Presentation%20to%20the%20President's%20Advisory%20Panel%20on%20Federal%20Tax%20Reform:%20The%20Value%20Added%20Tax%20(VAT)

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Presentation to the President's Advisory Panel
on Federal Tax ReformThe Value Added Tax (VAT)

• May 11, 2005

Charles McLure Senior Fellow Hoover
Institution Stanford University
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Overview

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

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Overview

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

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Credit-Method Value Added Tax (VAT)

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

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Credit-Method Value Added Tax (VAT)

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

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

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

Economic activity Farmer Miller Baker Total
Basic transactions Basic transactions Basic transactions Basic transactions Basic transactions
1. Sales 300 700 1,000
2. Purchases 0 300 700
3. Value added (sales - purchases) 300 400 300 1,000
Subtraction-Method Business Transfer Tax (BTT) Subtraction-Method Business Transfer Tax (BTT) Subtraction-Method Business Transfer Tax (BTT) Subtraction-Method Business Transfer Tax (BTT) Subtraction-Method Business Transfer Tax (BTT)
4. Business Transfer Tax (10 of line 3) 30 40 30 100
Credit-Method VAT (VAT) Credit-Method VAT (VAT) Credit-Method VAT (VAT) Credit-Method VAT (VAT) Credit-Method VAT (VAT)
5. Tax on sales (10 of line 1) 30 70 100
6. Less input tax on purchases 0 30 70
7. Net VAT liability 30 40 30 100
Retail Sales Tax (RST) Retail Sales Tax (RST) Retail Sales Tax (RST) Retail Sales Tax (RST) Retail Sales Tax (RST)
8. Retail Sales Tax Exempt Exempt 100 100
See appendix slide 21 for further discussion.
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Three Features of the Standard VAT

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

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Credit-Method VAT Exempting and Zero-Rating of
Last Stage
(Tax Rate 10)

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

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

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

Economic activity Farmer Miller Baker Total
Basic transactions Basic transactions Basic transactions Basic transactions Basic transactions
1. Sales 300 700 1,000
2. Purchases 0 300 700
3. Value added (sales purchases) 300 400 300 1,000
Exemption of Intermediate Stage Exemption of Intermediate Stage Exemption of Intermediate Stage Exemption of Intermediate Stage Exemption of Intermediate Stage
4. Tax on sales (10 of line 1) 30 Exempt 100
5. Less input tax on purchases 0 0 0
6. Net VAT liability 30 0 100 130
Zero-Rating of Intermediate Stage Zero-Rating of Intermediate Stage Zero-Rating of Intermediate Stage Zero-Rating of Intermediate Stage Zero-Rating of Intermediate Stage
7. Tax on sales (10 of line 1) 30 0 100
8. Less input tax on purchases 0 30 0
9. Net VAT liability 30 - 30 100 100
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Credit-Method VAT Summary of Effects of
Exemption and Zero-Rating
Stage of production/distribution process Stage of production/distribution process
Intermediate stage Last stage
Exemption Breaks chain of input credits increases tax Cascading tax and distortions Only value added at final stage is untaxed
Zero-rating No effect Entire value of sale is untaxed
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Choosing between Exemption and Zero-rating

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

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

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

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

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

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

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

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Evaluation Direct and Indirect Forms of
Consumption Taxes
Form of consumption tax Total replacement for federal income taxes Partial replacement for federal income taxes/additional source of federal revenue
Direct tax Consumed Income Tax Flat Tax Possibly No
Transactions-based indirect taxes Credit-Method VAT Retail Sales Tax No No Possibly Probably not
Accounts-based indirect tax Subtraction-Method BTT No No
See appendix slide 22 for further discussion.
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Subtraction-Method BTT Summary of Additional
Considerations

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

See appendix slides 23 and 24 for further
discussion.
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What Liberals and Conservatives Fear or Like
about the VAT

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

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Appendix
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Implications of Three Ways of Implementing
Indirect Consumption Taxes
Subtraction-Method BTT Credit-method VAT Retail Sales Tax
Key Feature Key Feature Key Feature
Business purchases are deductible Taxes on business purchases are creditable Business purchases are exempt
Revenue Implications Revenue Implications Revenue Implications
Benefits of paying no tax on any slice of value added Exemptions (base erosion) Evasion No benefit to not paying tax before the last stage Exemption (or evasion) at last stage loses only tax on value added at that stage Only zero-rating at retail level eliminates tax Exemption at prior stage raises total tax Benefits of paying no tax Exemptions (base erosion) Evasion
Key Effect Key Effect Key Effect
Taxes slices of value added Most revenue collected before the last stage Taxes paid before the last stage wash out in credits Only tax at last stage matters One bite at the apple (at the retail stage)
Political Implications Political Implications Political Implications
Highly vulnerable to base erosion Relatively invulnerable to base erosion Highly vulnerable to base erosion
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Extended Evaluation Direct and Indirect Forms
of Consumption Taxes
Form of consumption tax Total replacement for federal income taxes Partial replacement of federal income taxes/additional source of revenue
Direct consumption-based tax Consumed Income Tax Flat tax Possibly More friendly to saving Possibly simpler Raises international issues Transition rules No Two sets of rules for income taxes
Transactions-based indirect tax Credit-method VAT Retail Sales Tax No Tax rates so high (30-40) RST would not be administrable VAT might not be No simplification State income taxes would remain Tax rates even higher (well above 40) with no state income taxes Massive international disruptions EITC eliminated. Would it be replaced elsewhere? Possibly Would allow lower income tax rates Would reduce some (not all) distortions Would leave income tax, with its complexity, in place VAT/RST compliance is not simple Could facilitate improvement of state and local sales taxes Would poach on state and local fiscal preserve
Accounts-based indirect tax Subtraction- Method BTT No No simplification State income taxes would remain EITC eliminated. Would it be replaced elsewhere? Highly vulnerable to base erosion No Would leave income tax, with its complexity, in place Two sets of rules for similar taxes Would allow lower income tax rates Vulnerable to base erosion and thus distortion Would not facilitate improvement of state and local sales taxes Would (less obviously) poach on state and local fiscal preserve
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Subtraction-Method BTT Additional Considerations

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

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Subtraction-Method BTT Additional Considerations

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

25
Coordinating State and Local RSTs with a Federal
VAT

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

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Coordinating State and Local RSTs with a Federal
VAT

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