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The value-added tax.

Is it a reasonable alternative to raise federal revenue ?

The value-added tax (VAT) is viewed widely as a panacea for much-needed deficit reduction and revenue generation in the United States. The popular argument is the VAT is a relatively painless tax, since consumers may not know the amount of tax they actually are paying. The VAT also is viewed as

* A tax that does not affect business profits.

* A tremendous revenue raiser with relatively low rates.

* A self-enforcing collection process.

* An encouragement to save.

* A textbook answer to the nation's balance-of-payments problem.

In addition to raising revenue, tax policy also must satisfy a nation's social, economic and political aims. The pros and cons of a VAT can be debated at length in these terms. In his landmark work, The Wealth of Nations, Adam Smith outlined five characteristics of a "good tax": equity, neutrality, certainty, economy and simplicity (see the sidebar on page 47 for more complete definitions). For a tax to be "good" it should meet one or more of Smith's five characteristics or be desirable in terms of one of the three aims listed above.

Should the United States adopt a VAT? Within the framework of these eight characteristics and aims, this article will examine this question to determine if a VAT is a logical solution to the nation's economic and budget woes.

COMPUTING THE VAT

As the name implies, a VAT is a tax on the value added at each stage of a product's production, distribution or retail sale. In its most common form, it simply is the tax on a company's sales minus the tax paid on the company's purchases. This is the credit (invoice) method of computing the VAT. (See the exhibit on page 48, for a Treasury Department description of three methods of computing VAT.)

The subtraction method VAT creates fewer administrative burdens for both government and taxpayers since information to compute it already is available on businesses' federal income tax returns. This method, however, would be difficult to administer if Congress created many different tax rates and exempted or zero-rated goods or businesses.

Under the addition method, a company's VAT base is primarily untaxed inputs (wages, salaries, depreciation, profit and interest). The base is simply multiplied by the tax rate. Most countries do not consider this method as an alternative; the European Community (E C) requires use of the invoice method.

Given the need for flexibility in administering any tax, some experts consider the credit method the best for the United States.

There are three methods of treating VAT paid on capital purchases:

* Consumption method. Gross purchases are added to all other inputs.

* Income method. The VAT paid is amortized.

* Gross product method. No deduction is permitted for VAT paid.

The consumption method is most common and also considered best for the United States.

VAT-HISTORY AND CURRENT STATUS

The VAT is a multistage tax; the retail sales tax is a single-stage tax. Many European countries have had one of these taxes for many years. Even before the first VAT (in France in 1954) European countries had a "turnover tax" on each stage of a product's production. In the late 1960s, other countries joined the VAT movement: Denmark, 1967; Germany, 1968; and the Netherlands, Belgium and Sweden, 1969. Today all 12 members have a VAT as part of their tax system.

The Organization for Economic Coordination and Development (OECD) includes 17 European countries, Japan, Turkey, New Zealand, Australia, Canada and the United States. Of these 23 nations, at least 19 use a form of VAT. The latest countries to join the ranks were Japan in 1989 and Canada in 1990. The credit method currently is used by 18 of the 19 OECD nations that have a VAT.

In the United States, the VAT has been discussed at the national level since President Richard Nixon's Task Force on Business Taxation proposed a VAT as a corporate income tax alternative. In the late 1970s, Congressman Al Ullman proposed a VAT as part of the Tax Restructuring Act of 1980. In 1984 the Treasury Department released Treasury I, a study suggesting a VAT could reduce income tax rates and increase the potential for savings and investment. Two states, Michigan and Louisiana, currently have a VAT. Michigan had a VAT from 1953 to 1967 and again from 1976 to the present. Louisiana has a modified VAT.

MAJOR CONCERNS ABOUT A VAT

Assuming the United States adopts the credit method of computing VAT and a consumption VAT for capital asset transfers, a number of major concerns arise about their implementation in the U.S. economy.

Regressiveness. The VAT's burden is borne 100% by the final consumer. Thus, the greater the amount consumed relative to income, the greater the tax burden. The poor, retirees and young couples earn less and consume a greater portion of their incomes. This creates an equity (ability-to-pay) problem in a nation where a tax's progressiveness historically has been a concern. Some economists argue a VAT is regressive only on an annual basis. Over a lifetime, the tax is not regressive since consumption is proportional to lifetime income. However, income taxes in the United States are pay-as-you-go and not based on lifetime income.

Four policy options can mitigate regressivity:

* Exemptions or zero-ratings. Exempted businesses or the goods they sell--for example, bank and insurance services-- collect no taxes on sales but get no credit for taxes paid on purchases (inputs). Zero-rated businesses or the goods they sell--for example, food, medical care and exports---Collect no taxes on sales but may claim a refund for taxes paid on purchases.

* Multiple VAT rates (lowest rate for necessities and higher rates for other goods or services).

* Increased government transfer payments (food stamps, Supplemental Security Income).

* Tax credits (including state credits for sales tax on essential purchases and the federal earned income credit).

EC economists agree the regressivity gains from exemptions and zero-rated items do not outweigh the disadvantages of increased administrative and compliance costs. Multiple rates tend to distort consumption in ways that circumvent the normal selection process for both higher- and lower-rated goods. Most poor taxpayers, retirees and young couples do not receive government transfer payments and would not benefit from an increase in the amount of such payments.

Refundable credits at the state level and the federal earned income credit often go unfiled for or unclaimed by the poor. This suggests exempting food, housing and medical costs directly would be better than offering credits; over half the states do this now. The regressivity mitigators suggested above would, however, be difficult to implement and administratively costly. (Exemptions or zero-rated goods make businesses' compliance costs extremely high and could be an audit nightmare for the Internal Revenue Service.)

Administrative costs. Many economists argue VAT administrative costs per dollar of revenue are less in European countries than the cost of raising the same revenue with an income tax. However, the United States has had an income tax system since 1913, and many European countries have had sophisticated VAT systems for nearly 30 years. It would be many years before the United States could collect VAT as "efficiently" as it collects income taxes. In fact, U.S. VAT administrative costs are estimated at over $1 billion and would require hiring some 21,000 new IRS employees.

Inflationary woes. Since a VAT is passed on to the consumer, it is inherently inflationary; that is, the price of goods increases by the VAT amount. But proponents suggest a VAT's impact on inflation is a one-time-only effect. In most EC countries, monetary policy minimized inflationary trends after the first year. The same would be expected to be true in the United States. However, in the heavily unionized U.S. economy, consumers appear more conscious of price increases and many labor contracts are tied to the consumer price index.

Money machine fears. Government's size is a major concern for many Americans. Researchers estimate a VAT would raise $25 billion per percentage point of tax (for example, a 5% VAT would yield $125 billion in revenue). This revenue-raising potential causes many to fear putting a "money machine'' in Congress's hands. Some say the corporate income tax should be lowered (but no country with a VAT has done this), others say some of the funds should be earmarked for reducing the national debt and still others say Congress should not have the power to make the public sector any larger than it already is.

Neutrality. A tax generally is preferred if it is neutral that is, the tax does not affect economic decisions. A VAT would be neutral on

* Forms of doing business.

* Labor vs. capital, since capital is treated as an input.

* Debt vs. equity financing.

* Savings vs. consumption, since savings are not taxed until consumed. (An income tax taxes savings twice, thus favoring consumption. )

Businesses not in a position to pass on a VAT completely to the ultimate consumer will be disadvantaged. For example, startup businesses (such as auto dealerships and small retail shops) and businesses operating in highly competitive industries (such as computer hardware and software, electron* ics, furniture, etc.) may be put out of business if they have to absorb some or all of a VAT. Often, such businesses are operating on such a close profit margin that the addition of a 10% VAT (that can't be passed on) might put them out of business. Other businesses may be able to survive the new tax burden until some or all of it can be passed on to the consumer.

Although attitudes in the United States such as "what is good for business is good for the economy as a whole" may not be as prevalent as they once were, few Americans would want to see companies pushed out by the adoption of a VAT.

Another concern is the disadvantage to service industries. The primary input in their cost of goods sold is labor, which would make their VAT pass-on to the consumer higher. This can lead to increased unemployment if companies reduce hiring.

A politically attractive hidden tax. Unlike the retail sales tax, a VAT probably would not be listed separately on a consumer's final sales invoice. However, listing it would be crucial to intermediate producers and wholesalers to help them calculate and document taxes paid on inputs and take credits for VAT paid. Some suggest not revealing the tax to the consumer would help government increase revenue with less public resistance.

Replacing the corporate income tax. While a 5% VAT could certainly replace corporate income tax revenue, no country has done this. In addition, the corporate income tax has built-in countercyclical elements (including net operating losses, credit carryovers, etc.) to aid businesses in economic downturns and generally collects more revenue in times of economic growth. A VAT has no pity on businesses during economic downturns.

State and local government encroachment. A U.S. VAT likely would include numerous zero-rated and exempt goods. The District of Columbia and 45 states have a retail sales tax, and 2 have a VAT. Forcing businesses to integrate a VAT into their accounting records would be a major encroachment on state taxation. States have long argued the retail level is their territory. No state has ever piggy-backed using the same base for federal and state tax collection--any tax to the federal base.

Balance of payments help. Currently, all VAT countries zero-rate exports but add the VAT to imports. Since the corporate income tax is a direct tax (borne by the corporation), it does not qualify for zerorating (exports) or adding (imports). Replacing the corporate income tax with a VAT would not make U.S. companies more competitive in world markets. The U.S. exporter simply would be receiving a rebate of VAT paid on goods produced for export. The corporate income tax is assumed to be borne by the corporation, as opposed to being added to the price of the goods, and therefore is not part of the argument. Even ira VAT resulted in trade advantages, floating exchange rates quickly would level any positive effects.

Savings rate effects. There is considerable disagreement on whether a VAT has a positive impact on the savings rate. A VAT taxes savings only once; therefore, the taxpayer's rate of return is higher. But, the higher the return on savings, the less a person must save to reach a predetermined goal (income effect). In addition, as the savings rate of return increases, some consumers save today to enable them to consume at a greater rate in the future (substitution effect). These conflicting effects are said to have very little impact on the overall savings rate.

Working capital needs increase. A company pays the VAT as it purchases production inputs. However, the company must wait until the produced goods are sold and accounts receivable are settled before it collects the VAT. In the meantime, the company may have to remit the VAT to the government. This creates a "float," the cost of which the company is likely to pass on in the price of goods sold.

Another problem affecting working capital is filing for credits, A company may have to file for a VAT refund if taxes on inputs exceed taxes collected on sales. This may occur when

* The company has a great deal of exports.

* The company is a start-up business with few sales and many normal and capital asset purchases.

* The company has a great deal of capital expansion. When a company is due a refund, it must finance the float until the government processes, reviews or audits and pays over the refund. This can be a tremendous hardship.

NEW REVENUE SOURCES

Given the current tax climate on Capitol Hill and the administration's attitude about new taxes, the chances of a big change in tax revenue sources seem slight. Before 1990, the Graham-Rudman-Hollings deficit reduction bill required Congress to reach specific budget deficit targets by given dates or there would be an across-the-board budget cut. Even though the Omnibus Budget Reconciliation Act of 1990 revised these budget and spending limits to such an extent that across-the-board spending cuts are virtually impossible, the pressure is still on Congress to raise revenue; the deficit for the fiscal year ending 1992 is projected to be near $250 billion. Additionally, since the national debt has risen to $4.14 trillion from a 1980 mark of $900 billion, it is clear the government has high spending tastes. To satisfy these tastes it must have additional revenue sources.

* THE SUCCESS OF the value-added tax (VAT) in European countries has convinced many that it could be a viable solution to relieve federal budget woes in the United States. But questions still linger.

* A VAT is a tax on the value added at each stage of production, distribution or retail sale. The credit (invoice) method of computing the VAT is generally considered the most appropriate for the United States.

* AMONG THE MOST important concerns about a VAT is its regressivity. Because the final consumer pays 100% of the tax, the poor, the elderly and young couples, who consume a greater portion of their incomes, will bear much of the burden.

* OTHER CONCERNS ABOUT implementing a VAT in the United States include administrative costs (and the need for more IRS personnel), the fear Congress would turn it into a "money machine" and general concerns about its effect on the overall economic and business climate.

* A VAT WAS under consideration in the United States as far back as the Nixon administration. Today, with the addition of new taxes unlikely, few are convinced a VAT would address all of the concerns any new revenue source must satisfy.

ADAM SMITH'S CHARACTERISTICS OF A "GOOD TAX"

1. Equity. The tax is fair. To be fair, the tax must be relatively equal (horizontal equity) within taxpayer income classes or economic situations and different for taxpayers who are not in the same income class or economic situation.

2. Neutrality. The tax advances a goal when appropriate but is neutral otherwise. To be neutral, a tax must not favor certain industries, transactions or entities.

3. Certainty. The tax is not arbitrary. Rules are specifically provided that include methods of reporting, due dates, appeals procedures, etc.

4. Economy. The tax can be administered by the government and complied with by the taxpayer at low cost.

5. Simplicity. The tax is relatively simple for the taxpayer to comply with and for the government to administer.

Comparison of three methods of calculating value-added tax liability (10% VAT)
 Stage of production
 Company A Company B Company C Total
 manufacturer wholesaler retailer economy
1. Credit method
Sales $350 $850 $1,100 $2,300
Tax on sales 35 85 110 230
Purchases 100 350 850 1,300
Tax on purchases (1O) (35) (85) (130)
Value-added tax (tax on
sales less tax on
purchases) $ 25 $ 50 $ 25 $ 100
2. Subtraction method
Sales $350 $850 $1,100 $2,300
Purchases (100) (350) (850) (1,300)
Value added (sales
purchases) 250 500 250 1,000
Value-added tax $ 25 $ 50 $ 25 $ 100
3. Addition method
Factor payments plus
net profit
Wages $150 $300 $200 $ 650
Rent 50 100 20 170
Interest 25 75 20 120
Profit 25 25 10 60
Total 250 500 250 1,000
Value-added tax $ 25 $ 50 $ 25 $ 100
 Source: U.S. Treasury Department, Tax Reform for
Fairness, Simplicity, and Economic Growth (Washington,
D.C.: USTD, November 1984), 3:9.


CHARLES E. PRICE, CPA, PhD, is assistant professor of accountancy, Auburn University, Auburn, Alabama. He is a member of the American Institute of CPAs, the Alabama Society of CPAs and the American Accounting Association. THOMAS M. PORCANO, CPA, DBA, is Arthur Andersen & Co. Alumni Professor of Accountancy at Miami University, Oxford, Ohio. He is a member of the AICPA and the AAA.
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:as technique for federal deficit reduction
Author:Porcano, Thomas M.
Publication:Journal of Accountancy
Date:Oct 1, 1992
Words:2955
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