Wednesday, April 13, 2011

CRS Reports Examine The Potential Benefits And Drawbacks Of A U.S. VAT

Two recent Congressional Research Service (CRS) reports have examined a value-added tax (VAT), a broad-based consumption tax, as a possible fiscal solution to the high budget deficits and growing national debt. One, CRS report R41708, explains what is a VAT and how it operates; it's aptly entitled a “primer.” The other, CRS report R41602, discuss the feasibility of implementing a VAT in the U.S.; it provides a more comprehensive examination of the relevant issues.

Observation: CRS Report R41602 notes that a VAT option wasn't included in the report of the National Commission on Fiscal Responsibility and Reform, but was included in the report of the Debt Reduction Task Force of the Bipartisan Policy Center.

Background. A VAT is a broad-based consumption tax. Presumably, Congress has expressed interest in VATs because of its high potential revenue yield. Other aspects of a VAT that often raise interest or concern include international comparisons of the composition of taxes, VAT rates in other countries, equity, neutrality, inflation, balance-of-trade, national saving, administrative costs, compliance, intergovernmental relations, and size of government.

Two alternative methods of calculating VAT have been proposed for the U.S.: (1) the credit invoice method (which is used by 28 of 29 nations in the Organization for Economic Cooperation and Development (OECD) with VATs); and (2) the subtraction method.

* Under the credit-invoice method, a firm would be required to show VAT separately on all sales invoices. Each sale would be marked up by the amount of the VAT. A sales invoice for a seller is a purchase invoice for a buyer. A firm would calculate the VAT to be remitted to the government by a three-step process: (1) aggregate VAT shown on its sales invoices; (2) aggregate VAT shown on its purchase invoices; and (3) subtract the aggregate VAT on purchase invoices from aggregate VAT shown on sales invoices, and remit the difference to the government.

* Under the subtraction method, the firm calculates its value added by: (1) subtracting its cost of taxed inputs from its taxable sales; and (2) determining its VAT liability by multiplying its value added by the VAT rate.

A VAT may exempt either a product or a business from taxation. For example, a business might be exempt because it only produces exempt products or its sales fall below a minimum threshold. An exempt business would be outside the VAT system: it wouldn't register with tax authorities or have VAT compliance costs. An exempt business would not collect VAT on its sales and would not receive credit for VAT paid on its purchases of inputs. However, an exempt business's costs would include any tax paid on inputs, because it receives no credit for previously paid taxes.

A business or product could also be zero-rated, and so would not collect VAT on its sales but would receive credit for VAT paid on its inputs. This is equivalent to the business being charged a zero tax rate. Such a business would be a registered taxpayer, with the usual compliance and administrative costs. The producer of a zero-rate product would neither pay VAT on the inputs used to produce that product nor charge VAT on the sale of that product. However, a zero-rated business would receive a refund of any VAT paid on its inputs so its costs would not include VAT paid at earlier stages.

Considering the VAT option. CRS Report R41602 notes that the levying of a VAT has been discussed as one of many options to assist in resolving U.S. fiscal problems. Most other developed nations rely more on broad-based consumption taxes for revenue than does the U.S. For 2011, a broad-based VAT in the United States would raise net revenue of approximately $45 billion to $55 billion for each 1% levied.

CRS Report R41602 analyzed a number of VAT issues:

* Neutrality. The less the tax alters economic decisions—i.e, the greater its neutrality—the better. A VAT on all consumption expenditures, with a single rate that is constant over time, would be relatively neutral compared to other major revenue sources. Such a VAT would not alter choices among goods, and it would not affect the relative prices of present and future consumption. For a firm, the VAT would not affect decisions concerning method of financing (debt or equity), choice among inputs (unless some suppliers are exempt or zero-rated), type of business organization (corporation, partnership, or sole proprietorship), goods to produce, or domestic versus foreign investment.

* Regressivity. A VAT is regressive because lower-income households spend a greater proportion of their incomes on consumption than higher-income households. If disposable income over a one-year period is the measure of ability-to-pay (income), then a VAT would be viewed as extremely regressive; that is, the percentage of disposable income paid in VAT would decrease rapidly as disposable income increases. If disposable income over a lifetime (e.g., a life cycle of early years, peak earning years, and retirement years) is the measure of ability-to-pay, a VAT would be mildly regressive. Critics are especially concerned about the absolute burden of a VAT on low-income households and the impact on different age groups. VAT proponents have countered these concerns, arguing that policies could reduce or eliminate regressivity by any of three methods: (1) a refundable credit against income tax liability for VAT paid; (2) allocation of some of VAT revenue for increased welfare spending (including indexed transfer payments); or (3) exclusions and multiple rates, e.g., selective exclusion of some goods from taxation.

The CRS Report also notes that while all members of the European Union (EU) have multiple tax rates and exclude some goods from VAT based on equity grounds, most tax economists oppose these measures because: (1) the administrative, compliance, and neutrality costs are substantial (revenue lost from excluding goods must be offset by higher VAT rates); (2) the possible reduction in regressivity from exclusion and multiple rates is declining because consumption patterns for different income levels are becoming more similar; and (3) for a one-year time period, the reduction in regressivity is limited, particularly for low-income households.

* Exemption vs. zero-rating. Exemption breaks the VAT chain and so can cause problems. If exemption occurs at some intermediate stage, the value added before the exempt stage is effectively taxed more than once (i.e., cascading of the VAT occurs). Exemption of inputs will induce producers to substitute away from those inputs; that is, input choices are distorted. In addition, businesses have an incentive to self-supply rather than purchase an exempt input. Further, exemptions may create pressures for additional exemptions. For example, in some countries, the exemption of basic foodstuffs has created pressure for the exemption of agricultural inputs.

* VAT registration thresholds. The firm size at which registration for the VAT is compulsory (the VAT threshold level) is an important factor in reducing administrative and compliance costs. Firms below the VAT threshold might be allowed to register voluntarily. The considerations are the trade-off between lower administrative and compliance costs versus reduced revenue and the cost of distortions due to differential treatment. A significant gross receipts threshold for registration could reduce the costs of administration and compliance.

* VAT rates in other countries. VAT rates vary substantially among the 29 countries with VATs in the OECD. Japan and Canada have the lowest rate of 5%. Iceland has the highest rate of 25.5%, and four nations have a 25% rate. This high average rate is one reason for the robust revenue yield of VATs.

* Inflation. The imposition of a VAT would cause a one-time increase in this country's price level. But a VAT would not necessarily affect this country's future rate of inflation if the Federal Reserve offset the contractionary effects of a VAT with a more expansionary monetary policy.

* Balance of trade. All nations with VATs currently zero-rate exports and impose their VATs on imports—i.e., the destination principle for taxing trade (it's called that because a commodity is taxed at the location of consumption rather than production). Under the destination principle, a VAT using the credit-invoice method is border adjustable, unlike a standard subtraction method VAT which is origin based and so not border adjustable. If the U.S. continued its policy of flexible exchange rates, then the imposition of a VAT would not significantly affect the U.S. balance-of-trade.

* National savings. There is no conclusive evidence that a VAT would substantially change the rate of national saving (consisting of government saving, business saving, and personal saving) more than another type of major tax increase. Both a Congressional Budget Office (CBO) and CRS study found that a VAT would result in only a slight economic effect in the long-run.

* Administrative costs. A VAT would require the expansion of IRS. The administrative costs of a VAT would be significant, but they would be relatively low if measured as a percentage of revenue yield. The administrative expense per dollar collected would vary with the degree of the VAT's complexity, the amount of revenue raised, compliance, and the level of small business exemptions.

* Compliance. Compared to other broad-based consumption taxes (e.g., a retail sales tax), a VAT can produce relatively good compliance for four reasons: (1) a VAT collected using the credit invoice method offers the opportunity to cross-check returns and invoices; (2) each firm has an incentive not to allow suppliers to understate VAT on their sales invoices; (3) tax auditors can compare information about a VAT with information about business income taxation, which will increase compliance for both; and (4) firms legally required to remit VAT that do not register will receive no credit for VAT paid on inputs with the result that they are only partially able to evade the VAT. On the other hand, the level of noncompliance may be significant: firms legally required to remit VAT may not register, while others may evade VAT by altering or omitting information.

CRS's conclusion. The CRS reports concluded that a VAT has numerous positive characteristics, including a robust revenue yield, relative neutrality, good enforcement, border-adjustability, and reasonable administrative costs. While some critics are concerned about the VAT's regressivity, others say that policies are available to reduce or eliminate this regressivity.

CRS Report R41602 noted that the U.S. is the only developed nation without a VAT, and concluded that the VAT option may warrant inclusion in the debate on solving the U.S.'s long-term fiscal problems. The report finds that the prevailing view of tax professionals is that an optimal VAT would have a broad base, a single rate, the credit-invoice method of collection, the application of the destination principle, and a significant sales threshold for registration.

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