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Wednesday, August 25, 2010

The VAT: Not Just Another Tax

Recently there has been a great deal of speculation about how the U.S. government will deal with its massive budget deficits and increasing levels of debt. For readers of The Freeman the answer is rather simple: Since most of what the federal government does goes beyond its “legitimate” role, cut spending. Drastically. Discussions about balancing spending cuts with tax increases are misplaced given the current size and scope of government activity.

But, alas, Freeman readers are not the relevant decision-makers. Tax increases are driving much of the discussion, and no option is discussed more than a value-added tax, or VAT. Indeed there is much speculation that President Obama’s Bipartisan Commission on Fiscal Responsibility and Reform will include a VAT as the major source of new revenues in any set of recommendations.

The VAT is a pernicious and insidious tax that promises to fuel dramatic growth in government. But this cannot be understood without first examining the mechanics of the tax. The devil is indeed in the details.


Theoretically a VAT is levied on the “value added” at every stage of production to goods and services ultimately purchased by consumers. The consumer, however, pays the final tab.

The table below shows four stages of production leading to the final sale. (This example is from Michael Schuyler’s “Consumption Taxes: Promises and Problems,” Fiscal Issue 4, Institute for Research on the Economics of Taxation, 1984.) As each stage is completed, a partially finished product has value added before it is sold to the next stage. In this example, value added is taxed at 10 percent. To simplify, a starting point is picked with “prior producers” having added the first $10 of value. At the point of sale a 10 percent tax, $1, is collected. Thus the cost to the manufacturer is $11.

After adding further refinements the manufacturer sells his partially finished product for $30 to the wholesaler and charges a 10 percent VAT, receiving $33. To figure the tax, the manufacturer subtracts the tax from the previous stage to avoid double taxation. Before sending the tax to the government, he deducts the $1 paid to the original producer. With value added at $20, he sends $2 to the government.

The wholesaler adds $50 in value to the product and sells it to the retailer for $80 plus the 10 percent, for a total of $88. But before he sends the $8 to the government, he deducts the $3 in VAT paid to the manufacturer. The net tax collected is $5. Ultimately the retailer sells the finished product to the consumer for $100 plus the 10 percent VAT, or $110. Again, the retailer deducts the $8 that he had previously paid and sends $2 to the government, or 10 percent of the $20 in value added at this final stage. (If at any stage a producer sells his goods for less than the cost of his materials, he would pay tax only on the actual selling price.)

In principle there is no difference, in terms of the total tax collected, between a VAT and a retail sales tax. But the compliance costs of a VAT would be much higher because the tax is collected at every stage of production.

Practice: The Invoice-Credit Method

Most governments have adopted the “invoice-credit method” for collecting a VAT. The United States would likely do the same. This method makes tax collection automatic. In the example, which doesn’t use that method, companies deduct the amount of tax already paid at each stage of production before sending in the tax on value they added. But with the invoice-credit method, the taxpayer at each stage is responsible for the entire amount of the tax on his sale and can only obtain a credit for taxes paid previously if he provides an invoice from his suppliers. For example, the retailer that purchases the product from the wholesaler for $88, VAT included, must pay the full $10 tax on his sale to the final customer and then submit an invoice provided to him by the wholesaler showing that he paid $8 in tax. Only then can he get credit for it.

Michael Schuyler, economist at the Institute for Research on the Economics of Taxation, points out that the invoice-credit method ensures that the tax is “self-policing.” Focusing on the transaction between the manufacturer and wholesaler in the example, Schuyler writes, “Suppose . . . that the manufacturer wants to understate the sale price of its output . . . so that it can reduce its tax. . . . Would the wholesaler allow the phony amount to be listed on its purchase invoice? The wholesaler would object because the [amount gained by] the manufacturer would be lost to the wholesaler.”

Thus there is a strong incentive for businesses to police the reporting of their suppliers.

A Central Planner’s Dream Tax

From the perspective of the State, this is a near-perfect tax. It touches every stage in every production process, from new homes to hair cuts, and allows the government, because of the required invoices at every point, to keep track of every business’s buying and selling. For a State bent on managing the details of business, possibly to implement CO2 controls or to make sure that politically favored firms (say, unionized ones) are patronized, the information can establish a useful database.

But beyond this, the VAT would be a revenue-generating machine, unmatched by any other form of taxation. First, it guarantees that a percentage of the total value of all goods and services sold in the economy goes to the State. Nothing escapes the tax. Also, because it is levied on such a broad base, very small increases in the rate would bring in large amounts of revenue. While this is also theoretically true of a retail sales tax, the multilayered enforcement mechanism of a VAT makes it almost impossible to avoid. Note that the tax on the full value added up through any stage of production is the responsibility of the company operating at that stage, until the company provides the needed invoices from his suppliers that allow him to receive the credit. As a product passes through different stages of production, the incentive is always to collect the tax from those you are selling to and to collect the invoices from those you are buying from. Every business becomes a revenue agent. With very little enforcement effort, the government watches the money roll in.

Adding insult to injury for the taxpayer and icing on the cake for the State, the tax is usually hidden from the final consumer. Unlike a retail sales tax, the VAT is usually included in the sticker price of the product. Consumers are not directly confronted with the fact that they are paying it. This both makes the tax easy to increase and masks the true cost of government. If we are ultimately going to reduce the size of the State, individuals need to feel the pain it inflicts. This starts with making people keenly aware of the taxes they pay. There is no tax more hidden from the people who pay it than a VAT.

The VAT is not just another tax. It poses a fundamental threat to liberty and a free society. And since a tax with such massive revenue-generating capabilities would be nearly impossible to repeal, it is likely that there would be no turning back the advancement of Leviathan.

  • Roy Cordato is Vice President for Research and resident scholar at the John Locke Foundation in Raleigh, NC. He is also a part time faculty member at NC State University where he teaches a primarily Austrian course called Political Economy of the Market Process and is faculty advisor for the Austrian Economics Forum made up of graduate and undergraduate students. He is a member of the FEE Faculty Network.