Presentation to the President's
Advisory Panel
on Federal Tax Reform:
The Value Added Tax (VAT)
May 11, 2005
Charles McLure
Senior Fellow
Hoover Institution
Stanford University
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
2
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
3
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
4
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
5
Three Forms of Indirect Tax on Consumption:
An Illustration
(Tax rate = 10%)
Economic activity
Farmer
Miller
Baker
Total
Basic transactions
1. Sales
2. Purchases
3. Value added (sales - purchases)
$ 300
$ 700
$ 1,000
$0
$ 300
$ 700
$ 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
$ 30
$ 40
$ 30
$ 100
$ 100
$ 100
7. Net VAT liability
Retail Sales Tax (RST)
8. Retail Sales Tax
Exempt
Exempt
6
Three Forms of Indirect Tax on Consumption:
An Illustration
(Tax rate = 10%)
Economic activity
Farmer
Miller
Baker
Total
Basic transactions
1. Sales
2. Purchases
3. Value added (sales purchases)
$ 300
$ 700
$ 1,000
$0
$ 300
$ 700
$ 300
$ 400
$ 300
$ 1,000
Subtraction-Method Business Transfer Tax (BTT)
4. Business Transfer Tax
(10% of line 3)
$ 30
$ 40
$ 30
$ 100
 In their pure forms, BTT, VAT, and
RST have identical effect: taxation
of consumption
 VAT and RST are “transactionsbased” 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
Credit-Method VAT (VAT)
5. Tax on sales (10% of line 1)
$ 30
$ 70
$ 100
6. Less: input tax on purchases
$0
$ 30
$ 70
$ 30
$ 40
$ 30
$ 100
 Under BTT and VAT much of tax is
collected before the last stage
$ 100
$ 100
 Under VAT invoices showing tax
paid must support input credits
7. Net VAT liability
Retail Sales Tax (RST)
8. Retail Sales Tax
Exempt
Exempt
See appendix slide 21 for further discussion.
7
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
8
Credit-Method VAT:
Exempting and Zero-Rating of Last Stage
(Tax Rate = 10%)
Economic activity
Farmer
Miller
Baker
$ 300
$ 700
$ 1,000
$0
$ 300
$ 700
$ 300
$ 400
$ 300
Total
Basic transactions
1. Sales
2. Purchases
3. Value added (sales –
purchases)
$ 1,000
Exemption of Last Stage (Baker)
4. Tax on sales (10% of line 1)
$ 30
$ 70
Exempt
5. Less: input tax on purchases
$0
$ 30
$0
$ 30
$ 40
$0
6. Net VAT liability
$ 30
$ 70
$0
8. Less: input tax on purchases
$0
$ 30
$ 70
$ 30
$ 40
- $ 70
9. Net VAT liability
 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
$ 70
Zero-Rating of Last Stage
7. Tax on sales (10% of line 1)
 Input credits are allowed for zerorated sales, but not for exempt sales
 Zero-rating is common for exports
$0
9
Credit-Method VAT:
Exempting and Zero-Rating of Intermediate Stage
(Tax Rate = 10%)
Economic activity
Farmer
Miller
Baker
Total
effect on ultimate tax liability (Zerorating produces lower input credits)
Basic transactions
1. Sales
2. Purchases
3. Value added (sales –
purchases)
$ 300
$ 700
$ 1,000
$0
$ 300
$ 700
$ 300
$ 400
$ 300
 Exemption of intermediate stage breaks
$ 1,000
Exemption of Intermediate Stage
4. Tax on sales (10% of line 1)
$ 30
Exempt
$100
5. Less: input tax on purchases
$0
$0
$0
$ 30
$0
$ 100
6. Net VAT liability
7. Tax on sales (10% of line 1)
$ 30
$0
$ 100
8. Less: input tax on purchases
$0
$ 30
$0
$ 30
-$ 30
$ 100
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,
$ 130
Zero-Rating of Intermediate Stage
9. Net VAT liability
 Zero-rating of intermediate stage has no
incentives for self-supply, and other
economic distortions; zero-rating does
not
 Producers of intermediate stage goods
$ 100
and services do not want to be exempt;
this is politically important
10
Credit-Method VAT:
Summary of Effects of Exemption and Zero-Rating
Stage of production/distribution process
Exemption
Intermediate stage
Last stage
Breaks chain of input credits; increases
tax
Only value added at final
stage is untaxed
Cascading tax and distortions
Zero-rating
No effect
Entire value of sale is
untaxed
11
Choosing between Exemption and Zero-rating

Administrative differences


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)



Exemption requires allocation of input taxes; zero-rating does not
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
12
Exemption and Zero-Rating of Last Stage
Under BTT, VAT, and RST
(Tax Rate = 10%)
Economic activity
Farmer
1. Sales
2. Purchases
3. Value added (sales – purchases)
Miller
Baker
$ 300
$ 700
$ 1,000
$0
$ 300
$ 700
$ 300
$ 400
$ 300
Subtraction-Method Business Transfer Tax (BTT)
4. Business Transfer Tax
(10% of value added in line 3)
$ 30
$ 40
Exempt
Total
 Exemption of last stage under VAT or
BTT eliminates tax only on value added
at last stage
$ 1,000
 Zero-rating of last stage under VAT
eliminates tax on entire sales price, like
$ 70
a retail sales tax exemption
Credit-Method VAT: Exemption
5. Tax on sales (10% of in line 1)
6. Less: input tax on purchases
7. Net VAT liability
$ 30
$ 70
Exempt
$0
$30
$0
$ 30
$40
$0
$ 70
Credit-Method VAT: Zero-Rating
8. Tax on sales (10% of line 1)
$ 30
$ 70
$0
9. Less: input tax on purchases
$0
$ 30
$ 70
$ 30
$ 40
- $ 70
$0
Exempt
Exempt
$0
10. Net VAT liability
Retail Sales Tax
11. Retail Sales Tax
Exempt
13
Effects of Exemption of Intermediate Stage under VAT
and BTT
(Tax Rate = 10%)
Economic activity
Farmer
1. Sales
2. Purchases
3. Value added (sales –
purchases)
Miller
Baker
$ 300
$ 700
$ 1,000
$0
$ 300
$ 700
$ 300
$ 400
$ 300
Total
$ 1,000
Subtraction-Method Business Transfer Tax (BTT)
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
Less: input tax on purchases
$0
$0
$0
$ 30
$0
$ 100
Net VAT liability
Exempt
 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
$100
$ 130
14
Taxation of Financial Services under a
Credit-Method VAT
Business Customers
Conceptually
correct tax
treatment
Taxation or zero-rating
(Tax would not ultimately matter)
Households
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-taxation
No 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-taxation
No taxation of financial services
Simplest: Requires no allocation of input credits
HYBRID:
Business services
zero-rated;
Consumer services
exempt
Conceptually correct tax treatment
Under-taxation
No 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
15
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
16
Evaluation: Direct and Indirect Forms of Consumption
Taxes
Form of consumption tax
Direct tax
Consumed Income Tax
Flat Tax
Transactions-based
indirect taxes
Credit-Method VAT
Retail Sales Tax
Accounts-based indirect
tax
Subtraction-Method BTT
Total replacement for
federal income taxes
Partial replacement for federal
income taxes/additional source
of federal revenue
Possibly
No
No
No
Possibly
Probably not
No
No
See appendix slide 22 for further discussion.
17
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.
18
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
19
Appendix
20
Implications of Three Ways of Implementing Indirect
Consumption Taxes
Subtraction-Method BTT
Credit-method VAT
Retail Sales Tax
Key Feature
Business purchases are
deductible
Taxes on business purchases are creditable
Business purchases are
exempt
Revenue Implications
Benefits of paying no tax
on any slice of value added
Exemptions (base erosion)
Evasion
No benefit to not paying tax before the last stage
Exemption (or evasion) at last stage loses only tax on
value added at that stage
Only zero-rating at retail level eliminates tax
Exemption 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 stage
Taxes paid before the last stage “wash out” in credits
Only tax at last stage matters
One “bite at the apple” (at the
retail stage)
Political Implications
Highly vulnerable to base
erosion
Relatively invulnerable to base erosion
Highly vulnerable to base
erosion
21
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 consumptionbased 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
SubtractionMethod 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
22
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?
23
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
24
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)
25
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
26