What Is a Cascade Tax?

A cascade tax or cascading tax is a system that imposes sales taxes on products at each successive stage in the supply chain from raw material to consumer purchase. Each buyer in the supply chain pays a price based on its cost, including the previous tax or taxes that have been charged.

So, a cascade tax is a tax on top of a tax. There is a compounding effect, with a real sales tax higher than the official sales tax rate.

Understanding the Cascade Tax

Consider the gift wrap business. It starts with a tree, which is cut down and sold to a paper factory. The factory pulps the wood, flattens it, dries it, and cuts it into sheets and rolls. These rolls are purchased by a company that designs and prints fancy paper in large batches and sells them wholesale. The wholesaler then sells it to retail stores nationwide for sale in individual rolls. Finally, a consumer buys it.

Key Takeaways

  • A cascading tax is imposed repeatedly at each stage of a product's journey along the supply chain.
  • That inflates the price of a product due to the compounding effects of taxes on top of taxes.
  • The alternatives include a value-added tax or goods-and-services tax.

Every one of those transfers of ownership is a taxable transaction, and each transaction includes a sales tax. The total cost of the transaction is based on the cumulative business costs, including the sum of all taxes charged for each previous transaction.

A cascade tax is a type of turnover tax in which each successive transfer is taxed inclusive of any previous tax or taxes being levied. Because each successive turnover includes the taxes of all previous turnovers, the end tax amount will be greater than the official stated tax rate.

The Alternative to a Cascade Tax

The main alternative to a cascade tax is a single-stage tax such as the value-added tax (VAT), also called a goods and services tax (GST). This is a tax that is levied only on the value that its latest seller has added to the product. Thus, the tax is not based on the entire value of the product but on the value that has been added to it by the latest business in the chain.

The net result of a VAT tax is lower overall taxation than comparable rates levied in a cascading system. A VAT tax does not inflate the cost of finished goods.

About 160 countries use a value-added tax system. Most notably, member nations of the European Union charge a VAT tax. As of 2019, that tax was a minimum of 15%, with member nations permitted to add to it. Canada and Mexico also have VAT taxes.

Opponents of the VAT tax argue that it is a regressive tax that places a harsh burden on the lower-income population.

U.S. Tax Methods

The United States has no federal sales tax. Sales taxes are imposed by the states, at rates they set individually. They also may be imposed by cities, which may collect 1% or 2% on top of the state rate on some or all goods purchased.

A shopper in Delaware won't pay tax on a California avocado, but the avocado may have been taxed repeatedly during its journey from farm to wholesaler to supermarket.

State laws also determine the details. A state may collect sales tax on clothing but not on food unless it's candy, chewing gum, or sugary drinks.

Some states have no sales tax. As of the end of 2019, they included Alaska, Delaware, Montana, and New Hampshire.

The highest state sales tax was charged in California, at 7.250%, although Indiana, Mississippi, Rhode Island, and Tennessee all were close behind with 7% rates. The highest rate was effective not in a state but in a territory, Puerto Rico, at 11.5%.

The end result is that a shopper in Delaware will pay no sales tax when purchasing a California avocado, but that avocado's price may reflect repeated sales tax transactions during its journey from farm to wholesaler to supermarket.

Example of Cascade Tax

A cascade tax has a compounding effect that creates higher tax revenues than a single-stage tax.

For example, a government levies a 2% cascade tax on all goods produced and distributed. A company sells a slab of stone for $1,000 for a tax-inclusive price of $1,020 ($1000 + 2%) to an artist. The artist creates a sculpture. He hopes to make a $2,000 profit on its sale to an art dealer. That means the art dealer will pay $3,020 plus sales tax, bringing the cost to $3,080 ($3020 + 2% tax). The art dealer wants to make $5,000 for the sculpture, so the price in the art gallery comes to $8,080 plus sales tax, for a grand total of $8,242.

In sum, the government has collected taxes of $20 + $60 + $162 = $242, which is actually an effective tax rate of $242/$8,000 or 3.025%.

How a GST Tax Works

When a country imposes a GST tax rather than a value-added tax, it merges several taxes into one single tax. These may include central taxes such as sales tax, excise duty tax, and service tax, as well as state-level taxes such as entertainment tax, entry tax, transfer tax, and luxury tax. These become one single tax.

So, when a product is sold, each vendor in the supply chain is able to deduct the tax paid from tax collected and remit it to the government. No matter how many times the product changes hands, the final consumer pays the full tax rate but not a multiple of it.

Countries with cascade taxes may struggle to stay competitive in foreign markets. This is because such a tax system results in inflationary prices in comparison with those of international competitors.