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Annette Nellen
Annette Nellen

VAT Lessons for U.S. Tax Reform

What VAT lessons did the House Ways and Means Committee learn from a recent tax reform hearing?

August 25, 2011
by Annette Nellen, CPA, Esq.

Key lessons:

  1. If the U.S. pursues a national value-added tax (VAT), we can learn a lot from the over 130 countries that already use a VAT.
  2. Tax reform isn't easy.

Since its inception in January 2011, the 112th Congress has held more than 15 hearings on various aspects of tax reform. Topics covered include changes since the Tax Reform Act of 1986, job creation, burdens on families and individuals, administrative practices, international taxation and competitiveness, small business concerns and the tax gap.
A July 26 Ways and Means Committee hearing focused on consumption-based tax systems. Although there are a few different formulations for a consumption tax, the committee only addressed two — the "fair tax" (a national retail sales tax) and the VAT. Witnesses included those supporting and opposing these tax schemes.

This article focuses on the July 2011 testimony of the Government Accountability Office (GAO) on the VAT. This testimony was primarily based on a 2008 GAO study of how the VAT operates in the following five countries: Australia, Canada, France, New Zealand and the United Kingdom (U.K.). Selected observations made at the hearing about the VAT are also noted. Commentary is offered on the relevance of the hearing. The discussion starts with some comparative tax data of a few industrialized countries

A brief overview from the author of consumption taxes and how a VAT works is available here.

National Tax Mixes

The U.S. is an outlier when it comes to VAT. Over 130 countries including all industrialized countries (other than the U.S.) use a VAT at the national level. While the U.S. does not have a VAT, almost all states have a retail sales tax that has some similarities with a VAT.

Data for 2008 from the Organisation for Economic Co-operation and Development (OECD) on the tax mix and tax as a percentage of gross domestic product (GDP) in selected countries follows (OECD Tax Database).

Purpose Percent of total tax revenues from: Total tax revenues as a percent of GDP
Goods & services tax Income & profits tax Social Security tax
Image of National Flag Australia 27.4 59.3 27.1
Image of National Flag Canada 23.6 49.1 14.7 31.1
Image of National Flag France 24.5 24.1 37.2 43.2
Image of National Flag Germany 28.5 31.1 37.6 37.0
Image of National Flag Ireland 37.1 37.6 17.7 28.8
Image of National Flag Japan 18.0 33.7 38.6 28.1
Image of National Flag New Zealand 33.8 60.4 33.7
Image of Union Flag & Naval Jack U.K. 28.8 40.0 19.0 35.7
Image of National Flag U.S. 17.6 45.2 25.1 26.1

The absence of a VAT at the federal level in the U.S. makes consumption taxes less significant in terms of overall tax collections. Another difference that stands out is that in the U.S., taxes represent a smaller portion of GDP than in several other OECD countries. This and related data is useful in comparing tax systems of different countries. For example, the greater reliance on a federal VAT in other countries may make it easier to have a lower corporate income tax rate.

GAO VAT Report

The review of VAT in a few other countries highlighted some operational, administrative and compliance problems that can exist with a VAT. The GAO notes that just like other taxes, a VAT poses "compliance risks, administrative costs and compliance burden that increase with the complexity of the design."

See table from the GAO testimony highlights key compliance risks.

Audit activity is necessary to lessen the compliance risks. Yet, data from the U.K. suggests that administrative costs are likely lower for a VAT compared to an income tax. The U.K. determined the following administrative costs in terms of revenues collected:

VAT 0.50 percent
Income tax 1.25 percent

New Zealand's tax agency determined that while a quarter (25 percent) of income tax returns has errors, only three percent of VAT returns have errors.

Compliance costs tend to vary by business size. The GAO notes that in Canada, New Zealand and the U.K., compliance costs as a percentage of sales are about two percent for businesses with less than $50,000 of sales, but only 0.04 percent for those with over $1 million of sales.

As with the U.S. income tax, complexity exists in VAT systems studied due to the use of exemptions, exclusions and reduced rates. Additional complexity was found in Canada due to the need to coordinate the national VAT with that of some of the provinces. The GAO found that the degree of complexity depended on the type of coordination used in the province.

Finally, the GAO reported that "considerable resources" were needed to implement the VATs in Australia, Canada and New Zealand, each of which has a fairly new VAT relative to other countries. Implementation took 15 month to 24 months and the tax agency had to establish significant education efforts.

Observations of Witnesses

Written and oral testimony of the witnesses addressing a potential U.S. VAT covered many topics including the history of the U.S. income tax, design options, problems with the income tax and how a VAT might (or should not) fit into U.S. tax reform. A few observations from witnesses are noted below to illustrate the range of factors to consider in determining whether to implement a VAT in the U.S.

General observations:

  • The income tax has become too complex due to the numerous and often redundant special deductions, exclusions and credits. This could also be a problem for any tax, if elected officials try to make the tax do more than raise revenue.
  • A "VAT’s economic effects depend critically on key design issues and how VAT revenue is used." (Carroll (PDF))
  • Given that over 130 countries use a VAT, we can learn from other countries.

Advantages:

  • As a longstanding tax in the world, a VAT is a better consumption tax model than the flat tax or fair tax that have not been tested elsewhere. (Graetz (PDF))
  • VAT revenue can be used to remove most individuals from the income tax and lower the corporate rate. (Graetz (PDF))
  • All forms of businesses are subject to VAT in the same way.
  • A VAT is border-adjustable in that it is imposed on imports, but not exports. Some argue though that this does not necessarily help the balance of trade, due to price adjustments.
  • The VAT can generate revenue to help address deficit problems.
  • Compared to increasing income tax rates, a "VAT is an efficient revenue raiser that is likely to be significantly less damaging to economic growth." (Dr. Altshuler (PDF))
  • If people know in advance and the VAT is phased in, it "might stimulate the economy by encouraging consumption in anticipation of the imposition." (Dr. Altshuler (PDF))
  • A "properly designed VAT may actually help force [states] to redesign or improve their retail sales taxes." (Altshuler (PDF))

Disadvantage:

  • The VAT is regressive.
  • The VAT taxes labor.
  • Coordination with state sales tax systems would be needed.
  • A VAT rate increase can easily generate revenues that can lead to excess spending. "Politicians are attracted to the VAT because it is capable of raising enormous amounts of revenue." (Mitchell (PDF))

Commentary

The fact that the House Ways and Means Committee included consumption taxes in its set of tax reform hearings indicates an interest in looking broadly at reform. However, they omitted the flat tax of Drs. Hall and Rabushka and the consumed income tax which calls for individuals to measure consumption as "income less savings," with a progressive rate structure possible. Perhaps the committee limited its discussion to the fair tax and VAT because they would be suitable to add to an income tax rather than be a replacement tax (while "fair tax" advocates call for it to replace the income and payroll taxes, it could also be added to the current mix of federal taxes).

While problems were noted with our current income tax, many of these problems, such as complexity, using the tax for more than raising revenue, inequities, inefficiencies, a tax gap and an outdated international tax design, are not unique or inherent to an income tax. Politicians built them into the system, which means they could be built into a consumption tax as well.

Finally, discussion is needed on the goals for tax reform as that will help to determine whether a consumption tax should be added or if reforming the income tax will be sufficient. Better identification of goals will aid in the design for how international transactions are taxed, how labor and capital are taxed and how the system can operate to support the country's economic, societal and environmental goals.

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. Nellen is an active member of the tax sections of the AICPA, ABA and California State Bar. She chairs the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.