually become more important sources of 

revenue in most of the EEC countries since the adoption of the valueadded tax. (3) Because of the use of the cascade turnover tax, 

European countries were generally familiar with multistage sales 

taxes. Thus, adoption of the value-added tax drew on years of European experience with multistage taxation, but avoided the problems 

learned from that experience. 

that needs to be overhauled, nor does it have experience with multistage sales taxes. If the United States decides to adopt a valueadded tax, it should not be for the same:-reasons 3hat .appLi’ed in 

Europe. 

experience with the value-added tax. 

that the most workable form of the value-added tax is the consumption 

type, imposed on the destination principle, and collected by means of 

the tax-credit method. Second, serious administrative, compliance, 

and efficiency problems are involved in the use of the value-added tax 

to achieve non-revenue objectives. In particular, the European experience suggests that use of multiple rates of value-added tax and 

efforts to favor certain types of consumption through exclusions 

involve significant costs and complexities, as well as revenue loss. 

The United States, of course, does not have a Federal sales tax 

Nevertheless, the United States 
- 29 - 

Chapter 4 

ALTERNATIVE TYPES OF SALES TAXATION 

I. Introduction 

This chapter compares a value-added tax with alternative types of 

sales taxes. Sales taxes may be single stage in nature, applying to 

only one stage in the production or distribution process, such as the 

retail or manufacturing, or to all stages, such as the value-added 

tax. Notwithstanding its multistage character, a consumption-type 

value-added tax that extends through the retail level is, in effect, a 

tax on the final, retail sales of goods and services. Its tax base 

and revenue potential are equivalent to those of a single-stage retail 

sales tax with similar coverage and an identical tax rate. Therefore, 

the objective of taxing purchases of goods and services by consumers 

can also be accomplished with a retail sales tax. Forty-five of the 

states and many local governments have a retail sales tax, a singlestage tax that applies to all sales to final consumers, not just those 

made by retailers. Liability for the retail sales tax depends on the 

character of the sale, rather than on the business activity of the 

seller. A manufacturer, for example, may make some retail sales and a 

retailer may make some nonretail sales to business customers. 

the manufacturing or wholesale level, respectively; that is, on the 

sale by the manufacturer or on the last wholesale sale (the sale to 

the retailer). A value-added tax that excludes the retail level would 

be similar to a wholesale sales tax. A personal exemption value-added 

tax is another form of sales tax; it is a simplified flat-rate tax 

that has many of the characteristics of a value-added tax, but with a 

personal allowance and exemptions to alleviate the regressivity of the 

tax, It can also be viewed as an income tai with a deduction for 

saving, or as a tax on consumed income. 

With a manufacturers or wholesale sales tax, a tax is applied at 

11. Analytic Framework 

These sales tax alternatives, retail, manufacturers and wholesale 

sales, and personal exemption value-added tax are analyzed primarily 

with respect to two objectives: consumption and production neutrality. A tax is neutral toward consumption if it does not cause consumers to change their buying habits, to buy more of some commodities 

and less of others. A tax is neutral toward production if it does not 

induce business firms to change their production and distribution 

methods. Other important similarities or differences with the valueadded tax, however, will also be mentioned. 

A, Consumption Neutrality 

Some taxes are specifically intended to change economic behavior. 

For example, one justification for sumptuary excise taxes, such as 
- 30 - 

those on tobacco or alcohol, is to discourage the consumption of goods 

that may be associated with disease, accidents, and other social 

costs. But, without an accepted social justification for encouraging 

or discouraging certain types of consumption activity, a sales tax 

should not distort, or change, individual consumption behavior. On 

the assumption that individuals indicate the goods and services they 

want by the prices they are willing to pay, a sales tax should not 

alter the relative prices for the goods and services available to 

consumers. If a sales tax does change those prices by making some 

goods less expensive and other items more expensive, it will favor 

individuals with strong preferences for the lightly-taxed expenditures 

and penalize those preferring to buy the more heavily-taxed goods and 

services. Consumers, in general, will respond to the tax-distorted 

prices by buying more of some goods and less of others. The result is 

reduced consumer satisfaction and a less efficient use of the 

economyIs resources. 

To avoid distorting consumption patterns, a sales tax should constitute a uniform percentage of consumer expenditures. To achieve 

this, the sales tax should be the same on each dollar of expenditure. 

This objective is most likely to be accomplished by a tax that is 

levied at a uniform rate on all items of consumer expenditure. 

B. Production and Distribution Neutrality 

A sales tax should not cause business firms to change their 

methods of production or distribution. Assuming that in the absence 

of a tax business firms use the most efficient and least cost production techniques available, then any interference by a sales tax in 

those techniques would cause total output to fall. The result would 

be a smaller quantity of goods and services. 

To prevent any distortion of production methods, the sales tax 

borne by a product should be the same regardless of the choice of 

production techniques and distribution channels. If a manufacturer, 

for example, can reduce its tax liability by selling directly to a 

retailer, rather than through a wholesaler, then direct sales to 

retailers will be encouraged. Or, if a firm's tax liability can be 

reduced by combining certain production or distribution activities, 

the firm will have an incentive to integrate those activities. These 

artificial incentives to change business practices should be avoided 

because they will result in less output and a less efficient use of 

resources. 

The objective of production and distribution neutrality also 

requires that only consumer goods be taxed; capital goods and other 

inputs used in production should be excluded from the sales tax. 

Otherwise, in an attempt to minimize costs, firms will substitute 

labor for those capital goods and other business purchases that are 

taxed. Investment and economic growth will suffer and exports will be 

penalized. Some firms may even respond by producing their own inputs 

to minimize the tax. Taxation of capital goods and other business 
- 31 - 

purchases also distorts consumer expenditure since those goods produced with large amounts of the taxed equipment and material per 

dollar of output will be more heavily taxed. 

111. Value-added Tax 

briefly summarized. A properly designed consumption-type value-adped 

tax would be neutral with respect to consumption decisions and production methods. If the tax applies to most goods and services at a 

single rate, with only minimal exceptions for clear and justifiable 

social or administrative reasons, it would constitute a uniform percentage of consumer expenditure. Consumers would not be given an 

incentive to consume more of some goods and less of others. The 

credit for value-added tax paid by a firm on all items purchased for 

business use, including capital equipment, would ensure that the tax 

will be neutral with respect to production and distribution methods. 

Labor and capital intensive operations would be treated the same. 

There would be no incentive for vertical integration since combining 

or integrating production or distribution processes would not alter 

the total tax on a product. 

xv. Retail Sales Tax 

Like a broad-based value-added tax, a retail sales tax that 

exempted all production inputs, including capital goods, would be 

relatively neutral, with respect to both consumption and production 

decisions. Though it may not be an inherent defect, state experience 

with retail sales taxes, however, demonstrates the difficulties, at 

least in practice, of applying the tax to all consumer expenditures 

and of excluding business purchases. First, primarily to alleviate 

the regressivity of the tax, many states exempt food, utilities and 

fuel, and drugs and medicine. A few exempt clothing. In many states, 

only a limited group of services is subject to retail sales taxation. 

Chapter 8 describes the problems that arise with exemptions from the 

base and suggests some alternatives for reducing the burden on low 

income individuals. 

To establish a basis of comparison, the discussion in Chapter 3 is 

Second, unlike a value-added tax, most states do not fully exclude 

capital equipment and other business purchases from the scope of the 

retail sales tax. while all states exclude sales for resale, including sales of goods that become physical ingredients or component parts 

of goods produced by the purchaser, they have more limited exclusions 

for fuel, industrial machinery, farm machinery and equipment, office 

supplies and equipment, and other business purchases that are not 

consumed directly in the production process. All such expenditures 

should be excluded if the sales tax is to avoid interfering with 

consumption behavior and production techniques. 

There are two objectives to the proper taxation of business 

purchases: (1) to exclude capital goods and other business purchases 

from taxation, and (2) to ensure that exempt business purchases are 

not diverted to taxable consumption uses. The value-added tax is 
- 32 - 

generally regarded as superior to the retail sales tax in achieving 

the first of these objectives. The value-added tax provides an 

automatic mechanism for excluding business purchases, as the buyer is 

allowed a credit for any value-added tax paid on those purchases. 

A retail sales tax, in contrast, effects the exemption with two 

approaches. First, registered firms are allowed to make purchases for 

resale tax free. Normally, the buyer presents the seller with an 

exemption certificate, which authorizes the buyer to purchase free of 

tax, provided the purchases are for resale. This system frees business purchases from tax, but its scope is rather limited; only those 

items to be resold, or which become ingredients or parts of goods 

produced for sale may be purchased tax free on this basis. Secondly, 

fuel, equipment, machinery, and supplies, generally not covered in the 

purchases for resale category, are freed of tax only if they are 

specifically exempted in the state statute, and even then exemption 

certificates are often required. This system does not fully exempt 

business purchases from the retail sales tax. In practice, most 

states make no serious effort to exclude all purchases for business 

purposes from their retail sales taxes. About 20 percent of state 

retail sales tax revenue comes from taxing producers goods. One 

consequence of this is that U.S. exports bear some state retail sales 

tax. 

Under either a value-added or retail sales tax, the problem of 

ensuring that exempt purchases are not diverted to consumption uses 

arises. From a policy perspective, neither tax is the clear favorite 

in solving this problem. In the case of the value-added tax, the 

revenue authorities need only check that the business purchases for 

which a tax credit is claimed were actually used in the business. 

With the retail sales tax, the check begins with the seller. Once it 

is determined that a sale was made on an exempt basis and that the 

seller has an exemption certificate, it is necessary to confirm that 

the buyer used the items purchased for exempt business purposes. With 

either a retail sales or value-added tax, it is necessary to analyze 

the buying firm's sales and purchase information to verify that a 

reasonable relation exists between its sales and purchases. 

Like a value-added tax, a retail sales tax would be regressive and 

the destination principle of border tax adjustment would apply. The 

number of firms involved in the administration and enforcement of a 

retail sales tax would be somewhat smaller, perhaps 10 percent smaller 

than with a value-added tax. The reason the difference is not greater 

is because a retail sales tax is not confined exclusively to retailers. Nonretail firms making retail sales must also register for the 

tax. Moreover, even firms making tax-free purchases, and no retail 

sales, must be checked by auditors to verify that the purchases were 

for exempt uses. Because of experience at the state level, a retail 

sales tax would be more familiar to both consumers and firms than 

would a value-added tax. As noted in Chapters 2 and 3, it would be 

easiet to piggyback state retail sales taxes on a Federal retail sales 

tax than on a value-added tax. Either tax, retail sales or valueadded, would be viewed by state and local government officials as 
encroaching on the fiscal territory of the states and would be criticized as such, though the value-added tax might be more acceptable 

because of its cosmetic differences. 

V. Nanufacturers and Other Pre-retail Taxes 

Compared to a retail sales tax or value-added tax through the retail level, a pre-retail tax, levied on either the sale by the manufacturer or the last wholesale sale (the sale to the retailer), would 

apply to a smaller number of taxpayers. Either a manufacturers or 

wholesale tax would exclude the retail sector, which contains a large 

number of firms, some of them small. Developing countries view nonretail taxes as attractive since the number of taxpayers needs to be 

kept to a manageable size for administration and enforcement purposes. 

moreover, recordkeeping is often not adequate to apply a sales tax to 

the numerous small firms at the retail level in developing countries. 

Neither of these reasons has any relevance for the United States. 

State experience with retail sales taxes has persuasively demonstrated 

the feasibility of a retail level tax in the United States. 

unlike a retail sales or value-added tax, either a manufacturers 

or wholesale tax would create severe economic distortions; neither 

would be neutral with respect to consumption choices or production 

methods. Combined wholesale and retail trade margins vary widely 

among products. Because the amount of value that is added to a 

product after the manufacturing sale is not uniform for all products, 

a manufacturers tax would not constitute a uniform percentage of consumer expenditure. Products with the bulk of their value added after 

the manufacturing sale would bear less tax relative to consumer 

expenditures than products with low wholesale and retail trade 

margins. Services would probably be excluded from either a manufacturers or wholesale tax because they are inherently retail activities. 

(The concept of trade margins is not readily applicable to a service 

activity.) Consumers would respond to the varying tax burdens by 

buying more of the lightly-taxed items and less of the heavily-taxed 

items. Thus, both consumer satisfaction and tax revenue at a given 

tax rate would be reduced. This potential for changing economic 

behavior would be magnified by the fact that, because of the reduced 

base, the tax rates necessary to raise an equivalent amount of revenue 

would be higher than for the retail sales tax. To the extent that 

"necessities" are low margin goods and "luxuries" high margic, the 

regressivity of the tax would be aggravated. 

Distortions would also occur in production and distribution 

methods. Both a manufacturers and wholesale tax create incentives to 

restructure business operations in order to minimize tax liability, 

basically by transferring functions and costs forward beyond the point 

of impact of the tax. Less efficient production and distribution 

methods, combined with higher rates to generate an equivalent amount 

of revenue, are certain consequences. For example, in the case of a 

manufacturers tax, distribution and advertising activities may be 

shifted to affiliated entities beyond the manufacturing sector, and 

firms not willing or able to do this will be discriminated against. 
- 34 - 

Any effort to prevent this by requiring consolidated returns from 

affiliated firms or by not considering certain activities to be part 

of the tax base when carried on by the manufacturer is likely to cause 

serious administrative problems. A similar shifting of functions 

would occur with the wholesale tax, and large retailers who buy 

directly from manufacturers at low prices would be favored over small 

retailers buying from wholesalers. 

A major problem, particularly with a manufacturers tax, is the 

valuation of the manufacturers sale for the purpose of applying the 

tax. Some manufacturers control their own wholesale and even retail 

outlets. This may be done for sound business reasons, such as the 

desire to provide a uniform level of customer service. One example of 

this practice would be a petroleum company integrated from the oil 

field to the service station fuel pump. 

In the case where the manufacturing and distribution activities 

are under common ownership, rules must be specified for determining 

the value of the product to which the manufacturers tax will apply. 

Because the manufacturer has an incentive to understate the price (to 

minimize liability for the manufacturers tax), the price set by the 

manufacturer cannot be accepted for the purpose of determining the 

manufacturer's tax liability without careful scrutiny by tax administrators. This "transfer pricing" problem is a frequent occurrence in 

international transactions where countries are concerned about receiving their proper share of tax revenue from international businesses. 

Ideally, one would want to know the price at which the product would 

sell if the manufacturer and distributor were not related, that is, if 

they were dealing as independent entities operating at "arm's length." 

But, it may be impossible to know this if the manufacturer is not 

making similar sales to independent or uncontrolled distributors. In 

determining liability with a manufacturers tax, average margins may be 

added to costs or subtracted from the retail sales price, but they 

will only approximate the correct result and the margins will be 

different for different goods, thus complicating the administration of 

the tax. This problem is avoided under a retail sales or retail level 

value-added tax. The problem of determining the correct taxable value 

of a product also exists with a wholesale tax, but is less acute since 

fewer wholesalers own retail distribution networks than manufacturers 

own wholesale distribution outlets. 

Canadian experience with the manufacturers tax has Shown that a 

government is almost certain to allow some type of downward adjustment 

in the sale price for tax purposes when manufacturers are integrated 

forward and sell to retailers at prices higher than their competitors 

charge wholesalers; again the result is substantial operational 

complications. For this and other reasons, Canada is considering 

replacing its manufacturers tax with a value-added tax. 

treat imports the same as domestically-produced goods. Merely applying the tax to the tariff-inclusive value of imports is not sufficient; the imported value will not necessarily be on the same basis as 

Under either a manufacturers or wholesale tax it is difficult to 
- 35 - 

the value at which the manufacturers or wholesale tax would apply to a 

domestic good. If advertising expenditures, for example, are typically part of the manufacturers or wholesale tax base, applying the 

same tax rate to the import value, which presumably does not include 

any domestic advertising activity, would tax imports less heavily than 

domestic goods. Alternatively, imports would be taxed more heavily 

than domestic goods under a manufacturers tax if costs of some postmanufacturing or wholesale activity were incurred prior to 

importation. 

While any expected change in a sales tax will cause purchases to 

be either accelerated or deferred, a manufacturers tax creates a special type of problem. By its very nature, with a manufacturers tax, 

the inventories of wholesalers and retailers will have been subject to 

tax. If wholesalers and retailers expect the tax to rise, they will 

accelerate their purchases from the manufacturer to acquire additional 

inventory at the lower tax rate. Or, if a tax reduction is anticipated, they will allow their inventories to be depleted so that new 

inventory can be bought at the lower tax rate. In effect, firms will 

try to either increase the profits or reduce the losses associated 

with the tax change. This disruption in buying patterns can be 

avoided, but only if inventories are subject to a tax adjustment when 

the rate of tax changes. The Federal Government does this for its 

manufacturers excise taxes through floor stocks taxes or refunds, 

designed to place inventories and new purchases on an equal tax 

footing. The problem can be solved, but a specific procedure, involving added complexity, must be designed. It is not automatic as with a 

retail sales or value-added tax extending through the retail level. 

All. of these difficulties with the manufacturers and wholesale 

taxes would be encountered equally with a value-added tax that 

excluded the wholesale and/or retail sectors. 

VI. Personal Exemption Value-Added Tax 

The personal exemption value-added tax is a flat rate tax in which 

investment purchases are expensed (deducted in full in the year they 

are made). It can be viewed as a flat rate tax on consumption or as a 

consumption-type value-added tax with personal exemptions. 

Under the personal exemption value-added tax, a flat-rate tax 

would be levied on both personal and business income. In the case of 

individuals, taxable income consists entirely of wages, salaries, and 

pensions. The tax on labor income would be withheld by the employer, 

as with the present wage withholding under the income tax. Interest, 

dividends and fringe benefits would be taxed at the business, but not 

the individual, level by not allowing these payments as tax deductions. A personal allowance and exemptions for dependents would 

eliminate the tax liability on limited amounts of labor income and 

thus lessen the burden of the tax. Since capital income would be 

taxed at the business level through the disallowance of business 

deductions, rather than through direct attribution to households, the 
- 36 - 

personal allowance and exemptions would not reduce personal tax liability on non-labor income. Thus, the personal exemption value-added 

tax would not alleviate the burden of the tax for those not receiving 

wages, salaries, and pension income. 

The business tax portion of the personal exemption value-added tax 

would be levied at the same flat rate as applied to individuals on all 

business entities, regardless of legal form, proprietorship, partnership, or corporation. In calculating taxable business income, only 

three categories of expenditures would be allowed as deductions: (1) 

wages, salaries, and pensions to employees; (2) purchases of goods, 

services, and materials from other firms; and (3) expenditures for 

capital equipment, structures, and land. The full and immediate 

deduction for purchases of capital equipment defines the tax base as 

equal to consumption. No deductions would be allowed for interest 

payments, dividends, royalties, state and local taxes, or fringe 

benefits. Given the common flat rate on all business and individual 

income, disallowing business deductions for these items is equivalent 

to taxing the owners of the business at the individual level. This is 

why, for example, interest and dividends are not explicitly taxed at 

the individual level. 

The personal exemption value-added tax can be viewed as a 

subtraction method value--added tax in which employees are "in the 

system." That is, employees are treated the same as other taxpayers 

are treated under a conventional value-added tax, except that employees are allowed no deductions for purchases. Labor is subject to tax 

on its "sales" of labor to business firms in excess of the personal 

allowance and exemptions. Business firms pay tax on the difference 

between their sales and purchased inputs, including labor. In the 

absence of the personal allowance and exemptions, the withholding tax 

collected by the employer would exactly offset the deduction taken by 

the employer on wages. 

Individuals may respond differently to the personal exemption 

value-added tax tax than they would to a conventional consumption-type 

value-added tax. Though both taxes have a consumption base, they 

achieve this result in fundamentally different ways. With the typical 

value-added tax, individuals pay a tax only if they consume; they 

avoid, or at least postpone, the tax as long as they save. Both labor 

and capital income, however, are subject to value-added tax once they 

are used for consumption purposes. Under the personal exemption 

value-added tax, in contrast, the tax liability of individuals on 

their labor income is not affected by the decision to consume or save; 

all labor income is taxed when earned, regardless of whether it is 

consumed or saved. Unlike a sales of conventional value-added- tax, 

the tax burden on individuals would not be reduced by saving rather 

than consuming income earned as wages and salaries. Interest, dividends, and other forms of capital income, however, are not taxed at 

the individual level under the personal exemption value-added tax even 

if they are used for consumption purposes. 
- 37 - 

While the conventional and personal exemption value-added taxes 

are economically equivalent, the question is whether individuals would 

respond differently to these aLternative ways of implementing a consumption tax. Would they, for example, be more likely to save if 

there is no tax on the act of saving itself than if there is no tax on 

the income from saving? In the first instance, the exemption for 

saving is implemented through the use of income, in the latter case 

through the source of income. 

The personal exemption value-added tax differs from value-added 

taxes commonly in use in another important respect. The tax would not 

be collected on imports and it would not be rebated on exports. Thus 

it would be levied on the origin, rather than the destination, basis. 

Because of the personal allowance and exemptions, the personal 

exemption value-added tax offers a way of directly lessening the 

burden of the value-added tax on low-income families and individuals 

without resorting to multiple rates. As the discussion in Chapters 2 

and 3 notes, the preferred type of value-added tax would have the 

following characteristics: 

1. deductibility of capital purchases (consumption type); 

2. broad base; 

3. uniform rate; 

4. credit method; and 

5. destination principle of border tax adjustments. 

As proposed, the personal exemption value-added tax satisfies 

requirements 1, 2, and 3. Can it be modified to be a credit method, 

destination principle tax? 

The personal exemption value-added tax plan could be converted to 

a credit-based tax by simply deducting tax on inputs from tax on 

sales. Since workers are treated as "selling" labor, the employing 

firm would be allowed a credit for the tax on wages. To preserve the 

personal allowance and exemptions in the credit framework, it would be 

necessary to allow credit against the business tax for an amount equal 

to the tax that was not imposed on labor income because of the personal allowance and exemptions, as well as for the tax actually withheld on labor income. 

Once the tax had been adopted to the credit method, it would be 

relatively straight forward to implement the destination principle. 

There may be some question whether other countries would view a valueadded tax structured along these lines as being eligible for destination principle border tax adjustments under the General Agreement on 

Tariffs and Trade (GATT). The personal allowances and exemptions add 

an element of personal or direct taxation that might render the tax 

vulnerable to attack under the GATT. (Recall that a direct tax such 

as an income tax, is not eligible for export rebates or compensatory 

import taxes under the GATT.) The strongest argument for GATT 

legality would probably be that the personal exemption value-added tax 

incorporates, in a single tax, both revenue and expenditure features. 
- 38 - 

The personal allowance and exemptions, that is, can be viewed as a 

form of expenditure program designed to alleviate the regressivity of 

the value-added tax. They could, for example, be said to be similar 

to other countries' family allowances funded from value-added tax 

revenues. Alternatively, it could be argued that the combination of a 

value-added tax and refundable income tax credits would clearly be 

GATT legal. The personal exemption value-added tax can be used to 

achieve exactly the same objective, but in one framework, rather than 

two. 

The personal exemption value-added tax would probably have less 

immediate effect on prices than would a conventional value-added tax. 

If it were viewed as an income tax, it may not affect prices directly. 

If the credit method were used to implement the tax, it would more 

closely resemble a conventional sales or value-added tax and might 

have a similar effect on prices. As with any sales tax, a rise in the 

price level would require an accommodating monetary policy. 

VII. Summary 

the United States are a retail sales tax and a value-added tax 

extending through the retail level. Pre-retail taxes, such as 

manufacturers or wholesale sales taxes, should be rejected since they 

would distort consumption behavior and production decisions and 

techniques, as well as give rise to difficult tax administration and 

compliance problems. A personal exemption value-added tax would only 

lessen the burden of the tax on those receiving wage or pension 

income, not on those receiving only capital income or who are 

unemployed. Though they are economically equivalent in their purest 

form, there are administrative differences between the retail sales 

tax and value-added tax that tend to favor the value-added tax. In 

particular, a value-added tax may be superior to a retail sales tax in 

freeing capital goods and other business purchases from taxation. 

The only two types of sales taxes that should be considered for 
- 39 - 

Chapter 5 

MAJOR DESIGN ISSUES 

I. Introduction 

Before a value-added tax could be implemented, a number of basic 

decisions must be made about the structure of the tax. The most important issues, to be considered in this chapter, include: the 

distinction between zero rating and exemption; the alternatives for 

reducing the absolute burden on the poor and regressivity; the choice 

between single or multiple rates of tax; and the tax treatment of 

exports and imports. Nearly two decades oE European experience with 

the value-added tax have shown these to be the most important design 

issues. These issues are discussed in the context of a consumption 

value-added tax extending through the retail level with tax liability 

determined under the credit method. Other issues, such as the treat-. 

ment of small businesses, are considered in Chapter 6. 

11. Zero Rating versus Exemption 

Under a value-added tax, commodities, transactions, or firms can 

receive preferential treatment in two different ways, by zero rating 

or exemption. Under zero rating, all value-added tax is removed from 

the zero rated good, activity, or Eirm. In contrast, exemption only 

removes the value-added tax at the exempt stage, and it will actually 

increase, rather than reduce, the total taxes paid by the exempt 

firm's business or non-retail customers. It is for this reason that a 

sharp distinction must be made between zero rating and exemption in 

designing a value-added tax. 

A. Commodities 

If a commodity or service is zero rated, no tax applies to its 

sale and the seller of the zero-rated item receives a credit for the 

tax paid on the purchase of materials and other inputs used to produce 

it. By this procedure, the zero-rated commodity is freed of all 

value-added tax; the user bears no tax with respect to a zero-rated 

good or service. By contrast, if a commodity is exempted, the sale is 

not subject to tax, but the seller receives no credit for tax paid on 

the purchase of materials and other inputs used to produce the exempt 

item. users of the exempt item will thus bear some tax. 

If a commodity, for example, is exempt only at the retail level, 

then only the retail level is freed of value-added tax. Although the 

retailer would not charge value-added tax on its sale, the retailer 

would not be entitled to a credit €or tax paid on the purchase of an 

exempt item. Thus, exemption of a commodity through all of its production and distribution channels would be necessary to free it of its 
- 40 - 

entire value-added tax burden. But, with zero rating, unlike exemption, only the final sale of the commodity needs to be zero rated, 

since any tax previously paid would be credited on the last sale. 

B. Transactions 

If a particular type of transaction, for example exports, is zero 

rated, the seller (the exporter) would not be subject to tax and would 

receive a credit €or tax paid on the purchase of the goods and other 

purchased inputs. This procedure frees the zero-rated transaction of 

all value-added tax. If the transaction is exempted, rather than 

zero-rated, the sale itself would not be subject to value-added tax, 

but the exporter would not receive a credit for tax paid on the 

purchase of the exported good or other inputs used in its production. 

C. Firms 

Particular sets of firms, as distinct from commodities or transactions, may be either zero rated or exempted. If banks, for example, 

are zero rated, they would be registered and would be required to file 

value-added tax returns, but there would be no tax on the banking and 

financial services they provide. The banks would receive a credit 

(and file returns to obtain the refund) for tax paid on purchases of 

materials, equipment, and other inputs. If banks, however, are 

exempted, the value added by their activities would not be subject to 

value-added tax, but they would receive no credit for tax paid on 

their purchases. Exempt firms would not be registered and would not 

be required to file value-added tax returns. The difference between 

zero-rating and exemption can also be illustrated in the case of urban 

transit service. If urban transit service is zero rated, no tax would 

be charged on the transit service fares, and the transit system would 

receive credit (or refund) for the value-added tax paid on its purchases of equipment, motor fuel, supplies, electricity, and any other 

business-use items. But if transit service is exempt, the system 

providing the service would not apply tax on the fares received and it 

would not receive a credit or refund for tax paid on its various 

purchases. 

rated transactions, or that sell zero-rated goods, are "in the system"; they must be registered to obtain credits or refunds for the 

value-added tax paid on their purchases. Exempt firms and those selling solely exempt goods or engaging in only exempt transactions are 

not registered and are not required to file a value-added tax return; 

they are "outside the system". Firms making both exempt and taxable 

(or zero-rated sales), or engaged in both exempt and taxable (or zerorated) transactions, must be registered, but they receive credit only 

for the value-added tax paid on materials and other inputs used in the 

production of taxable or zero-rated goods. 

In summary, firms that are zero rated, that are engaged in zero- 
- 41 - 

D. Consequences of Zero Rating or Exemption 

In the case of an exempt firm selling to a final consumer, exemption, compared to full taxation, provides a clear benefit in the form 

of reduced taxation. This is because the value added by the exempt 

firm is not taxed and the ultimate consumer pays only the value-added 

tax incurred by the exempt firm on its purchases from other firms. ~f 

the exempt firm, however, sells to a registered taxpayer, exemption 

can result in more taxation than would prevail under full taxation of 

the exempt firm's sales. This is because the registered firm will be 

bearing the tax incurred by the exempt firm on the purchases made by 

the exempt firm. But when the registered firm, in turn, sells to a 

final consumer, no credit will be allowed for the taxes paid on the 

purchases by the exempt firm. In effect, those purchases will be 

taxed a second time, thereby taxing the final sale more heavily than 

it would be taxed under full value-added taxation. 

As an illustration, consider the situation when tax relief to 

farmers takes the form of exemption rather than zero rating. Valueadded tax would apply to the sales of fertilizer, supplies, tools, and 

other items to the farmers, but the farmers would not receive a credit 

for this tax. Thus, it would be borne by firms purchasing from the 

farm sector. When these firms sell goods with agricultural content, 

they would pay tax on the value added both by themselves and by the 

exempt farmers, but with no credit for tax paid on farm inputs; the 

apparent relief provided by the exemption for farmers is converted 

into an additional element of tax on farm products. Zero rating of 

farmers would avoid this problem, but this would require all farmers 

to be registered for value-added tax purposes. The avoidance of this 

registration requirement is one reason for exempting farmers. The 

same type of problem would arise If small firms are exempt and make 

sales to registered firms. 

The choice between zero rating and exemption should be made on the 

basis of two principal considerations: (1) Is it desirable to free 

the users of the good or service completely from value-added tax, or 

only partially? (2) Is it desirable to exclude certain firms from the 

requirement to register and file returns? Even from the standpoint of 

the firms themselves, there are conflicting considerations. Zero 

rating frees a firm and its customers completely from value-added tax, 

but the zero-rated firm must register and file a tax return. If a 

firm is exempt, it is not required to register and file a return, but 

the customers of an exempt firm bear the tax incurred by the exempt 

firm on its purchases. This may be particularly objectionable to the 

exempt firm's business customers who cannot receive credit for this 

tax. In this instance, exemption would place the exempt firm at a 

competitive disadvantage. 

cations that would arise if a firm handles both taxable and exempt 

commodities. With zero rating, such a firm receives credit for tax 

paid on all its purchases, whether for production or distribution of 

zero rated or of taxable goods. But if some goods are exempted, then 

One further advantage of zero rating is that it avoids the compli- 
the firm selling the exempt items is entitled to a credit only for the 

tax on those purchases of materials and other inputs that are used to 

produce taxable (or zero-rated) goods. It does not receive a credit 

for tax paid on purchases related to the exempt transactions. 

Handling both exempt and taxable (or zero-rated) goods involves 

major compliance and administrative problems. The task of keeping the 

various purchases segregated according to whether they are used for 

taxable or exempt products is a difficult one. Capital goods, for 

example, may be used for the production or handling of both taxable 

and exempt goods; allocation of the tax paid on the purchases of these 

capital goods would be troublesome, particularly since the relative 

use in the production of the taxable and exempt goods would not be 

known in the period in which the capital goods were purchased and the 

tax credit would be available. 

Thus, in general, zero rating is superior to exemption of commodities and services and of transactions, such as exports. Exemption is 

desirable only for those firms which the government does not wish to 

register, for administrative or other reasons, and/or does not seek to 

remove all the value-added tax from their customers. Farmers, small 

service establishments, sidewalk vendors, and charitable and religious 

organizations are possible examples of firms for whom exemption may be 

appropriate. 

E. Tax Credit versus Subtraction Method 

If, instead of the credit method, the subtraction method were used 

for determining a firm's tax liability, there would be no zero rating 

and exemption would apply only to the particular level of activity 

that is being exempted. Thus, to eliminate the value-added tax on 

food, it would be necessary to exempt the sale of food by all firms, 

manufacturers, wholesale distributors, and retailers. With the tax 

credit method, the final sale is the crucial one; application of a 

zero rate would remove all cumulated tax from food, making it unnecessary to exclude sales at earlier stages. With the subtraction method, 

it would not be possible to totally eliminate the value-added tax on 

food simply by not taxing the final sale; exemption of the final sale 

would not eliminate the value-added tax that had been paid prior to 

the retail sale. Eliminating all of the value-added tax on food would 

require the exemption of all pre-retail transactions. But exempting 

fertilizer, for example, would also have the unintended result of 

eliminating some of the value-added tax on sales of non-food items 

such as fibers. 

The subtraction method avoids the cumulative tax problem of breaking a link in the tax and credit chain. Such breaks, however, may be 

rare with the tax credit method because exempt firms are placed at a 

disadvantage in selling to registered firms since those firms would 

then not be able to take credit for tax entering into the prices of 

their purchases. With the subtraction method, however, exemption 

would clearly be desirable and thus the political pressure to obtain 

exemption would be great. 
- 43 - 

111. The Issue of Regressivity 

general sales tax, is that it would be unfair to lower income indi 

viduals and families. There are two aspects to this equity argument: 

the absolute burden of the tax on the lowest income groups, and the 

regressivity of the tax or the relatively higher burden of tax as a 

percentage of income at the lower income levels than at the higher. 

If the value-added tax applies at a uniform rate to all consumer purchases, a substantial amount of tax would be borne by persons below 

the poverty levels. The tax would be regressive because the percentage of income used for consumption purposes declines, on the average, 

as income increases. Of these two equity issues, the absolute burden 

on the poor is the more serious, since the regressivity of the valueadded tax can be offset, if necessary, by adjusting the progressivity 

of the income tax rates. 

Four alternatives exist for reducing the burden of the tax on the 

The most frequent objection to a value-added tax, or any form of 

lower income individuals and families and to lessening the regressivity of the tax. These are summarized here, and evaluated in 

Chapter 8. 

A. Adjustment of Government Transfer Payments 

Some government transfer payments, such as social security, are 

intended to reflect increases in the price level. Thus, the effect of 

the value-added tax on prices would be automatically offset by 

increased payments for those transfers that are indexed to reflect 

changes in the cost of living. Not all low income individuals and 

families, however, receive transfer payments; and many with income 

substantially above the poverty level do receive transfer payments. 

Therefore, the indexing of transfer payments would not completely 

alleviate the burden of the tax on low income families and 

individuals. 

0. Zero Rating of Food and Other NeCeSSitie6 

In lieu of indexing transfer payments, it would be possible to 

remove the tax from certain goods and services. Since food expenditures constitute a higher percentage of income in the lower income 

levels than in the higher, and since expenditures of lower income 

groups are heavily concentrated on food purchases, zero rating of food 

would materially reduce the burden of the tax on the poor, though not 

eliminate it, and would make the tax less regressive. Twenty-seven of 

the states exempt food purchases from the retail sales tax and one 

state applies a reduced rate to food purchases. There are, however, a 

number of objections to excluding food and other necessities from the 

value-added tax, including unnecessary revenue losses and compliance 

and administrative problems; these are considered in Chapter 8. 
- 44 - 

c. Provision of a Refundable Credit 

Another alternative, used by several states, is to provide a 

credit against the income tax for a dollar amount which represents the 

value-added tax paid on the consumption of goods and services necessary to maintain a minimum standard of living. The objective is to 

eliminate the value-added tax from an essential or necessary level of 

consumption. If the available credit exceeded one's income tax 

liability, it would be refunded in cash, as is done now with the 

earned income tax credit. While this system would avoid many of the 

objections to zero rating of food and other necessities, as well as be 

less costly, it could be interpreted as a basic change in the 

country's social welfare program. 

0. Personal Exemption Value-Added Tax 

The fourth method for addressing the problems of regressivity is 

the personal exemption value-added tax. Under this approach, workers 

would be considered to be selling their labor services to their 

employers. A value-added tax would apply to their wages and would be 

withheld by the employer. But workers would be exempt from valueadded tax on a specified amount of wages, designed to reflect a minimum or poverty level of income. The firm, in calculating its value 

added for tax purposes, would be allowed to deduct its wage payments, 

as well as its purchases of raw materials, capital goods, and other 

items purchased for business use from other firms. if the personal 

allowance and exemptions were available only with regard to labor 

income, this alternative would not lessen the burden of the tax on 

those low income individuals and families not receiving labor income, 

such as the unemployed. 

IV. Single versus Multiple Rates 

Apart from exports, which always would be zero rated, a single 

rate of value-added tax would greatly facilitate compliance with and 

administration of the tax and would avoid the loss in economic 

efficiency from changes in consumer buying decisions caused by taxinduced distortions in relative prices. In practice, however, nrost 

value-added taxes, in the European Economic.Community (EEC) have more 

than one non-zero rate of tax. Currently, all EEC countries have two 

or more rates of tax, with Italy having eight separate tax rates. The 

United Kingdom has 2 rates of tax, 15 percent and zero. In addition 

to a standard rate, Belgium, France, Ireland, and Italy have one or 

more "luxury" rates that apply to such commodities as automobiles, 

jewelry, furs, television sets, and cosmetics. Belgium, Denmark, 

France, Germany, Ireland, Italy, Luxembourg, and the Netherlands each 

has a reduced rate which is applied to articles regarded as seminecessities. Belgium, Denmark, Ireland, Italy, the Netherlands, and 

the United Kingdom apply a zero rate to basic necessities, such as 

food and medicine. The objective of the multiple rates is to make the 

value-added tax less regresssive. 
- 45 - 

There are a number of problems, however, with multiple rate of 

tax. Though zero rating of food eliminates the value-added tax on 

food purchases, it does so for everyone regardless of their income. 

Thus, in light of its basic objective of lessening the burden of the 

tax on lower income groups, it is very expensive in terms of revenue 

foregone. With, multiple rates, because firms must apply the correct 

tax rate to each sale, interpretative questions arise about the appropriate rate class, and audit issues become much more difficult to 

resolve. This creates difficulties for both taxpayers and tax administrators. The classification of commodities for each rate group is 

virtually never based on scientific studies of consumer buying patterns, but simply on conventional views as to what constitutes a 

"luxury" and a "necessity." Even if it were possible to specify a 

structure of tax rates that would make a value-added tax less regressive, or even proportional, it is doubtful whether it would be 

good policy to adopt that rate structure. Whatever the desired degree 

of progressivity in the Federal tax system, it can be achieved through 

the structure of income tax rates, rather than by imposing high valueadded tax rates on luxuries. The important equity objective in 

designing a value-added tax is to avoid the tax burden on the poor; 

some regressivity at higher income levels is a much less serious 

matter. 

If a single rate of value-added tax is politically unacceptable, 

the only other rate should be zero. It should be applied to necessities such as food and medicine, assuming other alternatives for removing the burden of the tax from the poor are not feasible. If zero 

rates are used, there is little need for, and much complexity created 

by, the use of reduced "semi-necessity'' and increased "luxury" rates 

of tax. 

V. Foreign Transactions 

In the Common Market countries, as explained in Chapters 2 and 3, 

exports and imports are taxed on the destination principle; goods 

traded internationally, that is, are taxed in the country of destination, or where they are consumed, rather than in the country of 

origin, or where they are produced. Thus, goods made in France and 

shipped to Germany are freed of tax under the French value-added tax 

since they are zero rated when exported, but they are subject to the 

German tax when imported. This procedure is followed because of the 

border tax adjustments that allow goods to be exported tax free and 

for the value-added tax to be imposed on imports. 

With the credit method, the border tax adjustments to implement 

the destination principle are straight forward: exports are zero 

rated and imports are taxed. Since the tax credit at the final stage 

includes taxes paid at all earlier stages, the government can ensure 

that all goods sold abroad are shipped free of tax by simply zero 

rating exports. In the importing or destination country, the goods 

arrive tax free and are subject to tax at importation and on subsequent sales in that country. Because the destination principle is the 
- 46 - 

accepted international practice and because it allows imports and 

domestically-produced goods to compete on an equal tax basis, it would 

undoubtedly be followed by the United States. 

As noted in Chapter 2, if the exporting country administers its 

value-added tax through the subtraction method, it is not possible to 

ensure that its exports will leave the country exactly tax free. 

Under the subtraction method, the value-added tax paid at each of the 

previous stages would be calculated and rebated. But if there is more 

than one rate of value-added tax, or if certain stages are exempt from 

the value-added tax, it is not possible to compute accurately the 

actual amount of value-added tax that should be rebated when goods 

leave the country. Similarly, it is impossible to know what tax to 

impose on imports to exactly equal tax paid under the subtraction 

method on comparable goods produced domestically. While in theory the 

subtraction method is simple, in reality multiple rates and exemptions 

make its operation very complex, if exports are to be completely free 

of tax and imports are not to be treated differently from domestic 

goods. Not only sales, but also purchases must be classified according to the various tax rates in order to calculate the value-added tax 

rebates to be given on exports and compensating taxes to be levied on 

imports . 

The EEC countries hope ultimately to apply the tax on an origin 

basis on trade within the EEC. The objective is to avoid making border adjustments on intra-EEC trade, just as the United States would 

allow goods to cross from one state into another without adjusting for 

a Federal value-added tax. Under this approach, continuing the example above, French value--added tax would apply to the value added 

within France, and there would be no refund of French tax at export to 

GeKmany; Germany would apply its value-added tax to domestic sales, 

giving appropriate credit to the value-added tax paid to France to 

ensure the taxation of only the value added created within Germany. 

Thus, application of the German tax on imports from France to Germany 

would not be necessary. But much greater uniformity in value-added 

tax rates, coverage, and other features are necessary before this 

change to the origin principle can be implemented. 
- 41 - 

Chapter 6 

IMPLEMENTING A VALUE-ADDED TAX 

IN CERTAIN INDUSTRIES AND ACTIVITIES 

I. Introduction 

A basic characteristic of a value-added tax is that it functions 

most effectively if it is applied uniformly throughout the entire 

economy. Yet this may not be possible with some forms of activity. 

The application of a value-added tax to the typical manufacturing, 

wholesale, and retailing business is conceptually clear cut, although 

some questions may arise about incidental issues, such as fringe benefits to employees. In the case of other types of economic activity, 

however, such as banking or farming, or with other organizations, such 

as governmental or nonprofit entities, a value-added tax encounters 

difficult questions of principle and of implementation. These issues 

are discussed in this chapter in the context of a consumption-type 

value-added tax with tax liability determined under the credit method. 

11. Taxation of Services 

A value-added tax is designed to be a general consumption levy on 

all consumer expenditures. Accordingly, expenditures by consumers on 

services, as well as those on commodities, should be subject to tax. 

The failure to tax expenditures on services would favor those persons 

with relatively strong preferences for services, distort consumption 

away from commodities and toward services, and substantially reduce 

the tax revenue available at a given tax rate. Moreover, the taxation 

of all expenditures on consumer services would make the value-added 

tax less regressive. Many, but not all, services are covered under 

the European value-added taxes; most states, however, tax only a 

limited range of consumer services under their retail sales taxes. 

Only Hawaii, New Mexico, and South Dakota include most services in the 

bases of their retail sales taxes. 

One major advantage of the value-added tax over the retail sales 

tax with regard to services is the ability to exclude from tax services rendered to business firms through the tax and credit mechanism; 

services provided to businesses are subject to value-added tax, but 

the business purchasing the services may credit this tax against the 

value-added tax due on its sales. In effect, this tax and credit procedure frees services provided to business customers from the valueadded tax until they are reflected in the retail sale of a good or 

service. State retail sales taxes do not routinely exclude all services provided to businesses. If these services are taxed, business 

firms are given an incentive to provide the services with their own 

employees, rather than to obtain them from firms that specialize in 

providing services. 
- 48 - 

In considering the value-added taxation of services, various 

problems are encountered which make it doubtful that the value-added 

tax could be comprehensively applied to all services. For one thing, 

the control of service establishments for tax purposes is generally 

more difficult than the control of those selling commodities because 

the relationship between purchases of produced goods and sales is 

relatively weak. Accordingly, it is more difficult to ascertain the 

correct sales volume of service establishments by reference to their 

purchases. Because many service establishments are relatively small, 

the control function of tax administrators is both difficult and time 

consuming. 

A. Services Clearly Suitable for Taxation 

Several groups of services provided to consumers are clearly 

1. Public utility services, such as electricity, gas, telephone, 

suitable for inclusion within the scope of a value-added tax: 

telex, cable, and probably water service. These services are provided 

by large firms or governmental units that are easy to control. There 

is no inherent objection to taxing these services, though some questions may be raised about value-added taxation of water because of its 

"necessary" aspect. If food is zero rated, water probably should be 

as well. 

2. Services rendered by commercial establishments, many of which 

also sell commodities. Thus, repair services, such as for motor vehicles, fabrication activities of all types, barber and beauty parlor 

services, and laundry and dry cleaning services, would all be taxed. 

Including these services in the value-added tax would facilitate 

administration and compliance, since these firms would not need to 

segregate their sales of commodities from their providing of services, 

as they now must do under most state retail sales taxes. 

3. Amusement and entertainment services of all forms, including 

4. Hotels, motels, other transient accommodations, and restaurant 

social, golf, health, and racquet clubs. 

meals. If residential housing rentals are not taxed, a somewhat 

arbitrary line must be drawn between personal housing and transient 

rental accommodations, probably based on the length of stay. 

video tapes, tools, and appliances. The rental firms would pay tax on 

its purchases of these goods and receive credit for the tax against 

the tax charged on the rentals. 

tectural, and related services. As with other services, business 

firms acquiring these services would receive credit for tax paid on 

the services against tax due on their sales. 

5. Rental of taxable durable commodities, such as motor vehicles, 

6. Bookkeeping, accounting, legal, consulting, engineering, archi- 
- 49 - 

B. Financial Services 

Under the income tax, taxation of financial institutions presents 

complex and troublesome issues for both the government and the institutions; the problems involved in the tax treatment of financial 

activities under the value-added tax are also formidable. 

On the one hand, value added in banking, thrift, and insurance 

activities is no less appropriate for inclusion in the value-added tax 

base than value added in, say, manufacturing. As explained in the 

previous chapter, there also are good reasons why both financial 

institutions and their business customers may favor the full inclusion 

of financial institutions in the value-added tax system. Nevertheless, the practical problems of taxing financial services have led all 

European Economic Community (EEC) countries to exempt the basic lending activities of banking, insurance, and related financial establishments from the value-added tax. 

1. Banking and related institutions. In the manufacture and distribution of commodities and many other services, identifying "value 

added" is a relatively straightforward exercise. Particular problems, 

however, arise with respect to banks, savings and loan associations, 

and similar institutions. 

"renters" of money. They "rent" from their depositors, to whom they 

pay interest (or provide free checking accounts), they (at least the 

commercial banks) "create" money through credit expansion, and they 

"rent out" money to borrowers, for which they receive interest, either 

directly or through the purchase of securities. The value added by 

banks and other financial institutions is basically the difference 

between what the banks pay their depositors and the amount received 

from their loans and investments. If their depositors were solely 

business firms already registered for the value-added tax, the banks 

could be charged tax on interest paid to these depositors; the banks, 

in turn, would apply the value-added tax to their "sales", that is, to 

the interest received on their loans, and receive credit for the tax 

paid to their "suppliers" or depositors. In this case, there would be 

little difference from the way the value-added tax applies to 

manufacturers or distributors. 

Banks, in their basic or core activities, are essentially 

There are, however, several complicating factors. 

Many of the banks' depositors are not business firms but 

individuals with savings or time deposit accounts. Since these nonbusiness depositors would not be registered taxpayers, the banks would 

not be charged value-added tax on the interest paid to non-business 

depositors. To require the business depositors to charge and remit 

value-added tax when individual depositors did not could easily create 

confusion for the bank and the various classes of of depositors. An 

individual, for example, would be treated differently depending on 

whether the deposit account was for "business" or "private" purposes. 
- 50 - 

Furthermore, the banks' depositors often do not receive a market rate 

of interest, but various bank services instead, such as checking 

accounts. 

In general, therefore, it would not be desirable to attempt to 

apply the value-added tax to depositors in financial institutions. As 

a consequence, banks would have no value-added tax 011 interest paid on 

their deposits to credit against the value-added tax due on the interest they would charge on their loans. 111 itself, this is not a 

serious matter; the banks would simply be remitting value-added tax on 

the value added both by themselves and their depositors. Thus, one 

general alternative for the treatment of banks and similar institutions would be to apply value-added tax to the interest they charge 

their borrowers on new loans. (To apply value-added tax to existing 

loans would cause the banks to suffer windfall losses.) Various questions can be raised, however, about doing so. They may be considered 

in reference to the major classes of borrowers. 

(a) Business borrowers. A substantial portion of bank lending is 

to business firms, who would be charged value-added tax on the interest paid to the bank. These business firms, if they are registered 

taxpayers, would receive credit for the value-added tax paid to the 

bank against the tax due on their sales. It would not be necessary to 

require banks to charge value-added tax on interest received with 

respect to the bank's holdings of corporate bonds. The corporation 

which issued the bond would not pay tax on its interest payments; nor 

would it receive any credit for tax not paid. 

chapter, farmers would not be registered for the value-added tax. If 

farmers were not registered taxpayers, they could not obtain credit 

for any value-added tax paid on interest charged on their borrowing. 

To avoid any cascading of value-added tax, it would be necessary to 

eliminate the tax on the farmers' "purchases." Accordingly, just as 

the purchases by farmers of feed, seed, fertilizer, and farm machinery 

would be free of value-added tax, interest paid by farmers on the 

money which they borrow should be excluded from the tax. 

occurs through the purchase of long and short term debt securities. 

The question is whether value-added tax should be charged on the 

interest paid on government bonds. Ideally, one could argue that tax 

should be charged so that government and private borrowers pay similar 

costs. Charging value-added tax on private, but not government, 

borrowing may be viewed as subsidizing government borrowing. State 

and local governments, however, may object to the imposition of a 

Federal value-added tax on their borrowing costs as a revenue transfer 

from sub-Federal governmental units to the Federal government. Thus, 

there may be pressure to exclude borrowing by state and local governments from the value-added tax. 

(b) Farmers. Under a proposal made in another section to this 

(c) Governments. Most, but not all, of the lending to governments 
- 51 - 

(d) Consumption loans. Loans to consumers are essentially a 

consumption expenditure that enable persons to consume sooner than 

otherwise. Accordingly, in principle, interest on these loans should 

be subject to value-added tax, along with all interest charges made by 

sellers to customers buying on credit. However, a closer look at the 

issue suggests some problems. Consumer credit can be grouped into two 

major classes. 

is for housing construction and purchase. As discussed in another 

section to this chapter, there is merit, from an equity standpoint, in 

avoiding a heavy value-added tax burden on housing. It may be viewed 

as unacceptable to add a value-added tax to interest paid on home 

mortgages. 

(ii) Other loans. Most other loans, in dollar amounts, are made 

for purchases of consumer durables. The value-added tax should apply 

to the interest on these loans since they are for consumption expenditures. Some retail sellers frequently include a carrying or finance 

charge in their sales prices, in effect, offering liberal payment 

terms in exchange for a higher price. Since the full sales price 

would be subject to value-added tax, the failure to tax interest on 

consumer loans would discriminate against this category of retailers. 

The alternative of requiring the retailer to separate the finance 

portion of the charge from the basic sales prices of the goods would 

be a major complication. 

Some consumer loans are kruly for hardship purposes, such as when 

a sudden loss of income or increase in emergency expenses (e.g., illness) requires one to borrow. Delineation of these from other consumer loans is virtually impossible, but their existence raises some 

doubt about the general desirability of taxing interest on consumer 

loans. 

Taxation of interest on consumer loans, when that on other loans 

is not taxed, would give rise to some borderline problems. A farmer 

may borrow to improve both his barn and his house. Individuals may 

borrow to buy securities. Some dividing lines can be developed, but 

not without administrative complications. 

the incentive that would be given to persons to borrow for consumption 

purposes from sources other than banks and other registered financial 

institutions. It may be possible to use income tax records to ensure 

that value-added tax is paid on loans from one individual to another. 

This, however, may greatly increase the number of value-added taxpayers. The problem is somewhat parallel to the problem of casual 

purchases of goods from other individuals, but there would appear to 

be substantially greater opportunity for this type of substitution of 

loans than for the purchase of goods. 

(i) Housing loans. A substantial portion of all household loans 

A final problem with regard to taxing consumer loans by banks is 
- 52 - 

(e) International complications. If application of a value-added 

tax to financial institutions is limited to interest on consumer 

loans, there should be no significant international complications. 

Interest paid by foreign borrowers would not be subject to value-added 

tax under the destination principle. Borrowing by U.S. consumers from 

foreign banks would technically be subject to tax and probably could 

be reached by treaty arrangements. 

and of other thrift institutions, there are three major options, the 

third being the closest to the European system, which generally 

exempts financial institutions: 

value-added tax would be a credit for registered business firms 

against their own value-added tax liability. Though this approach 

would subject consumer loans to value-added tax, it would also impose 

a value-added tax on housing loans, as well as farm and government 

borrowing; there are, as noted, objections to taxing these types of 

loans. 

(f) Summary. For the basic or core lending activities of banking 

(i) Apply value-added tax to interest charged on all loans. The 

(ii) Apply value-added tax to interest charged on all loans, but 

zero-rate interest charges on loans to government, farming, and 

housing to avoid imposing additional tax on these sectors. 

loans, but exclude interest charged on housing loans, All other loan 

interest would be exempt, not zero rated. Under this approach, banks 

would be treated as exempt on all of their lending activities, except 

for consumer loans. The primary objection to this approach is that 

banks and other financial institutions would have to distinguish 

between consumption loans and other loans. Ideally, they also would 

have to segregate their purchases related to taxable consumer loans 

from those related to their exempt lending activities. 

As distinct from their core banking functions, financial institutions also perform various services for which a specific charge is 

made. Some services such as checking accounts with above-minimum 

specified balances are provided free of direct charge, being financed 

by the interest earnings on the depositor’s money. But others are 

subject to a direct charge: rentals of safe deposit boxes, provision 

of printed checks, and brokerage activities. These services can and 

should be taxable. If most interest charges are exempt, the institutions would still be registered for their secondary activities. 

Establishments rendering taxable financial services would be able to 

credit value-added tax paid on purchases of material and equipment 

against taxes due on charges for brokerage, safety deposit boxes, 

trust functions, and other secondary activities, to the extent that 

the materials and purchases can be attributed to these secondary 

activities. This should not be a difficult procedure for the banks 

since many of these purchases, such as checks or safe deposit boxes, 

are directly related to the services provided. 

(iii) Apply value-added tax to interest charged only on consumer 
- 53 - 

2. Brokerage activities. There is a wide range of brokerage services, involving the sale of securities, real estate, and the like. 

These can be subject to a value-added tax, but the argument may be 

raised that taxing them would interfere with the free functioning of 

capital markets and that these services, such as for the purchase of 

securities, are not truly a consumption expenditure. 

3. Insurance. The value added of an insurance company is roughly 

equivalent to the payments it receives from policyholders for risk 

protection. In the case of a term life insurance policy, which has 

no, or minimal, savings element, value added is approximately equal to 

premium receipts less death benefits paid. For a life insurance 

policy with a cash value, value added would be equal to premium 

receipts less death benefits and the policy's savings component. 

Value added for other forms of insurance, such as automobile and 

health protection, also would be equal to premium receipts less claims 

paid. 

Ideally, a broad base value-added tax could be applied to the 

value added of an insurance company. However, the credit method 

value-added tax does not lend itself readily to insurance company 

taxation. Though the company could certainly charge value-added tax 

on its premium receipts, it presumably would not be charged valueadded tax by policyholders on amounts received as claims paid. The 

insurance company could possibly act as the withholding agent, but 

there may be substantial public opposition to imposing a value-added 

tax on amounts received on death benefits or health insurance claims. 

For the insurance industry, a subtraction type value-added tax may be 

preferable to the credit method value-added tax, but this, of course, 

would be a substantial departure from the basic credit method system 

that is the focus of this volume. As a second-best alternative, 

exemption of insurance companies may be the soundest policy choice. 

All. Member States of the EEC exempt insurance transactions, as 

allowed by the Sixth Directive. Thus, insurance companies are not 

taxed on the delivery of insurance services, nor are they allowed to 

deduct value-added tax imposed on purchases related to the delivery of 

those services. The effects of exempting insurance would be parallel 

those in the banking and finance area. Though exempt persons and 

final. consumers would benefit from buying insurance on an exempt 

basis, the impact on taxable persons may be adverse because of the 

multiple taxation problem created by not allowing the insurance firm a 

credit for the tax paid on its purchases. Still, given the difficulty 

of measuring value-added in the insurance industry, at least in the 

context of a credit method value-added tax, the best alternative may 

be to exempt, but not zero rate, insurance activities. 

C. Governmental Activities for Which No Charge Is Made 

Most governmental activities are financed through taxation, 

without a specific charge being made to the user of the service. 

Because of the absence of a price for most government services, the 

value-added tax cannot be applied in the usual fashion to traditional 
- 54 - 

government activities. The tax treatment of sales of certain commodities and services by governmental entities as well as of sales to 

Federal, state, and local governments will be discussed in a separate 

section. 

D. Services That Cannot Effectively Be Taxed for Administrative 

Some services would be suitable for value--added taxation, but they 

1. Foreign travel. A value-added tax should not be imposed on 

expenditures for travel outside the country. The taxation of airline 

tickets for overseas travel would distort consumer buying habits and 

cause American carriers to lose passenger traffic; many U.S. travellers would simply buy a ticket to the nearest Canadian city and then 

purchase a ticket in Canada for the remainder of the trip. 

Reasons 

cannot be taxed for administrative reasons. These include: 

2. Personal service rendered in the home by individual employees. 

There is no feasible way of including this service within the scope of 

the value-added tax, whether the persons are technically employees 

(and thus legally subject to social security withholding) or independent contractors, but not established firms. Payments to individuals 

providing household cleaning, babysitting, and lawn and garden services cannot be taxed, except when they are made to commercial establishments with a fixed place of business. Some economic distortion 

and inequity would result from failing to tax these services, but 

there is no ideal workable solution. A closely-related problem is the 

widespread "moonlighting" activity in home repair, painting, and 

plumbing by persons who are employees of commercial firms, but who 

also provide these services on their own time. 

E. Problems in the TKanSpOrtatiOn Fiel'd 

Some problems would arise in applying a value-added tax to transport services. Some forms of transportation are highly competitive 

with the "do-it-yourself" provision of transport service; the labor 

component of the latter cannot be fully taxed. Other transport is 

highly subsidized by the government. The application of a value-added 

tax to a subsidized service is likely to increase the government 

subsidy with no net revenue consequences. 

1. Freight transport. There is little justification for taxing 

freight transport under a single-stage retail sales tax of the type 

used by the states since it is rendered almost exclusively to business 

firms. But a value-added tax should be applied to freight transport 

since the transport firms would then receive a credit for the tax paid 

on their purchases of equipment, supplies, and fuel. Business customers would receive credit for the tax paid on their purchases of 

freight transport. If transport firms were not subject to value-added 

tax they would not receive a credit on their purchases and there would 

be a break in the tax and credit chain. But even with a value-added 

tax there are some problems. 
- 55 - 

Consider the purchase of transport service by an organization that 

is exempt, not zero rated. Since an exempt entity cannot obtain a 

credit for tax paid on its purchases, the cost of for-hire transport 

would be increased compared to private transport provided by the 

exempt entity itself. As with the purchase of any good or service by 

an exempt entity, this would give the exempt firm an incentive to 

provide its own freight transport service. 

ber of owner-operator truckers, as many as 100,000. Those who work 

under contract for common carriers do not need to be registered from a 

collection standpoint, since their receipts would be included in the 

charge made by the common carrier to the customer. If they are not 

registered, however, they cannot receive a credit for the value-added 

tax paid on their purchases. One solution, which would avoid registering these owner-operators, would be to allow the common carriers 

for which they operate to take the credit for the value-added tax paid 

by the owner-operators on their purchases. This, however, would 

require the owner-operators to maintain the records necessary to 

document the purchase credits taken by the common carriers. 

transport would involve a number of administrative difficulties, but 

these do not amount to a compelling reason for excluding transport 

firms from the coverage of tax. 

2. Urban passenger transport. Most urban transport is provided 

either by governmental agencies (transit authorities) or by private 

firms under contract. In either event, there is a substantial subsidy 

element; with some transit systems no more than a quarter of the revenue comes from passenger fares. If a value-added tax were applied to 

the fares, either the fare net of tax would be reduced to avoid the 

loss of passenger traffic, or, if the fare were increased by the 

amount of the tax, passenger traffic would fall. In either event, the 

required subsidy would be greater. There is nothing inherently wrong 

with this in an economic sense, although it would result in a revenue 

transfer from local governments to the Federal government. To the 

extent that encouraging the use of urban transit to alleviate street 

and road congestion and pollution is considered an important social 

objective, a case can be made for zero rating urban transit, including 

metropolitan area rail and bus commuter service. 

The issue of taxi service is more complex. It is tempting to 

think of taxis as being used primarily by higher income consumers, but 

some of the users are poor and others are business users. Many taxis 

are owner-operated, and it may be difficult to monitor them for tax 

administration purposes. Since zero rating of taxis would pave the 

way for abuse in the purchase and use of motor fuel and vehicles, 

exemption is the best solution. 

3. Intercity passenger service. This type of service should be 

subject to value-added taxation. The arguments for alleviating road 

congestion and air pollution apply with much less force than in the 

Another problem in freight transport arises out of the large numOn the whole, the application of the value-added tax to freight 

464-836 0 - 84 - 3 
- 56 - 

case of urban-area transport. Like urban transport, some of this 

transportation, such as that provided by AMTRAK, is also subsidized. 

But AMTRAK provides freight service as well as passenger transport. 

Exempting AMTRAK probably would not be acceptable to AMTRAK's business 

customers who purchase freight service. Zero rating, on the other 

hand, would be overly generous given the differences with urban transport. Air transport, as well as train service, should be subject to 

value-added taxation. 

Travel agencies constitute a special form of broker, but one that 

does not charge the customer for its services, which instead are paid 

for by the carrier out of ticket fares. Most of the services of 

travel agents relate to air transport; if air transport is taxed, the 

travel agency service would be included in the value-added tax base 

through the taxation of airline fares. The agency could only receive 

credit for value-added tax paid on its purchases if it registers. AS 

a selling agent it would apply the value-added tax to the charge for 

the tickets, but this would be remitted to the airline, which would 

pay it to the IRS. 

F. Services Involving Significant Social Policy Considerations 

A significant portion of total expenditures on services, about 17 

percent, are made for medical, dental, hospital, and related health 

services. Full value-added taxation of these services would be 

unlikely as a matter of social policy. Exempting the providers of 

these services, rather than zero rating the services, would place some 

tax on the services, but less on those that are labor intensive. 

Exempt entities would not need to file value-added tax returns. Zero 

rating would remove the burden of the tax entirely. The case for zero 

rating is probably stronger for hospitals than for the professional 

services themselves, as purchases are a more significant element in 

the total cost of hospital than of physicians' services. Differential 

treatment, however, may encourage the provisions of physicians' services in the hospital, where they would be zero rated, rather than in 

an office setting where they presumably would be exempt. 

firms would, of course, receive credit for value-added tax paid on 

these services against the tax due on their sales; the portion on individuals would rest upon the persons acquiring the services. There 

may be some objection that value-added taxation would interfere with 

the attainment of justice by making it more expensive. The case for 

exempting or zero rating of legal services, however, is not compelling. A substantial portion of legal work is for strictly consumer 

activities, such as the preparation of wills and resolution of 

domestic disputes. Legal services should be subject to value-added 

taxation. 

Some of the same considerations apply to legal services. Business 

Education is another type of activity to which application of the 

value-added tax may be regarded either as impractical or objectionable 

on social policy grounds. While some portion of private sperlding on 

education may represent consumption, some outlays for education can 
- 5'1 - 

also be viewed as contributing to human capital formation. Many educational services are provided more or less free of charge by governmental entities. Consequently, either no or a heavily-subsidized 

price is charged for publicly-provided educational services. Thus, it 

would be difficult to apply a value-added tax to the true value of 

these educational services. If public education were not taxed, 

consumers of private education would object to taxation of the tuition 

charges, especially since many private schools have religious affiliations, formal or otherwise. The same considerations apply to university education. As a matter of both social and economic policy, 

tuition charges should not be subject to value-added taxation. If the 

value-added tax is not imposed on most purchases by state and local 

governments, education should be zero rated, rather than exempt. 

tions. For the most part, those organizations do not charge a price 

for their services and value-added tax cannot be applied. The issue 

is not one of applying the value-added tax to their "sales," unless 

they operate incidental commercial activities such as gift shops, but 

how their purchases should be treated. This issue is considered in 

the section on nonprofit institutions. 

Similar policy issues relate to religious and charitable instituG. Summary 

For economic, revenue, and administrative reasons, a value-added 

tax should apply to as many services as possible. Any departures from 

this rule would favor those preferring to consume untaxed or lightlytaxed services, require higher tax rates to raise an equivalent amount 

of revenue, and complicate the administration of the tax. Accordingly, 

exemptions or zero rating of consumer expenditures on services should 

be kept to an absolute minimum. The only services which should be 

exempt or zero rated are those for which a clear and convincing 

justification is made on either social or administrative grounds. 

III. Taxation of Small Enterprises and Farmers 

A value added tax, like any sales tax, is collected from business 

firms. The effective operation of the tax requires that the firms 

collect the tax accurately from their customers, keep records of taxable sales and purchases and of tax collected on sales and of tax paid 

on purchases, file correct tax returns on time, and remit the tax to 

the government. These tasks create no major problems for most typical 

business firms, though they give rise to some compliance co8ts. But 

there are two general types of enterprises that may find compliance 

with the value-added tax difficult, and, in turn, effective control of 

them may be difficult. These are small businesses and farmers. 

A. Small Businesses 

Even in the United States, there are large numbers of small firms. 

They tend to be heavily concentrated in the service industries. Other 

vendors have no established places of business: sidewalk sellers, 
- 58 - 

house-to-house peddlers, housewares distributors operating from their 

homes, newsboys, and those selling in flea markets, farmers' markets, 

and the like. 

The basic issue is: should such firms be excluded from the coverage of the value-added tax, presumably by exemption? If so, how 

should the line be drawn between firms that are to be included within 

the scope of the tax and those to be excluded? One general approach 

is to exempt those firms with sales below a specified figure; they 

would not be registered, but tax would apply to sales to them and they 

would not receive credit for the tax paid on their purchases. 

1. The case for exemption. The argument for exemption of small 

firms is based on operational considerations; the concern that such 

firms would not maintain adequate records of sales and of value-added 

tax collected on sales and paid on purchases and that they would not 

file returns accurately, if at all. All of the EEC countries and most 

other countries using value-added taxes (as well as ones using manufacturers and wholesale sales taxes) do provide exemptions, usually on 

the basis of annual gross sales. Some of these countries then apply a 

"forfait" assessment to the small firms, based on external indicators 

of the likely volume of sales, such as the number of employees. This 

procedure is completely foreign to U.S. experience. The Sixth Council 

Directive of the EEC, issued in July 1977, gave the member countries 

the option of "applying simplified procedures" for small firms, and 

all have done so. Table 6-1 summarizes treatment of small firms in a 

number of countries. 

Apart from the compliance problems, the task of handling the tax 

returns, payments, and delinquencies of small firms would be a major 

one, for a relatively small amount of revenue. As shown in Table 6-2, 

a $10,000 gross receipts exemption would, on the basis of 1979-80 returns, have excluded over one-half of the sole proprietors and about 

one-third of the partnerships in the United States from responsibility 

for the tax, but only 2.5 percent of total receipts. A $25,000 figure 

would have excluded 70 percent of the proprietorships, and nearly 50 

percent of the partnerships, and about 7 percent of sales. As stated 

in Table 6-2, these figures exclude the farm sector. 

2. Objections to exempting small firms. From an economic standpoint, exempting small firms in regular production and distribution 

channels wobld create economic distortions. Registered taxpayers 

would be discouraged from buying from exempt firms, but consumers 

would tend to purchase from such firms. This would be particularly 

true if small retailers were excluded; they could, if they wished, 

sell more cheaply to consumers than their registered competitors. 

There would also be major problems with where to draw the line for 

exemption, the determination of whether firms fell above or below the 

line, and the possibility that a firm's tax status would change during 

the year. 
?able 6-1 

EX!XPCIONS OF EXALL FIM FRM SALES TAXES, WED ON SALES MLLME' 

rim Exempt with Exchange Rate Exeoption Expressed 

Country Yeat Annual Sales under May, 1984 in u.S. Collars meabnent 

Value Mded Tams: 

Belgim 1980 

&mark 1975 

France 1980 

Gemany 1984 

Eire 1980 

Italy 1980 

tuxenboucg 1977 

Sweden 1980 

United Kingdm 1980 

mgmtina 1980 

solivia 1977 

costa Rica 1971 

1ndonesia3 1984 

l+3""faCt"mrS Sales Tax: 

Ca"a3.3 1984 

Philippines 1983 

Kenya 1977 

zanbia 1982 

myna 1982 

molesale Sales Taxes: 

Rustralia 1982 

New zealand 1982 

Swi tzerland 1983 

Retail Sales Taxes: 

Zimhabwe 1983 

states of India6 1983 

Paraguay 1977 

France 1980 

Equivalent sales figure 

Netherland 1980 

Equivalent sales figure 

Australia-alternate 1982 

Bfr: 2.5 million 

2.5-4.5 million 

4.5-15 million 

kr 5,000 

fr 500,000 

M 20,000 

20,00060,000 

b 2,000 for 2 months 

if 90% sales exempt or 10% 

if rate above 10% 

others 

1,000 for 2 months 

300 service ad 

b 6 million' 

Bfr 100,000 

kr 10,000 

b 5,000 

P 36,000,000 

B 200,000 

C 800,000 

R 24,000,000 4 

SC 50,000 

P 2,400 

Ks 100,000 

K 10,000 

GS 10,000 

AS 12,000~ 

NZS 5,000 

Sfr 35.000 

2s 20,000 

G 1,800,OO 

R 10,000 to 50,000 

fr 1,350 

fr 7,670 

55.8 

10.05 

8.41 

2.135 

.a937 

1687.5 

55.8 

8.08 

.714 

41.6 

196 

41 

982 

1.22 

11 

14.4 

1.35 

3 

1,113 

1.54 

2.26 

1.05 

126 

10.22 

44,803 exempt 

44.803-80.646 equalization tax on supplier 

80,646-268,817 farfait 

498 

59,453 

7,312 

7,312-21,938 

2,238 

1,119 

336 

3,557 

1,792 

1,238 

7,003 

87,591 

1,020 

19,410 

24,439 

40,983 

218 

6,944 

7,407 

3,333 

10,782 

3,246 

15,486 

19,047 

14,285 

978-4,892 

memption Based on Tax Liability 

8.41 101 

912 

G 2,050 3.08 665 

G 11,388 3,697 

A 250 1.13 221 

exempt 

forfait 

exempt 

digressive scale 

1 

exempt 

forfait 

exempt 

exempt 

exempt 

special tax on purchases 

exempt 

exempt 

exempt 

exempt 

exempt 

exempt 

exempt 

exempt 

exempt 

exempt 

exempt 

exempt 

tax applies to purchase 

ex". 

exempt 

exempt 

exempt 

* 

1. 

2. and all retailers. 

to appar in Wlic Finance in the -11 of 1984. 

Exempt if a~ual tax under fr 1,350. 

3. 

4. 

5. 

6, 

T~X limited to manufacturing sector. 

or R 100 million capital OL total tax liability udee RS250. 

mst are retail sales taxes, 3 are essentially wholesale taxes, 1 is dual pint, 4 are casccdde (turnover) taxes. 

Exemption applies to manufacturers only. 
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- 61 - 

3. Is exemption necessary? In the context of the countries of 

southern Europe and the Third World exemption of small firms is probably imperative, given the large number of small entities with inadequate recordkeeping. But the case for exemption of small firms is not 

nearly as strong in the United States. Regular retailers, no matter 

how small, have learned to keep records adequately for complying with 

income, social security, and state retail sales tax requirements. The 

states do not exempt small firms, per se, and state tax officials, in 

general, report that the problem of small firms without adequate 

records is not significant. In general, the rule used by the states 

for sales tax purposes is that registration is required if sales are 

made on a regular basis as an essentially commercial establishment; 

this rule excludes persons making casual occasional sales (church 

bazaars or garage sales) and itinerant sellers, such as children 

selling fund-raising items for school, church, and social 

organizations. 

While regular retail. establishments, manufacturers, and wholesale 

distributors, even if relatively small, can be registered for the tax, 

there is a need for special treatment of small vendors without established places of business, including the large number of very small 

providers of services. The most satisfactory manner in which to draw 

the line appears to be that used by most states: exclude vendors or 

service establishments that do not have an established place of business or that sell on a casual nonregular basis. Legislative authorization could be given to the IRS along the following lines: Registration shall not be required of those categories of sellers determined 

not to be engaged in a regular business activity. Under this rule, 

excluded vendors would be exempt; no tax would be charged on their 

sale, but value-added tax would apply to the suppliers of these 

sellers. 

4. Other problems. If an enterprise that is exempt from the 

registration requirement sells to registered firms, the tax and credit 

chain is broken, and the purchaser cannot obtain credit for valueadded tax borne on the purchases of the exempt firm. In this case, 

the option of registering should be given to those enterprises not 

required to register. 

or a similar criterion should be provided, but registration for valueadded tax purposes should not be required of sellers having no established place of business and making only casual. sales. 

5. Summary. No exemption of small firms based on gross receipts 

B. Farmer6 and Value-Added Taxes 

The application of a value-added tax to farmers raises several 

issues. In general, it is not feasible to simply treat farmers and 

agricultural products in the same fashion as other segments of the 

economy. Several aspects of farm production and sale warrant 

consideration : 
- 62 - 

1. The existence of large numbers of small farmers. While agricultural output has become increasingly concentrated in large farms, 

there are still many small farms. According to IRS data drawn from 

the Statistics of Income, as shown in Table 6-3, in the 1979-81 

period, of 3.2 million farmers, 2.2 million had gross receipts from 

farming under $25,000 a year. While these small farmers must keep 

some records for income tax purposes, they are not subject to state 

sales taxes, and their records may not be adequate to file accurate 

value-added tax returns, Compliance costs to farmers of filing 

periodic value-added tax returns and of making payments would be nontrivial. Moreover, farmers would need to issue invoices to the purchasers of their products, which they may not now regularly do. The 

administrative costs to the IRS of handling all of these small 

returns, equal to at least 10 percent of total returns, would be no 

less significant than the additional compliance costs for farmers. 

2. Exports. A large portion of total agricultural output, about 

90 percent, consists of food, including livestock feed. A high percentage of farm output, about 30 percent overall, is exported. For 

major crops, the percentages exported in 1981 were wheat, 64; corn, 

27; soybeans, 45; cotton, 44; and tobacco, 32. Taxation at the farm 

level of crops that will. be exported involves no net revenue gain and 

substantial effort; it is not necessary to apply the value-added tax 

to the sale of a trainload of corn that is destined for export since 

the tax would be refunded when the farm products are exported. 

3. Solutions. The application of a value-added tax to 

agriculture would result in large numbers of small farmers being 

required to file value-added tax returns, with little net revenue 

gain. The IRS would incur substantial costs in handling these 

returns. There are several possible solutions: 

(a) Exempt small farmers, those with qross receipts less than a 

specific amount. This would lessen the problems of compliance by 

small farmers and the handling of larqe numbers of low tax returns by 

the IRS. But the problem of shifting-of the tax borne by these smali 

sellers on their purchased inputs would remain. Any borderline based 

on gross receipts would be arbitrary and firms would not know their 

tax status until the end of the year. Almost of necessity, the use of 

the previous year receipts figures would have to be sanctioned. There 

would be a small incentive to divide farms among family members to 

avoid having to file tax returns. Small farmers would be favored over 

larger ones on direct sales to consumers, but business purchasers 

would prefer to buy from larger registered farmers, who, by virtue of 

being registered, would get a credit for tax paid on their purchases 

of farm inputs. 

(b) Exempt all farmers from the value-added tax. This alternative 

would eliminate the borderline between large and small firms; no farmers would need to register or to file returns (unless they sold taxable farm products at retail in an organized, continuous fashion). But 

the tax and credit chain would be broken for all farmers; farmers 

could not obtain credit for tax on their farm inputs. Thus, the tax 
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- 64 - 

on farm inputs would be reflected in farm product prices. One solution that is widely used in Europe would allow the purchasers of farm 

products to presume that a specified percentage of the purchase prices 

of farm products consists of value-added tax on purchases by the 

farmer. But the average figure authorized by law would not equal the 

actual figure for many transactions. 

There are other partial solutions to the tax on inputs problem 

that arises if farmers are exempt. Farmers could be given the option 

to register if they wished; the experience in Europe is that many of 

the larger farmers would register. But this does not solve the problem completely. If most farmers register, then the objective of minimizing the number of small returns would not be attained. 

Another possible solution is to allow farmers a credit against 

their income tax liability for value-added tax paid on purchases. But 

this would complicate the income tax returns and may give farmers a 

temptation to overstate the credit. Very small farmers not now filing 

income tax returns would not get the credit without filing a return. 

(c) Zero ratinq farmers. The zero rating of farmers would solve 

the problem of the tax on farm inputs, buc it would require registration of farmers and the filing of returns to receive a refund of the 

taxes on purchased inputs. This alternative would accomplish little 

in the way of avoiding costly compliance work for farmers and additional administrative responsibilities for the IRS. 

(d) Exempting farmers and zero rating sales to farmers. The 

fourth alternative is to exempt farmers and zero rate sales to farmers 

of major classes of farm inputs: livestock and livestock feed, fertilizer, farm machinery, and possibly fuel for farm use. This approach would remove almost all value-added taxes on farm inputs; to 

also zero rate sales of minor items such as hand tools would pave the 

way for evasion (consumption use of the item) and create additional 

complexity. For those categories that are zero rated when sold to 

farmers, the suppliers would have to distinguish farm from nonfarm 

sales. But most of the sales of these classes of commodities, other 

than fuel, are made to farmers; the trade is highly specialized. Fertilizer sold in small quantities through retail stores, for example, 

would not be subject to the zero rating. Inevitably there would be 

some leakage, as a farmer used farm fertilizer for his lawn, but this 

is a minor problem. Zero rating of fuel for farm use may pose more of 

an abuse problem. Sellers of zero-rated farm inputs would receive 

credit for value-added tax paid on their purchases of the inputs. 

by the farmer of crops destined for export. Without some special 

rule, tax would apply on the sale by the country elevator to the subterminal or river elevator, and by the latter to the exporting firm. 

But it should be possible to devise some form of licensing system that 

would permit these transactions destined for export to be free of 

application of the tax. 

This solution would avoid applying the value-added tax on the sale 
- 65 - 

5, Illustration of alternative approaches. Table 6-4 illustrates 

four alternative methods for dealing with the problem of farmers: 

full taxation; exemption; use of the EEC system of allowing the firm 

purchasing the farm products to treat a specific percentage of the 

purchase price as consisting of value-added tax on farm inputs; and 

exemption of the farmer with zero rating of sales to farmers of major 

farm inputs. The table is based on the assumptions that the farmer 

can directly add the tax to his selling prices and that food is 

taxable. 

treatment under a 10 percent value-added tax that applies to a farm 

supplier, a farmer, and a food wholesaler. In the example, total 

value added by these firms is $2,000, which at a 10 percent rate would 

yield $200 of value-added tax revenue. 

farmer is simply exempt from the value-added tax. The wholesaler cannot claim any credit for the value-added tax included in the purchases 

from the farmer (there is a break in the chain of credits) and the 

government actually collects more value-added tax ($60 more in this 

case) than in the ordinary situation shown at the top of Table 6-4. 

This occurs because the value added by the farmer's supplier, the seed 

seller, is, in effect, taxed twice. 

The third section of Table 6-4 illustrates how the EEC alternative 

The top section of the table illustrates ordinary value-added tax 

The second section of Table 6-4 illustrates the situation if the 

treatment for farmers would operate. As is shown, the farmer charges 

no tax on sales and receives no credit for value-added tax paid on 

seed purchases (or purchases of any other inputs). The wholesaler 

pays a gross value-added tax of $250 on its sales and then subtracts 

both the actual and assumed value-added tax paid on purchased inputs. 

In the example, it is assumed that the wholesaler is allowed to deduct 

4 percent of the value of purchases from the farmer from its gross 

value-added tax liability or $40; the wholesaler also subtracts $50 of 

value-added tax actually paid on other purchases. Using these assumptions, the wholesaler's net value-added tax would be $160. The total 

value-added tax collected by the government, in this example, would be 

$220 as compared with $200 under ordinary value-added tax treatment. 

Under the EEC system, the total tax on a product may be either 

more or less than would prevail under ordinary value-added tax treatment. The outcome depends on the percentage of the purchase price of 

farm products that the farmers' business customers are allowed to 

credit. In the Table 6-4 example, the farmer actually paid the seed 

seller value-added tax of $60; this is the amount that should ideally 

be allowed as a credit to the wholesaler. However, in the example, 

the wholesaler is allowed to credit only $40 against its gross liability. The $20 difference between the amount the wholesaler should 

ideally have credited and the amount of tax allowed as a credit represents the difference between the total tax collected under the EEC 

alternative system ($220) and the amount that would be collected under 

ordinary value-added tax treatment ($200). Thus, under the EEC alternative tax treatment, the total value-added tax imposed on a product 
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- 67 - 

is only an approximation of what would happen under ordinary treatment. Only by chance would the value-added tax collected under the 

EEC system turn out to be the same as would be collected from farmers 

and their customers under ordinary value-added tax treatment. 

value-added tax system. If they join the system, their sales are 

taxed and they are allowed to credit the value-added tax paid on their 

purchased inputs against their gross value-added tax liability. Many 

of the large, highly mechanized farms find it to their advantage to be 

in the regular value-added tax system since they pay more value-added 

tax on their purchases than they would be allowed as credits under the 

special system for small farmers. In addition, farms producing goods 

for direct export must join the standard value-added tax system in 

order to get refunds for the value-added tax paid on their purchases. 

The lower part of Table 6-4 shows the situation with exemption of 

farmers and zero rating of sales to farmers of major inputs, such as 

seed. The total tax shown is $200, the same as under ordinary valueadded tax treatment. The actual tax may be somewhat higher because of 

the tax element in the purchases of any non-zero rated farm inputs. 

In all the EEC countries, farmers may elect to join the standard 

6. Summary. There is no ideal solution to the farm problem. The 

recommended solution would exempt farmers and zero rate the sales to 

farmers of basic primary farm inputs: livestock and livestock feed, 

seed, fertilizer, farm machinery, and, probably, fuel--primarily 

diesel--sold for farm purposes. It should be possible to devise some 

system to avoid taxing at pre-export stages the very large volume of 

sales of farm products for export. 

IV. Governments and Not-for-Profit Institutions 

the tax should apply to activities of governmental entities and nonprofit institutions. 

In designing a value-added tax, questions may arise as to whether 

A. Governmental Units 

Under any form of sales tax, the treatment of governmental units 

encounters special issues concerning general policy, administration, 

competitive equity, and intergovernmental relations. 

and therefore value-added tax cannot apply to the services per se. 

There are four issues that arise under a value-added tax: 

Most governmental services are provided without a specific charge, 

1. Should the tax apply to sales by governments when a charge is 

2. HOW should government purchases be treated? 

3. Should Federal, state, and local governments be treated in the 

4. Should government-owned corporations or the equivalent be 

made ? 

same fashion? 

treated differently from government agencies? 

464-836 0 - 84 - 4 
- 68 - 

1. Sales by governments. In general, the basic rule should be 

that if the activity is taxable when it is provided by private firms, 

value-added tax should apply to sales by government units, unless 

there are compelling reasons to the contrary. Thus, essentially 

commercial activities of government, such as the sale of electric 

power by government-owned utilities, alcoholic beverages by state 

liquor stores, prints by a government art museum, meals in government 

cafeterias, highway toll roads, and parking garages (but presumably 

not parking meters), would be subject to tax. Governmental units 

providing these goods and services would be registered for the valueadded tax. 

But there are borderline cases. Charges are made for various traditional government activities, such as recording deeds, issuing passports, and licensing household pets. Sales of government documents 

have a somewhat similar status. There would appear to be little gain 

from applying the value-added tax to these traditional governmental 

activities. Another borderline case is the postal system; should 

value-added tax be applied to postal charges? For parcel post the 

case seems clear: tax should apply if it does to transport by private 

firms. While there is no economic reason not to apply a value-added 

tax to first class and special delivery postal charges as well, there 

may be some political objection. 

Problems would also arise with activities such as garbage collection. In many municipalities, garbage collection is financed out of 

general tax revenue with no separate charge to the users. But some 

municipalities do charge separately for the service, and users are 

charged for all garbage collection provided by private firms. But to 

apply a value-added tax to either of these charges when garbage 

disposal financed by general tax revenue would not be subject to the 

tax raises serious questions of equity and,may create economic 

distortions. 

2. The tax treatment of government purchases. With regard to the 

value-added tax treatment of purchases by Qovernmental units, there 

are three alternatives: 

(a) Exempt governmental units. Under this approach, government 

units would not be registered (except when they are subject to valueadded tax on their charges) and would not file value-added tax returns. But they would bear the full burden of the tax applied to 

their purchases. At the Federal level, there should be no great objection to this, though would be no net revenue gain from collecting 

the tax on Federal purchases, because the cost of government purchases 

would increase by the amount of the tax. With exemption, the filing 

of value-added tax returns by Federal agencies and the issuing of 

large refunds that would involve only intragovernmental transfers 

would be avoided. 

The issue, however, is quite different with respect to state and 

local purchases, as exemption would involve a net transfer of resources from sub-Federal governmental units to the Federal government. 
- 69 - 

There may even be constitutional issues, quite apart from the political ones. Thus, some method must be adopted to remove the valueadded tax burden from the purchases of state and local governmental 

units. There is no objection, incidentally, to applying more lenient 

treatment to the states and local governments than to the Federal 

government, though there would be to the reverse. 

(b) Zero rate governmental units. This approach would remove the 

value-added tax burden from the governmental units since they would 

receive a credit or refund for tax paid on their purchases. But, for 

both the governmental units and the IRS, it would involve tremendous 

paperwork in the filing of returns and issuing of refunds to the large 

number of Federal, state and local government units. Moreover, since 

applying the tax to Federal government purchases would reflect the 

true costs of government operations, it does not seem sensible to 

refund the value-added tax. Thus, there is no need to zero rate the 

Federal government. With exemption but not zero rating, the tax would 

still be collected on the purchases by the Federal government, but the 

administrative and compliance costs associated with filing returns and 

processing refunds would be avoided. 

if another alternative is not used to eliminate the value-added tax on 

state and local purchases. Zero rating would remove all value-added 

tax burden, and it would avoid the necessity of the governmental units 

distinguishing between purchases for the provision of commercial services on which they collect value-added tax and those for other purposes. But it would require every state and local government unit, 

including the myriad of special districts, to register as a valueadded tax taxpayer and file for refunds. However, suppliers would 

treat sales to government in the same fashion as other sales. 

At the state-local level, however, zero rating would be necessary 

(c) Zero rate the sales to qovernmental units and exempt the 

units. This alternative is similar to that suggested for farmers and 

would also remove the burden of the value-added tax from the governmental units. The suppliers would not app1.y tax to their sales to 

governmental units, and would receive credit for value-added tax that 

has applied to the commodity up to sale to the government. By not 

registering government units, this approach would avoid a substantial 

number of tax returns and refund payments. But it would require sellers to distinguish in their sales between governmental and nongovernmental purchasers, as they must do now under most state sales taxes. 

This would not be a major task for large suppliers such as defense or 

highway contractors, or suppliers of large quantities of heating oil. 

to a school district. But it would be more difficult for retailers 

supplying small quantities of goods to local government units. Some 

loss of tax revenues on otherwise taxable transactions would be inevitable. The question is whether this is a more serious problem than 

the returns and refund problem that would arise with zero rating of 

governmental units. This procedure could be applied to the states and 

localities and not to the Federal Government, but it is the local government level where the greatest danger of leakage of tax revenue may 

occur. 
- IO - 

3. Government corporations. Government corporations and similar 

entities primarily often provide commercial services; the principles 

outlined above should apply on commercial services whether provided by 

a governmental agency or a government-owned corporation, such as 

AMTRAK. Various governments use different systems; the legal status 

of the entity should not be a relevant consideration. 

4. Summary. Value-added tax should apply to taxable goods and 

services, regardless of whether they are publicly or privately provided. There would be little gain from applying the tax to traditional governmental fees and license charges. 

Purchases by the Federal government should be subject to valueadded taxation to properly reflect the costs of government operations. 

This would have a net effect on the Federal budget; value-added tax 

receipts would be higher, but so would appropriations to pay the costs 

associated with the tax. If it is necessary to allow states and local 

governments to make purchases on a tax-free basis, two possibilities 

exist: to zero rate the governmental units or exempt the governmental 

units and zero rate the sales to them. In many respects the latter is 

simpler as it avoids excessive filing of returns and subsequent 

refunds, but it would create some problems for suppliers. 

8. Taxation of Nonprofit Institutions 

A wide range of nonprofit institutions is not subject to Federal 

income tax. Decisions must be made as to their treatment under a 

value-added tax; exclusion from one form of tax does not necessarily 

warrant exclusion from another; each exclusion from the value-added 

tax would increase the credibility of other pleas for special treatment. There are three major issues: 

1. Should all nonprofit institutions be treated the same? 

Consideration of special treatment should focus not on the nonprofit 

nature of the institutions, but on the activities they perform. In 

general, special treatment should be considered only for those nonprofit institutions whose services are considered unsuitable for 

taxation under a value-added tax, as a matter of social policy. These 

include hospital, charitable, religious, and educational institutions. 

There is no justification for special treatment for consumer-buying 

cooperatives, farm cooperatives, labor unions, farmer and business 

associations, fraternal and social organizations, and the like. Some 

of these will make no sales of taxable goods and services and thus 

will not be registered under the value-added tax, but their purchases 

would be taxed in the regular manner; those organizations making 

taxable sales would be registered and subject to tax. 

of services, many services are provided without a charge in the usual 

sense; one does not pay a charge to attend church and persons receiving charity do not pay a charge for it. Accordingly, a value-added 

tax cannot, indeed should not, be applied to the services for which no 

charge is imposed. Some of these institutions, however, may provide 

2. Tax treatment of sales. As noted in section I1 on the taxation 
other services for a charge or sell commodities. The most satisfactory general rule is to apply value-added tax to the charge if the 

tax would apply if the service or commodity were provided by profitmaking firms. Thus, a university or research institution selling 

books or personal computers would be registered and would collect 

value-added tax on these sales. This would also be true of sales in 

hospital gift shops and of sales by workshops for the blind. Tuition 

charges for education and hospital charges would not be taxed on the 

basis of both economic and social policy considerations. 

3. The alternatives on purchases. Because it is not necessary to 

encourage all forms of activity undertaken by nonprofit institutions, 

the argument for special treatment of purchases of nonprofit institutions is much weaker than in the case of their sales. If some of the 

institutions are to receive special treatment for their purchases on 

social policy grounds, there are several options: 

(a) Exemption of the institution. If the institution is exempt, 

it would not be subject to value-added tax on the services it renders, 

but it would receive no refund of tax on its purchases. The result 

would be that the institution would bear the burden of value-added tax 

on its purchases, but not on its own value added. Thus, there would 

be little burden on labor intensive types of activities. Under this 

rule, nonprofit institutions would not be registered, except for incidental activities such as operating a cafeteria for the public; they 

would receive credit only for the purchases for the registered activity. This would be a source of some problems but it is not insolvable. 

(b) Zero rating of the institutions. This would free them from 

all value-added tax on their purchases and would eliminate the need 

for distinguishing between purchases for their general functions and 

for specialized taxable activities. But they would be registered and 

file returns to obtain refunds; tax would be collected from their 

suppliers, and in turn refunded to the institutions. The choice of 

this method vs. exempting should be made on the basis of social 

policy: is it essential to remove the value-added tax on their purchases, and is this worth the administrative and compliance costs of 

handling large numbers of returns and refunds which yield no revenue? 

(c) Exempt the institutions and zero-rate sales to them. By this 

means, the institutions would not be recristered as value-added tax 

taxpayers (except on their specialized faxable activities, if any); 

they would be issued a special institution number as hospital, religious, educational, or charitable organization, enabling them to buy 

tax free. Not only would all sales to them be free of tax, but the 

seller would receive credit for tax paid on the purchase of these 

goods or on their inputs. Thus, all value-added tax burden would be 

removed from the institutions without the need for their being registered as taxpayers and filing returns. The suppliers, however, would 

have the troublesome task of distinguishing sales to these institutions (in the same fashion that firms selling for export must identify 

export sales). Though there might be some abuse of this privilege, 

the difficult administrative problems of handling the returns from 
- 72 - 

these institutions, itself subject to some possible abuse, would be 

avoided. The procedure would be comparable to that used by the states 

in excluding sales to these institutions and to the treatment suggested for farming in an earlier section. 

One further issue relates to the treatment of for-profit institutions in the hospital and education fields. For hospitals the same 

treatment should be applied to profit and nonprofit institutions; the 

zero rating would apply to hospitals regardless of the for-profit 

situation. It would be difficult to do otherwise, since the tax is 

presumably borne by the users of the service. 

4. Summary. Special treatment of nonprofit institutions under the 

value-added tax would give rise to a number of administrative problems 

and would lessen the generality of the tax. Special treatment should 

be considered only for those of a religious, charitable, educational, 

or health care nature; while others are not subject to Federal income 

tax there is no need to give them special treatment under a valueadded tax. For those receiving special treatment, a choice must be 

made among the three techniques: exempting them, zero rating them, or 

exempting them and zero rating of sales to them. Only the second and 

third would remove all value-added tax burden. Zero rating of nonprofit institutions would require registration, filing of returns, and 

granting of refunds. Zero rating of sales to them would avoid these 

problems, but would require suppliers to distinguish these sales from 

others. 

V. Housing and Construction 

The taxation of housing services is one of the most troublesome 

aspects of a value-added tax, as is the related issue of taxation of 

real property construction. Much of the problem arises because a 

large portion of total housing is owner-occupied, the remainder being 

rental; complete equality in treating homeowners and tenants is difficult if not impossible to achieve under a value-added tax. The 

second aspect of the problem is that housing facilities have very long 

lives compared to other consumption; housing built or acquired in one 

year will be consumed over a long period of time. A similar timing 

problem arises with nonhousing construction. 

tion is: should consumption of housing be subject to a value-added 

tax? The general answer, as to all consumption spending, is yes, 

unless there are compelling reasons for not doing so. One reason for 

not so doing is the importance of housing costs in the family expenditure patterns of the low-income groups. If there is no general system 

to reduce value-added tax on the poor, such as refundable credits, a 

convincing argument can be made for attempting to exclude a minimum 

housing expenditure from tax, just as there would be for zero rating 

of food. This is not easily accomplished. General exclusion of housing from the tax would favor those persons with relatively high preferences for housing and provide an artificial incentive to increase 

housing consumption relative to that of other goods. The base of the 

Before these issues are considered, however, the threshold ques- 
- I3 - 

tax would be reduced materially, requiring higher rates to raise an 

equivalent amount of revenue. 

A. Housing: Homeowner versus Tenant 

If the principle is accepted that housing expenditures should be 

subject to at least some value-added tax, the most difficult issue to 

resolve is the provision of reasonable equality of treatment between 

homeowner and tenant, a problem aggravated by the long lives of housing facilities. The failure to provide equality of treatment would 

encourage the favored type--almost certainly homeownership--and would 

discriminate against families that could not or did not wish to own 

their homes. 

With rental housing, there is no major problem in applying a 

value-added tax; the building owner would apply the value-added tax to 

the rental charge and would in turn receive credit for value-added tax 

paid on the building and all other purchases of produced goods necessary to provide the rental facilities. (The timing problem of crediting the tax on the purchase of the building is discussed below). 

Under this approach, all lessors would be registered and would file 

value-added tax returns. The only operational problem would arise 

with persons renting only one or two houses, or rooms in their own 

homes; it would be difficult to ensure that all such persons registered for value-added tax purposes, compliance would be a burden, and 

delinquency in the filing of periodic returns would probably be high. 

With respect to owner-occupied housing, each home or condominium 

unit owner could be required to pay value-added tax periodically on 

the imputed rental value of the home or unit. This, however, would 

give rise to several problems. First, it would require that each 

homeowner be registered for the value-added tax, thus sharply increasing the number of registered units and creating significant administration and compliance costs in handling returns and delinquencies. A 

second problem is that of determining the imputed rent, or what the 

house would rent for if it were rented in an open market transaction, 

net of expenses. This would be a notional value; but notional, as 

distinct from market, prices are always troublesome in any form of 

sales tax. Third, historically there has been strong resistance to 

including imputed rent in income for income tax purposes; there also 

would be restrained enthusiasm to doing so under a value-added tax. 

If imputed rent were taxed, homeowners would be required, in effect, 

to include the imputed rental value as an element in income (even if 

was not taxable for income tax purposes) and simultaneously treat it 

as a consumption expenditure. There would be public resistance to 

paying value-added tax on an element which does not appear as or arise 

from a monetary transaction. Because of these problems, it would not 

be feasible to include imputed rent on owner occupied housing within 

the scope of a value-added tax. Therefore, rent paid on rental 

housing should not be included either, for reasons of both equity and 

economic efficiency. 
1. Taxation of purchases of new residential housing. One alternative would be to tax persons on the purchase of newlv-constructed 

houses less the value of the land, or 'the equivalent, fax the entire 

contract price when a person enters into a contract for the construction of a new home. This would require that all general contractors 

be registered for value-added tax as well as subcontractors and speculative builders. The tax would apply to all new housing facilities 

whether purchased by landlords or occupiers. This approach would provide equity between homeowners and tenants in a rough way, but it is 

not without its problems. 

It would require the registration of all general contractors, a 

group that the states have found to be difficult to control for sales 

tax purposes. Many contractors are small concerns, which may build 

only one or two houses a year. Subcontractors would be less of a 

problem since many are also wholesalers or retailers of building 

materials and would be registered anyway. With this alternative, tax 

would apply on the charges made by the subcontractors for materials 

and services provided to the general contractors; the latter would 

receive a credit for this tax against their own tax liability. Exclusion of the value of the land is troublesome, but if it is not 

excluded, the land would be sold separately. Taxation of land, per 

se, is not appropriate under a consumption tax; the purchase of land, 

from the standpoint of the economy, is not a consumption activity. 

initial sales of new construction, plus repair and alteration work. 

Persons already owning their homes at the time the tax was introduced 

would escape value-added tax on their housing expenditure, except for 

repairs and maintenance. The sale and rental value of existing houses 

would tend to rise, because new houses would be more expensive, creating a windfall gain for the present owners. 

There also is a timing problem. Though a house may be used for 75 

years, tax would be borne when the new house is acquired. On other 

expenditures, the purchased item will be used immediately or with few 

exceptions over a relatively short period. But with housing, a large 

sum of tax would be paid for consumption to be spread out over 

decades. The consequent increase in the cost of housing would undoubtedly reduce somewhat the construction of new housing, since many 

families can afford only a certain monthly payment for the purchase of 

homes. 

The more serious problem is that the tax would apply only to the 

2. Taxation only of materials. A second alternative, which parallels the practice in most states under the retail sales taxes, would 

be to tax-only the materials and other produced inputs going into real 

property construction. General contractors would, in effect, be exempt. The general contractors would not be registered (unless they 

also were dealers in materials) and they would not file value-added 

tax returns. If they were registered because they were a150 dealers 

for construction materials, they would file returns and charge tax 

only for their dealership activity. Tax would not apply to sales of 

new housing by general contractors; nor would they receive a credit 
- 75 - 

for value-added tax paid on their purchases of materials. Thus, tax 

would be reflected in their contract prices. Subcontractors would 

typically be registered because they usually are dealers for construction materials. Subcontractors would charge value-added tax on 

their sales to general contractors and would receive a credit for tax 

paid on their purchases. The general contractor would not receive 

credit for tax paid on purchases from the subcontractor. 

The principal merit of this approach is that, since it parallels 

state practice, the building industry would be familiar with it. It 

also would reduce the tax burden on housing, compared to the alternative of taxing the full sale price (excluding land) of newlyconstructed housing. This alternative, however, would encounter some 

operational problems. If a different rule were used for nonhousing 

construction, contractors would have to segregate the two types of 

contract work. This would be complicated by the fact that some buildings are built for both housing and commercial use. 

B. Commercial (Nonhousing) Construction 

The value-added tax should apply to the contract price of nonhousing commercial construction. Under this approach, the contractor 

would apply value-added tax to the contract price and would receive a 

credit for tax paid on materials. A building owner renting space to 

commercial tenants would apply value-added tax to the rental charges, 

and would receive a credit for tax paid on the purchase of the building. Or, a manufacturer or distributor constructing a new building 

would pay tax on the contract price, or on the materials if it did the 

construction with its own employees, and would receive a credit for 

this tax against the tax due on its sales. 

There may be a timing problem of some consequence. The manufacturer who contracts for the construction of a factory building would 

bear a value-added tax on the full purchase of the building. If the 

firm does its own construction, it would pay tax only on the materials 

purchased, not on the labor used to erect the building. In both 

instances, it would receive credit for the tax paid on purchases 

against value-added tax due on sales, but the timing of the payment 

and credit may be different and many affect the choice between selfcontracting and the use of an outside contractor. 

If general contractors are not registered, even for work on 

business construction, and merely pay tax on their materials for business construction, as well as for housing construction, the chain of 

tax and credits would be broken, and the firm for which the construction is undertaken could not receive a credit for tax on the construction materials. This would create a strong incentive for selfconstruction, or for the purchase of the materials by the firm for 

which the building is being erected. An alternative would be to allow 

the registered firm acquiring the building a credit equal to a certain 

percentage of the contract price as representing the value-added tax 
- 76 - 

on materials, but the amount would be an average and somewhat arbitrary. This would be similar to the EEC treatment of farmers, discussed above. 

It is not impossible to use different rules for residential and 

nonresidential construction, but this would require contractors doing 

both types of work to keep distinct records, as they would receive 

credit for tax paid on materials only for the nonhousing construction. 

If housing construction were freed entirely from value-added tax, this 

would greatly aggravate the problem of distinguishing between housing 

and nonhousing construction, and between housing construction and 

taxable repair activities. 

ty: that of distinguishing between real property construction on the 

one hand and installation of "fixtures," such as stoves, carpeting, 

and drapes, on the other. Presumably, the tax should apply to the 

full sale price of "fixtures" such as stoves, and not the contractor's 

purchase price, as with materials. This is a troublesome issue, but 

the states have developed workable rules, and the value-added tax 

could use the same ones. 

With all approaches to the problem, there is one special difficulC. European Experience 

Under the Sixth Directive of the EEC, the leasing of immovable 

property is tax exempt. Most countries follow the directive and do 

not levy the value-added tax on residential rents. However, the 

value-added tax may be imposed on rental payments of taxable entities 

if they opt for it. A restaurant, for example, may wish to be taxed 

on its rent so that it may credit the value-added tax against its 

gross value-added tax liability. Otherwise, the restaurant's customers would be subject to taxation both on the restaurant's meals and on 

the non-creditable tax borne by the restaurant on the taxable 

purchases of its lessor. 

European experience shows that there are no easy solutions to the 

problems of applying the value-added tax on housing. The European 

regulations that are designed to cope with these problems are so complex that it is difficult to generalize about their provisions. The 

practice in European countries using the value-added tax varies considerably. In Great Britain, sales of new homes are zero rated while 

such sales are taxed fully in Belgium and the Netherlands. The practices in most of the other EEC countries appear to fall somewhere 

between the two extremes of fully taxed or totally free of tax. 

For the most part, neither the sale nor the leasing of land is 

subject to the value-added tax in Europe, although France imposes the 

value-added tax on the transfer of building sites. On the other hand, 

the value-added tax is levied on work done to improve the land, such 

as project engineering, leveling, construction and on alteration, 

repairs, or maintenance of existing buildings. 
- 71 - 

D. summary 

real. property construction. Equitable application of value-added tax 

to rents from housing is clearly impossible, in view of the fact that 

there is no possibility of tax being applied to the imputed rental 

value of owner-occupied housing. This is a major area in which universal application of the value-added tax is simply not feasible. The 

second best alternative is to apply the tax to the sale price or total 

contract figure on new housing construction, or, following state practice, to the cost of materials to the contractors. The choice between 

these two must be made primarily on the basis of whether taxing sales 

of new housing is considered to be too harsh. Application of the 

value-added tax to the full contract price would allow the same policy 

to be used for nonhousing construction. 

There is no ideal solution to the problem of taxing housing and 

VI. Taxation of Used Durable Goods 

The value-added tax treatment of sales of used goods, both 

consumption goods and business assets, is closely related to the issue 

of the taxation of housing. 

A. Consumption Goods 

Purchases of used consumer goods constitute a significant element 

in the annual volume of consumption. In a sense, the sale of most 

homes constitutes a sale of "used" goods; clearly these would not be 

taxed, in part, because most sales are made between individuals who 

would not be registered for value-added tax. Motor vehicles are the 

other major category, but there are substantial sales of used 

furniture and other items as well. 

iture from the standpoint of the buyer, there are several reasons for 

not fully applying the value-added tax on such transactions: 

1. After the tax has been in effect for a few years, the sale 

price of used consumer goods would reflect the value-added tax paid on 

the original purchase, and thus the purchaser of the used good would 

share a portion of the tax borne by the initial purchaser. Imposing 

value-added tax a second time when the item is sold as a used good 

would constitute a double tax. 

2. In terms of the economy, no new consumption activity is 

involved in the purchase of used goods; except for the value added by 

the used goods dealers, resources are not being used for the production of consumption goods. A part of the existing stock of durable 

consumption goods is simply being shifted from some persons to others. 

nonregistered individuals, including garage sales and "flea market" 

While the purchase of used goods constitutes a consumption expend3. Many of the transactions in used goods are between 
- 78 - 

sales that would be difficult to control. Attempts to fully tax sales 

of used goods by registered firms would drive even more transactions 

to flea-market types of arrangements. 

separate tax element on the purchases of those goods for which to take 

value-added tax credit. 

In light of the above, one general rule could be: do not apply 

4. On sales of used goods by registered firms, there would be no 

value-added tax to sales of used goods. But this approach is not 

without problems: 

(a) For the first few years after enactment of the tax, the used 

goods that are sold would not have been taxed on the original purchase. Instead, as in the case of owners of existing housing, the 

owners would enjoy a windfall gain as the prices of used goods would 

rise, reflecting higher prices on new goods. But this is an inevitable transitional problem and is virtually impossible to resolve without serious complications. 

(b) Used goods sometimes sell for a price many times higher than 

the original purchase price. This is particularly true of antique 

automobiles. A car that cost $700 in 1925 may sell for $50,000 today. 

The same is true of other antiques. But there is no suitable way of 

adjusting between these and other used goods. 

(c) A further problem is that sellers of both used and new goods 

must segregate sales between the two classes if used goods are not 

taxed. This would not be a problem for motor vehicle dealers selling 

new and used cars, but this segregation may not be done accurately by 

many repair shops handling both repair and sale of new and used items, 

nor by second-hand stores, which often sell new merchandise as well as 

old. 

(d) If used goods were not taxed, firms selling only used goods 

would not be registered (technically, they would be exempted). Thus, 

value-added tax would apply to their inputs and thus to a portion of 

their value added. But, as noted, most used.goods dealers sell some 

new goods as well. They are therefore registered. To attempt to 

require them to segregate inputs between new and used goods (electricity, for example) would be impossible except in some very arbitrary 

way. Yet, to allow them to obtain full credit for tax paid on all 

inputs against the tax due on their sales of new goods would give them 

a competitive advantage over firms that handled only used goods, 

unless the latter were allowed to register voluntarily. 

value to the goods they handle. The extreme case is that of motor 

vehicle dealers who often perform substantial work on the vehicles 

before reselling them. But if the selling price is taxable, no tax 

credit on the purchase would be available to the dealer. Yet to free 

5. A more serious problem is that the used goods dealers do add 
- 79 - 

the sale completely from value-added tax would allow current value 

added and consumption expenditures to escape taxation. There are two 

alternatives to this problem: 

the repair work. This would allow the labor, the chief element in 

many repair jobs, to escape taxation, but at least the parts would be 

taxed. But this would require the dealer to segregate inputs between 

those used for repair of goods for resale and those used in direct 

repair work for customers. This would be a major complication. 

(a) Disallow the credit for value-added tax paid on the inputs for 

(b) Allow the dealer to assume that 10 percent (assuming a 10 percent value-added tax rate) of the purchase price of the used car or 

other used goods (the trade-in allowance when the good was obtained as 

a trade-in on the purchase of another item) constitutes the valueadded tax element on the purchase, and to take credit for this against 

the tax due on the sales, along with tax on the other inputs. This is 

somewhat arbitrary, but would appear to be the most satisfactory 

approach. 

Quite apart from repair, all second-hand goods dealers add value; 

the amounts are typically smaller, of course, where no repair work is 

done. This suggests the desirability of registering all firms selling 

used goods (not individuals selling casually), requiring them to pay 

value-added tax on their sales, and allowing them to take credit for 

tax paid on their purchases under the assumption that 10 percent of 

their purchase prices consists of the value-added tax element. In a 

rough way, this reaches the value added they have created. How they 

bill their customers for the tax would be left to the firms. 

6. Trade-in allowances. A related question is the tax status of 

trade in allowances, which are, of course, highly important in the 

sale of consumer durables. Does value-added tax apply to the total 

sale price, or the net price after deduction of trade in allowances? 

The actual consumption expenditure involved is the net price after 

trade-in allowance, not the gross; the buyer has not completely utilized all of the traded-in article, on which he has paid value-added 

tax, and to pay tax on the gross price would involve paying valueadded tax twice on the same sum. From the standpoint of the seller, 

likewise, the amount received on the sale is the price actually paid, 

that is, net after trade-in. The dealer has also received a used good 

for which he has "paid," essentially the amount of the trade-in allowance. If eventually he sells the traded-in good, under the rule proposed above he would apply tax to the selling price and then deduct 

10 percent of the amount of the trade-in allowance granted as reflecting the value-added tax element in the purchase. 

lem. There is no possibility of applying value-added tax to transactions between individuals without hopelessly complicating the tax and 

increasing tax administration and compliance costs. General application of the tax to the full selling price of used goods would be 

contrary to the principle of a consumption tax, assuming that prices 

7. Summary. There is no ideal solution to the used goods prob- 
- 80 - 

of used goods reflect value-added tax paid on the original purchase. 

Full taxation of used goods would likely make the tax more regressive 

because of the importance of used goods in the expenditure patterns of 

the poor. 

tial labor performed on used cars before their resale and on other 

elements of value added by used goods dealers. Thus, the most workable solution would be to register all used goods dealers, and allow 

all sellers of used goods to assume that 10 percent (if the tax rate 

is 10 percent) of the price of acquiring the used goods represents the 

value-added tax in the purchase price. Used good dealers would be 

allowed to credit this tax against the tax due on their sales. 

It is, however, undesirable to lose the revenue from the substan8. Sales of Used Business Assets 

A related question is whether there are problems with the sale of 

used business assets between registered firms that would require 

special treatment under a value-added tax, comparable to those with 

used consumer durables. 

Generally, the answer is no. For example, suppose that a business 

firm buys a turret lathe in 1988, paying value-added tax to its supplier and crediting the amount of the tax on the purchase of the lathe 

against the tax due on its sales. In 1994, the firm which purchased 

the lathe decides to sell the lathe to replace it with a more modern 

one. It sells the used lathe to a new small manufacturer. The seller 

of the used lathe applies value-added tax, as on any sale. The business purchaser of the lathe, in turn, receives credit for this tax 

against the tax due on its sales during the period. On both the original and the subsequent sale, the tax and credit procedure serves to, 

in effect, free the lathe of value-added tax. 

Suppose, instead, that on the subsequent sale the lathe is sold to 

someone who is not registered for value-added tax, for example a 

farmer or a hobbyist. In this case, the lathe has now become a consumption good. The seller would apply value-added tax, as it does to 

all sales, and collect it from the customer. The customer would not 

receive credit for the tax since it is not a registered firm. Accordingly, no distinction needs to be made by business firms between the 

sale of capital assets and sales from inventory; such distinctions are 

usually required under retail sales taxes. The sale of used capital 

assets can be treated in the same fashion as any other sale by registered firms under a value-added tax; there is no necessity of special 

treatment. 

VII. Tax Treatment of Fringe Benefits 

Fringe benefits, which are essentially substitutes for monetary 

compensation, have grown in importance in recent years because many 

are free of the income tax. In one sense, they constitute simultaneous earning of income and of consumption expenditures, which may be 

regarded as being made either by the firm OK by the recipients. 
- 8.1 - 

value-added tax should be paid on fringe benefits if the benefits are 

taxable when purchased in the usual fashion. The questions are: by 

whom should the tax be paid and on what value should it be based? 

A. Forms of Fringe Benefits 

Fringe benefits take a variety of forms, and precise uniform 

treatment for value-added tax purposes is impossible. 

employees that would be taxable if purchased directly by the 

employees. Thus, the employer may purchase a gold watch for a 

retiring employee, pay for dinners for executives or other employees, 

buy television sets to give to sales persons exceeding their quotas, 

or provide tours to Hawaii for employees and their spouses. 

applies in this case. The first is to require the firm to include the 

sale value of the benefits in its own sales and to pay value-added tax 

on that value. It would, of course, be entitled to a credit for tax 

paid on the purchases related to the benefits. The second is to deny 

the firm a credit for value-added tax paid on the purchase of the 

goods provided as fringe benefits or on the inputs used by the firm to 

produce the benefits. This second approach, which is the simpler 

method, in effect, would treat the firm as the consumer of the fringe 

benefits. Whether the value-added tax should be charged to the recipient of the benefits is a separate issue; it is not a matter of tax 

policy, but an internal matter between the firm and its employees. 

Generally, the firm would not charge the recipient for the tax on the 

benefits. If the employees had been given money instead, they might 

not have acquired the goods at all and charging the employee for the 

tax would be contrary to the general intent of many fringe benefits. 

2. The second situation is that in which the firm provides to its 

executives or other employees, either free or at substantial discount, 

commodities which the firm produces. In principle, the same rule 

should be followed as in (1) above: the firm should not be allowed a 

credit for value-added tax paid on the inputs used to produce the commodities. But disallowance is virtually impossible, as the inputs 

cannot be effectively segregated to isolate those that are used to 

produce the items that are provided as fringe benefits. This is particularly true of the cost of capital equipment and buildings used 

in the production process. In this instance, the best solution would 

appear to be the one that is used with retail sales taxes: the firm 

must include in taxable sales, at their commercial sales value, the 

value of the goods given to employees or used by the proprietors. 

Again, whether the employer withholds this sum from the employee's pay 

is essentially an internal matter between the employer and employee. 

Suppose, however, that the firm does not give the items to employees, but sells them at an employee discount. This is a very common 

practice, but so are numerous other discounts to the elderly, to 

members of various organizations, and the like. It would not be 

1. The employer may purchase commodities or services for the 

There are two general approaches to ensuring that value-added tax 
- 82 - 

worthwhile to attempt to adjust the taxable price upward by the amount 

of this discount; value-added tax should apply--and presumably be collected from the employee--on the basis of the actual selling price, as 

long as the discount does not exceed a certain percentage (to prevent 

the avoidance of value-added tax by selling at a 99 percent discount). 

3. A third case, related to the second, is that in which the firm 

provides certain services free or at substantial discount to its 

employees and the services are of such a nature that providing them to 

the employees does not require any additional inputs. The principal 

case is free plane trips for airline employees, available only when 

space is not purchased by customers. Since application of the tax in 

this instances would reduce the use of this service, though it has no 

economic cost, value-added tax should not be imposed. 

4. A final case is that in which the firm provides various goods 

for the use of some of its employees, typically its executives, such 

as company cars. Workers may be provided lounges with television 

sets. It is very difficult to draw the line between the provision of 

vehicles as a necessary element in the operation of the business and 

the provision of them as consumption goods. One solution, when the 

firm provides automobiles or other goods (e.g., television sets, personal computers) for the exclusive personal use of particular employees would be to require the firm to include in its taxable receipts 

the sale price or rental value of the items. 

is to deny the credit for all tax arising from purchase of automobiles, as is done in some EEC countries. This may be somewhat 

drastic, as many firms must of necessity provide cars for employees' 

use in the business operation (telephone companies, for example). A 

difficult delineation is that between automobiles and pickup trucks 

and related vehicles. But general denial of credit on automobiles 

should be considered. 

Since automobiles are the chief category involved, the alternative 

B. summary 

AS under the income tax, fringe benefits create difficult problems 

with a value-added tax. The following, necessarily imperfect, solutions are recommended: 

1. In principle, if a particular commodity or service that is 

ordinarily taxable is provided an employee and if the employee would 

purchase the item if given money income instead, value-added tax 

should apply. Most instances, however, in which fringe benefits are 

provided are not this straightforward. 

2. When goods are purchased by a firm for the specific purpose of 

giving them to employees, the firm would be denied credit for tax paid 

011 the purchases. 
- 83 - 

3. when a firm gives goods that it produces to its employees, it 

would apply value-added tax at the typical price at which it sells 

these goods. Whether it bills the employee for the tax is an internal 

matter for the firms. 

4. When the firm sells at an employee discount to its employees, 

the tax would apply to the discounted price, as long as the discount 

does not exceed a specified percentage. 

5. When a firm provides a service to an employee that requires no 

additional inputs, value-added tax would not apply. 

paid by a firm for meals and drinks under all circumstances. The same 

policy should be considered for automobiles. 

6. There is merit in disallowing the credit for value-added tax 
- 85 - 

Chapter I 

VALUE-ADDED TAX BASE 

The projected 1988 level of total personal consumption expenditure 

is about $3,100 billion; therefore, each percentage point of a valueadded tax levied on this total would yield about $31 billion. In 

fact, as explained in Chapter 6, a realistic value-added tax base 

would be well below this, because of the difficulty or inadvisability 

of taxing certain items of consumer expenditure. Drawing on the 

recommendations in Chapter 6, this chapter describes some alternative 

value-added tax bases. 

The rental value of owner- and tenant-occupied housing constitutes 

about one-sixth of total 1988 personal consumption expenditure. In 

the case of owner-occupied housing, the rental figure is an imputed 

amount or a measure of what the housing would rent for on the open 

market. Since it would not be practical to apply a value-added tax to 

this amount, the rent on tenant-occupied housing would not be subject 

to a value-added tax either. As shown in Table 7-1, exempting the 

rental value of all housing would remove $460 billion from the 1988 

base. Since housing rents would be exempt, rather than zero rated, no 

credit would be allowed for value-added tax paid on expenditures for 

repair and maintenance. Applying the value-added tax to sales of new 

housing, plus repairs and alterations would add $170 billion to the 

tax base, since these items are not reflected in the total of personal 

consumption expenditure. 

A number of other items of personal consumption expenditures would 

also be at least partially excluded for a variety of reasons. For 

these categories, recall the important distinction between exemption 

and zero rating. With exemption, no value-added tax would apply to 

the sale of the exempt good or service, but no credit would be allowed 

for tax paid on items that were purchased to produce or provide the 

exempt good or service. An exempt good or service, therefore, bears 

some value-added tax, namely the tax on the purchased inputs used to 

produce it. Zero rating, on the other hand, totally frees a good or 

service from value-added tax. No tax applies on the sale, and a full 

credit or refund is allowed for tax paid on purchased inputs. 

arrive at the comprehensive base include the services of physicians, 

dentists, and other health professionals, which would be exempt and 

hospitals, education, and religious and welfare activities, which 

would be zero rated. As noted in Chapter 6, this treatment is necessitated by a combination of social and distributional considerations. 

Additional exclusions from personal consumption expenditure to 
- 86 - 

Table 7-1 

ESTIMATE OF VALUE-ADDED TAX BASE 

($ Billions) 

1988 Levels of Expenditures 

Total Personal Consumption Expenditures 

Less: Rental value of owner- and tenantoccupied housing (including farms) 

Medical care (including health insurance) 

Insutance and finance (other than health 

Education 

Religious and welfare 

Foreign travel 

Local transportation 

in su r a 11 c e ) 

Other: Food produced an- consumed on 

farms, military-issued clothing, 

domestic services) 

Plus: Sales of new housing 

Comprehensive Value-Added Tax Base 

$3,127 

460 

232 

74 

48 

47 

13 

8 

7 

_. 

- 889 

__ 

170 

$2,408 
- 87 - 

primarily because of the administrative difficulty of measuring value 

added, banking and insurance would be exempt, except for those activities for which there is an explicit charge, such as the rental of safe 

deposit boxes. Expenditures for foreign travel also would be excluded 

from the base (zero rated) for administrative reasons. (Expenditures 

by foreigners traveling in the IJnited States would generally be subject to tax.) Both local transit service and commuter rail transport, 

which are frequently subsidized, would be zero rated to encourage 

their use. Taxi service, on the other hand, would be exempt for 

administrative reasons. All of the exclusions which are used to 

arrive at the comprehensive value-added tax base of $2,408 billion (at 

1988 levels of expenditure) or 77 percent of total consumption are 

listed in Table 7-1. 

It would be preferable not to exclude food consumed at home from 

the base, if an alternative for lessening the burden of the tax on the 

poor were available. If, however, it is decided to exclude food, zero 

rating of food would reduce the base by an additional $349 billion to 

$2,059 billion or 66 percent of total consumption. Zero rating of 

sales of new housing, prescription drugs, and household energy expenditures for electricity, gas, fuel oil, and water and sanitation 

services would reduce the base further to $1,713 billion or 55 percent 

of total consumption. 
- 89 - 

Chapter 8 

DISTRIBUTIONAL EFFECTS OF THE VALUE-ADDED TAX 

I. Introduction 

The most frequent criticism of a value-added tax, as of any sales 

tax, is that the distribution of the tax burden by income group would 

be unfair. As noted in Chapter 5, two aspects to this criticism can 

be identified: (I) the absolute burden of a value-added tax on low 

income individuals and families, and (2) the relative burden of the 

value-added tax at various income levels. 

A comprehensive or broad-based value-added tax imposed at a uniform rate, the type described in Chapter 7, would place a significant 

tax burden on low income groups. Moreover, it would be regressive; 

that is, the amount of tax paid as a percentage of income would be 

greater at the lower income levels than at the higher because individuals at low income levels consume a larger percentage of their income 

than those at higher income levels. Moreover, persons in the higher 

income groups spend a higher percentage of their incomes on services, 

some of which, such as expenditures on foreign travel, education 

abroad, and personal services rendered in the home, cannot be reached 

by a value-added tax. 

11. Some Underlying Assumptions 

The view that a value-added tax would burden the poor and be 

regressive is based on the standard assumption that the tax would be 

shifted forward to consumers through price increases. If a valueadded tax causes a direct and uniform increase in costs affecting all 

competing firms, immediate price increases can be expected under usual 

pricing conditions and methods, given a monetary policy that permits 

or "ratifies" these price increases. 

A general increase in the price level can occur only if the 

appropriate accommodative adjustments occur in the total supply of 

money (or its velocity). In the face of an unchanged nominal or money 

value of the gross national product, the price level cannot rise in 

response to the tax, and either wages and other factor incomes or the 

level of output must decline. It is reasonable to assume that to 

prevent any decline in real output, the monetary adjustments necessary 

to allow firms to pass the tax forward will be made. Accordingly, the 

tax burden can be assumed to rest "on consumers" in the sense that it 

would be proportional to consumer spending on goods and services 

included in the taxable base. 

Another underlying assumption (sometime implicit) is that the 

appropriate basis for comparing value-added tax burdens among various 

individuals and families is current income. Some experts criticize 

this approach on the grounds that lifetime or "permanent" income, 
- 90 - 

rather than the current year's income, should be used to measure a 

family's living standard over its lifespan. On a lifetime income 

basis, a value-added tax would be less regressive, and perhaps even 

proportional, because consumption tends to be a uniform proportion of 

lifetime or permanent income at all income levels, except for those 

who leave estates and thus do not consume all of their lifetime 

income. In any particular year, however, for families in a given 

income class, current income may differ from permanent income because 

of: sudden and unexpected windfalls, such as the receipt of gifts or 

bequests; reduced earnings caused by the temporary loss of employment 

or illness; or youth or old age. 

To the extent that consumption is determined by permanent, rather 

than current income, consumption will not be a constant percentage of 

current income at all levels. In any given year, for example, lowincome families may have consumption expenditures in excess of their 

income for that year, and high income families may consume less than 

current income. Thus, the regressivity of the tax is probably overstated with reference to current income. Still, it is the current 

year's income that in large part determines the current living standard and the sum out of which most taxes are paid. Moreover, the 

current year's income is usually regarded as the most practical basis 

for the comparison of value-added tax burdens at various income 

levels. Despite its limitations, it is used in this chapter. 

111. The Alternative Solutions 

Whether the absolute burden of a value-added tax on the poor and 

the regressivity of the tax are objectionable is, in the first 

instance, a value judgment. Nevertheless, most would agree that the 

poor should not be subjected to any significant tax burden and that 

the overall distribution of the Federal tax system should not be 

regressive. Of these two elements, the absolute burden of the valueadded tax on the poor is the more serious problem, since the tax would 

deprive those persons of the income necessary to maintain a minimum 

standard of living. In comparison, the regressivity of a value-added 

tax over other income ranges can be offset by adjustments in the 

income tax rates; a progressive tax structure does not require each of 

the taxes in that structure to be progressive or even proportional. 

This chapter considers four alternatives for dealing with the problems 

of the burden of the tax on low income families and its regressivity. 

In evaluating these alternatives, the distributional effects are based 

on 1983 levels of income and patterns of spending, and the expenditure 

and revenue effects of the alternatives are based on 1988 levels of 

income and expenditure. (As explained in Chapter 9, the Internal 

Revenue Service considers 1988 to be the first full year for which a 

value-added tax could be effective.) 

The distributional results and figures presented in this chapter 

are classified by family economic income class. As explained in 

Appendix 4-A to Volume 1, Overview, economic income is a comprehensive 

measure of income that is intended to approximate the standard definition of income, consumption plus changes in net worth. It includes 
- 91 - 

forms of income that are not subject to tax, such as tax-exempt interest from state and local bonds and government transfer payments. ~t 

also measures more accurately certain other forms of income, such as 

real interest income. This broader measure of income, therefore, 

provides a better yardstick than adjusted gross income for evaluating 

the abilities of families to pay taxes and for comparing tax burdens 

by income class. (The small number of families with negative economic 

income are excluded from the results because this unusual situation, 

typically associated with large capital or operating losses, is not 

relevant for assessing the distributional burden of the value-added 

tax. ) 

A. Adjustments in Transfer Payments 

Some government-provided transfer payments, such as social 

security and food stamps, are automatically indexed to reflect changes 

in the cost of living. If imposition of a value-added tax caused the 

price level to increase, the indexed transfer payments would also rise 

to adjust for the effect of the tax on prices. Under the indexing 

provisions of current law, the burden of the value-added tax on low 

income families would be reduced by the automatic adjustment of transfer payments. This alternative would not eliminate the burden of the 

tax on those low income families who received either no or only modest 

amounts of indexed transfers. 

In 1983, there were nearly 14 million families and individuals 

with economic incomes below $10,000. Of these, 12 million received 

some form of governmental transfer payments; 2 million did not receive 

any transfer payments. Almost 10 million of these families and individuals received one or more types of benefit that is already indexed 

for cost of living changes; the effect of the value-added tax on 

prices would automatically be reflected in higher benefits under these 

programs. Approximately 2 million families and individuals with economic incomes less than $10,000 received only non-indexed transfer 

payments. Therefore, a total of 4 million of these low income households would not benefit from the automatic indexing of transfer 

payments. 

Social security payments are the most widespread of these indexed 

transfer payments, going to 7 million families and individuals, or 

one-half of those with economic incomes below $10,000. Other indexed 

programs are food stamps, supplemental security income, and government 

pensions; these programs reach a total of 7 million low income units, 

over half of which also receive social security benefits. Not all 

government income maintenance systems are indexed, including some 

programs financed at least in part by the Federal government, such as 

unemployment compensation and aid to families with dependent children, 

as well as direct welfare relief provided by state and local governments. While these nonindexed transfers could conceivably be adjusted 

to reflect the effect of the value-added tax on prices, this would 

involve additional expenditures by state and local, as well as the 

Federal, government. 
Since only about 80 percent of consumption expenditures would be 

subject to the broad-based tax, it can be expected that a 10 percent 

value-added tax would cause the consumer price index (CPI) to rise by 

about 8 percent. The distributional consequences of indexing transfer 

payments are illustrated in Table 8-1 and Figure 8-1 for a 10 percent 

value-added tax. The percentages show value-added tax payments as a 

percent of economic income for various economic income classes. For 

expositional convenience, illustrations of distributional effects are 

calculated for a 10 percent value-added tax. For lower rates of tax, 

monetary magnitudes would be correspondingly lower. For purposes of 

comparison, the distributional effects of a broad-based or comprehensive value-added tax of the type described in Chapter I levied in the 

absence of indexing are also shown. It is important to emphasize that 

this indexing of transfer payments would be automatic under current 

law. Thus, barring any change in current law indexing provisions, the 

bottom line in Table 8-1 and Figure 8-1 may be a more accurate description of the actual distributional burden of a broad-based valueadded tax than is the upper line. The indexing of transfer payments 

would reduce, but not eliminate, the burden of the value-added tax on 

low income families and individuals. This is true because not all low 

income families receive indexed transfers, and in any given year, some 

low income families have consumption expenditures in excess of their 

income. As shown in the last column of Table 8-1, the indexing of 

transfers under current law would absorb about 11 percent of the 

revenue from the comprehensive value-added tax. 

8. Zero Rating of "Necessities" 

Though many studies of distributional burdens have shown that a 

broad-based sales tax is regressive if levied at a single rate, a 1981 

study by the Organisation for Economic Cooperation and Development, 

"The Impact of Consumption Taxes at Different Levels of Income," shows 

that the value-added taxes in seven European countries, with their 

exclusions and multiple rates, are generally not regressive, except at 

high income levels. Even the comprehensive value-added tax base 

described in Chapter I does not include all consumer expenditures on 

goods and services; rents on residential housing, for example, would 

be excluded from the tax base. A second alternative for reducing the 

burden of the tax on low income families would exclude additional 

goods and services from the tax base. If this approach were used in 

combination with the indexing of transfers, it would provide some 

families and individuals with more relief than others. That is, zerorating would eliminate tax on some goods for all taxpayers. Indexing 

of transfers would insulate transfer recipients from the burden of tax 

on goods that are not zero-rated. Thus, zero rating of commodities 

might be done in lieu of adjusting transfers. To prevent transfers 

from being indexed to reflect the value-added tax, the tax would have 

to be excluded from the consumer price index used for indexing 

transfers. 

This alternative would identify those taxable commodities on which 

lower income families and individuals spend a large proportion of 

their income and remove those expenditures from the tax base by zero 
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rating them. That is, no tax would be charged on their sale, but the 

firm selling the zero-rated commodities would be entitled to a credit 

or refund for the tax paid on its purchases that are related to the 

production and sale of the zero-rated commodities. Thus, the zerorated commodities would be freed of any value-added tax. Consumer 

expenditures on the goods and services identified in the remainder of 

this section are regressive; that is, as a percentage of income, 

expenditures decline as income rises. Zero rating these items would 

reduce both the burden of the tax on lower income groups and the 

regressivity of the tax. 

at home (but not restaurant meals) from retail sales taxation. With a 

retail sales tax, of course, exemption frees the exempt item of all 

retail sales tax. Expenditures on food prepared at home exhibit a 

regressive pattern, constituting a higher percentage of income in the 

lower income groups than in the middle and upper income levels. On 

the basis of data derived from the Bureau of Labor Statistics, 1980- 

1981 Consumer Expenditure Survey (hereafter referred to as the CES), 

families with economic income of less than $10,000 spent 32 percent of 

their before-tax income on home-consumed food. Thus, zero rating of 

home-prepared food would remove a substantial portion of the burden of 

the value-added tax from the families in the lowest economic income 

group. By comparison, those with economic income between $20,000 and 

$30,000, spent 11 percent, and those with economic income of over 

$200,000 spent less than 1 percent of their income on home-prepared 

food. The effect of zero rating expenditures on food is illustrated 

in Table 8-2 and Figure 8-2. For purposes of comparison, the distributional burden of a broad-based value-added tax with no indexing is 

also shown. 

1. - Food. More than one-half of the states exempt food prepared 

Though, the exclusion of food would address some of the 

distributional objections to a broad-based value-added tax, there are 

a number of difficulties with this approach that policy makers should 

consider : 

(a) Excluding food would substantially reduce the revenue yield 

of the tax. State experience with retail sales taxes indicates that 

the states lose from 15 to 20 percent of their' sales tax revenue if 

food is exempt; zero rating of food would reduce the base of a Federal 

value-added tax by about $349 billion at 1988 levels of expenditures, 

or, according to the last column in Table 8-2, by about 14 percent of 

the comprehensive base described in Chapter 7. Excluding food has a 

relatively larger impact on the states' tax base because, unlike the 

value-added tax described in Chapter 7, most state retail sales taxes 

do not include services. Because zero rating of food removes the food 

expenditures of the middle and upper income groups from the tax base, 

as well as the expenditures of the poor, much of this erosion in the 

base is unnecessary to achieve the objective of lessening the burden 

of the tax on lower income families and individuals. Nearly 90 

percent of the erosion in the base is from expenditures on food by 

those with economic incomes above $10,000. By comparison, this group 

accounts for 92 percent of all consumption. 
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- 98 - 

(b) Zero rating of food would favor those individuals and 

families with relatively strong preferences for food, and it may 

create economic distortions by increasing purchases of food relative 

to those of taxed goods. 

(c) Even if home-prepared food is exempt, restaurant meals are 

almost always taxed under state retail sales taxes. A few jurisdictions, however, exempt meals below a certain price. But drawing the 

line between a restaurant meal and home-prepared food is very troublesome, particularly with the popularity of fast food takeout restaurants and delicatessen and prepared food departments in grocery 

stores. The argument for taxing restaurant meals is that commerciallyprepared meals involve "luxury" spending. Actually, according to the 

SASS-based estimates, spending on restaurant meals also exhibits a 

regressive pattern by income class, though it is less regressive than 

expenditures for food prepared at home. A policy of excluding only 

restaurant meals below a certain price would be arbitrary and would 

create problems with billing customers. For example, would separate 

bills be required for each member of a group eating together to take 

advantage of the exclusion? The problems with restaurant meals illstrate the inherent objections of trying to solve the regressivity 

problem by excluding certain categories of expenditure from the valueadded tax. 

(d) Zero rating of food would materially complicate the administration and operation of a value-added tax. The distinction between 

zero-rated food purchases and other taxable commodities is not clear 

cut. There inevitably would be problems of delineating food from 

other commodities. For example, there is no sharp distinction between 

soft drinks, which might be taxable, and various fruit juices and 

drinks, which might not be. If ice cream is taxable, it may be difficult, and inappropriate, to differentiate it from tax-exempt frozen 

yogurt. Zero rating of food would raise many borderline issues of 

this sort. In each case, the tax administrator must specify the 

dividing line between taxable and non-taxable commodities and the food 

store clerk must be aware of these distinctions if the proper amount 

of tax is to be charged. 

(e) In addition to these delineation problems, the compliance 

problems of sellers and the control problems of the Internal Revenue 

Service (IRS) would be substantially increased by zero rating of food. 

very few stores sell only food items. If food were zero rated, large 

supermarkets would have to ensure the correct application of the tax 

at the cash register, and they would be required to keep separate 

records of food and nonfood sales. There would be a tendency for 

firms to overstate the portion of total sales consisting of food, and 

the audit task of the IRS would be made more difficult. State experience with the retail sales tax indicates that checking on the food 

exemption absorbs a substantial portion of the time of sales tax 

auditors . 
- 99 - 

2. Zero rating of other commodities. As shown by Table 8-2 and 

Figure 8-2, zero rating of food would not remove the entire valueadded tax burden from the lowest income groups. According to the 

estimates from the CES, approximately two- thirds of the expenditures 

of the families with economic incomes under $20,000 consists of purchases of goods and services in the comprehensive base other than 

home-prepared food. The burden on low income groups could be reduced 

further by excluding three other categories of consumer expenditures. 

(a) Housing costs. As noted in Chapter 6, housing expenses cannot be fully taxed because of the inability to reach imputed rent on 

owner-occupied housing. Since residential rents on either tenantoccupied or owner-occupied housing would not be taxed, the burden of 

the broad-based value-added tax on the poor would be less than what it 

would be with full taxation of housing rents. The comprehensive 

value-added tax base described in Chapter 7, however, does include 

purchases of newly-constructed, as well as renovated, housing. Complete exclusion of all housing costs, including those of new construction and renovation, would reduce the burden on the poor still more. 

This could be accomplished by zero rating sales of newly-constructed 

housing and the repair and renovations of existing housing. As with 

zero rating of food, however, this reduction in the tax base would be 

at the expense of a substantial loss of revenue from expenditures by 

persons in the middle and upper income groups and would cause inequity 

and economic distortions. Zero rating the sales of new housing would 

reduce the value-added tax base by about $170 billion, or 7 percent of 

the comprehensive base. About 94 percent of the revenue loss issuesated with this base erosion would be from expenditures on new housing 

(plus repair and renovation) by those families with economic incomes 

above $10,000. 

(b) Drugs and medicines. Though most medical care would be 

either zero rated or exempted even under the comprehensive value-added 

tax base, zero rating of prescription drugs and medicines would further reduce the burden of the value-added tax on low income families. 

zero rating of prescription drugs and medicine, which would reduce the 

tax base by about $16 billion, would create fewer compliance and 

administrative problems than in the case of food because this category 

is clearly delineated by the need for a physician's prescription. 

Zero rating of nonprescription drugs, however, would create 

troublesome operational problems. Nonprescription medicine is sold by 

a great variety of stores handling other goods as well, and it is not 

clearly delineated from other commodities. State and local governments that have exempted nonprescription drugs from retail sales 

taxation have encountered both compliance and audit problems. 

(c) Energy, water, and sanitation services. Consumer spending on 

electricity, gas, fuel oil, and water and sanitation services could 

also be zero rated; of course, this would conflict with recent proposals for an energy tax, either to raise revenue or discourage the 

consumption of energy. For those families with economic income of 

less than $10,000, this category of expenditures represents about 6 

464-836 0 - 84 - 5 
- 100 - 

percent of total consumption expenditures. Zero rating of expenditures on these items for all consumers would reduce the value-added 

tax base by about $160 billion or by 7 percent of the comprehensive 

base; about 90 percent of the revenue loss associated with this base 

erosion would be from those families with economic income above 

$10,000. 

The bottom line in Table 8-2, as well as Figure 8-3, illustrates 

the distributional effects of zero rating expenditures on homeprepared food, new housing, prescription drugs and medicines, household energy, and water and sanitation services. The effect of zero 

rating these expenditures is to reduce substantially the burden of the 

tax on those with economic income below $10,000 and to reduce, but not 

eliminate, the regressivity of the value-added tax. 

In general, any attempt to lessen the absolute burden of a valueadded tax on the poor and reduce the regressivity of the tax by 

excluding various categories of goods and services from the tax cannot 

fully solve the equity problem, and almost inevitably would cause 

discrimination, loss of economic efficiency, and unnecessary loss of 

tax revenue. As shown in the last column in Table 8-2, zero rating 

the expenditures discussed in this section would reduce the revenue 

from a comprehensive value-added tax by nearly 30 percent. It would 

materially complicate the tasks of both taxpayers and the IRS, and 

perhaps pave the way for evasion of the tax. 

C. Reimbursement for Value-Added Tax 

Under another alternative for lessening the burden of the tax on 

the poor, no effort would be made to zero rate the purchases of 

necessities under the value-added tax. The value-added tax would 

apply to the comprehensive base of consumer expenditures, as described 

in Chapter 7. The burden of the value-added tax on the poor would be 

reduced by reimbursing those at the lower income levels for a specified amount that would be roughly equal to the amount of value-added 

tax paid. The objective would be to free from the value-added tax the 

consumption necessary to sustain a minimum standard of living. Minimum or essential consumption could be defined by reference to the 

poverty income level. In other words, the poverty level of income 

could be considered to be equivalent to the consumption required to 

attain a minimum standard of living. 

transfers; that is the effect of the value-added tax would be excluded 

from the consumer price index used to index transfers. If transfer 

recipients were allowed a credit, on top of having transfers indexed, 

they would be left more than whole. 

This reimbursement could be implemented in either of two ways: 

(1) A credit could be provided against one's Federal income tax 

liability for a sum representing the value-added tax borne on the 

consumption necessary to sustain a minimum standard of living. This 

This approach would be an alternative to the indexing of 
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- 102 - 

amount would be taken as a credit on Federal income tax returns in the 

same fashion as income taxes withheld and the earned income tax credits are credited against one's income tax liability. 

If the amount of the credit exceeded one's income tax liability, 

it would be refundable, as is true of the earned income credit and of 

income tax withholding. Although a nonrefundable credit would reduce 

the regressivity of the tax in some income ranges, it would not help 

those persons below the tax threshold--basically those below the 

poverty line. These are the people whom the credit is intended to 

help. 

The refundable credit approach is used by Hawaii, Massachusetts, 

New Mexico, Vermont, and Wyoming to lessen the burden of the sales 

tax. The credit system has been used in five other states to offset 

retail sales tax liability, but was replaced by a food exemption, 

apparently not because the system did not function well, but primarily 

because a food exemption had greater political appeal. 

(2) Alternatively, it would be possible to alleviate the valueadded tax on a necessary level of consumption by providing a system of 

refunds independent of the income tax. Kansas follows this approach, 

even though it has an individual income tax. A form separate from the 

income tax return is used to apply for the rebate. South Dakota, 

which does not have an income tax, uses this procedure as well. 

some are restricted to the elderly. South Dakota, for example, 

restricts the refunds to persons 65 or older and to the disabled. 

Wyoming has similar restrictions. The state systems also differ in 

whether all persons receive the credit regardless of income, or only 

those below certain income levels. New Mexico, and, in the past, 

Colorado, Indiana, and Nebraska provided a flat credit for all individuals. Other jurisdictions either phase the credit out at income 

levels above a specified figure, or eliminate it at a given income 

level without a phaseout. In Hawaii, for example, the full credit 

($48 per person in 1983) is given to persons with adjusted gross 

income under $5,000, but it is phased out between $5,000 and $20,000 

of income in 10 intermediate steps. 

reimbursement approach would avoid many of the problems that arise 

with the zero rating of commodities and services. If the reimbursement were targeted at the poverty level of income, most of the tax 

burden on essential consumption could be removed from persons in the 

lowest income groups, not merely a portion of it. To the extent that 

low-income individuals qualifying for the credit have consumption 

expenditures in excess of the poverty level of income in a given year, 

they would still bear some tax burden. If this is considered to be 

unacceptable, the reimbursement amount could be increased somewhat. 

From a budgetary perspective, the money necessary to pay for the 

reimbursement can be viewed as reducing the net amount of revenue 

generated by the value-added tax. If the reimbursement were phased 

Most of the state reimbursement systems apply to all persons, but 

Although it is by no means a problem-free solution, the 
- 103 - 

out, as income rises, the loss of tax revenue at the upper income 

levels would be avoided; if it were not phased out, the revenue loss 

would be roughly equivalent to that from zero rating food, new housing, prescription drugs, energy, and water and sanitation services. 

If the reimbursement were available to everyone, it would absorb about 

25 percent of the revenue from a comprehensive value-added tax, as 

defined in Chapter 7. If it were phased out between the poverty level 

of income and 150 percent of that level, it would absorb only about 5 

percent of the revenue. This is much cheaper than zero rating of 

essential commodities, or even indexing transfers. Though the reimbursement approach would avoid the compliance and audit problems 

created by zero rating of necessities, there are several issues that 

must be resolved. 

(1) The amount of credit or refund to be granted must be determined. The poverty level of income for a family of four is estimated 

at $12,612 in 1988. (As explained in Chapter 9, 1988 is probably the 

first full year for which a value-added tax could be effective.) This 

level of income, in other words, would be necessary to finance the 

consumption to sustain a minimum standard of living. Since housing 

rents, medical and dental expenditures, and urban transportation, as 

well as other consumer expenditures, would not be included under even 

a comprehensive value-added tax base, about 77 percent of consumer 

expenditures would actually be subject to tax. For a family of 4, a 

credit of about $971 would be needed to remove the burden of a 10 

percent value-added tax from essential consumer expenditures. The 

credit would be equal to the poverty level of income ($12,612) times 

the proportion of total consumption subject to the value-added tax (77 

percent) times the tax rate (10 percent). A credit of about $325 for 

the household head plus $216 for each dependent (or two-thirds of the 

amount for the household head) would provide about the right measure 

of relief for the average four-person family. 

(2) An adjustment must be made for the number of dependents. 

With the credit illustrated here, the additipnal amount for each 

dependent would be less than the primary amount, under the presumption 

that each additional member of the household would add less than a 

proportionate amount to the living expenses of the household and thus 

to the value-added tax burden. The simple credit illustrated here is 

based on the assumption that the consumption expenditures of each 

additional household member are about two-thirds those of the household head. Alternatively, an entire schedule of credits could be 

constructed based on the poverty levels of income for each family size 

or based on a structure similar to that of the zero bracket amounts 

and dependent exemptions proposed in Volume 1, Overview, for the 

income tax. 

(3) A flat credit or refund without a phaseout would be simpler, 

but, as indicated above, would have a very substantial budgetary 

effect. ~f the credit or refund is phased out at higher income 

levels, questions will arise over the appropriate concept of income on 

which to base the phase-out. Logically, the figure should include 

adjusted gross income for Federal income tax purposes plus income 
-- 104 - 

excluded from the Federal income tax, such as interest on state and 

local bonds and the untaxed portion of social security benefits. (A 

portion of social security benefits is now subject to Federal income 

tax if income exceeds certain levels.) Transfer payments and food 

stamps should also be included. Using a definition of income different from the definition for tax purposes, however, would be controversial and would cause complexity. 

reimbursement system. Ideally, it should be the consumption unit, 

usually a family. If the credit or refund for each additional household member is smaller than the amount for the household head, as 

suggested here, there would be a "marriage penalty." But it may be 

overly generous to allow the full credit or refund for two members of 

the same household. Some groupings of people are substantially 

different from the traditional family unit. For example, a group of 

single adults each of whom may file an income tax return, might be 

living together. Individually they would claim a larger total credit 

or refund than if a single return were filed for the household group, 

particularly if the credit or refund has a phaseout. 

system: 

requests would have to be processed by a new bureaucracy if the system 

is not integrated with the income tax. If the system were administered through income tax, the number of income tax returns would 

increase, as shown by state experience with credits designed to offset 

the retail sales tax. When the reimbursement provision was introduced 

at the state level, the number of tax returns increased by between 5 

percent (Nebraska) and 15 percent (Massachusetts). A similar pattern 

developed in Canada, where the availability of refundable credits for 

dependent children increased the number of individuals filing tax 

returns to 130 percent of the labor force. Very simple returns could 

be provided for use by persons not otherwise required to file income 

tax returns. If refund requests were handled separately from the 

income tax, the number of the requests would depend upon eligibility. 

(2) Some eligible individuals may fail to file to obtain the refund of value-added tax. Federal experience with the earned income 

credit indicates that about 8 percent of those eligible fail to claim 

the credit; in these cases, the Internal Revenue Service recomputes 

individual tax liabilities to allow for the credit, issuing a refund 

where necessary. The problem would be somewhat different under the 

value-added tax credit. Whereas the IRS can identify those who file 

returns that have not claimed an earned income credit for which they 

are eligible, the problem with the value-added tax credit would be to 

identify those who are eligible but file no income tax return. This 

problem has arisen in the states, and a number of reasons have been 

identified for it: lack of knowledge of the system; unwillingness to 

take the trouble; fear that filing may lead to questions about actual 

income and why income tax returns had not been filed. But, with 

(4) The appropriate filing unit must also be determined under a 

Several operational problems would arise under a reimbursement 

(1) Additional income tax returns would be filed, or new refund 
- 105 - 

adequate publicity and the availability of relatively simple returns, 

this should not be a serious drawback, as the Canadian experience on 

refundable credits has shown. 

(3) Minor problems have arisen in the states with some ineligible 

persons obtaining refunds, or persons receiving more than one refund. 

(4) The availability of refunds would, under the phaseout 

approach, depend upon income; individuals therefore would be given an 

additional incentive to understate their income for income tax 

purposes. 

Though a phaseout of the credit at higher income levels is desirable for both equity and revenue reasons, the marginal tax rate in the 

phaseout range would be increased over that of the income tax alone. 

AS an individual's or family's income rose, the income would not only 

become subject to income tax on the extra income, but a portion of the 

value-added tax credit also would be lost. Consider the credit discussed here, which would be phased out between the poverty level of 

income and 150 percent of that level. A family of four with a poverty 

level of income of $12,612 would see the credit of $971 phased out by 

the time income rose to $18,918. Thus, if the family earns an additional $1,000 of income, its value-added tax credit would be reduced 

by approximately $154. The marginal tax rate associated with the 

declining credit on the additional $1,000 of income would be 15 

percent. This would be in addition to the marginal income tax rate on 

that extra income. The combined marginal tax rate effects would be a 

disincentive to additional work effort. The effect would be even 

worse if the credit were equal to tax on consumption of 150 percent of 

poverty-level income, but phased out over the range between 100 and 

150 percent of poverty-level income. 

individuals for the value-added tax on their purchases would be over 

and above the earned income tax credit allowed under current law. It 

would be fully available to all families and individuals below the 

poverty level and would phase out only once income exceeds the poverty 

level. By comparison, the earned income tax credit is available only 

to those who work and have dependents. The Tax Reform Act of 1984 

established that, for tax years beginning after 1984, the earned 

income credit increases with income until it reaches a maximum of $550 

and then phases out to zero by the time income reaches $1,100. If 

only earned income were involved, the earned income tax credit would 

normally be fully phased out before the phase-out of the value-added 

tax credit began. This would be desirable to avoid the high marginal 

tax rates that would result from having both credits phase out simultaneously. If different definitions of income were used to calculate 

the two phase-outs, it would be possible that the two credits could 

phase out simultaneously. Care would be required to coordinate these 

two credits to avoid the adverse incentive effects of dual phase-out, 

as well as for administrative reasons. 

The credit intended to compensate low-income families and 
- 106 - 

Under a reimbursement approach, the value-added tax would be borne 

during the year on purchases of taxable goods and services, but the 

tax credit would not be refunded until the end of the year. By contrast, zero rating of goods and services, or the adjustment of transfer payments discussed below, would occur during the year. This 

problem is most pronounced when the system is first introduced and 

eligibility first determined, since once a reimbursement is made it 

can be used to fund tax liability on subsequent purchases. If, however, the delay is regarded as a serious problem, estimated payments 

could be made in the course of the year. The advance payment procedure is already used to provide the benefits of the earned income 

credit during the year. In general, this problem can be solved and is 

not a major objection to the plan. 

Even though the earned income credit in current law is refundable 

to low income taxpayers, some may object that the use of a reimbursement plan to offset the value-added tax may be regarded as introducing 

a new family allowance or negative income tax system. A portion of 

the New Mexico system, which provides a tax rebate for low income 

individuals and families, is essentially this. Thus, it can be argued 

that a reimbursement of value-added tax would bring in by the back 

door a major change in the country's income maintenance system without 

adequate consideration. In other words, such a system should be 

debated on its own merits, rather than being introduced as an indirect 

consequence of a value-added tax. 

tax credit under existing Federal law. Several of the states have 

used this approach for lessening the burden of the sales tax without 

kindling a debate over welfare reform. In Iowa, however, the political argument was made that the tax system was inherently undesirable 

for making direct money payments. 

The system would be similar to the refunding of the earned income 

Table 8-3 and Figure 8-4 show the distributional consequences by 

income class of two refundable, phased-out credit plans. One would 

provide a credit based on the poverty level of income; the other a 

credit based on 150 percent of the poverty income level. Neither of 

the two credits illustrated here would eliminate entirely the valueadded tax burden on the lowest income families, primarily because many 

families with income at or near the poverty level in a particular year 

have consumption expenditures in excess of that income. A credit 

based on an amount in excess of the poverty level might be justified 

on the basis of consumption exceeding income at the low-income levels. 

Each of the credits illustrated here would be phased out between the 

poverty level of income and 150 percent of that level. The last 

column of Table 8-3 also shows the budgetary effect of each of the 

credits as a percent of the revenue from the broad-based value-added 

tax. As noted above, the budgetary costs associated with this 

alternative are much lower than those for either zero rating essential 

purchases or for indexing transfers. 
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I). Personal Exemption Value-Added Tax 

As explained in Chapter 4, a personal exemption value-added tax 

would be substantially different from a conventional value-added tax. 

It would resemble, at first glance, a flat-rate income tax, but, in 

effect, could be regarded as a consumption tax of the value-added 

type, at least in terms of its base, with a personal allowance and 

exemptions to lessen the burden on the poor and the regressivity of 

the tax. As with the credit alternatives, the personal exemption 

approach probably would be in lieu of any indexing of transfers. 

Under this personal exemption value-added tax, a tax would be 

levied, at a flat rate, on two forms of income: 

(1) For individuals, wages, salaries, and pensions would be the 

only types of income subject to tax. The tax would be withheld by 

employers and pension payers, and paid to the IRS. Individuals would 

be given an allowance and personal exemptions, related to the number 

of dependents, and the amount of tax withheld by employers would be 

adjusted in terms of the allowance and exemptions. The personal 

allowance and exemptions would apply only to labor income; they would 

not be available with respect to the receipt of capital income. 

and corporate, business income would be taxed at the same rate as 

income of individuals. In calculating taxable business income, 

deductions would be allowed only for wages and salaries taxable to 

employees, for purchased inputs, and purchases of capital equipment. 

Because capital equipment purchases would be deductible, the personal 

exemption value-added tax closely resembles a consumption-type valueadded tax, though with a feature that reduces regressivity and the 

absolute burden on the poor. But this alternative would only reduce 

the burden on low income individuals and families receiving labor or 

pension income. Thus, those dependent on income from capital, such as 

retired persons, would not be aided by the personal exemptions, nor 

would the unemployed be helped. 

(2) For all business enterprises, proprietorship, partnership, 

IV. Summary 

As illustrated in Table 8-1 and Figure 8-1, a broad-based valueadded tax, like any general sales tax, would be regressive relative to 

current annual income and would place a substantial absolute burden on 

the lowest income groups. It is commonly agreed that any viable proposal for a value-added tax must address these problems. 

Families with economic incomes below $10,000 receive over half of 

their income in the form of indexed transfer payments, such as social 

security payments and food stamps. These tranfers would increase 

automatically to reflect the effect of the value-added tax on prices; 

thus indexing would lessen the burden of the tax on 1,ower income 

families. Nonindexed transfers, which 2 million families receive, 

could be adjusted, if necessary, but this would have budgetary effects 

as well as ramifications for Federal-state financing of some of those 
- 110 - 

nonindexed transfers. Approximately 2 million of the 14 million 

families with economic incomes below $10,000 do not receive any transfer payments, either indexed or nonindexed. These families would not 

be affected by any adjustment of transfer payments. 

An alternative for making a value-added tax more acceptable in 

terms of its burden distribution, attractive from both an economic 

efficiency and a revenue and budgetary standpoint, would be to provide 

a refundable credit against income tax that was phased-out as income 

increased above the poverty level. A properly designed credit could 

remove the burden of the tax on consumption equal to the poverty level 

of income and would lessen the regressivity of the tax. It would be 

much cheaper than either indexing transfer payments or zero rating of 

certain commodities; the benefits of these two alternatives would go 

to families in a11 income classes, not just those at the lowest 

levels. An important objection to the credit alternative is that it 

may be viewed as involving the introduction of a new family allowance 

as a by product of the value-added tax and without direct public 

debate on welfare reform. 

An alternative to a refundable credit is zero rating of 

expenditures on food, prescription drugs and medicines, household 

energy, and water and sanitation services. This has many disadvantages, particularly the loss of revenue from those with income above 

the poverty level and operational and compliance problems. To attempt 

to extend the zero rating beyond these categories of expenditure would 

compound the operational problems and the revenue loss. The alternative of a personal exemption value-added tax would only help those 

receiving labor or pension income. 

Table 8-4 summarizes the distributional and revenue consequences 

of the alternatives presented in this chapter: (1) automaticallyindexed transfer payments; (2) zero rating of food; (3) zero rating of 

food, new housing, prescription medicine, household energy, and water 

and sanitation services; and (4) refundable, phased-out credits based 

on 100 and 150 percent of the poverty level of income. An important 

conclusion is that either the transfer payment or credit alternative 

would substantially reduce the burden of the tax on those families 

with economic incomes below $10,000, but with much smaller revenue 

consequences than the zero rating of essential commodities. This 

result is shown in the last column of the table. 
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- 113 - 

Chapter 9 

ADMINISTRATION OF A VALUE-ADDED TAX 

I. Introduction 

The Internal Revenue Service (IRS) has developed a provisional 

plan for administering a consumption type value-added tax with liability determined by the credit method. When fully phased in, it would 

cost about $700 million per year and necessitate the hiring of about 

20,000 additional employees. These costs and administration assumptions would need to be reassessed for either a subtraction or addition 

type value-added tax. In general, the value-added tax would apply to 

all sales of goods and services, but, as explained in Chapters 6 and 

7, certain commodities, transactions, and types of activity would 

probably be excluded from the tax base. 

11. General Information 

The IRS would be primarily responsible for the administration of 

the value-added tax. Although a collection responsibility would be 

assigned to the U.S. Customs Service with respect to imports, all 

other tax administrative functions would be the obligation of the IRS. 

The IRS would administer the value-added tax program within its 

existing organizational structure i.e., the same districts, regions, 

and service centers as are presently responsible for administering the 

income tax. Thus, the value-added tax would be an additional element 

in the Federal tax system, but it would not cause changes in the basic 

structure of how the other Federal taxes are administered. 

In projecting the expected administrative costs, it was estimated 

that there would be about 20 million taxpayers under the value-added 

tax. Exclusions for specific industries or classes of taxpayers could 

result in somewhat lower numbers. For comparative purposes, an analysis of the current number of state retail sales tax filers was made. 

Under the state retail sales taxes, there were approximately 5.5 

million registered firms in 1984. If this figure is extended to cover 

the 5 states not using the retail sales tax, the figure would be about 

5.75 million. Many of the states, however, do not tax services; 

Hawaii and New Mexico do. If the very broad-based taxes of Hawaii and 

New Mexico, which apply to virtually all services, are considered, the 

number of sales tax filers on a national basis would be approximately 

17 million and 15 million, respectively. None of these estimates, 

either for the Federal value-added tax or the state sales taxes, 

includes farmers. 

There would be limited integration of the value-added tax with the 

income tax, i.e., enactment of a value-added tax would necessitate 

separate forms, filing requirements, and penalties. The IRS, however, 

would offset overpayments of other taxes with any uncollected value- 
- 114 - 

added tax liability. This is currently done, for example, when income 

tax overpayments are offset for underpaid employment taxes. The IRS 

would also offset any overpayments of value-added tax against underpayments of other types of taxes. To effect these offsets, the valueadded tax statute would require a value-added tax taxpayer who is also 

a Form 1040 Schedule C filer to disclose his Social Security Number 

(SSN) on the value-added tax return. This action would be similar to 

the entry under current law of an Employer Identification Number (EIN) 

on a Schedule C. 

The examination of value-added tax returns by the IRS would 

usually be conducted independently from the audits of income tax 

returns and the examination of records for value-added tax purposes 

would not constitute an examination of books and records for income 

tax purposes. For example, if a taxpayer's sales as determined by an 

examination of the value-added tax return are proven to be significantly in error by subsequent examination of the taxpayer's income tax 

return, the value-added tax examination would be reopened and sales 

for value-added tax purposes would be corrected. 

111. Recordkeeping 

Taxpayers would be required to maintain books and records in 

sufficient detail so that both sales and purchases subject to valueadded tax could be accurately determined. These records would be 

required to be kept in a form that would allow their review by the IRS 

for the purposes of verifying reportable value-added tax transactions. 

The records would have to show all taxable goods and services 

purchased or sold in the course of business, as well as a description 

of any items converted to personal use. The records would also indicate all zero-rated purchases or sales. 

The specific form of the taxpayer's records would not be prescribed by the IRS, but if the records did not clearly reflect taxable 

sales and purchases, taxpayers would be required to make the necessary 

and appropriate changes in recordkeeping. The accounts and records 

should reflect cross referencing to all relevant supporting documents, 

such as orders, invoices, and correspondence. The taxpayer's records 

would be subject to the same retention rules as currently apply for 

income tax purposes. Taxpayers who supply or receive goods on consignment or similar terms would be required to keep separate records 

of such transactions, including the date when a transaction has been 

made or the goods have been returned to the supplier. 

To enable the IRS agents to check the records of a business, 

taxpayers would be required to summarize their taxable sales and purchases for each taxable period, including any goods applied to nonbusiness use. Necessary adjustments would be made for exempt transactions and activities. These summaries would be developed to coincide with the deposit periods for payment of value-added tax. 
- 115 - 

Receipts would be required to document all transactions; however, 

invoices would be issued only between registered business firms, or at 

the customer's request. While invoices are normally intended to enable the purchaser to verify that the goods supplied are as ordered, 

they also are essential to a credit method value-added tax. Credit 

for tax paid on business purchases would only be allowed if the invoice itemized the tax payment separately. When an invoice is 

required, a seller would be required to issue an invoice to the purchaser within 30 days of the sale. 

of the seller; the amount of the value-added tax, separately stated; a 

description of the quantity and nature of the goods or services; the 

date of issue of the invoice; the date the goods or services were delivered; the base price, i.e., the price upon which the value-added 

tax is levied; the transaction date; and, at the option of the purchaser, the EIN of the purchaser. For purposes of the tax, the base 

price would include Federal excise taxes. Refunds and credits would 

be recognized only where the purchaser's EIN is shown on the invoice. 

Invoices must be retained to verify value-added tax paid on purchases. 

Refunds for value-added tax paid on exports would be allowed only 

if appropriate documentation is on file for goods and services exported. A credit for value-added tax paid on imports would be allowed 

only if import invoices certified by the U.S. Customs Service indicate 

that the tax had been paid to the government. Third party information 

reporting (e.g., Forms 1099) is not contemplated in the administration 

of the value-added tax. 

Each invoice would be required to show: the name, address and EIN 

IV. Filing of Returns and Payment of Taxes 

The IRS currently processes all income tax returns in 10 service 

centers located in various regions of the United States. These same 

centers would be used for processing value-added tax returns and payments. 

For purposes of collecting and paying the value-added tax to the 

IRS, the filing entry would be the same as for income or employment 

tax purposes; thus, a business with multiple locations and one EIN 

would file one value-added tax return. Each entity would use its EIN 

when filing. Those entities which do not now have an EIN, e.g., a 

business with no employees, would be required to obtain an individual 

All value-added tax taxpayers would be deemed to be on a calendar 

year basis and returns would be required to be filed quarterly within 

30 days after the end of each calendar quarter. A form similar to 

Form 6400 (Appendix 9-A) would be used for reporting taxable valueadded tax sales and allowable purchase credits. This form would be 

filed with the same IRS Service Centers where taxpayers now file 

income tax returns. 

EIN. 
- 115 - 

Value-added tax collections would generally be governed by the 

deposit rules that apply to employment taxes, except as to frequency 

of payments. Value-added tax payments would be made using the Federal 

tax deposit (FTD) system. Deposits would be made at a Federal Reserve 

Bank or other authorized financial institution. Each deposit would be 

accompanied by a FTD coupon. Deposits would be automatically credited 

to the taxpayers' accounts under this system. 

The frequency of value-added tax deposits would be based on the 

amount of value-added tax owed. A monthly or semimonthly deposit 

system would be used. If value-added tax liability is less than 

$2,000 for a particular month, a monthly deposit would be due by the 

last day of the month immediately following. However, if the valueadded tax liability is $100 or less at the end of the first or second 

month in a quarter, it would be carried over to the next succeeding 

month. If a value-added tax liability is $100 or less at the end of 

the third month, it would be deposited or paid with the return by the 

due date of the return. If the liability exceeds $2,000 for any month 

of the quarter, semimonthly deposits of taxes would be made for the 

following quarter. The amount owed would be deposited by the 9th day 

following the semimonthly period for which it is reported. 

The tax would be calculated on all goods and services not 

explicitly exempt or zero rated, regardless of the purchaser. Those 

entities that might normally qualify for value-added tax refunds, such 

as states, local governments, exempt organizations, and importers 

would receive quarterly refunds of value-added tax paid by filing Form 

6400 with the IRS. Other taxpayers would have the option to carry 

forward unused credits against value-added tax owed in succeeding 

quarters or to receive refunds on a quarterly basis. This election 

would be made on Form 6400. The IRS would honor this quarterly election by refunding the value-added tax after offsetting the available 

value-added tax credits for any underpayments of other types of taxes. 

v. Imports 

The U.S. Customs Service would be responsible for collecting the 

value-added tax on items imported into the United States. The rules 

for establishing the taxable value of items would follow the same 

rules now used for the purposes of collecting duties on those items. 

For example, the value of imported merchandise is generally the transaction value of the goods, that is the price actually paid or payable 

for the merchandise when sold for exportation to the United States, 

plus certain other amounts which include packing costs, selling commissions, royalties, or license fees. If the transaction value cannot 

be determined, then certain other valuation methods are applied such 

as the transaction value of identical or similar merchandise, or a 

deductive or computed value. For the value-added tax, as for duties 

and certain Federal excise taxes, it would be the responsibility of 

the U.S. Customs officer to establish the value. Also, the requirements for providing the proper entry document, packaging of imported 
- L17 - 

merchandise, inspecting such merchandise, collecting the tax, assessing subsequent tax if the value is originally understated, and disprrting and appealing the determination of value upon which the tax is 

assessed would follow the rules established for purposes of collecting 

import duty. 

If no duty is collected by U.S. Customs because the item is 

entitled to enter the t1.S duty-free, the value-added tax would still 

be collected unless that item is zero rated under the value-added tax 

rules and thus would not be subject to the tax. However, if an item 

is imported and classified by the U.S. Customs as qualifying for temporary free importation because that item is to be held temporarily in 

a bonded warehouse for export, no value-added tax would be collected. 

If, instead, the item were exempt from duty because it was imported 

for use by the person importing the article, the value-added tax would 

be collected. The bonds or sureties required to guarantee payment of 

duties would also be required to assure payment of the value-added 

tax. Likewise, the rules which apply for nonpayment of duty, such as 

those governing the disposition of goods, would apply for nonpayment 

of the value-added tax. The Customs' rules defining who is liable for 

the duty, internal advice procedures, protests, and appeals would also 

be applicable to Customs' procedures for assessment and collection of 

the value-added tax. 

The rules governing the method and time period for collection of 

duty would generally govern for value-added tax purposes. However, if 

the value-added tax were collected along with import duty and if the 

duty were later refunded, such as occurs when certain goods are held 

in the United States temporarily and then exported, the value-added 

tax would not be refunded since it would be assumed that credit for 

payment of the value-added tax would already have been taken against 

the importer's value-added tax liability. 

VI. Enforcement 

Once a value-added tax is in place, the success of the IRS in 

collecting the tax revenue will depend primarily on two program areas: 

Examination and Collection. An effective examination function must be 

developed to detect receipt and invoicing distortions along with a 

collection system which will permit early detection of delinquent taxpayers . 

A. Examination 

In the initial years of any new tax, an effective system of tax 

administration should have a significant audit presence. This would 

be particularly true with respect to a value-added tax in the United 

States. 

As shown in Table 9-1 the income tax compliance levels of sole 

proprietorships (Schedule C) and corporations have been declining in 

recent years. The data below, developed from IRS taxpayer compliance 
- 118 - 

Table 9-1 

Taxpayer Compliance Levels: Individual and Corporate 

Selected Years, 1976-1981 

(Percent) 

COMPLIANCE LEVELS 

Tax Year Tax Year 

1979 1976 

Total Individual 

Schedule C, Gross Receipts 

$1 - $25,000 

$25,000 - $100,000 

$100,000 and over 

Total Corporations 

No Balance Sheet 

$1 - $1,000,000 Assets 

$1,000,000 - $10,000,000 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

90.8 91.8 

66.3 72.9 

76.0 81.5 

74.8 78.8 

processing Processing 

Year 1981 Year 1978 

80.6 83.3 

60.6 63.0 

70.4 73.9 

85.9 88.8 

December 7, 1984 
- 119 - 

measurement programs, reflect this decline (i.e., the ratio of tax 

liability reported to correct tax liability exclusive of math errors.) 

Based on the assumption of approximately 20 million taxpayers, the 

IRS audit coverage and staffing by categories of taxpayers are shown 

in Table 9-2. 

Since a value-added tax would be a new Federal tax, about 8,500 

new hires would be added to the examination staff. It would not be 

practical to acquire these new hires more rapidly than one third per 

fiscal year beginning in the year the tax is effective. This limitation is due to many factors, such as the availability of qualified 

candidates, the resources that would be needed to recruit, interview, 

select, and train the new hires, and the nonavailability of valueadded tax work for some of the people if hired too early in the implementation process. 

Over the years, the IRS has continued to perfect its computerized 

methods of selecting income tax returns for examination with the result that the yield from its examinations has increased and its rate 

of no-change examinations has decreased each year. This has been the 

result of gathering extensive statistical data relating to the returns 

examined and filed and of conducting periodic research and taxpayer 

compliance measurement programs. Such an information base would not 

be available initially for developing a selection system for valueadded tax returns. 

In the early years of a value-added tax, the IRS would develop a 

computerized selection system. But until an extensive information 

base is acquired either through a research study or the taxpayer compliance measurement program, the system would not be as effective as 

the income tax system in terms of revenue yield and low no-change 

rates. rt would probably take as long as 5 years after the effective 

date of a value-added tax to develop an effective return selection 

system. 

Until the IRS has developed an information base with respect to 

non-compliance areas, it will be difficult to classify returns for 

examination merely on the basis of Form 6400. Accordingly, during the 

first 5 years after the effective date of a value-added tax, returns 

would be selected on the basis of largely untested characteristics. 

The IRS would also include special value-added tax compliance checks 

in the examination of income tax returns to check the accuracy of 

value-added tax reporting. 

Examinations of sole proprietorship (Schedule C) taxpayers are the 

most time consuming of all individual income tax examinations. This 

is because many of these taxpayers do not maintain reliable books and 

records. Generally, their books and records are a single-entry system 

maintained by the taxpayer, with personal and business accounts comingled and receipts maintained in a haphazard fashion. 
Taxpayers 

- 120 - 

Table 9-2 

Audit Coverage and Staffing for Value-Added Tax 

By Categories of Taxpayers 

Receipts 

jmillions o? dollars) -- Less than: 

$1.0 :$1.0-10.0 :$lo-100 :Over $100 : Total 

18.8 .9 .3 15K 20.0 

Audit coverage (overall) 2% 4% 8% 28% 2.2% 

Hours per case 15 20 40 80 

"Staffing 6,269 800 1,066 374 8,509 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

December 7, 1984 

* The above estimate includes support personnel; 7,032 of the 8,509 

are technical staff years and 1,477 are support staff years. 
- 121 - 

Since the reporting of sales figures would likely be a major area 

of abuse, the IRS would need a recognized method of determining sales 

for those value-added tax taxpayers whose books and records are not 

reliable. The staffing estimates in this section are based on IRS 

examiners using examination techniques similar to those employed by 

state sales tax examiners, which require much less time than the indirect methods currently employed in Federal income tax examinations. 

This would mean extensive use of percentage mark-up techniques in 

auditing . In order to minimize disputes and to obtain maximum coverage, it would be useful for these techniques to be recognized as 

appropriate auditing systems in the codification of a value-added tax. 

B. COll@CtiOn 

The collection function would operate under the same procedures 

and techniques that are employed in enforcing the income and withholding taxes. If value-added tax returns are filed with balances 

due, the service center staff would generate up to 4 notices to taxpayers at intervals of approximately 5 weeks. Cases that remain 

unresolved after notice processing would be forwarded to the automated 

collection staff for telephone contact and additional processing. 

continued delinquencies would be turned over to a field officer for 

personal contact and resolution. At that point, more sophisticated 

collection techniques would generally be required. 

Collection costs for a value-added tax are based on the IRS's 

experience with employment tax returns. Assuming 80 million valueadded tax returns (quarterly returns by the 20 million taxpayers), the 

IRS estimates that there would be 1.06 million delinquent accounts and 

1.4 million investigations of possible unfiled returns. Though some 

of these delinquencies would be part of an investigation for other 

taxes (employment or income, for example), it is estimated that the 

automated collection system would close approximately 65 percent of 

the remaining issuances so that the district offices would receive 

about 300,000 delinquent account referrals and 238,000 delinquency 

investigations. 

staffing of about 2,900 individuals. As with the examination staff, 

the collection staff would be increased in approximately one third 

annual increments. Assuming a July 1, 1987 effective date, the 

collection function would hire one-third of the required staff by 

March 1987, another one-third by March 1988, and the remaining onethird by March 1989. This would enable the IRS to devote sufficient 

resources to training new hires while maintaining its compliance 

coverage. 

The value-added tax would necessitate an increase in collection 

C. Criminal Investigation 

The IRS would handle the criminal investigation part of valueadded tax administration as an additional responsibility of the current staff of investigators. History has shown that when any new tax 
- 122 "- 

is enacted, a body of civil tax law must be established before criminal enforcement can be achieved. Precedents in the civil area are 

generally required before courts will accept criminal prosecutions in 

tax matters. 

primarily from referrals coming from the examination and collection 

functions. As case law and taxpayer practices become established, the 

criminal investigation would then be able to address specific segments of noncompliance, as they now do in the income tax. 

Development of a criminal investigation workload would flow 

D. Appeals Procedures 

Value-added tax taxpayers would have appeal rights in disputes 

with the IRS similar to those under the income tax. In pursuing a 

disagreement with adjustments proposed by the IRS, the taxpayer would 

have the opportunity to request an appeals hearing within 30 days 

after the receipt of the examiner's report. Once requested, the hearings would be conducted promptly by the Appeals office of the IRS. 

If the liability recommended by the IRS continues to be unresolved, the taxpayer would then have the opportunity to pay the full 

amount of any tax due and appeal to the U.S. Court of Claims or to any 

federal district court. In this connection, the value-added taxpayer 

would be treated the same as if an excise OK payroll tax were in dispute. Before the taxpayer could appeal to the courts, the tax would 

be assessed and must be paid. 

VII. Public Education Strategy 

Unless these is adequate and timely publicity before a value-added 

tax is introduced, resistance based on inaccurate or inadequate data 

could become a serious problem. Every country that has adopted a 

value-added tax has preceded its implementation with a one-to-two year 

intensive public information campaign. The time required in the 

United States could conceivably be shorter. However, because the 

value-added tax would impose new requirements on taxpayers, a 

carefully-planned taxpayer information campaign would be necessary. 

The IRS would take the following steps. 

1. It would prepare and disseminate a basic Value-Added Tax 

Public Education package which would include fact sheets, proposed 

speech inserts, and written questions and answers. 

2. It would issue a series of news releases announcing filing 

dates and explaining the use of the new forms. 

It would publish a series of op-ed articles under the byline 

of the Commissioner of the Internal Revenue Service and other senior 

Administration officials. These articles would explain the philosophy 

behirid the value-added tax, its advantages, and its operation. 

3. 
- 123 - 

4. The IRS would also arrange numerous press conferences and 

press briefings at the national, regional, and district office levels. 

5. It would schedule and manage a large number of briefing 

meetings with such organizations as the 1J.S. Chamber of Commerce, the 

National Association of Manufacturers, and other business-related 

organizations. 

coordinated wide-ranging speakers programs to provide the public, 

practioners, and industry groups with information on the value-added 

tax. 

VIII. Returns Processing 

Returns would be processed using the present 10 IRS service 

centers and the National Computer Center. The IRS would process 80 

million returns (20 million per quarter) and 120 million deposits of 

tax. Along with the 50 million notices of various types which would 

be issued, it is expected that 5 million new EINs would need to be 

issued to value-added tax filers who do not now have an EIN. Five 

million adjustments (i.e., changes to taxpayer accounts after returns 

are filed) would be required per year. 

IX. Data Processing Activities 

Implementing a value-added tax would necessitate the acquisition 

of additional data processing equipment by the IRS. These costs are 

shown in Appendix 9-8. The computer services costs reflect expenditures for software development and hardware procurement. They include 

staffing to program and test, or contract for, software modifications 

to a series of IRS systems. The computer equipment costs (about $259 

million over a four year period) would involve: the purchase and maintenance of Optical Character Recognition (QCR) devices to scan FTDs 

and returns (about $50 million); upgrades to data entry, main processing, and printing systems in the 10 service centers (about $121 

million); machinery to maintain value-added tax accounts in master 

files at the National Computer Center (about $7 million); upgrades in 

12 existent call sites for automated collection operations and computers in 8 new call sites under the Automated Collection System (ACS) 

(about $36 million); and portable computers for field personnel under 

the Automated Examination System (AES) (about $45 million). In accordance with IRS procurement practices, costs of $214 million are 

displayed under 4-year, lease-to-ownership plans (LTOP) and related 

maintenance schedules. In accordance with projected examination 

staffing, AES equipment costs would occur in 4 installments with an 

annual purchase cost of $10.5 million and an incremental maintenance 

fee geared to the aggregate number of portable computers acquired 

through each installment. 

6. On both the national and field levels, the IRS would mount 
- 124 - 

X. Cost Estimates 

administering the value-added tax. At today's prices, these estimates 

indicate that it would cost about $700 million per year once the administrative program is fully effective. These costs do not include 

the following: costs to the private sector of complying with the 

recordkeeping and filing requirements; costs to other Federal agencies 

involved in administering a value-added tax, e,?., the Customs Service 

for imports and the Bureau of Government Financial Operations (currently $.SO per FTD is paid to banks for processing); and opportunity 

costs to the IRS, since the income tax revenue produced by enforcement 

personnel may decline during the conversion to a value-added tax 

because a significant number of the IRS's experienced personnel would 

be involved in training, planning, and managing the value-added tax 

system. 

education) are based on IRS general experience with new legislation. 

There is no comparable experience with the introduction of a radically 

different tax. The category of resource and other costs includes the 

necessary costs to hire, train, support, and house the staff involved 

in the operational segments of the IRS. Certain support personnel 

costs would rise in direct ratio to operational staff expansion: 

e.g., personnel, internal audit, internal security, and training. In 

addition, the costs of increased office space, travel, and the like 

would be incurred. 

The IRS has made preliminary cost estimates (Annex 2) for 

The costs for taxpayer services (which includes taxpayer 

XI. Summary 

To implement a value-added tax successfully, there must be 

adequate preparations. These would include designing the system for 

administration; developing complete staffing and equipment needs; puttirig together a practical public relations program; and adhering to a 

realistic timetable. The IRS would need at least 18 months after 

enactment before it could begin to administer a value-added tax. 

Thus, even if a value-added tax were enacted by the end of 1985, IRS 

administration could not begin before July 1, 1987. If an enacted 

value-added tax were materially different from the value-added tax 

assumed in developing these cost estimates, the projected leadtime and 

costs could be substantially modified. 
- 125 - 

Appendix 9-A 

(July 198X) 

Oepsnment of theTieaiuly 

l"te,nal Revenue sewice 

OMB No 1595 XXXX 

Federal Value Added Tax (VAT) Return 

Calendar quarter ending CI March. CI June, September. December. 19 . 

Taxpayer's name 

If you are an exempt entity, use this Form 6400 to report only transactions connected with an unrelated trade or business 

For all other transactions. file Form 64008 instead 

Taxpayer's idsnllfylng number 

Tax Computation 

Address 

1 Total sales on invoices issued during the quarter (and issued during prior quarters but not pre 

reported on a Form 6400) Enter total sale 

2 Zero rated sales shown on invoices included on line 1 

3 Returns. allowances. discounts not previously claimed on a Form 6400 

4 Allowance for uncollectibles allocated to quarter 

5 Total deductlons (add lines 2.3 and 4) 

6 Taxablerales(subtract line 5from line 1) 

7 TentativeVAT(multip1y line6by.xn) 

Business code number 

8 Total VAT paid on invoices received during the quarter 

9 Total VAT paid on invoices received during prior quarters but not 

previously reported on a Form 6400 

10 VAT credit carried over (from line 16 of last filed Form 6400) 

11 VATdeposits(fr0m Part 11) 

12 TotalVATcredlts(add lines8.9, l0and 11) 

10 

11 

I12 I I 

13 If line 7 is greater than or equal to line 12, subtract line 12 from line 7 and enter net undeposlted VAT 

due 

14 if line 12 is greater than line 7. subtract line 7 from line 12 and enter net VAT overpayment 

15 Amount on line 14 to be refunded to you 

: 

16 Amount on line 12 to be amlied as a VAT credit carwover (subtract line 15 from line 14) I 

Under penalties of perjury. I declare that I haveexamined this return, includingaccompanyingschedulesand statements. and to the best of my knowledge 

and belief, it is true, correct. and complete, 

Form6400 (7-ax) 
- 126 - 

Appendix 9-A, continued 

Month 

First month 

Second month 

Third month 

Form MCO(7-8Xl Page 2 

Deposit Schedule and Record of Tax Liability (See Instructions) 

Day 

1st through 15th day 

16th through last day 

Total for month. , , . . . , . , . . . . . 

1st through 15th day 

16th through last day 

Total for month. . . . ............. 

1st through 15th day, 

16th through last day 

Total for month. , . , 

l-+- 1 Total liability for the quarter 

2 Total deposits for the quarter Enter here and on line 11 of the Tax Computation 

3 If you make semimonthly deposits and claim one of the deposit exceptions. please indicate the exception: 

a C] bC] cm dC] ~ 
- 121 - 

Appendix 9-A, continued 

. - ..- 

(July 198X) 

Depanmenl nl the Treaiuv 

lnteinal Revenue Service 

F".", 1 Application for Refund of Value Added Taxes I 

For Exempt Entities , 19 I OMBNo 1545xXXX 

Return for period beginning, 19 , and ending 

EntlWrname Enlily's idsnllfylng numbs, 

Address 

0 Exempt under section 501( 

the Period for which you are filing this application. but not 

1 Total VAT paid on invoices receiv 

2 Total VAT paid on invoices rec 

previously reported on either a Form 6400 or a Form 6400.R 

3 Amount to be refunded. Add lines 1 and 2 . ... .... 3 

signature b Title b -. Date b 

Form 6400.R (744 
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