Annette Nellen
Annette Nellen

VAT Mania

After decades of dismissal, there is now frequent attention in the press and elsewhere about a federal VAT. Is this a good thing?

April 29, 2010
by Annette Nellen, CPA, Esq.

Over the past few decades, there have been several proposals for a value-added tax (VAT). For example, in 1980 House Ways and Means Committee Chairman Al Ullman (D-Ore.) introduced VAT legislation (H.R. 7015, 96th Congress). A 1984 Treasury Department study on the VAT included draft federal tax forms for reporting and collecting a credit invoice VAT (Tax Reform for Fairness, Simplicity and Economic Growth, Value-Added Tax, Volume 3, November 1984). In 1996, Congressman Sam Gibbons (D-FL) introduced H.R. 4050 (104th Congress) calling for a 20 percent subtraction method VAT for businesses with a modified income tax maintained for high income individuals.

Numerous reports on a VAT have been issued by the Treasury Department, Congressional Budget Office (CBO) and Government Accountability Office (GAO) in the past 30 years. Recently, the GAO issued a report, Value-Added Taxes — Lessons Learned from Other Countries on Compliance Risks, Administrative Costs, Compliance Burden and Transition (April 2008). The 2009 annual report issued to Congress by the Internal Revenue Service (IRS) National Taxpayer Advocate includes a section on administrative issues of a consumption tax, such as a VAT (Volume II).

Earlier tax reform discussions tended to dismiss a pure VAT as an undesirable "money machine." Nevertheless, several past and present reform proposals are variations on a VAT, but with different names, such as a Business Activity Tax (BAT) or flat tax. We also have a few lawmakers and others garnering national attention by specifically calling for a VAT or saying it should not be automatically dismissed from tax and budget reform discussions. Most notably, Paul Volcker, an adviser to President Obama, has suggested a VAT as a deficit-reduction tool (CBSMoneyWatch.com, VAT: New Tax Coming Soon? by Cait Murphy (April 7, 2010)).

This article describes several questions and factors to be considered in any serious discussion of a national VAT.

VAT Form

Excerpt of the proposed credit invoice VAT form included in Treasury's 1984 report.

VATs and Their Place in a Tax System

A VAT is generally a type of consumption tax. The most common VAT is a credit invoice VAT in which the tax is collected on all purchases with businesses receiving a refund for VAT paid. Thus, businesses provide the collection mechanism but the tax burden falls upon consumers. The same amount of revenue can be generated with a different VAT approach called a subtraction method VAT. This is calculated similarly to the formula for the income tax except assets are expensed rather than depreciated, interest income and expense are omitted and wages are not deductible. With either formula, labor and profit are taxed, representing the "value added" by the business. In theory, a VAT is similar to a sales tax except the VAT is collected differently, tends to tax a broad base of goods and services and is not imposed on business purchases (states impose sales tax on some business purchases) generally.

For details on how different forms of VAT work and links to tax reform reports and proposals, see the author's Tax Reform Information website.

A VAT (or any national consumption tax with a broad base) has tremendous revenue potential. Data from the U.S. Bureau of Economic Analysis indicates that personal consumption of goods and services in 2009 was approximately $10 trillion (March 2010 News Release (PDF), Table 2). Thus, a one percent VAT on the broadest base of personal consumption could generate $100 billion of revenue annually.

At the federal level in the U.S., excise taxes are the main consumption tax utilized and represent less than four percent of total revenues (Tax Policy Center data). The primary use of a consumption tax in the U.S. is the state and local sales tax which generates about 32 percent of a state's revenue on average (Federation of Tax Administrators, 2009 data).

Today, the U.S. is the only industrialized country without a VAT. The Organization for Economic Co-operation and Development (OECD) reports that over 130 countries use a VAT. [OECD, Consumption Tax Trends — 2008 Edition website]

Countries with a VAT also likely have an income tax. In OECD countries, on average, VAT represents almost 19 percent of all taxes (OECD, Table 3.6). The OECD reports that for 2007 the individual and corporate income tax, represented, on average, 25 percent and 11 percent, respectively of total taxation in OECD countries. Consumption taxes, such as the VAT, represented on average, 31 percent of total taxation in these countries. [OECD, Revenue Statistics 1965 – 2008, 2009, Tables 7, 11, 13, 25]

VAT rates in OECD countries range from five percent to 25 percent (OECD, Table 3.8). In contrast, sales tax rates in the U.S. are below 10 percent.

Questions and Issues

Adding a VAT to the federal revenue base would be a significant change whether enacted as an additional tax to help reduce the deficit or as a complete or partial replacement to another tax or taxes. A complete discussion and analysis of the issues and opportunities of fundamental tax reform at the federal level are beyond the scope of this short article. What follows is a brief introduction to some of these considerations to provide a sense of their range and importance.

  • Broad-based taxes: Taxes with a broad base and low rate are more likely to meet the principles of good-tax policy. For example, fewer deductions, exemptions and credits make a tax more simple and more neutral (because there are few or no special provisions and a low rate is feasible). Effects of a broad-based consumption tax versus broad-based income tax or some mix of the two need to be evaluated.
  • Simplification: A broad-based VAT imposed at a single rate could be simple and calculated using existing records kept for income-tax purposes. Many VAT countries have special rates and exemptions though. Would a simple VAT be possible in the U.S. given that lawmakers and the public generally like tax preferences?
  • Equity: Some types of consumption taxes can be calculated with a progressive rate structure. This would not work for a credit invoice VAT. Like a sales tax, the VAT would be regressive. Issues exist as to how to alleviate this without making the system complicated and providing poorly targeted relief. For example, while food could be exempt from a VAT, higher income individuals spend more money on food and thus would enjoy a larger tax break. A VAT or other consumption tax imposed along with an income tax enables tax relief to be determined and provided through the income tax. Questions also exist as to how to evaluate regressivity, such as on an annual basis or a lifetime perspective.
  • Transparency: Consumption taxes vary in the degree of transparency attained. State sales taxes appear to be transparent because the amount is noted on sales invoices. However, because states also impose sales tax on some business purchases that then factors into prices charged resulting in the imposition of tax on a tax ("pyramiding"), state sales taxes are not completely transparent. A VAT generally does not include pyramiding (VAT paid by businesses is refunded to them under the credit VAT), resulting in greater transparency.
  • How much change: Suggestions of a VAT or other consumption tax vary as to whether it would be in addition to existing taxes, replace part of an existing tax or replace one or more taxes completely, including the income tax. Thus, the range of proposals and their effects is quite varied. Discussions need to consider many factors including who pays which taxes, equity, simplicity, economic efficiency, the reality that the current income tax is used for more than raising revenue, state taxation and international competitiveness.
  • State taxes: Tax reform raises various issues for state governments. For example, would state government purchases be exempt from a national VAT? Would states be able to replace their sales tax with the national consumption tax? If the federal income tax were replaced with a consumption tax, would states also conform? If yes, what would be the effect of such a large federal and state consumption tax? Also, since a consumption tax does not apply to interest income, how would state financing costs change when all bonds become tax-exempt?
  • Goals: Reform for the sake of change would generate risks and costs with perhaps no improvement in the tax system. Goals for reform need to be clearly identified so that proposals can be evaluated as to how well they meet the goals.

Looking Forward

Despite expression by some high-profile people of interest in a VAT, not everyone is eager to see it discussed. Senate Amendment 3724 to H.R. 4851 (Cong. Rec. S2302, April 14, 2010), a sense of the Senate resolution that the VAT "is a massive tax increase that will cripple families on fixed income and only further push back America's economic recovery," passed on April 15, 2010 by a vote of 85 to 13. However, ignoring the VAT in any reform discussions would arguably diminish the quality and depth of the discussions. Given the longstanding, widespread use of the VAT in the world today, there is a lot of data on its operation and effects. Also, given that it can be imposed on a destination basis (border adjustable), it warrants consideration in international and business tax reform discussions. Finally, because it is so similar to other consumption tax proposals currently proposed, such as the national retail sales tax (H.R. 25, 111th Congress), business activity tax (Treasury, December 2007) and the flat tax (S. 932 and H.R. 1040, 111th Congress), its inclusion in reform discussions can help in better understanding these proposals and consumption taxes in general.

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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.