presentation to the president's advisory panel on federal tax reform: the value added tax (vat)...

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%)


Basic transactions

1. Sales $ 300 $ 700 $ 1,000

2. Purchases $ 0 $ 300 $ 700

3. Value added (sales - purchases)

$ 300 $ 400 $ 300 $ 1,000


4. Business Transfer Tax (10% of line 3)

$ 30 $ 40 $ 30 $ 100

Credit-Method VAT (VAT)




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


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



Zero-Rating of Last Stage



9. Net VAT liability $ 30 $ 40 - $ 70 $ 0

10

Credit-Method VAT: Exempting and Zero-Rating of Intermediate Stage


Basic transactions

1. Sales $ 300 $ 700 $ 1,000

2. Purchases $ 0 $ 300 $ 700


$ 300 $ 400 $ 300 $ 1,000

Exemption of Intermediate Stage

4. Tax on sales (10% of line 1) $ 30 Exempt $100



Zero-Rating of Intermediate Stage



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


1. Sales $ 300 $ 700 $ 1,000

2. Purchases $ 0 $ 300 $ 700

3. Value added (sales – purchases) $ 300 $ 400 $ 300 $ 1,000


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



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


1. Sales $ 300 $ 700 $ 1,000

2. Purchases $ 0 $ 300 $ 700


$ 300 $ 400 $ 300 $ 1,000


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

20

Appendix

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

presentation to the president's advisory panel on federal tax reform: the value added tax (vat)...

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