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A value-added tax and state and local governments: lessons from Canada.

Recently there has been increased interest in the United States in consumption taxation. Among the reasons for discussions of this revenue option are the potential additional revenues a new consumption tax could produce for deficit reduction purposes and the possibility of using a value-added tax (VAT), one form of consumption tax, to pay for health care reform. During the GFOA annual conference in Vancouver, B.C., the Committee on Governmental Debt and Fiscal Policy addressed this timely issue by inviting Hugh Creighton, deputy director of finance for Vancouver, to discuss the Canadian experience with a consumption tax and, in particular, the tax treatment of local governments under the Canadian Goods and Services Tax (GST).

To start, it should be clarified that consumption taxes take many forms. This broad category includes not only value-added taxes but also retail sales taxes, specific commodity or excise taxes, business transfer taxes and the much-maligned Btu energy tax proposed by President Clinton but dropped in favor of an increase in the transportation fuels tax in the final version of the Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66). In general, consumption taxes are levied on a taxpayer's expenditures for goods and services rather than on total income.

During the 1993 annual conference, GFOA members clarified and updated GFOA's public policy position on consumption taxes. The membership supported the exemption of state and local governments from federal consumption taxes. This position reaffirms the GFOA's long-standing support for intergovernmental tax immunity.

While many of the members of the GFOA Committee on Governmental Debt and Fiscal Policy did not think the adoption of a value-added tax was imminent, they did agree that GFOA should continue to study the issue. This article provides a brief overview of value-added taxation and the Canadian value-added tax, with special emphasis on Canadian local government experience with the GST.

Types of VATs

To those who have never traveled or lived outside the United States, the VAT concept may seem entirely foreign. In part, what makes this form of taxation so mysterious is the terminology used to describe it. In general, a VAT is a tax on the estimated market value added to a product or material at each stage of its manufacture or distribution. The main differences between the three types of VAT, which are described below, relate to the treatment of capital expenditures made by the firms that are involved in the production and distribution of goods and services subject to taxation.

Gross-product VAT. To calculate the tax, each firm in the production and distribution process deducts its raw material purchases, but not capital equipment purchases, from its total sales and applies the tax rate to this base.

Income-type VAT. Calculation of the tax owed is basically the same as the gross-product VAT, except that depreciation on the capital goods also is deducted from total sales.

Consumption-style VAT. This VAT, which is the most commonly used, is a multi-stage sales tax. It permits the deduction of all business purchases so that no distinction is made between capital and current expenditures and so that no depreciation calculations are required.

The tax liability under a consumption-style VAT may be calculated using one of three methods.

* Addition method: A firm calculates its tax base by adding wages paid, rent, interest expense and profit.

* Subtraction method: The value added is presumed to be equal to sales minus purchases. The tax is calculated once during the reporting period by multiplying the tax rate by the total value of sales minus the total value of purchases. Since the taxpayer can rely on its book of accounts, no additional invoices or other records are required for tax compliance purposes.

* Tax credit method: Again, the value added is presumed to equal sales minus purchases; however, the tax is calculated for each individual transaction. The tax rate is applied to the price charged for a good or service and is printed on the sales receipt or purchase invoice, and a tax credit is taken for all taxes previously paid on purchases.

Features of VATs

There are various design features of a VAT that permit certain policy objectives to be achieved. For example, a VAT can be imposed either at the point of sale or where the value is added. Under the so-called "destination principle," a good or service is taxed where sold and is presumed consumed. If the "origin principle" is applied, the good or service is taxed where value is added, and the tax is not visible to the ultimate consumer.

Another important feature of the tax is the determination of the tax base. If the tax-inclusive basis is used, the tax rate is applied to both the base price of the good or service plus the tax already paid at other levels of production and distribution. The tax-exclusive method applies the tax to the base price only.

An accounts-based VAT is one where the taxpayer calculates his tax liability from his book of accounts records providing information about total sales and purchases. Under an invoice-based VAT, purchases and the tax shown on the sale invoices are used to calculate tax liability.

In order to mitigate the economic effects of VATs, several methods have been employed. One frequently used option is to exempt certain firms or sectors. If a firm or sector is exempt, it does not have to collect any tax or turn over any revenue to the government. Exemption does not mean, however, that the exempt firm or sector will receive a rebate on value-added taxes paid on its purchases from other firms. Exemptions often are provided where it is difficult to calculate the value added by the firm or sector, such as in the financial sector and the government sector.

Another option is to "zero-rate" a good or service, which eliminates any VAT paid from the price of a good or service. Taxpayers who consume zero-rated goods or services must continue to register with the tax authority and file a return. Zero-rating is commonly used for exports.

Sometimes different tax rates have been employed on various goods and services. Multiple rates are used to offset the regressivity of the tax. For example, household goods are likely to have a lower rate in a multiple-rate system.

Canada's GST

The GST came into effect in 1991 as a substitute for a federal manufacturer's sales tax and in conjunction with overall tax reform and the lowering of income tax rates. It is a single-rate (7 percent), consumption-based VAT that employs the tax-credit method to calculate the tax. Although the tax is calculated using the tax-credit method, sellers are not required to issue invoices with the tax stated on the invoice. The common practice, however, is to identify the GST on the invoice, as this allows the purchaser to identify the GST component of their inputs and to claim the Input Tax Credit at time of purchase. Instead, sellers must attest to their purchasers that their GST liability has been paid. Purchasers must retain records of taxes paid on purchases in order to be eligible for a credit. Taxes are only due on the sales price of the good or service. The tax is owed by the purchaser, and the seller acts as the collecting agent. Exhibit 1 demonstrates the mechanics of the tax.

Some of Canada's methods to modify the impact of the tax are listed below.

Exemptions. The following goods and services are exempt from the GST: certain real property transactions, health care and educational services, child care, legal aid, goods and services supplied by governments and charitable organizations, and financial services.

Zero-rated Goods and Services. A zero rate is provided for prescription drugs, medical devices, basic groceries, exports and international transportation.

Rebates and Special Treatment. Partial rebates on taxes are given to certain sectors, and special treatment is accorded to the MUSH sector--municipalities, universities, schools and hospitals.

One of the interesting policy issues faced in Canada revolved around negotiations on the tax treatment of local governments under the new federal VAT. Local taxpayers are not required to pay the GST due to the difficulties involved in assigning a "price" for governmental services. Instead, the local government is treated as the ultimate consumer of its own services and the tax is applied accordingly on the government. Before selecting this method, two others were considered: 1) to levy the federal VAT on local property taxes or 2) to have the local government itself assess the value of its services, pay the tax and collect the tax from the public.

Representatives of local governments successfully sought a rebate for a portion of the taxes they paid. It was noted that the complexity involved in obtaining a rebate is "horrendous" because of the administrative burden.

Other Tax Policy Issues

The most frequently cited intergovernmental impact of VATs is the concern that a federal VAT will make it more difficult to increase sales taxes at the state and local levels. Other considerations include state and local officials' fear that they will be pressured to alter their tax base to conform with the federal tax base and that there will be an increase in tax evasion because of the high combined rate of taxation at the retail level.

These issues are indeed important, but they tend to overshadow some of the basic design problems and impacts of a VAT on local governments. As the Canadian experience illustrates, the potential for complexity and administrative burdens should be a primary concern for state and local governments in a nation that has not yet imposed a VAT.

Author CATHY SPAIN is director of GFOA's Federal Liaison Center.
COPYRIGHT 1993 Government Finance Officers Association
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Spain, Cathy
Publication:Government Finance Review
Date:Oct 1, 1993
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