What is a Value-Added Tax (VAT)?
A value-added tax (VAT) is a consumption tax placed on a product whenever value is added at each stage of the supply chain, from production to the point of sale. The amount of VAT that the user pays is on the cost of the product, less any of the costs of materials used in the product that have already been taxed.
More than 160 countries around the world use value-added taxation, and it is most commonly found in the European Union. But it is not without controversy. Advocates say it raises government revenues without punishing success or wealth, as income taxes do, and it is simpler and more standardized than a traditional sales tax, with fewer compliance issues. Critics charge that a VAT is essentially a regressive tax that places an increased economic strain on lower-income taxpayers, and also adds bureaucratic burdens for businesses.
- A value-added tax, or VAT, is added to a product at every point on the supply chain where value is added.
- Advocates of VATs claim that they raise government revenues without punishing success or wealth, while critics say that VATs place an increased economic strain on lower-income taxpayers and bureaucratic burdens on businesses.
- Although many industrialized countries have value-added taxation, the U.S. is not one of them.
Value-added taxation is based on a taxpayer's consumption rather than their income. In contrast to a progressive income tax, which levies greater taxes on higher-level earners, VAT applies equally to every purchase.
How a VAT Works
A VAT is levied on the gross margin at each point in the manufacturing-distribution-sales process of an item. The tax is assessed and collected at each stage, in contrast to a sales tax, which is only assessed and paid by the consumer at the very end of the supply chain.
Say, for example, Dulce is an expensive candy manufactured and sold in the country of Alexia. Alexia has a 10% value-added tax.
- Dulce’s manufacturer buys the raw materials for $2.00, plus a VAT of $0.20—payable to the government of Alexia—for a total price of $2.20.
- The manufacturer then sells Dulce to a retailer for $5.00 plus a VAT of 50 cents for a total of $5.50. However, the manufacturer renders only 30 cents to Alexia, which is the total VAT at this point, minus the prior VAT charged by the raw material supplier. Note that the 30 cents also equals 10% of the manufacturer’s gross margin of $3.00.
- Finally, the retailer sells Dulce to consumers for $10 plus a VAT of $1 for a total of $11. The retailer renders 50 cents to Alexia, which is the total VAT at this point ($1), minus the prior 50-cent VAT charged by the manufacturer. The 50 cents also represents 10% of the retailer’s gross margin on Dulce.
VAT's International Track Record
The vast majority of industrialized countries that make up the Organisation for Economic Cooperation and Development (OECD) have a VAT system. The United States remains the only notable exception.
Most industrial countries with a VAT adopted their systems in the 1980s. Results have been mixed, but there is certainly no tendency among VAT countries to have small budget deficits or low government debt. According to one International Monetary Fund study, any state that switches to VAT initially feels the negative impact of reduced tax revenues despite its greater revenue potential down the road.
VAT has earned a negative connotation in some parts of the world where it has been introduced, even hurting its proponents politically. In the Philippines, for example, Senator Rafael Recto, the chief proponent of VAT in the 1990s, was voted out of office by the electorate when he ran for re-election. But in the years that followed its implementation, the population eventually accepted the tax. Recto ended up finding his way back to the Senate, where he became the proponent of an expanded VAT.
In 2009 and 2010, respectively, France and Germany famously implemented huge cuts in their VAT rates—France by almost 75%, from a 19.6% rate to a 5.5% rate.
Industrial nations that have adopted a VAT system have had mixed results, with one study noting that any country making the switch feels an initial negative impact from reduced tax revenues.
VAT vs. Sales Tax
VATs and sales taxes can raise the same amount of revenue; the difference lies in at what point the money is paid—and by whom. Here is an example that assumes (again) a VAT of 10%:
- A farmer sells wheat to a baker for 30 cents. The baker pays 33 cents; the extra 3 cents represents the VAT, which the farmer sends to the government.
- The baker uses the wheat to make bread and sells a loaf to a local supermarket for 70 cents. The supermarket pays 77 cents, including a 7 cent VAT. The baker sends 4 cents to the government; the other 3 cents were paid by the farmer.
- Finally, the supermarket sells the loaf of bread to a customer for $1. Of the $1.10 paid by the customer, or the base price plus the VAT, the supermarket sends 3 cents to the government.
Just as it would with a traditional 10% sales tax, the government receives 10 cents on a $1 sale. The VAT differs in that it is paid at different stops along the supply chain; the farmer pays 3 cents, the baker, 4 cents and the supermarket, 3 cents.
However, a VAT offers advantages over a national sales tax. It is much easier to track. The exact tax levied at each step of production is known; with a sales tax, the entire amount is rendered after the sale, making it difficult to allocate to specific production stages. Additionally, because the VAT only taxes each value addition—not the sale of a product itself—assurance is provided that the same product is not double-taxed.
There's been much debate in the U.S. about replacing the current income tax system with a federal VAT. Advocates claim it would increase government revenue, help fund essential social services and reduce the federal deficit. Most recently, a VAT has been advocated by Democratic presidential candidate Andrew Yang.
In 1992, the Congressional Budget Office conducted an economic study on implementing a VAT. At the time, the CBO concluded that a VAT would add only $150 billion in annual revenue, or less than 3% of the national output. If you adjust $150 billion to current dollars, it comes out to just under $250 billion; 3% of the 2016 gross domestic product (GDP) comes out to just over $557 billion. Using these approximations, it can be estimated that a VAT might raise between $250 billion and $500 billion in revenue for the government.
Of course, these figures don't account for all of the outside impacts of a VAT system. A VAT would change the structure of production in the United States; not all firms will be equally able to absorb the hike in input costs. It is unknown if the additional revenue would be used as an excuse to borrow more money – historically proved to be the case in Europe – or reduce taxes in other areas (potentially making the VAT budget-neutral).
The Baker Institute, in conjunction with Ernst & Young, conducted a macroeconomic analysis of the VAT in 2010. The three principal findings were that the VAT would reduce retail spending by $2.5 trillion over 10 years, the economy could lose up to 850,000 jobs in the first year alone and the VAT would have "significant redistributional effects" that would harm current workers.
Three years later, in a 2013 Brookings Institution report, William Gale and Benjamin Harris proposed a VAT to help solve the country's fiscal problems coming out of the Great Recession. They calculated that a 5% VAT could reduce the deficit by $1.6 trillion over 10 years and raise revenues without distorting savings and investment choices.
Pros and Cons of a Value-Added Tax
In addition to the fiscal arguments, proponents of a VAT in the U.S. suggest that replacing the current income tax system with a federal VAT would have other positive effects.
Substituting a VAT for other taxes would close tax loopholes.
Provides a stronger incentive to earn more money than a progressive income tax does.
Creates higher costs for businesses.
Encourages tax evasion.
Conflicts with the ability of state and local governments to set their own sales tax levels.
Passed-along costs lead to higher prices—a particular burden on low-income consumers.
Pro: Closing Tax Loopholes
Not only would a VAT greatly simplify the complex federal tax code and increase the efficiency of the Internal Revenue Service (IRS), proponents argue, but more important, it would make it much more difficult to avoid paying taxes. A VAT would collect revenue on all goods sold in America, including online purchases. Despite efforts to close tax loopholes that allow internet companies to avoid charging customers taxes in states where they do not have a brick-and-mortar business, unpaid taxes on online sales cost states billions in potential income that could fund schools, law enforcement and other services.
Pro: A Stronger Incentive to Earn
If a VAT supplants American income tax, it eliminates the disincentive-to-succeed complaint levied against such progressive tax systems: Citizens get to keep more of the money they make and are only affected by taxes when purchasing goods. This change not only confers a stronger incentive to earn, it also encourages saving and discourages frivolous spending (theoretically).
Con: Higher Costs for Businesses
Opponents, however, note many potential drawbacks of a VAT, including increased costs for business owners throughout the chain of production. Because VAT is calculated at every step of the sales process, bookkeeping alone results in a bigger burden for a company, which then passes on the additional cost to the consumer. It becomes more complex when transactions are not merely local, but international. Different countries may have different interpretations on how the tax is calculated. This not only adds another layer to the bureaucracy, it can also result in unnecessary transaction delays.
Con: Encouraging Tax Evasion
In addition, while a VAT system may be simpler to maintain, it is costlier to implement. And tax evasion can still continue, even be widespread, if the general public does not give it its wholehearted support. Smaller businesses in particular can evade paying VAT by asking their customers if they require a receipt, adding that the price of the product or service being purchased is lower if no official receipt is issued.
Con: Conflicts with State and Local Governments
In the U.S., a federal VAT could also create conflicts with state and local governments across the country, which currently set their own sales taxes at varying rates.
Con: Higher Prices—Especially for Low-Income Consumers
Critics also note that consumers typically wind up paying higher prices with a VAT. While the VAT theoretically spreads the tax burden on the added value of a good as it moves through the supply chain, from raw material to final product, in practice the increased costs are typically passed along to the consumer.
Even so, better-off consumers could ultimately benefit if a VAT replaced the income tax: As with other flat taxes, a VAT's impact would be felt less by the wealthy and shouldered more heavily by the poor, who spend a larger percentage of their take-home pay on necessities. In short, lower-income consumers would pay a much higher proportion of their earnings in taxes with a VAT system, critics, including the Tax Policy Center, charge. That could be mitigated to some extent if the government excluded certain necessary household goods or foodstuffs from the VAT, or provided rebates or credits to low-income citizens to offset the tax's effects.