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Presentation to the President's Advisory Panel
on Federal Tax Reform:The Value Added Tax (VAT)
May 11, 2005
Charles McLureSenior Fellow
Hoover InstitutionStanford University
2
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
3
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
4
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
5
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
6
Three Forms of Indirect Tax on Consumption:An Illustration
(Tax rate = 10%)
Economic activity Farmer Miller Baker Total
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)
4. Business Transfer Tax (10% of line 3)
$ 30 $ 40 $ 30 $ 100
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)
8. Retail Sales Tax Exempt Exempt $ 100 $ 100
7
Three Forms of Indirect Tax on Consumption:An Illustration
(Tax rate = 10%)
Economic activity Farmer Miller Baker Total
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)
4. Business Transfer Tax (10% of line 3)
$ 30 $ 40 $ 30 $ 100
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)
8. Retail Sales Tax Exempt Exempt $ 100 $ 100
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
See appendix slide 21 for further discussion.
8
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
9
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
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)
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
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
10
Credit-Method VAT: Exempting and Zero-Rating of Intermediate Stage
Economic activity Farmer Miller Baker Total
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
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
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
(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
11
Credit-Method VAT: Summary of Effects of Exemption and Zero-Rating
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 finalstage is untaxed
Zero-rating No effect Entire value of sale isuntaxed
12
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
13
Exemption and Zero-Rating of Last Stage Under BTT, VAT, and RST
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)
4. Business Transfer Tax (10% of value added in line 3)
$ 30 $ 40 Exempt $ 70
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
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
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
(Tax Rate = 10%)
14
Effects of Exemption of Intermediate Stage under VAT and BTT
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)
Business Transfer Tax (10% of value added in line 3)
$ 30 Exempt $ 30 $ 60
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
(Tax Rate = 10%)
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
15
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
Normal taxation Infeasible: There are no transactions to tax
Exemption Break in chain of credits, producing Over-taxation Cascading Incentive for self-supply
Under-taxationNo taxation of value added by financial institutions
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-taxationNo taxation of financial services
Simplest: Requires no allocation of input credits
HYBRID:Business services zero-rated;Consumer services exempt
Conceptually correct tax treatment Under-taxationNo taxation of value added by financial institutions
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
16
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
17
Evaluation: Direct and Indirect Forms of Consumption Taxes
Form of consumption taxTotal 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
NoNo
Possibly Probably not
Accounts-based indirect tax Subtraction-Method BTT
No No
See appendix slide 22 for further discussion.
18
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.
19
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
21
Implications of Three Ways of Implementing Indirect Consumption Taxes
Subtraction-Method BTT Credit-method VAT Retail Sales Tax
Key Feature
Business purchases aredeductible
Taxes on business purchases are creditable Business purchases areexempt
Revenue Implications
Benefits of paying no taxon any slice of value added Exemptions (base erosion) Evasion
No benefit to not paying tax before the last stageExemption (or evasion) at last stage loses only tax on
value added at that stageOnly zero-rating at retail level eliminates taxExemption at prior stage raises total tax
Benefits of paying no tax Exemptions (base erosion) Evasion
Key Effect
Taxes “slices” of value added Most revenue collected before the last stageTaxes paid before the last stage “wash out” in creditsOnly tax at last stage matters
One “bite at the apple” (at theretail stage)
Political Implications
Highly vulnerable to base erosion
Relatively invulnerable to base erosion Highly vulnerable to baseerosion
22
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
23
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?
24
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 (S&L) 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 Court’s decision in Quill, based on complexity
Potential benefits of coordinating S&L 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)
26
Coordinating State and Local RSTs with a Federal VAT
S&L counter-arguments Federal VAT would “pre-empt” traditional S&L tax base Coordination reduces state sovereignty over tax base and administration
S&L 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