Value-Added Tax as a New Revenue Source

Value-Added Tax as a New Revenue Source

Order Code IB91078
CRS Issue Brief for Congress
Received through the CRS Web
Value-Added Tax as a
New Revenue Source
Updated April 20, 2006
James M. Bickley
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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
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Value-Added Tax as a New Revenue Source
SUMMARY
President George W. Bush has stated that
ity, that is, the less the tax alters economic
tax reform will be one of his top priorities in
decisions. A VAT is a relatively, but not
the 109th Congress. Some form of a value-
completely, neutral tax. A VAT cannot be
added tax (VAT) has been frequently dis-
levied on all goods; consequently, a VAT
cussed as a full or partial replacement for the
would raise the prices of taxed goods relative
U.S. income tax system. In addition, some
to untaxed goods. This change in relative
Members of Congress have expressed interest
prices would distort households’ choices
in the feasibility of using a value-added tax to
among goods. A VAT cannot be levied on
finance health care reform.
leisure; consequently, a VAT would affect
households’ decisions concerning work versus
A VAT is imposed at all levels of pro-
leisure.
duction on the differences between firms’
sales and their purchases from all other firms.
The imposition of a VAT would cause a
Policymakers may be interested in the follow-
one-time increase in this country’s price level.
ing aspects of a VAT: revenue yield, interna-
But a VAT would not affect this country’s
tional comparison of composition of taxes,
future rate of inflation if the Federal Reserve
vertical equity, neutrality, inflation,
offset the contractionary effects of a VAT
balance-of-trade, national saving, administra-
with a more expansionary monetary policy. If
tive cost, intergovernmental relations, size of
the United States continued its policy of
government, and public opinion.
flexible exchange rates, then the imposition of
a VAT would not significantly affect the U.S.
For calendar year 2004, a broad-based
balance-of-trade. There is no conclusive
VAT would have raised net revenue of ap-
evidence that a VAT would increase the rate
proximately $70 billion for each 1% levied.
of national saving more than another type of
Most other developed nations rely more for
major tax increase.
revenue on broad-based consumption taxes
than does the United States. A VAT is shifted
The high revenue yield from a VAT
onto consumers and, consequently, is regres-
would cause administrative costs to be low
sive because lower-income households spend
measured as a percentage of revenue yield. A
a greater proportion of their incomes on con-
federal VAT would encroach on the primary
sumption than higher-income households.
source of state revenue, the sales tax. But
This regression could be reduced or even
precedents exist for the federal government to
eliminated by any of three methods: a refund-
levy a tax that some states have already im-
able credit against income tax liability for
posed. A federal-state VAT could be col-
VAT paid, allocation of some of VAT revenue
lected jointly, but a state would lose some of
for increased welfare spending, or selective
its fiscal discretion. The hypothesis that a
exclusion of some goods from taxation.
federal VAT would increase the size of the
U.S. government has not been proven empiri-
From an economic perspective, a major
cally.
revenue source is better the greater its neutral-
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MOST RECENT DEVELOPMENTS
On Tuesday, May 9, 2006, the Subcommittee on Select Revenue Measures of the House
Ways and Means Committee will hold a hearing on corporate tax reform. This will be one
of a series of Committee hearings on the issue of federal tax reform.
BACKGROUND AND ANALYSIS
President George W. Bush has stated that tax reform is one of his top priorities in the
109th Congress. Some form of a value-added tax (VAT) has been frequently discussed as a
full or partial replacement for the U.S. income tax system. In addition, some Members of
Congress have expressed interest in the feasibility of using a VAT to finance health care
reform or to fund America’s war effort. Consequently, the value-added tax, 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
calendar year 2004, a VAT imposed on most goods and services could have raised a net
revenue of approximately $70 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 29
nations (out of 30 nations) with VATs in the Organization for Economic Cooperation and
Development (OECD) in 2003, relevant to the feasibility and operation of a possible U.S.
VAT. In 2003, the OECD consisted of 22 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 calendar year 2004, each
1.0% rate for a VAT could have raised net revenue of approximately $70 billion with a broad
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 2003, for taxes on general consumption (e.g., VATs and sales
taxes), the United States (federal, state, and local governments) had a lower reliance (8.4%)
of total tax revenues than any other OECD nation. Also for 2003, the United States’
(federal, state, and local governments) general consumption taxes as a percentage of gross
domestic product (2.1%) 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. General Consumption Taxes in
OECD Countries
General
Total tax revenue
General
consumption
as a % of GDPa
consumption taxes
taxes as a % of
at market prices
as a % of GDP
total tax
Country
(2003)
(2003)
revenues (2003)
Australia
31.6%
4.3%
13.7%
Austria
43.1
7.9
18.4
Belgium
45.4
7.1
15.6
Canada
33.8
5.1
15.1
Czech Republic
37.7
6.4
17.1
Denmark
48.3
9.7
20.1
Finland
44.8
8.7
19.4
France
43.4
7.3
16.8
Germany
35.5
6.4
17.9
Greece
35.7
8.0
22.4
Hungary
38.5
10.1
26.1
Iceland
39.8
11.0
27.7
Ireland
29.7
7.3
24.5
Italy
43.1
6.1
14.2
Japan
25.3
2.4
9.5
Korea
25.3
4.6
18.2
Luxembourg
41.3
6.4
15.5
Mexico
19.0
3.7
19.4
Netherlands
38.8
7.7
19.7
New Zealand
34.9
9.1
26.1
Norway
43.4
8.7
20.0
Poland
34.2
7.4
21.7
Portugal
37.1
8.5
22.9
Slovak Republic
33.1
6.8
22.0
Spain
34.9
6.0
17.2
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General
Total tax revenue
General
consumption
as a % of GDPa
consumption taxes
taxes as a % of
at market prices
as a % of GDP
total tax
Country
(2003)
(2003)
revenues (2003)
Sweden
50.6
9.3
18.4
Switzerland
29.5
4.0
13.4
Turkey
32.8
8.2
24.9
United Kingdom
35.6
7.0
19.8
United States
25.6
2.1
8.4
Source: Adapted by CRS from OECD, Revenue Statistics 1965-2004, Paris, 2005.
a. GDP is an abbreviation for gross domestic product, which is a measure of total domestic output of goods
and services.
LEGISLATION
H.R. 15 (Dingell). National Health Insurance Act. Provides for a program of national
health insurance. Imposes a five percent value-added tax (VAT) to finance health benefits.
Revenue from the VAT would initially be deposited into the proposed National Health Care
Trust Fund. Introduced January 4 2005; referred to the House Energy and Commerce
Committee and the House Ways and Means Committee. On January 25, 2005; referred to
Subcommittee on Health of the House Ways and Means Committee.
H.R. 25 (Linder). Fair Tax Act of 2005. 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 4, 2005; referred to the Committee on Ways and Means.
H.R. 1040 (Burgess). Freedom Flat Tax Act. This bill would allow individuals to elect
irrevocably to pay a flat tax as an alternative to our current income tax. In the first two years,
the flat tax rate would be 19%, but in subsequent years the rate would decline to 17%. This
bill would become effective in tax year 2006. It was introduced March 2, 2005, and referred
to the Committee on Ways and Means.
H.R. 1601 (Fattah). Comprehensive Transform America Transaction Fee Act of 2005.
This bill would require a study and comprehensive analytical report on transforming America
by reforming the federal tax code through elimination of all federal taxes on individuals and
corporations and replacing the federal tax code with a transaction fee-based system.
Introduced April 13, 2005; referred to the Committee on Ways and Means.
H.R. 4707 (English). Simplified USA Tax Act of 2006. 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
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may utilize the equivalent of universal Roth IRAs to encourage savings. Introduced February
8, 2006; referred to the Committee on Ways and Means.
H.R. 4725 (Goodlatte). Tax Code Termination Act. On December 31, 2009, this act
terminates the tax code except for Social Security taxes and Railroad Retirement taxes.
States that “Congress ... declares that any new federal tax system should be simple and fair
....” Establishes a new federal tax, which has a low tax rate and eliminates the bias against
savings and investment. Requires that the new federal tax system be approved by Congress
not later than July 4, 2009. Introduced February 8, 2006; referred to the House Committee
on Ways and Means.
S. 25 (Chambliss). Fair Tax Act of 2005. 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 24, 2005; referred to the Senate Finance Committee.
S. 812 (Specter). Flat Tax Act of 2005. 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 tax. This flat tax would consist of two components: a wage tax and a cash-
flow tax on businesses. Introduced April 15, 2005; referred to the Senate Finance
Committee.
S. 1099 (Shelby). The Tax Simplification Act of 2005. 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 23, 2005; referred to the Committee on Finance.
S. 1921 (DeMint). The Savings for Working Families Act of 2005. Replaces the
current individual income tax, the corporate income tax, and the estate and gift taxes with
an 8.4% national retail sales tax and an 8.4% subtraction-method value-added tax (referred
to as a business tax). Introduced October 26, 2005; referred to the Committee on Finance.
S. 1927 (Wyden). Fair Flat Tax Act of 2005. Proposes to make the federal income tax
system simpler, fairer, and more fiscally responsible. Introduced October 27, 2005; referred
to the Committee on Finance.
S. 2122 (Isakson). 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 and fair methods of funding the revenue requirements of the
government; (3) whether the present income tax system should be replaced with a flat tax,
a national sales tax , or any other specified tax system; (4) whether the Internal Revenue
Code can be simplified, absent wholesale restructuring or replacement; and (5) the transition
costs (including the length of time recommended for a smooth transition) associated with any
changes to the present federal tax system. Authorizes appropriations for the Commission.
Any new federal tax system would require approval by Congress no later than July 4, 2008.
If a new federal tax system is not approved by July 4, 2008, then Congress would be required
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to vote to reauthorize the Internal Revenue Code of 1986. Introduced December 16, 2005;
referred to the Senate Committee on Finance.
FOR ADDITIONAL READING
CRS Products
CRS Issue Brief IB95060, Flat Tax Proposals and Fundamental Tax Reform: An Overview,
by James M. Bickley.
CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Sales Tax: Overview
of the Issues, by Gregg A. Esenwein and Jane G. Gravelle.
CRS Report 98-529, Flat Tax: An Overview of the Hall-Rabushka Proposal, by James M.
Bickley.
CRS Issue Brief IB92069, A Value-Added Tax Contrasted with a National Sales Tax, by
James M. Bickley.
CRS Report RS22367, Federal Tax Reform and Its Potential Effects on Saving, by Gregg A.
Esenwein.
CRS Report RS22242, Tax Reform and the Goal of Revenue Neutrality, by Gregg A.
Esenwein.
CRS Report RL32266, Transaction Tax: General Overview, by Maxim Shvedov.
CRS Report RL33025, Fundamental Tax Reform: Options for the Mortgage Interest
Deduction, by Pamela J. Jackson.
CRS Report RL30351, Consumption Taxes and the Level and Composition of Saving, by
Steven Maguire.
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