Value added tax

The Value Added Tax (VAT) taxes all business profit and labor. Profit being gross receipts minus all business expenses including the 'tax' on labor which is considered a cost of doing business. Profit and labor could be lumped together by subtracting all other business expenses from gross receipts and then taxing the remainder at a uniform VAT tax rate.

The cost of materials, subcomponents, tools, equipment, facilities, supplies, etc, and any services purchased from other businesses isn't taxed (again) under the VAT. Those purchases would have already been subjected to the VAT by the supplying businesses.

VAT in more details

The VAT was invented by a French economist in 1954. Maurice Lauré, joint director of the French tax authority, the Direction générale des impôts, as taxe sur la valeur ajoutée (TVA in French) was first to introduce VAT with effect from 10 April 1954 for large businesses, and extended over time to all business sectors. In France, it is the most important source of state finance, accounting for approximately 45% of state revenues.

The value-added tax ( VAT ) that extends through the retail level is levied on each firm in the production and distribution chain, from the extraction of raw materials through the manufacturing and distribution processes, to the last sale to final customers. Thus, under a comprehensive value-added tax, all businesses, not just those that sell at retail, would pay tax on their sales. An important characteristic of a value-added tax is that tax is applied only to the value added by the firm, that is, to the excess of its sales over its purchases of goods from other business firms.

The VAT is usually collected by the tax credit method; each firm applies the tax rate to its taxable sales, but is allowed a credit for value-added tax paid on its purchases of goods and services for business use, including the tax paid on purchases of capital equipment under a consumption-type value-added tax. As a result, the only tax for which no credit would be allowed would be that collected on sales made to households, rather than to businesses.

Since the sum of the values added at all stages in the production and distribution of a good are equal to the retail selling price of the good, the revenue base of a retail sales tax and a value-added tax with the same coverage are theoretically identical, and a given tax rate will yield the same amount of tax revenue under either approach and under equal conditions of implementation, e.g., no exceptions, exemptions, etc.

Thus, despite its multistage character, a value-added tax is very much like a retail sales tax in that it is a tax on expenditures by consumers or, in other words, it is just another type of consumption tax.

Comparison of VAT with a Sales tax

Retail sales tax, the familiar percentage tax on retail sales, is one type of consumption tax. Of the various forms of consumption taxes, the sales tax surely has the great advantage for most of tax-payers of eliminating the despotic power of the government over the life of every individual, as in the income tax, or over each business firm, as we shall see the VAT might do. Sales tax also does not distort the production structure as would the VAT, and it would not skew individual preferences as would specific excise taxes ( Rothbard, 1994 ).

The VAT consumption tax, proposed in the U.S., imposes a bit of hierarchical tax on the "value added" by each firm and business.

Here, instead of every individual, every business firm would be subjected to intense bureaucratic scrutiny, for each firm would be obliged to report its income and its expenditures, paying a designated tax on the net income.

This would tend to distort the structure of business. For one thing, there would be an incentive for uneconomic vertical integration, since the fewer the number of times a sale takes place, the fewer the imposed taxes. Also, as has been happening in European countries with experience of the VAT, a flourishing industry may arise in issuing phony vouchers, so that businesses can over-inflate their alleged expenditures, and reduce their reported value added.

Surely a sales tax, other things being equal, seems to be both simpler, less distorting of resources, and enormously less bureaucratic and despotic than the VAT. Indeed the VAT seems to have no clear advantage over the sales tax, except of course, if multiplying bureaucracy and bureaucratic power is considered a benefit ( ibid., 1994 ).

Several possible disadvantages of VAT

• Growth of government ( see also “Administrative Costs”):

The United States stands almost alone among the developed countries of the free world in not levying a national sales tax. Virtually all of the members of the European Economic Community (EEC) employ a national value-added tax. Of the twenty-three ( original ) members of Organization for Economic Cooperation and Development (OECD), only two countries — Japan and Turkey — use neither a value-added tax nor a general sales tax. In Canada, there is a bit similar national tax ---- apart from bewildering array of, by no means harmonized, provincial sales taxes --- called GST or General Sales tax.

The lack of a national sales tax ( e.g. VAT ) in the United States is reflected closely in the percentage of Gross Domestic Product (GDP) devoted to public use in the United States and in other countries. In 1982 total tax revenues at all levels of government averaged 30.5 percent of GDP in the United States. The comparable figure for the EEC countries was 40.1 percent and for the countries of the OECD, exclusive of the United States, it was 37.1 percent.

In the United States, sales taxes (state and local) took approximately 6 percentage points less of GDP than in the EEC and in the OECD (exclusive of the United States). It is not only sales taxes that are lower in the United States; corporate income and social security taxes also are substantially lower in the figures suggest that even if a sales tax were initially imposed as a partial replacement for the income tax in a revenue-neutral change, public spending in the United States would eventually be greater with a national sales tax than without one.

• Regressivity:

A general sales tax --- as all types of consumption taxes inclusive of ( Retail ) sales tax ---- is often criticized as unfair to lower income individuals and families. There are two aspects to this equity argument: ( 1 ) The absolute burden of the tax on the lowest income groups, and the regressivity of the tax or the relatively higher burden of the tax at the lower income levels than at the higher. Simultaneously, ( 2 ) there are several alternatives for lessening the burden of the tax on the poor. For those individuals and families that are above the poverty level of income and thus subject to the income tax, the regressivity of a sales tax can be offset through the adjustment of income tax rates or through non-refundable credits against the income tax.

• Effect on prices:

Assuming an accommodating monetary policy, a sales tax would almost certainly increase the price level by roughly the percentage it represents of consumption spending. That is, a 4 percent sales tax that applied to 75 percent of consumption expenditures would increase the general price level by about 3 percent.

Although this would be a one-time occurrence, not an annual increase, it might cause "ripples" of wage increases, because of cost-of-living adjustments ( ! ) and these could be reflected in further price increases. To the extent the sales tax replaced part of the income tax, there would be little offsetting reduction in prices or wages.

• Administrative costs:

Administration of a Federal value-added tax would require substantial additional resources. The Internal Revenue Service estimates that once the administrative program was fully phased in, the annual administrative costs would run about $700 million (at 1984 prices), or about 0.4 percent of revenues from a 10 percent broad-based value-added tax. To administer a value-added tax, the IRS would require approximately 20,000 additional personnel.

• Federal pre-emption:

States, and more recently local governments, consider the sales tax base their exclusive fiscal domain. Federal imposition of a sales tax might reduce somewhat the ability of state and local governments to tax that base and would therefore be seen by those governments as an unwelcome intrusion.

This concern could be reduced if Federal adoption of a retail sales tax led to increased cooperation between the various levels of governments in tax administration and collection. This cooperation would be much easier to achieve if the Federal Government adopted a retail sales tax than if it adopted a value-added tax. If the state and Federal tax bases were identical, state taxes could be collected by the Federal Government as it collected its own tax. Of course, a Federal sales tax could not simply be collected by the states, because of the current differences in state tax bases.

Possible Advantages of VAT

One of the more interesting theoretical arguments for a VAT is that the new tax would improve economic performance by facilitating a reduction in other taxes. According to some advocates, the additional revenue generated by a VAT—$37 billion for every percentage point, according to the Congressional Research Service15—could be used to lower, or perhaps even eliminate, personal and corporate income taxes.

Hence, if the VAT was actually used to eliminate all income taxes, this theory would have considerable merit. There is no doubt that personal and corporate income taxes do more damage per dollar raised than a VAT would.

A national sales tax ( VAT ) thus should have several major advantages over the current combination of national income tax and states’ ( provincial ) taxes. If it were used to replace part of the income tax, a Federal sales tax would allow even lower income tax rates. By taking pressure off the definition and measurement of taxable income, a sales tax would help reduce income tax avoidance and evasion as well as lessen the incentive to shelter income from the income tax. Based on consumption, rather than income, a national sales tax ( VAT ) would not discriminate against saving the way the income tax does ( about this issue look to the below paragraph.)

Accordingly, it may increase the level of private saving and generate a corresponding increase in capital formation and economic growth. A broad-based sales tax would almost certainly distort economic choices less than the income tax does. In contrast to the income tax, it would not discourage capital-intensive methods of production or risk taking and it would be neutral with regard to other major revenue sources.

Further implication of all of this means that goods and services purchased for business use are automatically freed from tax; by and large, only goods and services sold to households are ultimately taxed under the value-added tax. Tax auditors need only to check the purchasing firm to ensure that purchases for which a credit is claimed were used for business purposes. By comparison, it is more difficult under a retail sales tax to completely exempt all business purchases. Firms must provide exemption certificates to their suppliers to buy tax free, and auditors must check both the supplier and purchaser in cases of doubt.

At the state level, this system of exemption certificates applies only to goods purchased for resale or goods that become component parts or physical ingredients of produced goods; other purchases, such as machinery and equipment, are only exempt if specifically provided in the state statute. The end result is that not all business purchases are free of retail sales tax; about 20 percent of sales tax revenue is from taxing business purchases.

Another important advantage of the value-added form of sales tax is the fact that tax is collected as products move from stage to stage in the production-distribution process. Thus by the time a product reaches the retail stage, much of its total value has already been taxed.

To summarize: Theoretically, a VAT would be acceptable if it were combined with ratification of a constitutional amendment that permanently prohibits both the personal and corporate income taxes, but, unfortunately, this is an extremely unlikely scenario. In fact, as yet no nation has ever implemented a VAT (or a national sales tax) and used the money to eliminate all income taxes.

The Impossibility of Taxing Only Consumption

A few arguments of why VAT, as a consumption tax, cannot replace the income tax should be mentioned now.

Orthodox neoclassical economics has long maintained that, from the point of view of the taxed themselves, an income tax is "better than" an excise tax on a particular form of consumption, since, in addition to the total revenue extracted, which is assumed to be the same in both cases, the excise tax weights the levy heavily against a particular consumer good.

But, all through the comparison of the income as compared to an excise tax one thing is well experienced by every tax-payer in the U.S. ( and many other countries ). Income taxes are collected in the course of a coercive and even brutal examination of virtually every aspect of every taxpayer's life by the all-seeing, all-powerful Internal Revenue Service.

An excise tax, say, on whiskey or on movie admissions, will intrude directly on no one's life and income, but only into the sales of the movie theater or liquor store. It is quite feasible that, in evaluating the "superiority" or "inferiority" of different modes of taxation, even the most determined imbiber or moviegoer would cheerfully pay far higher prices for whiskey or movies than neoclassical economists contemplate, in order to avoid the long arm of the IRS ( NOTE [1] ).

However, the only coherent argument offered by advocates of consumption against income taxation is that of Irving Fisher, based on suggestions of John Stuart Mill. Fisher argued that, since the goal of all production is consumption, and since all capital goods are only way-stations on the way to consumption, the only genuine income is consumption spending. The conclusion is quickly drawn that therefore only consumption income, not what is generally called "income," should be subject to tax( Rothbard, 1977, pp. 98–100.)

The market, in short, knows all about the productive power of savings for the future, and allocates its expenditures accordingly. Yet even though people know that savings will yield them more future consumption, why don't they save all their current income?

Clearly, because of their time preferences for present as against future consumption. These time preferences govern people's allocation between present and future. Every individual, given his money "income"---defined in conventional terms---and his value scales, will allocate that income in the most desired proportion between consumption and investment. Any other allocation of such income, any different proportions, would therefore satisfy his wants and desires to a lesser extent and lower his position on his value scale.

It is therefore incorrect to say that an income tax levies an extra burden on savings and investment; it penalizes an individual's entire standard of living, present and future. An income tax does not penalize saving per se any more than it penalizes consumption.

"......Having challenged the merits of the goal of taxing only consumption and freeing savings from taxation, we can now proceed to deny the very possibility of achieving that goal, i.e., we maintain that a consumption tax will devolve, willy-nilly, into a tax on income and therefore on savings as well. In short, that even if, for the sake of argument, we should want to tax only consumption and not income, we should not be able to do so...." ( Rothbard, 1977 ).

We can see it on a simple example. Let us take a, seemingly straightforward, tax plan that would exempt saving and tax only consumption. Let us take Mr. Jones, who earns an annual income of $100,000. His time preferences lead him to spend 90 percent of his income on consumption, and save-and-invest the other 10 percent. On this assumption, he will spend $90,000 a year on consumption, and save-and-invest the other $10,000.

Let us assume now that the government levies a 20 percent tax on Jones's income, and that his time-preference schedule remains the same. The ratio of his consumption to savings will still be 90:10, and so, after-tax income now being $80,000, his consumption spending will be $72,000 and his saving-investment $8,000 per year ( NOTE [2] ).

Suppose now that instead of an income tax, the government follows the Irving Fisher scheme and levies a 20 percent annual tax on Jones's consumption. Fisher maintained that such a tax would fall only on consumption, and not on Jones's savings. But this claim is incorrect, since Jones's entire savings-investment is based solely on the possibility of his future consumption, which will be taxed equally.

Since future consumption will be taxed, we assume, at the same rate as consumption at present, we cannot conclude that savings in the long run receives any tax exemption or special encouragement. There will therefore be no shift by Jones in favor of savings-and-investment due to a consumption tax ( NOTE [3]).

In sum, any payment of taxes to the government, whether they be consumption or income, necessarily reduces Jones's net income. Since his time preference schedule remains the same, Jones will therefore reduce his consumption and his savings proportionately. The consumption tax will be shifted by Jones until it becomes equivalent to a lower rate of tax on his own income.

If Jones still spends 90 percent of his net income on consumption, and 10 percent on savings-investment, his net income will be reduced by $15,000, instead of $20,000, and his consumption will now total $76,000, and his savings-investment $9,000. In other words, Jones's 20 percent consumption tax will become equivalent to a 15 percent tax on his income, and he will arrange his consumption-savings proportions accordingly (NOTE [4]).

History of VAT in OECD and Tax burden comparison with USA

Some statistical comparison between USA and EC-15 ( i.e. the original 15 European states prior to enlargement in 2004.

VATs Associated with Higher Aggregate Tax Burdens

• “Taxes as a Percent of GDP”:…. 1967………………………...2002

USA……………………………….25. 3%....................................29. 8 % EU-15……………………………..25. 5 %.................................. 42.1 % Source: Organization for Economic Co-operation and Development, Revenue Statistics, 1965–2003 (Paris: OECD Publications, 2004)

Burden of Government ( Spending and Debts ): the U.S. vs. Europe

• “Government Spending as Percent of GDP”

USA……………………………35.7 % EU-15………………………….47. 6 %

• “Government Debt as Percent of GDP”

USA……………………………26. 6% EU-15………………………….50.1% Source: Organisation for Economic Co-operation and Development, OECD in Figures, 2004 ed., at www1.oecd.org/publications/e-book/0104071E.pdf (May 9, 2005).

GST- Federal Consumption Tax in Canada

Most of what was said above about the VAT possible, and in some countries real, problems holds for Canada as well. The following excerpts tells it all : “…the GST ( General Sales Tax ) warrants greater scrutiny. While the GST was an advance in some respects over the manufacturers sales tax, it has significant deficiencies of its own. First, it is relatively costly to administer and places major compliance burdens on business, especially small firms, as well as on consumers. Second, its base is far from comprehensive, necessitating a higher rate, creating consumer inefficiencies, and introducing numerous practical complexities. Third, the GST adds an entirely new layer of difficulties for operation of the tax system, such as for employee fringe benefits and services sourced abroad. Fourth, the input tax credit mechanism is open to abuse, such as the recently reported evasion by fictitious exporters costing scores of millions of dollars in revenues….”( Kesselman, 1997)

Under the above comments and some of the statistics on the tax burden differentials in OECD vs. USA, there is not much hope for lowering Canadian over-all tax level at least to the U.S. one anytime soon. Even if --- and maybe because of it --- the latest recommendations call for: (1) repealing GST and substituting it with VAT, (2) harmonizing provincial sales taxes with GST , or (3) combining GST with VAT.

Conclusion

There are obviously two contradicting views on the very basics of VAT. Let us seek a help to this conundrum from a genuine free-market approach to Jean-Baptiste Say, who contributed considerably more to economics than Say's Law. Say was under no illusion that taxation is voluntary nor that government spending contributes productive services to the economy. Say pointed out that, in taxation, "……The government exacts from a taxpayer the payment of a given tax in the shape of money. To meet this demand, the taxpayer exchanges part of the products at his disposal for coin, which he pays to the tax-gatherers….." ( Say, 1880 ). Eventually, the government spends the money on its own needs, so that "in the end . . . this value is consumed; and then the portion of wealth, which passes from the hands of the taxpayer into those of the tax-gatherer, is destroyed and annihilated." Note, that as in the case of the later Calhoun, Say sees that taxation creates two conflicting classes, the taxpayers and the tax-gatherers. Were it not for taxes, the taxpayer would have spent his money on his own consumption. As it is, "….The state . . . enjoys the satisfaction resulting from that consumption….."( ibid. ). Taxation, then, for Say is the transfer of a portion of the national products from the hands of individuals to those of the government, for the purpose of meeting the public consumption of expenditure.” . . . It is virtually a burthen imposed upon individuals, either in a separate or corporate character, by the ruling power . . . for the purpose of supplying the consumption it may think proper to make at their expense…..”( ibid, p. 446 ). But taxation, for Say, is not merely a zero-sum game. By levying a burden on the producers, he points out, taxes, over time, 'cripple production itself. Writes Say: “…..Taxation deprives the producer of a product, which he would otherwise have the option of deriving a personal gratification from, if consumed . . . or of turning to profit, if he preferred to devote it to an useful employment. . . Therefore, the subtraction of a product must needs diminish, instead of augmenting, productive power……( ibid, p. 447 ). J. B. Say's policy recommendation was crystal clear and consistent with his analysis and that of our VAT treatise: "…..The best scheme of [public] finance is, to spend as little as possible; and the best tax is always the lightest….."( ibid. ,1880 ). To this, there is nothing more to add.

Notes and Reference

• Kesselman, J., “Public Policies To Combat Child Poverty: Goals and Options,” in A New Social Vision for Canada? Perspectives on the Federal Discussion Paper on Social Policy Reform, Keith Banting and Ken Battle, eds. Queen’s University, School of Policy Studies, Kingston, Ont. 1994, pp. 73-97

• Kesselman, JGeneral Payroll Taxes: Economics, Politics, and Design, Canadian Tax Foundation Toronto, 1997

• Rothbard, Murray, “Consumption Tax : A Critique” , Review of Austrian Economics, Volume 7, No. 2, , 1994, pp. 75–90.

• Rothbard, Murray, Power and Market: Government and the Economy, 2nd ed. Sheed Andrews & McMeel, Kansas City, 1977
• [1] It is particularly poignant, on or near any April 15, to contemplate the dictum of Father Navarrete, that "the only agreeable country is the one where no one is afraid of tax collectors," Chafuen, Christians for Freedom, p. 73. Also see Murray N. Rothbard, "Review of A. Chafuen, Christians for Freedom: Late Scholastic Economics," International Philosophical Quarterly 28 (March 1988): 112–14. For a fuller treatment, and a discussion of who is being robbed by whom, see Murray N. Rothbard, Power and Market: Government and the Economy, 2nd ed. (Kansas City: Sheed Andrews & McMeel, 1977), pp. 120–21
• [2] We set aside the fact that, at the lower amount of money assets left to him, Jones's time preference rate, given his time preference schedule, will be higher, so that his consumption will be higher, and his savings lower, than we have assumed.
• [3] In fact, per note [2], supra, there will be a shift in favor of consumption because a diminished amount of money will shift the taxpayer's time preference rate in the direction of consumption. Hence, paradoxically, a pure tax on consumption will and up taxing savings more than consumption! See Rothbard, Power and Market, pp. 108–11.
• [4] lf net income is defined as gross income minus amount paid in taxes, and for Jones, consumption is 90 percent of net income, a 20 percent consumption tax on $100,000 income will be tantamount to a 15 percent tax on this income. Rothbard, Power and Market, pp. 108–11. The basic formula is that net income,

where G=gross income, t=the tax rate on consumption, and c, consumption as percent of net income, are givens of the problem, and N = G – T by definition, where T is the amount paid in consumption tax.

• Say, Jean-Baptiste A Treatise on Political Economy, 6th ed. (Philadelphia: Claxton, Remsen & Heffelfinger, 1880), pp. 412–415, 446; also see Murray N. Rothbard, "The Myth of Neutral Taxation," Cato Journal 1 (Fall 1981): 551–54.

External links

• VAT Related Services at the Open Directory Project
• VAT in INDIA
• What is VAT?: General overview
• An introduction to VAT
• European VAT rates by service type
• German VAT
• VAT/GST sales tax rates around the world
• Consolidated version of the Sixth VAT Directive (398k pdf)
• HM Revenue & Customs
• UK VAT Threshold Rates
• What is the Single Business Tax? (Michigan Department of Treasury)
• A Guide to the latest VAT news in the UK by PricewaterhouseCoopers

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