The best of both: where the VAT and tax integration converge.

The Best of Both: Where the VAT and Tax Integration Converge 

Introduction

Up to a point, the patterns of modern tax reform in the United States and Canada have been similar -- lowering marginal rates and broadening the tax base. With the Goods and Services Tax (GST), Canada is, perhaps, about to take another major step: adoption of a fairly traditional value-added tax (VAT) that is effectively adjusted at the border for imports and exports. While that will not be easy in Canada, it would be much more difficult in the United States. Even in Canada, where there is a considerable tradition of indirect taxes, it has been necessary to vary the traditional VAT pattern somewhat.

In the United States, where tax history has been different and political biases run strongly against anything that even appears to be a tax on consumers, we probably cannot follow the traditional VAT pattern at all. Instead, we must find some other formulation of an indirect tax, consistent with our own history and politics, that can be adjusted at the border for imports and exports.

The strong emphasis at the outset on border tax adjustments, which usually are permitted for indirect taxes but not for direct taxes, highlights an important point. The dominant reason for adopting a VAT, as such, is to adjust the tax for imports and exports. The other consequences of such a tax can be achieved by other means.

To suggest that the distinction under the GATT between indirect and direct taxes is largely a matter of form highlights another important point. It may be possible to achieve indirect tax status and border tax adjustments, without adopting a multi-stage sales tax.

Therefore, in the United States, we may be able to gain the traditional advantages of a VAT without having to suffer the political disadvantages of adopting a tax on consumers as such. By borrowing certain key ingredients from the VAT and melding them into our existing U.S. tax structure, we may also be able to go even further, and gain the major additional advantage of a fully integrated corporate and individual tax system.

Just as the United States stands nearly alone in relying on direct taxes on net income that cannot be adjusted at the border, it also stands nearly alone with a nonintegrated corporate income tax that greatly increases the cost of capital and distorts the preference for debt over equity -- a matter that has been much in the news in recent days.

Treasury Secretary Nicholas Brady has emphasized his intention to integrate the corporate tax and has directed his staff to develop a detailed set of options for public discussion and potential enactment. Many believe that the Administration will seriously pursue tax integration. The principal barrier is a potentially large revenue cost.

While Treasury officials openly advocate tax integration, no one in the Administration will even talk about a VAT or any other additional tax. For the same and other reasons, almost no one in the U.S. business community will actually advocate enactment of a VAT at this time. Despite the obvious advantages of border tax adjustments and the philosophical desire to shift the tax burden away from savings and investment, when it gets down to reality, there are just as many negatives as positives. With a half dozen exceptions, members of Congress shudder at the idea of telling their constituents that they voted for any new tax, especially one on consumers. It may be good for Canada and elsewhere, but a multi-stage sales tax VAT is not in the cards for the United States.

Instead, we may borrow the good parts from a VAT, leave the rest behind, and move forward with historic tax reform by fully integrating the corporate and individual taxes in the United States. Assume, for example, that the gross profit tax base found in the VAT were extracted and substituted for the present U.S. corporate income tax. Also assume that such a uniform gross profit business tax were fully integrated so that, in effect, it became solely a withholding tax -- not just a withholding tax on dividends but a withholding tax on wages and interest as well.

Assume further that such a gross profit tax is, like a VAT, an indirect tax that may, under the GATT, be imposed on imports and rebated on exports. Finally, assume that the border tax on imports, net of the rebate on exports, produced enough new revenue to pay for full tax integration and, perhaps, more.

These are, of course, large assumptions that need to be put in context by examining the actual tax base of a VAT, by considering the VAT as an additional tax and as a substitute tax, and by briefly reviewing the nature of the distinction under the GATT between a direct tax and an indirect tax.

Consumer-Type VAT vs. Business-Type Vat:

Similarities and Differences

As a practical matter, there are two distinctly different VATs. The most familiar is the consumer-type VAT developed and widely adopted in Europe many years ago. The other is the business-type VAT that has most recently been discussed in the United States. I understand that the Canadian Finance Department first considered the business VAT before deciding on the GST.

Both the classic consumer VAT and the business VAT are imposed on business gross receipts from sales minus the cost of capital equipment, inventories, and services purchased from other businesses. Thus, in both cases, the "gross profit" tax base -- which may be arrived at by either the subtraction method or the addition method -- corresponds to the return to equity plus wages paid to employees and interest paid to lenders. Typically, corporations and other businesses pay the VAT taxes at least quarterly, with a reconciliation at year-end.

The consumer VAT is frequently described as a multi-stage sales tax. This characteristic is reinforced by a system of tax invoices which associates with each sale -- from one business to another -- a portion of the tax paid by all businesses up to that point. Sometimes, the accumulated tax is stated on an invoice to the retail customer, but often is not. The assumption is that the accumulated tax is finally passed on to the consumer and paid by the consumer in addition to the price of the goods. Hence, the idea of a multi-stage sales tax collected at various points in the stream of commerce but finally paid by the consumer.

The business VAT does not include the invoicing system. If the tax paid by a business is passed on at all, it is buried in the price of goods and services much the same as a corporate income tax. Some people suggest that this tax is really not a VAT at all. Instead, they would classify it as a border-adjustable tax on gross profit that is greatly analogous to a payroll tax in combination with an income tax that allows expensing of capital equipment.

Additional Tax vs. Substitute Tax

Any VAT is a substitute tax if the assumption is that it is being enacted in lieu of increasing existing income taxes, or if the VAT replaces revenue lost through earlier income tax cuts. Indeed, in order to gain the maximum benefit from the border tax adjustments, a VAT really ought to be preceded or accompanied by reductions in other domestic business taxes. There are also the cases where, in a mechanical sense, a VAT replaces another pre-existing indirect tax that worked less efficiently. For example, in Canada, the GST to replace existing excise taxes, and, earlier in Europe, the VAT to replace turnover or gross receipts taxes.

Nevertheless, in the United States, I suggest that the consumer VAT is generally viewed as an additional tax, viz., the form of a VAT that is most likely to be added on top of existing taxes ostensibly to pay for deficit reduction but most likely to be absorbed by spending in combination with a variety of politically expedient tax cuts for lower income individuals to offset the supposed increase in the cost of consumer goods.

I further suggest, however, that despite the invoicing system under the consumer VAT, not all U.S. businesses are confident that they can pass on all the consumer VAT they pay without some give in prices or volume somewhere along the line. Many U.S. businesses are also concerned about the runaway revenue potential of the consumer VAT. To the extent that all three of these events transpired -- enactment of an initially low-rate VAT offset by individual (not business) tax cuts, some significant "stickiness" in the ability of businesses to pass on the tax, and a gradual edging up of the VAT rate in the future -- business could end up bearing a much greater overall tax burden than at present.

The business VAT is generally considered most likely to be a true substitute tax. In the United States, such a tax has in fact been proposed as a substitute for both the existing U.S. corporate income tax and the employers' share of the payroll tax. The business VAT would avoid concentrating the tax on the consumer sector. Such concentration under the consumer VAT is a concern not only to retailers but to many goods manufacturers as well. The business VAT would also avoid the concerns about the effects of a consumer price index (CPI) increase thought to be associated with a consumer VAT. The business VAT should have no more CPI effect than the existing income or payroll taxes it might replace. Because the business VAT is clearly a tax on business gross profit, its revenue potential should be constrained by the same factors that constrain the present corporate income tax.

There is, on the other hand, certainly no groundswell in the U.S. business community for the business VAT. If substituted for the U.S. corporate income tax on a revenue-neutral basis (and the import tax revenues used for deficit reduction), corporations, as a group, would pay about the same total amount of taxes as at present. There would, however, be considerable shifting around of the corporate tax burden. As we saw in the Tax Reform Act of 1986, such a reallocation is a major problem. The business VAT would tend to be an additional tax for small businesses which either are not incorporated or, through one means or another, are not really required to pay the present U.S. corporate income tax. The results would be mixed among major corporations. Net exporters, domestic manufacturers that get some competitive help from the import tax, and capital-intensive firms that benefit from expensing capital equipment probably would tend to be better off. Other companies, especially labor-intensive firms, certain "high value added" firms, and companies with large amounts of debt would tend to pay the same or more tax than under present law. In many cases, companies are not sure exactly what the combined competitive and tax impact on them would actually be.

Heretofore, no occasion has arisen where there is a clearcut advantage to business from advancing the business VAT as a substitute tax. With the advent of renewed interest in tax integration, there may now be that occasion where there is not only a clearcut benefit but the potential for a major advance in tax policy in the United States.

Distinction Between Direct and Indirect Taxes

Under the GATT, sales taxes and excise taxes are considered to be indirect taxes, i.e., taxes on goods instead of taxes on persons. A gross receipts tax is also generally considered to be an indirect tax. For present purposes, let us assume that to be true. The income tax is, however, under the GATT, considered to be a direct tax, i.e., a tax on persons instead of a tax on goods.

To rebate the income taxes of an exporter is widely considered to be a GATT violation. Roughly speaking, the reasoning is, as follows. Because the income tax is a direct tax on the exporter, it is part of his costs just the same as labor and materials and to rebate that tax is a prohibited subsidy to exports. A sales tax, on the other hand, is not considered to be a tax on the manufacturer or seller of goods and, therefore, not to be part of his costs. Instead, it is considered to be a tax on the goods themselves and, therefore, a tax paid by the purchaser in addition to the price of the goods. Accordingly, the application of the sales tax to imported goods is not a violation of the national treatment requirement under the GATT and the nonapplication of sales taxes to exports is not a prohibited subsidy.

The rationale for the border tax adjustments under a VAT is similar, derivative, and circular -- because the VAT is assumed to be passed on to consumers, even though collected from and paid by businesses, it is a multi-stage sales tax that may be imposed on imports and rebated on exports.

The business VAT does not, of course, provide for invoicing and there is no particular reason to think that it is paid by consumers in addition to the price of goods. Nevertheless, it has exactly the same gross profit tax base as the typical consumer VAT. Thus, while the ability to border adjust the business VAT -- particularly for exports -- can be debated, it is certainly a sufficiently plausible proposition to warrant further investigation with the positive expectations (i) that there would be no clearcut bar against it, and (ii) that, as a practical matter, our trading partners would not challenge it.

Possibility of a Uniform Business Tax

That Is Integrated and Border-Adjustable

At this point, I suggest that in the United States we now put behind us both the idea and the terminology of a "VAT" and use what we have learned from years of debate to construct a fully integrated border-adjustable tax system that is more congenial with our own circumstances in the 1990s.

Although many major structural aspects, as well as numerous details, remain to be worked out, such an integrated Uniform Business Tax (UBT) might operate approximately, as follows:

1. A low rate flat tax would be imposed on the gross profit of each incorporated and unincorporated business. A corresponding tax would be imposed on imports. The tax would be rebated on exports.

2. The UBT would replace the corporate income tax and the individual income tax as applied to unincorporated businesses.

3. Because the UBT tax base would consist of three "conduit" items (wages and interest plus the return to equity after paying those two costs out of gross profits), the UBT would be treated as a pre-paid withholding tax for employees, lenders, and shareholders (or the owners of unincorporated businesses). The cost of integrating the business and individual taxes would be paid for by the revenues from the import tax.

4. Because the UBT would replace nearly all the complex provisions of the present income tax, the underlying tax on individuals would become primarily a tax on gross wages, gross interest, and gross dividends plus comparable amounts paid to themselves by the owners of unincorporated businesses.

5. The underlying individual income tax could be made progressive with rates going up to, say, 25 or 30 percent. Only those individuals in tax rate brackets higher than the UBT rate would pay taxes in addition to the pre-paid withheld amounts.

From the standpoint of corporations, the overall result of the UBT should be similar to repeal of the corporate income tax and the imposition of withholding taxes on interest and dividends. We already have withholding on wages. Depending on the rate of tax under the UBT, which might range from 5 to 15 percent, payroll taxes might also be reduced, the tax rates for the underlying individual tax might be lower than suggested, or alternatively, there might be border tax revenues left over for deficit reduction.

Conclusion

At the bottom line, the UBT is a type of cash flow tax. Former CEA Chairman, Martin Feldstein, and others have recently suggested cash flow taxes. As long ago as 1977, in Blueprints for Tax Reform, the Treasury Department discussed a type of cash flow taxation. In academic writings prior to his appointment to serve as the Treasury Department's Deputy Assistant Secretary for Tax Policy, Michael J. Graetz suggested an integrated cash flow tax where the corporation would be treated as a conduit for both interest and dividends.

Except for the particular approach to integration where the corporation would be treated as a conduit for wages, as well as interest and dividends, and except to point out the analogy to the gross profit tax base of a VAT and the potential for border tax adjustments, the UBT is not a new idea. Even the border tax adjustments were contained in the Business Transfer Tax introduced by Senator Roth as S. 1102 in 1985.

What is new is the fact that various longstanding pressures -- the need to expand the tax base, concerns about international competitiveness, concerns about debt vs. equity, concerns about the increased cost of capital in the United States after the Tax Reform Act of 1986, and concerns about the ability of our complex income tax to continue to function -- all are about to converge on some major overhaul of the U.S. tax system. The outcome could be good or bad.

The integrated Uniform Business Tax is better than many alternatives. It is also better than continuing to divert ourselves by largely pointless arguments about something called a VAT.

This article is adapted from the author's presentation to Tax Executives Institute's 1989 Annual Conference in Toronto, Ontario. The October 18, 1989, presentation was made to a joint session of the Institute's Canadian Commodity Tax Committee and its Consumption Tax Committee. The views expressed in the article are those of the author and should not be construed to necessarily be those of Tax Executives Institute.

Ernest S. Christian., Jr. is a partner in the Washington, D.C., law firm of Patton, Boggs & Blow. He was formerly the Deputy Assistant Secretary of the Treasury for Tax Policy and the Tax Legislative Counsel of the Treasury. Mr. Christian is a member of the American Law Institute, the American College of Tax Counsel, and the Section of Taxation of the American Bar Association. He serves on the Boards of Directors of the National Tax Association-Tax Institute of America, the Institute for Research on the Economics of Taxation, and the American Council for Capital Formation.