Order Code IB91078
CRS Issue Brief for Congress
Received through the CRS Web
Value-Added Tax as a
New Revenue Source
Updated August 4, 2003
James M. Bickley
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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CONTENTS
SUMMARY
MOST RECENT DEVELOPMENTS
BACKGROUND AND ANALYSIS
Revenue Yield
International Comparison of Composition of Taxes
Vertical Equity
Neutrality
Inflation
Balance-of-Trade
National Saving
Administrative Cost
Intergovernmental Relations
Size of Government
LEGISLATION
FOR ADDITIONAL READING
CRS Products

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Value-Added Tax as a New Revenue Source
SUMMARY
Some Members of Congress have ex-
pletely, neutral tax. A VAT cannot be levied
pressed interest in the feasibility of using a
on all goods; consequently, a VAT would
value-added tax (VAT) to either replace all or
raise the prices of taxed goods relative to
part of the income tax, finance health care
untaxed goods. This change in relative prices
reform, or to fund America’s war effort. A
would distort households’ choices among
VAT is imposed at all levels of production on
goods. A VAT cannot be levied on leisure;
the differences between firms’ sales and their
consequently, a VAT would affect house-
purchases from all other firms. Policymakers
holds’ decisions concerning work versus
may be interested in the following aspects of
leisure.
a VAT: revenue yield, international compari-
son of composition of taxes, vertical equity,
The imposition of a VAT would cause a
neutrality, inflation, balance-of-trade, national
one-time increase in this country’s price level.
saving, administrative cost, intergovernmental
But a VAT would not affect this country’s
relations, size of government, and public
future rate of inflation if the Federal Reserve
opinion.
offset the contractionary effects of a VAT
with a more expansionary monetary policy. If
For FY2000 a broad-based VAT would
the United States continued its policy of
have raised net revenue of approximately
flexible exchange rates, then the imposition of
$37.8 billion for each 1% levied. Most other
a VAT would not significantly affect the U.S.
developed nations rely more for revenue on
balance-of-trade. There is no conclusive
broad-based consumption taxes than does the
evidence that a VAT would increase the rate
United States. A VAT is shifted onto con-
of national saving more than another type of
sumers and, consequently, is regressive be-
major tax increase.
cause lower-income households spend a
greater proportion of their incomes on con-
The high revenue yield from a VAT
sumption than higher-income households.
would cause administrative costs to be low
This regression could be reduced or even
measured as a percentage of revenue yield. A
eliminated by any of three methods: a refund-
federal VAT would encroach on the primary
able credit against income tax liability for
source of state revenue, the sales tax. But
VAT paid, allocation of some of VAT revenue
precedents exist for the federal government to
for increased welfare spending, or selective
levy a tax that some states have already im-
exclusion of some goods from taxation.
posed. A federal-state VAT could be col-
lected jointly, but a state would lose some of
From an economic perspective, a major
its fiscal discretion. The hypothesis that a
revenue source is better the greater its neutral-
federal VAT would increase the size of the
ity, that is, the less the tax alters economic
U.S. government has not been proven empiri-
decisions. A VAT is a relatively, but not com-
cally.
Congressional Research Service ˜ The Library of Congress

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MOST RECENT DEVELOPMENTS
On July 31, 2003, Senator George Voinovich, the chairman of a Senate GOP working
group on fundamental tax reform, said that the group initially is focusing on tax code
simplification issues. He stated that later he hoped the group would explore the larger
question of whether the federal government should shift from an income tax system to a
consumption tax system.
BACKGROUND AND ANALYSIS
Proposals to replace all or part of the income tax system with a consumption tax and
proposals for national health care have caused Members of Congress to consider different
tax options that would yield large amounts of revenue. The value-added tax (VAT), a
broad-based consumption tax, is the subject of congressional interest.
The value-added of a firm is the difference between that firm’s sales and its purchases
from all other firms. A VAT is levied on firms’ value added at all stages of production. For
FY2000, a VAT imposed on most goods and services could have raised a net revenue of
approximately $37.8 billion for each 1% rate levied.
Aspects of a VAT that often raise interest or concern include revenue yield,
international comparison of composition of taxes, administrative cost, vertical equity,
neutrality, inflation, balance-of-trade, national saving, administrative cost, intergovernmental
relations, and size of government. This issue brief considers the experiences of the 28
nations (out of 29 nations) with VATs in the Organization for Economic Cooperation and
Development (OECD) relevant to the feasibility and operation of a possible U.S. VAT. The
OECD consists of 21 European nations, Turkey, the United States, Canada, Australia, New
Zealand, Japan, Mexico, and South Korea.
Revenue Yield
The primary reason for considering a VAT for financing health care reform or replacing
all or part of our income tax system is its enormous revenue potential. Economists and
public officials use the operating assumption that a VAT would be fully shifted to final
consumers in the form of higher prices of goods. A VAT (or any other major tax increase)
would have a contractionary effect on the economy unless offset by other economic policies.
Consequently, the revenue estimates in this issue brief are made under the assumption that
the Federal Reserve would use an expansionary monetary policy to neutralize the
contractionary effects of a VAT. These revenue estimates also do not take into account the
possible shifts in consumption patterns that might be expected if some items are taxed and
others are excluded from taxation.
The potential revenue per 1.0% rate from a VAT would vary with the
comprehensiveness of the tax base. A broad-based VAT would have limited exclusions,
while a narrow-based VAT would have numerous exclusions. Obviously, the broader the
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tax base, the lower the tax rate necessary to raise a given amount of revenue. Furthermore,
the broader the VAT base, the more efficient the tax system. For fiscal year 2000, each 1.0%
rate for a VAT could have raised net revenue of approximately $37.8 billion with a broad
base and net revenue of approximately $20.0 billion with a narrow base.
International Comparison of Composition of Taxes
One argument frequently made for a U.S. VAT is the relative reliance on consumption
taxes in other developed countries. Most other developed nations do rely more on
consumption taxes. For 2000, for taxes on general consumption (e.g., VATs and sales
taxes), the United States had a lower reliance (7.5%) of total tax revenues than any other
OECD nation. Also for 2000, the United States’ (federal, state, and local governments)
general consumption taxes as a percentage of gross domestic product (2.2%) were lower than
any other nation in the OECD.
Vertical Equity
The vertical equity of a tax concerns the tax treatment of households with different
abilities-to-pay. Vertical equity may be affected by the measure of ability-to- pay and the tax
period. Some economists argue that personal consumption is the best measure of
ability-to-pay because consumption is the actual taking of scarce resources from the
economic system. The most common measure of ability-to-pay is still income. Proponents
of income as a measure of ability-to-pay argue that saving yields utility by providing
households with greater economic security.
Tax incidence usually is measured by using a one-year period. Data on consumption
and income are readily available in one-year increments and the concept of a one-year period
is easily understood. But some tax economists believe tax incidence is more accurately
determined by measuring consumption and income over a household’s lifetime.
If consumption is used as a measure of ability-to-pay, a single-rate VAT with a broad
base would be approximately proportional regardless of the time period. In other words, the
percentage of consumption paid in VAT by households would be approximately constant as
the level of household consumption rises.
If disposable income over a one-year period is the measure of ability-to-pay then a VAT
would be viewed as extremely regressive; that is, the percentage of disposable income paid
in VAT would decrease rapidly as disposable income increases. In most discussions of tax
policy, both a one-year period and annual disposable income (or some other annual income
measure) are used; consequently, the VAT is viewed as being extremely regressive.
If disposable income over a lifetime is the measure of ability-to-pay, a VAT would be
mildly regressive. For lower and middle income households, it appears that nearly all
savings are eventually consumed. Thus, it may be that for the vast majority of households,
lifetime consumption and lifetime income are approximately equal. High income households
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tend to have net savings over their lifetimes; consequently, they would pay a lower
proportion of their disposable incomes in VAT than lower income groups.
Some supporters of progressive taxation oppose the VAT primarily because they believe
that it is regressive. Some of these critics are especially concerned about the absolute burden
of a VAT on low income households. The degree of regressivity, however, can be reduced
by government policy. Three often-mentioned policies are exclusions and multiple rates,
income tax credits, and earmarking of some revenues for increased social spending
(including indexed transfer payments).
Neutrality
From an economic perspective, the greater a source of revenue’s neutrality, the more
it is generally preferred; that is, the less it affects economic decisions. Conceptually, a VAT
on all consumption expenditures with a single rate that is constant over time would be
relatively neutral compared to other major revenue sources.
For households, two out of three major decisions would not be altered by this
hypothetical VAT. First, this VAT would not alter choices among goods because all goods
would be taxed at the same rate. Thus, relative prices would not change. Second, a VAT
would not affect the saving-consumption decision because saving would only be taxed once;
that is, when savings are spent on consumption. But the third decision, a household’s
work-leisure decision, would be affected by a VAT. Leisure would not be taxed, but the
returns from work would be taxed when spent on goods. (In contrast, the income tax affects
both the saving-consumption decision and the work-leisure decision.)
For a firm, the VAT would not affect decisions concerning method of financing (debt
or equity), choice among inputs (unless some suppliers are exempt or zero-rated), type of
business organization (corporation, partnership, or sole proprietorship), and goods to
produce. Other types of taxes may affect one or more of these types of decisions.
But this conceptually pure form of a VAT is not feasible. A VAT cannot be levied on
all consumer goods; consequently, prices of taxed goods will rise relative to untaxed goods.
This change in relative prices would affect consumers’ decisions about which goods to
purchase, and, consequently, firms’ decisions about which goods to produce. Furthermore,
most nations with VATs have more than one rate. Multiple VAT rates alter relative prices
of taxed goods. Finally, VAT rates in most nations have tended to rise over time. Despite
these deviations from a pure form of VAT, a broad- based VAT is relatively neutral. This
neutrality is greater if the tax rate is relatively low, as could be the case for a VAT to reduce
the U.S. deficit.
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Inflation
A VAT initially would cause a one-time increase in the price level if the Federal
Reserve had an expansionary monetary policy to offset the contractionary effects of the tax.
For example, a 4% VAT on 75% of consumer outlays might cause an estimated increase in
consumer prices of approximately 3%.
A VAT would have some secondary price effects. Some goods would rise in price
because their factors of production, especially labor, are linked to price indexes. Yet, if the
Federal Reserve disregarded these secondary price increases in formulating monetary policy,
these secondary price increases would tend to be offset by price reductions in other sectors
of the economy. In summary, a VAT would probably cause a one-time increase in the price
level but not affect the rate of inflation, i.e., increased prices in the future.
Balance-of-Trade
Currently, all nations with VATs zero-rate exports and impose their VATs on imports.
This procedure for taxing trade flows is referred to as the destination principle because a
commodity is taxed at the location of consumption rather than production. The destination
principle creates a level playing field because imported commodities rise in price by the
percentage of the VAT, but exported commodities do not increase in price. For a particular
nation, the VAT rate on domestically produced and consumed products would be the same.
The VAT rate on a particular good would vary among nations.
With flexible exchange rates, the supply and demand for different currencies determine
their relative value. If a country has a deficit in its balance-of-trade, this deficit must
financed by a net importation of foreign capital. But net capital inflows cannot continue
indefinitely. Thus, over time, this country’s currency will tend to decline in value relative
to the currencies of other nations. Consequently, this country’s balance-of-trade deficit will
eventually decline as its exports rise and imports fall. Hence, economic theory indicated that
a VAT offers no advantage over other major taxes in reducing a deficit in the
balance-of-trade.
National Saving
If a VAT is levied to replace part of income tax revenue, what would be the effect on
the personal saving rate. A VAT taxes savings when they are spent on consumption,
allowing savings to compound at a pre-tax rate. But an income tax is levied on all income
at the time it is earned, regardless of whether the income is consumed or saved. The income
tax is also levied on the earnings from income saved. Consequently, some proponents of the
VAT have argued that choosing a VAT rather than an income tax to raise revenue would
increase the return from saving, and, consequently, raise the savings rate.
The rate of return on savings, however, has never been shown to have a significant
effect on the savings rate because of two conflicting effects. First, each dollar saved today
results in the possibility of a higher amount of consumption in the future. This relative
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increase in the return from saving causes a household to want to substitute saving for
consumption out of current income (substitution effect). But a higher rate of return on
savings raises a household’s income; consequently, the household has to save less to
accumulate some target amount of savings in the future (income effect). Thus, this income
effect encourages households to have higher current consumption and lower current saving.
In summary, there is no conclusive evidence that a VAT would increase the rate of national
saving more than another type of major tax increase.
Administrative Cost
The value-added tax would require the expansion of the Internal Revenue Service. But
the high revenue yield from a VAT could cause administrative costs to be low measured as
a percentage of revenue yield. The administrative expense per dollar of VAT collected
would vary with the degree of complexity of the VAT, the amount of revenue raised, the
national attitude towards tax compliance, and the level of the small business exemption.
Proposed VATs for deficit reduction usually are estimated to yield approximately $100
billion per fiscal year which would result in the spreading of administrative costs. In 1984,
officials at the U.S. Treasury estimated that a completely phased in VAT would require
additional staff of 20,694 at a cost of $700 million or approximately $1 billion at 1991 salary
levels. For FY1991, the Internal Revenue Service had operating costs of $6.1 billion and
average positions realized of 115,628.
Intergovernmental Relations
A federal VAT would encroach on the primary source of state revenue because states
would find it more difficult to raise their sales tax rates. But, precedents exist for the federal
government to levy a new tax that states have already imposed. For example, the federal
government levied death taxes and personal income taxes after many states already had
passed them.
The possibility exists for the joint collection of a federal-state VAT. But states would
have to replace their sales taxes with VATs with the same tax base as the federal VAT.
Consequently, states would lose some of their fiscal discretion.
Size of Government
There is an hypothesis that a relatively hidden tax such as the VAT leads to an
expansion in the size of government. A VAT has the capacity to raise enormous revenues
at a low tax rate. Households may underestimate their total tax burden because they pay
VAT in small increments, and thus households may be less resistant to a higher VAT rate.
But no conclusive evidence is currently available to support this hypothesis and it appears
that the largest expansions in government spending in recent years have not been associated
with any tax increases.
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Table 1. Data About Value-Added Taxes of
Selected European Countries
Total Tax Revenue as a
General
General
% of GDPa at Market
Consumption
Consumption Taxes
Country
Prices
Taxes as a % of
as a % of Total Tax
(2000)
GDP (2000)
Revenues (2000)
Austria
43.7%
8.3%
19.0%
Belgium
45.6
7.4
16.3
Denmark
48.8
9.5
19.6
Finland
46.9
8.5
18.0
France
45.3
7.7
16.9
Germany
37.9
7.0
18.4
Greece
37.8
8.6
22.7
Ireland
31.1
6.7
21.5
Italy
42.0
6.6
15.8
Luxembourg
41.7
6.0
14.3
Netherlands
41.4
7.2
17.3
Norway
40.3
8.0
19.7
Portugal
34.5
8.3
24.2
Spain
35.2
6.2
17.6
Sweden
54.2
7.2
13.4
United
37.4
6.9
18.4
Kingdom
Source: Adapted by CRS from OECD, Revenue Statistics 1965-2001, Paris, 2002.
a. GDP is an abbreviation for gross domestic product, which is a measure of total domestic output of goods
and services.
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LEGISLATION
H.R. 25 (Linder)
To promote freedom, fairness, and economic opportunity by repealing the income tax
and other taxes, abolishing the Internal Revenue Service, and enacting a national sales tax
to be administered primarily by the States. Introduced January 7, 2003; referred to the House
Committee on Ways and Means.
H.R. 269 (English)
Simplified USA Tax Act of 2003. Replaces the individual income tax, the corporate
income tax, and the estate and gift taxes with a border-adjustable business tax (subtraction-
method VAT) and a progressive consumed-income tax. Individuals may utilize the
equivalent of universal Roth IRAs to encourage savings. Introduced January 8, 2003;
referred to the House Committee on Ways and Means.
H.R. 278 (Graves)
Date Certain Tax Code Replacement Act. Establishes within the legislative branch a
National Commission on Tax Reform and Simplification that shall review and submit to
Congress a report on (1) the present structure and provisions of the Internal Revenue Code;
(2) whether tax systems imposed under the laws of other countries could provide more
efficient, simple, and fair methods of funding the revenue requirements of the government;
(3) whether the income tax should be replaced with a tax imposed in a different manner or
on a different base; and (4) whether the Internal Revenue Code can be simplified, absent
wholesale restructuring or replacement. Authorizes appropriations for the Commission. Any
new federal tax system would require approval by Congress no later than July 4, 2007. If a
new federal tax system is not approved by July 4, 2007, then Congress would be required to
vote to re-authorize the Internal Revenue Code of 1986. Introduced January 8, 2003; referred
to the House Committee on Ways and Means.
H.R. 1783 (Burgess)
Freedom Flat Tax Act. Allows individuals to elect irrevocably to pay a flat tax as an
alternative to our current income tax. Individuals engaged in a business activity could elect
irrevocably, as an alternative to our current income tax system, to be taxed on business
taxable income that equals gross sales less the cost of business inputs for business activity,
wages, and retirement contributions. Introduced April 11, 2003; referred to the House
Committee on Ways and Means.
H.R. 1789 (Crane)
Crane Tithe Tax Act of 2003. Repeals the individual income tax, the corporate income
tax, and the estate and gift taxes, and replaces these taxes with a flat rate tax of 10% on
individuals’ earned income. Provides for amnesty for all tax liability attributable to legal
activities for prior years. Introduced April 11, 2003; referred to the House Committee on
Ways and Means.
S. 112 (Hollings)
War Financing Act of 2003. To amend the Internal Revenue Code of 1986 to impose
a value added tax and to use the receipts from the tax to fund America’s war effort.
Introduced January 9, 2003; referred to the Senate Committee on Finance.
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S. 907 (Specter)
Flat Tax Act of 2003. Imposes a 20% flat rate consumption tax (modified VAT) as a
replacement of the individual income tax, the corporate income tax, and the estate and gift
taxes. Introduced April 11, 2003; referred to the Committee on Finance.
S. 1040 (Shelby)
The Tax Simplification Act of 2003. Repeals the corporate income tax, the individual
income tax, and the estate and gift tax, and replaces these taxes with a flat rate consumption
tax of 19% for the first two years (declining to 17% in the third year). Introduced May 12,
2003; referred to the Senate Committee on Finance.
FOR ADDITIONAL READING
CRS Products
CRS Report RL30351. Consumption Taxes and the Level and Composition of Saving, by
Steven Maguire.
CRS Report 98-248. A Federal Tax on Consumed Income: Background and Analysis, by
Gregg A. Esenwein.
CRS Report 98-529. Flat Tax: An Overview of the Hall-Rabushka Proposal, by James M.
Bickley.
CRS Report 95-1141. The Flat Tax and Other Proposals: Who Will Bear the Tax Burden?
by Jane G. Gravelle.
CRS Report 96-315. The Flat Tax and Other Reform Proposals: Overview of the Issues,
by Gregg A. Esenwein and Jane G. Gravelle.
CRS Issue Brief IB95060. Flat Tax Proposals and Fundamental Tax Reform, by James M.
Bickley.
CRS Report 98-901. Short-Run Macroeconomic Effects of Fundamental Tax Reform, by
Thomas G. Woodward and Jane G. Gravelle.
CRS Issue Brief IB92069. A Value-Added Tax Contrasted with a National Sales Tax, by
James M. Bickley.
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