Value-added tax, national
Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377
International Monetary Fund
Updated by Robert Ebel
The Urban Institute and World Bank
Tuan Minh Le
A broad-based business tax imposed at each stage of the production and distribution process that, when applied nationally, is typically designed to tax final household consumption
The value-added tax (VAT) is a general sales tax on all goods and services. It is levied on the business at each stage of the production and distribution process and is applied on the sale price of goods and services by the taxpayer net of the cost of all purchases from other firms, including previous value-added tax paid on those purchases. The sum of all such VAT payments is equivalent to a tax on final household consumption.
The VAT is therefore distinct from broader-based "gross receipts" or "turnover levy," which is also applied at each stage of the extractive, production, and distribution process, but for which no provision is made for taxpayers to deduct purchases from other firms, including taxes embedded in the cost of those purchases.
Similarly, the VAT is broader than a conventional corporate net income (profits) tax since taxpayers’ payments for labor (payroll), land (rents), and capital (interest and net profits) are excluded from the "interfirm purchases" calculation (and thus included in the firm's value-added tax base).
A modern tax
Before its introduction, domestic indirect taxes were typically levied either on a narrow base (excises on various consumer items) or as broad-based turnover taxes. The distortions the turnover tax creates, such as the incentive for vertical integration and tax cascading, provided the case for a less distortionary but still highly revenue-productive tax (Ebrill et al. 2001).
The first VAT proposals were introduced in France in the 1920s and by the Shoup Mission to Japan in 1949. In 1948 France enacted a manufacturers’ excise tax that some argue looked like a VAT, but it gave no allowance for capital goods. This was transformed into consumption variant (expensing of capital goods) in 1954; so arguably, this is the date of the first modern VAT.
Beginning in the late 1960s, VAT adoptions accelerated. Today, it is a key source of revenue in 125 countries (and the number is growing), with the United States as one of the few non-VAT countries. The International Monetary Fund (IMF) estimates that about 4 billion people-70 percent of the world’s population-live in counties with a VAT. Today worldwide VAT revenue is estimated at $18 trillion. On average, it accounts for 25 percent of national governments’ revenues (Ebrill et al. 2001).
Value added can be measured either by subtracting from the taxpayer’s gross business receipts (sales) the purchases from other firms, or by adding the sum of the payments to the factors of production (land, labor, capital, and entrepreneurship).
Nearly all countries use the subtractive type destinationbased VAT pioneered by France. This variant does not actually require the trader to calculate value added by subtracting inputs from outputs, but rather, taxes every sale and purchase and then nets out the difference in tax liabilities for each trader. In this way, a trader registered for the VAT applies the tax rate on all sales. Likewise, the taxpayer pays a VAT charged on his purchases by his suppliers. Then, each taxable period (e.g., a month), the trader credits the tax paid on purchases against the tax liability on sales, and the difference is the net VAT liability to be paid to the authorities. Note that under this method of tax base computation, actual value added is never calculated; it is only the difference between two tax liabilities on outputs and inputs from other firms that is computed. The emphasis placed on each transaction means that the evidence for each sale or purchase, the invoice, becomes a crucial document to monitor and administer the VAT. For this reason, this type of VAT computation is termed a "creditinvoice VAT." The process does not always go smoothly. Delayed VAT refunds can become a problem in developed and developing countries alike. To address this for their clients, the IMF promotes a model for refund processing that includes randomized sampling for auditing high refund-risk claimants.
An alternative subtractive method is to use company accounts to deduct purchases from sales and apply the tax rate to the value added derived from these accounts. This requires calculating value added. This "accounts method" is used in Japan and administered by the income tax administration. The tax base should be the same as that when the creditinvoice method is used, but only a single VAT rate is applied (Japan applies a standard 5 percent rate). Companies make provisional tax payments through the year, and reconciliation is performed when the accounts are closed at the end of the year.
Applied nationally, the sum of all value added at each stage of production equivalent to-but not the same form of tax as-a national retail sales tax (NRST). Unlike a VAT, an NRST is applied only at the final sale to a consumer. At a glance, this may sound like the simpler of the two systems, but as a national tax vis-à-vis the VAT, the NRST creates two problems:
First, the sale at retail is frequently the easiest transaction to misrepresent and the most difficult for the tax administrators to check. This is in contrast to the VAT, in which the taxpayer must record the invoices for each transaction at each stage of production. Thus the VAT provides the better audit trail as well as incorporates a "self-enforcing" element since the taxpayers have the incentive to record all receipts for credits against taxes levied on their sales.
A second key difference between the VAT and NRST is that under the VAT, capital goods can be exempted entirely from the tax. This can be accomplished either through scheduler depreciation (the income variant) or immediate, full expensing (consumption variant). In theory, a tax that solely falls on retail sales would exclude capital goods, which are intermediate in the extraction, production, and distribution process. But the reality is that defining what is and what is not an intermediate or retail sale is such an unwieldy problem that the typical "retail sales tax" may include many intermediate goods (in some U.S. states, as much as 40 to 50 percent of the tax base).
Border tax adjustments and international trade
The VAT has another feature: it is a type of sales tax that can be identified on exports and imports. Under a credit-invoice approach, an exporting business can receive credit for the tax it paid as part of the invoice on an interfirm purchase and yet not be required to levy the tax on the value of its sale for export. That is, the export sale is zero-rated (“VAT free”). Note that this is not the same as being exempt from the tax, since, in this zero-rating case, the business firm (exporter) is a registered taxpayer.
Similarly, the VAT becomes a de facto customs levy for imported products that can be levied at the country’s border at a rate identical to that used for domestic production. Thus, imports are taxed, exports are not. Note that zero rating exports and taxing imports works “both ways” among trading countries. Thus, for example, if the export leaves a country at a zero tax rate, it faces a VAT tax at its destination country’s domestic VAT rate. Thus, one cannot argue—as one often hears—that the VAT promotes a nation’s favorable international trade advantage. Rather, it avoids a trade-tax disadvantage. Note further that the way this border-tax adjustment works gives countries as a group the incentive to adopt the credit-invoice tax calculation.
Consumption vs. income. A broadly levied VAT is often argued to be the fairest tax. There are two aspects to this argument. The first is that since an individual’s consumption is one of the best indicators of living standards, consumption is therefore a fair tax base. The political "catch" to this view is that to the extent the tax is shifted to the final consumer, it will be regressive. This makes the argument for a consumption base a lot more difficult to make in a developed country that also utilizes a broad-based income tax than in a developing country, where establishing an income tax is a challenging administrative task. Recognizing both perspectives, Ebrill et al. (2001) conclude that since (1) very few taxes (including VAT) are well suited to the pursuit of vertical equity and (2) the "first duty" of taxation is to raise revenue with as little distortion of economic activity as possible, for poverty alleviation the focus should be on the expenditure side of the budget. If the tax system is to be used for low-income relief, that relief should be well targeted.
Neutrality. The second argument deals with the question of tax neutrality. This is the clearer and more conventional of the two VAT "fairness" issues. The "best practice" VAT base will be one that includes all goods and services, and that is levied on all business firms regardless of legal organization or industrial structure. As such, it includes proportionally in its base all production factors and thus neither favors or discriminates against one type of input (e.g., capital vs. labor) or organizational structure (e.g., corporate vs. noncorporate).
Thus, to the extent that special provisions and exemptions erode the VAT base, these exemptions also erode its neutrality. Typically exempt sectors include the public sector (even though it may provide services in competition with private firms), basic education and health services (inter alia, the rationale is that it competes with the tax-exempt public sector), and finance and real estate.
From a conceptual perspective, the finance and real estate sector is the most problematic. Identifying the tax base for financial services is particularly difficult because the charge for financial services is often a spread that may be only a few basis points. Moreover, only part of this charge is for the service of financial intermediation, and it is impossible to unbundle it from the other fees. This means that banks and insurance companies may pay a VAT on their purchases, which can be substantial (e.g., computers, buildings), and yet cannot readily determine the value added and thereby claim any credit for their payment. As a result, financial services are often exempt, but then subject to in lieu taxation.
Second-hand goods are taxed only on their markup (e.g., the added value of seller fees). However, because there is no VAT on the purchase, no credit is available if a VAT is applied to the value of the final sale. For casual sales this is a straightforward matter-they are tax-free. The problem arises most prominently with the largest category of second-hand goods: residential houses. The usual treatment is to tax new houses fully, including the builder’s profit, but tax only the real estate broker-agents’ margins on sales of old houses.
The practice of applying a rule that a minimum threshold dollar amount of receipts (or other measure) must be exceeded before the trader or firm becomes subject to tax has merit as a strategy to eliminate from the tax base taxpayers whose administration and compliance costs are greater than their benefit (revenue) generated. Thus, all VAT countries establish some threshold below which a firm is exempt. These thresholds vary greatly. Denmark, for example, taxes all traders with an annual turnover of $1,600. Latvia’s threshold is $18,000; Poland, $23,000; Spain, $341,000; Italy, $587,200; and Gabon, $1,742,000 (2001 or most recent year available, Ebrill et al. 2004).
The use of the threshold serves to make a final point regarding efficiency. Although in theory the most neutral (efficient, horizontally equitable) VAT is one that is broadly based and applied, some adjustments to (erosions of) the tax base will enhance, not diminish, economic efficiency. This is the case when the costs of not making the adjustment outweigh the benefits. Again, the obvious case is a threshold in which the revenues generated fall below the administration and compliance costs. A similar case can be made for in lieu taxation of some financial services.
Rates and revenue
The VAT is capable of generating large amounts of revenue (on average, typically equivalent to 5 to 10 percent of GDP worldwide). In practice, many countries use multiple rates that erode the neutrality of the VAT because of political pressures to correct social inequities. Such complications make the VAT more complex and expensive to administer and increase opportunities for evasion.
However, the multirate approach is beginning to lose favor. Before 1990, only one-quarter (12) of the 48 VAT countries employed a single rate. As of 2001, the number had risen to 68 of 125 countries (54 percent). Although there are some equity arguments for differential rates, the argument for the single rate is persuasive: simplifying taxpayer compliance, facilitating audits, and reducing incentives for misclassification of transactions. In contrast, multiple rates tend to jeopardize revenue by weakening enforcement (Agha and Haughton 1960). However, some evidence exists that a targeted rate reduction and introducing a second VAT rate may produce an equity gain for the poor. But this can be a slippery slide; the more rates proliferate, the more cumbersome the equitytargeting problem becomes, and with a third, fourth, or fifth rate, the offsetting costs of administration and compliance outweigh the tax-rate subsidy benefit (Ebrill et al. 2004).
The conventional assumption is that the VAT is passed forward fully in prices and therefore is regressive in effect. This is an oversimplification. Depending on the elasticities of demand and supply, taxes may be shifted to individuals in one or more roles as consumers or factory suppliers. Nonetheless, that the VAT is an imbedded, broad-based tax on sales certainly gives the tax a regressive character. (Even if it is shifted backward, the burden may fall on suppliers of labor rather than of capital.)
With respect to vertical equity, governments frequently exempt items that feature prominently in low-income household budgets, such as food. Whether all food (e.g., in the United Kingdom) or only "essential" food is zero-rated, this favored treatment erodes revenue, creates definition problems, and can lead to costly settling disputes on what is and what is not a taxable item. Moreover, this approach uses the VAT to try to attain distributional ends for which it is ill suited. The VAT is levied primarily for revenue. There are more appropriate strategies for providing budget relief for the poor.
Because the VAT is an additional tax on household consumption, it may be reflected in higher prices in the form of a onceand- for-all jump in the price level. Whether this will, in turn, lead to an accelerated rise in prices depends on the wageprice nexus and whether the money supply is expanded to accommodate the rising prices. The evidence is that in most countries the introduction of a VAT led to a once-and-for-all shift in the price level, but not to a change in the rate of inflation. Note that this is not to say the overall national tax burden rises. If the VAT replaces other existing taxes in a revenueneutral shift, the net burden will likely remain unchanged, but the distribution of that burden will change.
The VAT is not a cheap tax to administer. For the revenue raised to be equivalent to an NRST, more taxpayers must be registered and more tax returns made. Much money is collected only to be returned, and fraud is possible through suppression of sales figures, barter transactions, understated debtors, false invoices, misdescriptions, multiple claims, and fictitious businesses. The costs of VAT administration will vary depending on the exemptions, thresholds, number of zero-ratings, number of tax rates, frequency of audits, and the role played by other collection agencies (e.g., customs).
Cnossen (1994) reports administration costs for a "best practice" VAT for countries in the Organisation for Economic Co-operation and Development (OECD) is estimated at approximately $100 per year, but the range is wide depending on tax complexity (e.g., New Zealand has a VAT of $50 a year in New Zealand with a single rate of 12.5 percent and a simplified tax form that limits the exception to certain types of financial services, residential rental, and supply of donated goods by nonprofits; the United Kingdom, on the other hand, has a VAT of $200 a year with a standard 17.5 percent combined with reduced rates for certain items, such as a zero rate on children’s clothing and the standard rate for adult clothing). Compliance costs are estimated at $500 to $700 a year, and because compliance costs tend to be fixed regardless of business size, the burden disproportionately falls on small traders. This result, plus the fact that small traders often have relatively little market power to forward shift the tax to consumers, further stresses the case for a minimum threshold as well as provides an explanation why small firms are typically the most vigorous VAT opponents.
A United States VAT?
The United States has debated the possibility of adopting a VAT on numerous occasions. It has been seen as a way to reduce the budget deficit, finance Social Security, replace the corporate and personal income tax, and finance new programs. In the United States, a 1 percent broad-based VAT would yield approximately $37.8 billion for each percentage point levied (Bickley 2003). Recognizing that this estimated rate of revenue productivity per percentage point assumes a tax free of likely sectoral and institutional exemptions, the potential productivity of a U.S. VAT is above that of most other VATlevying countries (e.g., about twice that of Belgium, Denmark, and the United Kingdom; 70 percent higher than Germany; and 30 percent higher than Switzerland).
At what rate shall a U.S. tax be applied? The typical VAT rate worldwide is between 15 and 20 percent. The European Union (EU) standard is 15 percent, although different rates apply in the various member countries, including some as high as 25 percent (Sweden) and as low as 5 percent on certain products in other countries (e.g., domestic fuel in the United Kingdom).
If the United States were to adopt the 15 percent EU standard rate and enact a broad-based tax, the yield would allow, on a revenue-neutral basis, a total reduction of 30 percent of other federal taxes. There is a caution here, however: such a federally administered VAT would be supplemental to existing state and local sales taxes, the combined rates for which range from 4 percent (Hawaii, Guam, and the Virgin Islands) and 5 percent (Maine, Maryland, and Massachusetts) to 9.4 percent (Tennessee). Thus, with an EU standard rate plus a state and local sales tax, Tennessee would look, tax-wise, something like Sweden.
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