Value-Added Taxes: Potential Lessons for the United States from Other Countries' Experiences
Published: 2011-07-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Dissatisfaction with the federal tax system has led to a debate about U.S. tax reform, including proposals for a national consumption tax. One type of proposed consumption tax is a value-added tax (VAT), widely used around the world. A VAT is levied on the difference between a business's sales and its purchases of goods and services. Typically, a business calculates the tax due on its sales, subtracts a credit for taxes paid on its purchases, and remits the difference to the government. While the economic and distributional effects of a U.S. VAT type tax have been studied, GAO issued a report in 2008 that looked at lessons learned from VAT administration in Australia, Canada, France, New Zealand, and the United Kingdom. These countries provided a range of VAT designs from relatively simple to more complex. This statement, which is based on the 2008 report, focuses on (1) the effect VAT design choices, such as exemptions and enforcement mechanisms, have on compliance, administrative costs, and compliance burden; (2) Canada's experience with administering a VAT in conjunction with several different subnational consumption tax arrangements; and (3) the experience that some countries had transitioning to a VAT.
section_title: What GAO Found
paragraphs: VATs have grown in popularity over the past five decades with recent estimates showing more than 130 countries worldwide using a VAT. Nonetheless, like other tax systems, even a simple VAT--one that exempts no goods or services--has compliance risks and, largely as a consequence, generates administrative costs and compliance burden. For example, all of the study countries reported devoting significant enforcement resources to compliance issues. Like an income tax, VATs can be vulnerable to compliance schemes that either result in undercollection of taxes due or overclaiming of credits for taxes paid. Also, as with other taxes, adding tax preferences--such as exempting certain goods or services from tax--generally decreases revenue, increases complexity, and increases compliance risks. Increased complexity also increases the record-keeping burden on businesses and government resources needed for enforcement. Canada's experience administering a national VAT along with a variety of provincial VATs and sales taxes demonstrates that multiple arrangements in a federal system are feasible, but increase administrative costs and compliance challenges for both governments and businesses. Businesses, particularly retailers, in provinces with a sales tax face greater compliance burdens than those in other provinces because they are subject to dual reporting, filing, and remittance requirements. When implementing their VAT, Australia, Canada, and New Zealand all devoted considerable resources to educate and assist businesses subject to the new tax. Both Australia and Canada provided direct monetary assistance to qualifying small businesses to help meet new bookkeeping and reporting requirements. Both had trouble getting businesses to register for the VAT by the implementation date.

section_title: Letter
paragraphs: I am pleased to be here to discuss our prior work on the lessons the  United States can learn from other countries’ experiences with a value- added tax, or VAT.VATs have grown in popularity over the past five  decades with recent estimates showing more than 130 countries  worldwide using a VAT. The United States is the only member of the  Organisation for Economic Co-operation and Development (OECD)  without a VAT.
Dissatisfaction with our current federal tax system has fueled a debate  about fundamental tax reform due to concerns about the current federal  tax system’s economic inefficiency, unfairness, and complexity. Part of  this debate has involved switching to a consumption tax or combining a  consumption tax with an income tax. One type of consumption tax that  some have proposed is a VAT. A VAT is applied to the difference  between a business’s sales of goods and services and its purchases of  goods and services (excluding wages). Thus, businesses pay tax only on  the value they add to the goods or services they sell. Unlike retail sales  taxes, VATs are collected at all stages of production and distribution  process. All types of businesses, not just retail businesses, are subject to  the tax, and sales to both consumers and other businesses are taxable.
My testimony today will discuss five countries’ experiences with their  VATs. These study countries are Australia, Canada, France, New  Zealand, and the United Kingdom. They represent a range of VAT design  options from relatively simple to more complex and include some with  federal systems and some that recently implemented a VAT. Specifically,  I will cover (1) the effect that VAT design choices, such as the number of  tax rates and tax exemptions, have on compliance, administrative costs,  and compliance burden; (2) Canada’s experiences with administering a  national VAT in conjunction with several different subnational  consumption tax arrangements; (3) the experiences that countries had  transitioning to a VAT; and (4) our concluding observations on the  lessons the United States can learn from these countries’ experiences.
This testimony is based on our report issued in 2008. Although some time  has passed since our report was released, the challenges that our study  countries encountered in implementing and administering VAT systems  remain insightful to the United States should it consider a national  consumption tax. For that report we selected our study countries based  on several criteria, including the complexity of VAT design, the age of the  VAT system, and whether the country had a federal system. For each  country, we performed in-depth literature reviews and conducted  extensive interviews of government officials and VAT experts. We also  collected and analyzed documents and data on the countries and their  VAT systems. Additional information on our scope and methodology is  available in our published report.
We conducted the performance audit work that supports this statement in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provided a reasonable basis for our findings and  conclusions based on our audit objectives. We did not make any  recommendations.
subsections: section_title: Background: How a Simple VAT Works
paragraphs: Under a VAT, businesses pay tax on the value they add to the goods and  services they purchase from other businesses. VAT liability is typically  calculated in industrialized countries using what is known as the credit- invoice method. Under this method, businesses apply the VAT rate to  their sales but claim a credit for VAT paid on purchases of inputs from  other businesses (shown on purchase invoices). The difference between  the VAT collected on sales and the credit for VAT paid on input  purchases is remitted to the government.
Figure 1 illustrates a VAT with a 10 percent rate. A lumber company cuts  and mills trees and has sales of $50 to a furniture maker. Assuming no  input purchases from other businesses, to keep the illustration simple, the  company adds the tax to the price of the goods sold and remits $5 in tax  to the government. The purchase invoice received by the furniture maker  would list $50 in purchases plus $5 in VAT paid.
If the furniture maker has sales of $120 to a retail store, $12 of VAT would  be added to the sales price but the furniture maker could subtract a credit  for the $5 VAT paid on purchases and remit $7 to the government. The  retailer would receive an invoice showing purchases of $120 and $12 of  VAT. Similarly, if the retailer then has sales of $150, $15 of VAT would be  added but the retailer could subtract a credit for the $12 paid on  purchases and remit $3 to the government.
In total, the government would receive VAT equal to 10 percent of the  final sales price to consumers. Thus, a 10 percent VAT is equivalent to a  10 percent retail sales tax in terms of revenue. Under both taxes, the final  consumer ultimately bears the economic burden of the tax ($15), except  in a VAT, the tax is collected in stages, not just in the final sale.
section_title: Like Other Taxes, VATs Have Compliance Risks, Administrative Costs, and Compliance Burden That Increase with the Complexity of the Design
paragraphs: Our study countries’ experiences with noncompliance suggest that even a  conceptually simple VAT—one that applies a single tax rate to all goods  and services—would have compliance risks and would generate  significant administrative costs and compliance burden. Further, like other  types of taxes, adding complexity through preferences increases these  risks, costs, and burden. While our study countries had VATs of varied  designs and complexity at the time of our original review in 2008, they all  devoted significant enforcement resources to addressing compliance  issues that would be found in even a simple VAT.
subsections: section_title: Compliance Risks
paragraphs: As shown in table 1, compliance risks for a VAT can stem from either  underpayment of taxes owed on sales, or overstating taxes paid on  purchases. These risks include refund fraud and missing-trader fraud.  VATs are vulnerable to refund fraud because businesses with taxable  sales less than taxable purchases are entitled to refunds. All of our study  countries were concerned about illegitimate businesses or fraudsters  submitting fraudulent refund claims that result in the theft of funds from  the government. In the case of a missing trader, a business is set up for  the sole purpose of collecting VAT on sales and then disappearing with  the proceeds.
Because of compliance risks, even simple VATs require enforcement  activities, such as audits and record keeping by businesses, that create  administrative costs for the government and compliance burden for  businesses. Of course, compliance risks and the associated  administrative costs and compliance burdens are not peculiar to VATs.  While the specifics may vary, other types of taxes also carry compliance  risks.
section_title: Administrative Costs
paragraphs: A VAT, like any tax system, will require government resources to  administer. The drivers of administrative costs in many tax systems  include the number of taxpayers (businesses, individuals, or both) subject  to the tax, how often they file returns, and the percentage of taxpayers  audited. In the case of a VAT, administration requires the government to  process tax returns and provide certain services to businesses. Even a  simple VAT warrants education and assistance services, in part to  address compliance risks. Tax administrators also need to spend  significant resources on audit and enforcement activities.
Some available data from our study countries indicate a VAT may be less  expensive and easier to administer than an income tax. In 2006, the tax  administration agency in the United Kingdom measured administrative  costs for the VAT to be approximately half a percent of revenue collected  compared to over one and a quarter percent for the income tax. Officials  at the New Zealand Inland Revenue Department also told us that  administering their VAT was easier than administering some of their other  taxes. For example, only 3 percent of VAT returns submitted to New  Zealand’s revenue agency are found to have errors, compared to  approximately 25 percent for income tax returns.
section_title: Compliance Burden on Taxpayers
paragraphs: As with other taxes, compliance burden with a VAT is mostly driven by  record-keeping requirements, filing-frequency requirements, and time and  resources to deal with audits. The “fixed cost” nature of many compliance  costs associated with a VAT means that smaller businesses often face a  proportionally higher burden than larger businesses in complying with the  VAT. The three most comparable studies we identified estimated that the  compliance burden as a percentage of annual sales in Canada, New  Zealand, and the United Kingdom ranged from approximately 2 percent  for businesses with less than $50,000 in sales to as low as 0.04 percent  for businesses with over $1,000,000 in sales. Private accounting and tax  experts we spoke with also agreed that as the size of the business grows,  the VAT compliance burden decreases per dollar of sales.
section_title: Adding Complexity through VAT Preferences Decreases Revenue and Generally Increases Compliance Risks, Administrative Costs, and Compliance Burden
paragraphs: All of the countries we studied have added complexity to their VAT  designs, mainly through the use of tax preferences. Tax preferences— also called tax expenditures—result in foregone tax revenue due to  preferential provisions that generally shrink the tax base. Tax preferences  can also exist in other tax systems, such as income taxes or retail sales  taxes. In our study countries, some economic sectors, such as certain  consumer essentials like food and health care and public-sector  organizations are often provided VAT preferences because of social or  political considerations. Other sectors, such as financial services,  insurance, and real estate, are provided exemptions or exclusions  because they are inherently hard to tax under a VAT system.
Countries’ use of VAT preferences—such as exemptions and reduced  rates—generally results in reduced revenue and greater compliance risks,  administrative costs, and compliance burden. However, some  preferences, such as thresholds for businesses, may not increase  administrative costs and compliance burden because they reduce the  number of entities subject to VAT requirements. Additionally, in most  study countries, certain financial-services and real-estate transactions are  exempt for administrative purposes, which could result in reduced  compliance burden.
VAT preferences used in our study countries included exemptions,  exclusions, and thresholds. An exempt good or service is not taxed when  sold, and businesses that sell exempt goods or services cannot claim  input tax credits for inputs used in producing the exempt output. While no  VAT is collected with the final sale, the government still collects tax  revenue throughout the stages of production. Tax is paid and collected on  inputs. In contrast, excluding a good or service, more commonly referred  to as zero rating, removes it entirely from the tax base resulting in an  effective tax rate of zero. For goods and services that are zero-rated, VAT  that was paid in the production of the good or service can be fully  recovered through input tax credits. As a consequence, no net VAT  revenue is actually collected by the government from the sale of zero- rated goods and services.
A threshold is a type of exemption that excludes businesses below a  certain size from collecting and remitting VAT and from being able to  claim input tax credits. Businesses with sales below the threshold are not  required to charge VAT on their sales and cannot claim input tax credits  for VAT paid on purchases. Businesses with annual sales above the  threshold level are required to register with the tax agency, and collect  and remit the VAT.
section_title: In Canada, Tax System Complexity and Compliance Burden Varied among Provinces Depending on Level of Coordination with a Federal VAT
paragraphs: One issue the United States would face if it adopted a national VAT is its  interaction with retail sale taxes levied by states and localities. Although  there are several countries with a federal system of government, Canada  is the only country that we identified that has a national VAT administered  alongside a variety of subnational consumption taxes. Canada  administers its federal VAT and provincial consumption tax systems  differently in different provinces. The four types of national/subnational  consumption tax structures in Canada are:    a separate federal and provincial VAT, both of which are administered    a joint federal and provincial VAT administered by the federal  government;    a separate federal VAT and provincial retail sales tax administered    a federal VAT only.
Canada’s experience administering a national VAT along with a variety of  provincial VATs and sales taxes demonstrates that multiple arrangements  in a federal system are feasible, but results in increased administrative  costs and compliance challenges for both government and business.  Businesses in provinces where the provincial and federal VATs tax the  same goods and services and are administered by the federal  government have a relatively lower compliance burden since they only  have to comply with one set of requirements. In contrast, businesses,  particularly retailers, in provinces with a sales tax face greater compliance  burdens than those in other provinces because they are subject to dual  reporting, filing, and remittance requirements.
section_title: VAT Implementation Involved Considerable Resources to Educate, Assist, and Register Businesses
paragraphs: Australia, Canada, and New Zealand, the study countries that most  recently implemented a VAT, all built on preexisting administrative  structures. All had national consumption taxes that were paid by  businesses prior to transitioning to a VAT. Despite the preexisting  structure, implementation of the new tax in these countries involved  multiple agencies, the development of new policies and processes, and  the hiring of additional staff. Interagency committees were also  established in all three countries to facilitate and coordinate  implementation efforts. These three study countries took 15 to 24 months  to implement the VAT and devoted a great deal of time and effort to  education activities.
Before entities subject to VAT requirements can be expected to comply,  they must know what those requirements are and what they mean to  specific economic and industry sectors. According to International  Monetary Fund guidance on VAT implementation, development and  testing of tax forms early in the implementation process is important  because they are a key part of the education effort. For Australia,  Canada, and New Zealand, this also included extensive outreach efforts  through a variety of direct and indirect assistance. For example,  Australian officials said a key part of their education and outreach  strategy was to target key players in various industry sectors, such as  local chambers of commerce. Both Canada and Australia also provided  direct monetary assistance to qualifying small businesses to defray the  costs of acquiring the necessary supplies needed to meet new  bookkeeping and reporting requirements.
Despite significant efforts to encourage businesses to submit materials  early for VAT registration, both Australia and Canada still had difficulty  getting businesses to register prior to the VAT implementation date. In  both countries, this resulted in significant spikes in registration and  education-related workload just prior to implementation. In Canada, for  example, only 500,000 or 31 percent of the 1.6 million total registrants  had voluntarily registered 3 months prior to VAT implementation.
section_title: Potential Lessons for the United States
paragraphs: The experiences of our five study countries show that all VAT designs  have compliance risks that generate considerable administrative costs  and compliance burden and that, similar to the U.S. tax system, adding  complexity to the tax’s design increases these risks, costs, and burden.  While our study countries had VATs of varied designs and complexity,  they all devoted significant enforcement resources to addressing  compliance that would be found in even a simple VAT. Enforcement  activities, such as audits, and record keeping by businesses create  administrative costs for the government and compliance burden for  businesses. Of course, compliance risks and the associated  administrative costs and compliance burden are not peculiar to VATs.  While the specifics may vary, other types of taxes also carry compliance  risks.
One overriding lesson about VAT design is that, like our income tax  system, adding tax preferences to the system may satisfy economic,  distributional, or other policy goals but at a cost. Tax preferences—in the  form of exemptions, zero rates, or reduced rates—often reduce revenue,  add complexity, and increase compliance risks. To mitigate the increased  risk, countries have imposed additional record-keeping and reporting  requirements on businesses, delayed refunds, and done more auditing of  businesses. The end result is an increase in compliance burden for  businesses and administrative costs for the government.
The choice of tax type is typically heavily influenced by criteria other than  administrability. Revenue needs, effect on economic performance, and  distributional consequences are prominent considerations and have been  at the forefront of the debate in the United States about tax reform.
Administrability and the details of how a new tax would be implemented  often get less attention. However, administrability and design details do  matter. The benefits of a new or reformed tax system, in terms of  revenue, economic performance, or equity, would be at least partially  offset by poor design that unnecessarily increased compliance risks,  administrative costs, and compliance burden.
Chairman Camp, Ranking Member Levin, and Members of the  Committee, this completes my prepared statement. I would be happy to  respond to any questions you may have at this time.
section_title: Contacts and Acknowledgments
paragraphs: For further information on this testimony, please contact James R. White  at (202) 512-9110 or whitej@gao.gov. In addition, contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this statement. In addition to the individual named above,  Jay McTigue, Assistant Director; Brian James; and Danielle Novak made  key contributions to this testimony.
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