Executive summary of 'Value-Added Taxes: A Comparative Analysis.'.

• Author: Glaser, Gareth E.

Editor's Note: The following article summarizes Value-Added Taxes: A Comparative Analysis, a book by the Consumption Tax Committee of Tax Executives Institute. The book, which was published by the I 1992, may be purchased for $30 (plus applicable sales tax) by writing to Tax Executive Institute, 10 N.W., Suite 320, Washington, D.C. 20004-2505, Attention: VAT Book.

In November 1992, the Consumption Tax Committee of Tax Executives Institute released its long-awaited report entitled Value-Added Taxes: A Comparative Analysis. Two years in the making, the book's publication was especially timely, since it follows on the heels of significant activity in Washington in the field of consumption taxes.

In July 1992, United States Senators John Danforth (R-Missouri) and David Boren (D-Oklahoma) created an advisory group to provide suggestions on ways to alter the current system of Federal income taxation by incorporating a national consumption tax.(1) A key guideline established for the group is that any proposal must be revenue neutral. At the same time, a commission chaired by United States Senators Sam Nunn (D-Georgia) and Pete Domenici (R-New Mexico) has endorsed a plan to abolish the present tax code and enact a new system that would tax consumption while exempting savings. This proposal is part of an economic blue-print issued by the bipartisan "Strengthening of America Commission." It appears that the Nunn-Domenici commission will be looking to the Danforth-Boren advisory group for guidance on how a national consumption tax might be implemented.

In the midst of all this, the United States had a presidential election in which taxes were, as usual, a major focus of debate. President Clinton made it clear during the campaign (and since) that he intends to propose major changes in many aspects of the U.S. economy. What form these changes will take in the tax area is a matter for speculation, but a consumption tax could well find its way to the national agenda.

TEI's Value-Added Taxes: A Comparative Analysis offers a comprehensive review of the policy issues surrounding value-added taxes. It can be an important tool in the coming debate over a national consumption tax, since it provides an objective and technically sound analysis of the relevant issues. The following summary of the Institute's VAT book follows the organization of the main report and draws liberally on the work of the Institute's Consumption Tax Committee to whom the authors of this summary, who themselves were members of the committee during the book's development, are indebted. The authors recognize that events have, to a certain extent, overtaken the book -- perhaps most notably developments in the European Community. Nevertheless, they -- and Tax Executives Institute -- continue to believe the book can serve as a valuable research tool.

1. INTRODUCTION

   TEI'S VAT book begins by acknowledging that VATS "provoke widely divergent and strongly held opinions." Among the arguments in favor of a VAT that are presented in the book are that a VAT is necessary for U.S. businesses to compete internationally, to encourage capital formation, to reduce the federal deficit and to simplify the tax system. Opponents argue that a VAT is regressive and a "money machine" that discourages spending restraint by government, is costly to administer and comply with, and encroaches on state revenue sources. With this as an introduction, the book remains objective throughout, emphasizing factual explanation and technical analysis.

2. SOME DEFINITIONS

   The two major forms of value-added taxes discussed in the book are the subtraction-method VAT and the credit-method VAT. Under the subtraction-method VAT, the tax base equals sales less purchases (including capital equipment). This form of value-added tax is often referred to as a business transfer tax. The most common form of value-added tax is the credit-method VAT. Under this method, tax is imposed on the price at which goods and services are sold at each stage in a chain of production and distribution. To avoid taxing the same value added more than once, a credit is allowed to a seller for VAT paid on its purchases. These two forms of value-added tax are illustrated in the accompanying two tables.

   The first table illustrates a subtraction-method VAT imposed at a 10-percent rate on net receipts at each stage. The total VAT collected is equal to the rate times aggregate net receipts. In comparison, the second table illustrates a credit-method VAT also imposed at a 10-percent rate. The total VAT collected is equal to the tax rate times the total value-added (on a before-VAT basis). The net value added in both cases is 405.

   The book defines terms frequently used in discussing value-added taxes, among the most important of which is the so-called destination principle by which goods and services are taxed where they are sold. Under this principle, VAT is imposed on imports but not on exports.

   The book also defines the terms "exemption" and "zero-rating." Exemptions from VAT fall into either of two categories: exemption without credit for VAT previously incurred (the so-called "true exemption"), or exemption permitting credit for VAT previously incurred ("exemption with credit"). Under a credit-method VAT, a key feature of "true exemption" is that the exempt taxpayer cannot claim a credit for tax paid on purchases related to its exempt sales, since taxpayers with these exemptions fall outside the VAT system and do not file returns. Exempting taxpayers in this manner simplifies administration of the tax, but requires exempt firms either to pass the tax through to customers by increasing prices or to absorb the price increases. An exemption with credit or zero-rating does not take taxpayers out of the system. Firms still file returns so that they can claim a credit for VAT paid on purchases. Exemption with credit and zero-rating are virtually identical.

   The other major defined term is "multiple rates." This refers to systems that impose different rates of VAT on different types of goods and services. For example, lower rates are often applied to necessities than to luxuries.

3. TAX POLICY ISSUES

   The book objectively discusses the following key tax policy issues that are raised in the VAT debate: (1) Administration and Compliance Costs, (2) Breadth of Tax Base, (3) Who Bears Burden of Tax, (4) State Government Concerns, (5) Trade Implications, and (6) Presumed Effects on Economy. The conclusions of the book are summarized in the following sections.

   1. Administration and Compliance Costs

      The book stresses the importance of minimizing the costs of administration and compliance in any tax system. It contains a wealth of statistical information regarding the cost of administering and complying with a VAT. The book notes, however, that the only comprehensive study of such costs for a VAT in the United States was done by the Department of the Treasury in 1984. The study estimated that to administer a credit-method VAT with minimal exemptions would take 20,000 additional federal employees and a $700 million annual budget. At a 3-percent rate, this would mean that a VAT would be twice as costly to administer as an income tax to raise the same amount of revenue. The book clarifies, however, that the cost of administering a VAT is relatively static -- i.e., the percent administration cost goes down as the tax rate increases. For example, the Treasury study concludes that VAT administration costs will equal those of an income tax at a rate of 6 percent.

      For comparison purposes, the book notes that the European experience is that a VAT is typically cheaper to administer than an income tax. The book cites a 1988 study by the Organisation for Economic Cooperation and Development (OECD) showing that administration costs, as a percentage of revenue, are greater for income taxes than for broad-based consumption taxes. For example, income tax administration costs in Europe average 2 percent of revenue, whereas VAT administration costs average between 0.32 percent and 1.09 percent of revenue.

      None of these amounts reflects the cost of taxpayer compliance and the lost revenue associated with the added expense to taxpayers. In the recent debate over tax reform in the United States, these costs are referred to as "dead-weight" costs. The more complex a tax system, the greater the dead weight costs. The VAT book concludes that the simpler a VAT is, both from a recordkeeping and other compliance perspectives, the less will be its administration and compliance costs.

      Finally, the book compares the relative costs of administering and complying with the two main types of VAT, but does not conclude which type of VAT would be least costly. It does note, however, that a credit-method VAT containing numerous exemptions and multiple rates would probably create burdensome paperwork, whereas a straightforward subtraction-method VAT would probably involve lower recordkeeping costs.

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