Even as the economic meltdown of the past two years shows signs of improvement, Americans are faced with an economic crisis of a different sort. New government spending, on everything from the economic stimulus to health care reform, means federal deficits are heading toward record highs.
Assuming that tax revenues and spending remain unchanged, the Congressional Budget Office projects deficits of $600 billion or more per year between 2011 and 2020.
To stem the rising tide of red ink, elected officials are faced with the usual choices:
- Cut Spending – Never a popular or politically expedient option, especially in an election year.
- Raise Current Taxes – This is already happening at the federal and state levels.
- Federal income tax rates are scheduled to increase for high income individuals.
- Several states are considering expanding their sales taxes to include service providers like attorneys, architects and accountants.
- Health care reform legislation contains provisions to impose "penalties" (a.k.a. taxes) on individuals who do not purchase health care coverage, and on large and mid-sized employers that do not offer it to employees. Those with very expensive "Cadillac plans" will pay a 40 percent excise tax starting in 2018.
- High income individuals face an additional tax and an additional Medicare contribution.
Importing the VAT
It is the third option that has some looking to the example set by more than 100 foreign countries with various forms of a value added tax (VAT). Most of Europe, Japan and Canada are among the nations that have used a form of value added tax for decades to support government programs. Although a U.S. VAT has been considered in the past, advocates now say it may be the only way out from under current and future deficits. Of course, new taxes never come without debate or controversy, and proponents on both sides of the VAT issue have been out in force. Some believe a VAT is inevitable, although maybe not in the immediate future. Others are steadfast in their opposition and skeptical of the fairness and benefits of such a scheme. At this writing, neither camp had succeeded in formally introducing a VAT, nor have they completely eliminated it from the realm of possibility.
What is a VAT?
A VAT is often called a consumption tax and works much like a sales tax. There is one major difference: Instead of the tax being levied on the final retail sale to the consumer, a VAT is collected at each stage of the production chain as "value" is added to the product. In the very simplest scenario, the government with a VAT collects the same amount as it would with a more traditional sales tax. But because each individual or business along the way is able to take credit for the tax paid on its own purchase of goods, the end consumer ultimately pays the full amount of the tax.
It sounds complicated, but a VAT is actually easier for the government to collect than a sales tax because of the multiple levels of accounting and reporting. It becomes complex when interest groups begin lobbying for exemptions and special rates on certain purchases. Unlike the income tax, which has individuals with higher income paying more tax, a VAT is considered by some to be a regressive tax because it applies equally to everyone, regardless of their income.
Here’s How a VAT Works
Start with a broad-based VAT of 10 percent. A farmer grows some wheat, then sells the wheat to a baker for 20 cents, plus a 10 percent VAT, for a total of 22 cents. The farmer sends 2 cents in VAT to the government.
The baker now turns the wheat into flour and bakes a loaf of bread, which is sold to a grocery store for 66 cents. Six cents of that total (10 percent of 60 cents) is VAT. The baker collects the 6 cents in VAT from the store, but sends only 4 cents to the government after taking credit for the 2 cents paid when the wheat was purchased from the farmer.
Along comes the consumer, who buys the loaf of bread from the grocery store for $1.10, which includes $1.00 for the bread and 10 cents in VAT. The grocery store collects 10 cents in VAT, but takes credit for the 6 cents paid when the loaf was purchased from the baker. The store sends the government 4 cents.
In the end, the government collects 2 cents from the farmer, 4 cents from the baker and 4 cents from the store. That adds up to 10 cents, which is 10 percent of the final sale price of $1.00.
Since everyone along the way received a credit for taxes paid except the consumer, it is the consumer who actually shoulders the burden of the tax. Generally, the tax applies to everyone who "consumes" goods and services, regardless of their income.
In this basic model, the same principles would apply to all goods and services. In reality, it is likely that there would be exemptions and exceptions that would complicate the calculation and collection of the VAT.
Implementing a VAT in the United States
As simple as a VAT is in theory, it would require a whole new way of thinking about taxation if it were to come to the United States. Changes in tax accounting, auditing, wholesale and retail pricing, reporting and fraud prevention would all need to be implemented in virtually every organization.
In Europe, where VAT has been a part of the business landscape for decades, tax professionals acknowledge that passing and implementing such a tax on this side of the ocean would be difficult.
"It would take a tremendous effort to implement a VAT in the United States," says Arnold Stange, tax and legal partner with HLB Stueckmann in Bielefeld, Germany. "There are implications for businesses that you can’t even imagine."
- Invoices and the computer software that produces them would need to be updated to reflect VAT paid on every transaction for goods and services.
- Pricing, from retail shops to manufacturers, would trend upward in order to include VAT as a component of total cost
- An elevated risk of fraud would require enhanced internal control
- Rise of black market goods and services purchased with cash and bypassing the system
- Training/retraining of internal and external tax professionals
- Implementation of new income reporting procedures and schedules
Problems with a VAT
As attractive as a VAT may be to some, it also has plenty of detractors. Among them are those who point out the fact that all but a few states already have a sales tax, which is often the state’s primary revenue source. States may be unwilling or unable to repeal their sales tax in order to make way for a federal tax. Adding a federal VAT on top of the state sales tax could significantly increase the cost of goods and services for consumers.
Advocates for low-income taxpayers also point to the potentially regressive nature of the VAT tax – a person with $50,000 in annual income pays the same rate as a person with $1 million in annual income. In practice, the tax is relatively fair considering the higher consumption of more and higher priced goods and services by those with higher incomes.
Spend More, Tax More
Consumption taxes like a VAT have been around for decades. So why all the sudden talk about a value added tax in the United States? Because government spending is rising much faster than revenue. The 2009 economic stimulus, health care reform, and existing entitlements like Medicare and Social Security are predicted to produce record deficits in the coming years, as high as $600 billion annually, according to the Congressional Budget Office. Left unchecked, this level of spending without accompanying program cuts and/or new revenue streams is considered by many to be unsustainable.
The VAT is often called a "money machine" because of its potential to generate billions of dollars in revenue. Statistics from the U.S. Bureau of Economic Analysis show personal consumption of goods and services in 2009 was about $10 trillion. Even a 1 percent VAT could produce as much as $100 billion in revenue.
VAT in Other Countries
The United States is the only industrialized nation without a VAT. The Organization for Economic Cooperation and Development (OECD) lists more than 130 countries that use a VAT. Here are the standard rates in a few of them.
|Country||Standard VAT Rate*|
*Rate may be lower on certain goods and services – food, books, public transportation and medical services, for example. Others, like not-for-profits, may be exempt from paying VAT.
Source: Organization for Economic Cooperation and Development (OECD)