Value-Added Tax (VAT) as a Revenue Option: A Primer

Value-Added Tax (VAT) as a Revenue Option: A Primer

Value-Added Tax (VAT) as a Revenue Option:
A Primer
James M. Bickley
Specialist in Public Finance
March 22, 2011
Congressional Research Service
7-5700
www.crs.gov
R41708
CRS Report for Congress
P
repared for Members and Committees of Congress

Value-Added Tax as a Revenue Option: A Primer

Summary
This report summarizes issues, arguments, and concerns relevant to a value-added tax (VAT).
Long-term fiscal problems, which were exacerbated by the recession that ended in June 2009,
resulted in widespread concern about the need to formulate a fiscal solution to the high budget
deficits and growing national debt. The levying of a value-added tax, a broad-based consumption
tax, has been discussed as one of many options to assist in resolving U.S. fiscal problems. CRS
Report R41602, Should the United States Levy a Value-Added Tax for Deficit Reduction? provides
a more comprehensive examination of issues, extensive footnoting of sources, and presentation of
relevant data.
A VAT is imposed at all levels of production on the differences between firms’ sales and their
purchases from all other firms. Arguably, the primary reason for congressional interest in a VAT is
its high potential revenue yield. Other aspects of a VAT that often raise interest or concern include
international comparison of composition of taxes, VAT rates in other countries, equity, neutrality,
inflation, balance-of-trade, national saving, administrative costs, compliance, intergovernmental
relations, and size of government.
This report considers the experiences of the 29 nations with VATs in the 30-member Organization
for Economic Cooperation and Development (OECD), relevant to the feasibility and operation of
a possible U.S. VAT. In order to examine different aspects of a VAT, explanations are initially
provided concerning the concept of a value-added tax, the different methods of calculating VATs,
exemption, and zero-rating.
The prevailing view of tax professionals is that an optimal VAT would have the following
characteristics: a broad base, a single rate, the credit-invoice method of collection, the destination
principle, and a significant sales threshold for registration.
This report will be updated as issues develop, as legislation is introduced, or as otherwise
warranted.

Congressional Research Service

Value-Added Tax as a Revenue Option: A Primer

Contents
Introduction ................................................................................................................................ 1
Methods of Calculating VAT ....................................................................................................... 1
Exemption and Zero-Rating ........................................................................................................ 2
Exemption ............................................................................................................................ 2
Zero-Rating .......................................................................................................................... 2
Revenue Yield............................................................................................................................. 2
International Comparison of Composition of Taxes ..................................................................... 3
VAT Rates in Other Countries ..................................................................................................... 4
Equity ......................................................................................................................................... 4
Vertical Equity ...................................................................................................................... 4
Policy Options to Alleviate Regressivity................................................................................ 4
Horizontal Equity.................................................................................................................. 5
Neutrality.................................................................................................................................... 5
Inflation ...................................................................................................................................... 5
Balance-of-Trade ........................................................................................................................ 6
National Saving .......................................................................................................................... 6
Administrative Costs................................................................................................................... 7
Compliance................................................................................................................................. 7
Intergovernmental Relations........................................................................................................ 7
Encroachment on a State Tax Source ..................................................................................... 7
Joint Collection..................................................................................................................... 8
Size of Government .................................................................................................................... 8
Conclusions ................................................................................................................................ 9

Contacts
Author Contact Information ........................................................................................................ 9

Congressional Research Service

Value-Added Tax as a Revenue Option: A Primer

Introduction
A value-added tax (VAT) is a broad-based consumption tax. Long-term fiscal problems, which
were exacerbated by the recession that ended in June 2009, resulted in widespread concern about
the need to formulate a fiscal solution to the high budget deficits and growing national debt.
Arguably, the primary reason for congressional interest in a VAT is its high potential revenue
yield. Other aspects of a VAT that often raise interest or concern include international
comparisons of the composition of taxes, VAT rates in other countries, equity, neutrality, inflation,
balance-of-trade, national saving, administrative costs, compliance, intergovernmental relations,
and size of government.
This report considers the experiences of the 29 nations with VATs in the 30-member Organization
for Economic Cooperation and Development (OECD), relevant to the feasibility and operation of
a possible U.S. VAT.1 In order to examine different aspects of a VAT, it is important to understand
the concept of a value-added tax, the different methods of calculating VATs, exemption, and zero-
rating.
Methods of Calculating VAT
Two alternative methods of calculating VAT have been proposed for the United States: the credit-
invoice method and the subtraction method. Under the credit-invoice method, a firm would be
required to show VAT separately on all sales invoices.2 Each sale would be marked up by the
amount of the VAT. A sales invoice for a seller is a purchase invoice for a buyer. A firm would
calculate the VAT to be remitted to the government by a three-step process. First, the firm would
aggregate VAT shown on its sales invoices. Second, the firm would aggregate VAT shown on its
purchase invoices. Finally, aggregate VAT on purchase invoices would be subtracted from
aggregate VAT shown on sales invoices, and the difference remitted to the government. Under the
subtraction method, the firm calculates its value added by subtracting its cost of taxed inputs from
its taxable sales. Next, the firm determines its VAT liability by multiplying its value added by the
VAT rate.
The credit-invoice method is used by 28 of 29 nations in the Organization for Economic
Cooperation and Development with VATs.3 Tax economists differ in their classifications of the
Japanese VAT. Both the credit-invoice and the subtraction methods have been discussed for the
United States. The prevailing view of economists is that the credit-invoice method is superior
because of better enforcement.4 This method requires registered firms to maintain detailed records

1 For a more robust examination of VAT issues, see CRS Report R41602, Should the United States Levy a Value-Added
Tax for Deficit Reduction?, by James M. Bickley.
2 An exception is the final retail stage where policymakers have the option of including or excluding the VAT from the
retail sales slip.
3 The OECD is an intergovernmental economic organization in which the 30 economically developed countries discuss,
develop, and analyze economic and social policy and share expertise. The OECD members are 22 European nations,
Turkey, the United States, Canada, Mexico, Australia, New Zealand, South Korea, and Japan. The United States is the
only member without a VAT. For an examination of the OECD, see CRS Report RS21128, The Organization for
Economic Cooperation and Development, by James K. Jackson.
4 Itai Grinberg, “Where Credit is Due: Advantages of the Credit-Invoice Method for a Partial Replacement VAT,”
(continued...)
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Value-Added Tax as a Revenue Option: A Primer

that are cross indexed with supporting documentation. A VAT shown on the sales invoice of one
firm is the same as the VAT shown on the purchase order of another firm. Hence, the credit-
invoice method allows tax auditors to cross check the records of firms.
The Government Accountability Office found that three countries, with relatively new credit-
invoice method VATs (Australia, Canada, and New Zealand), took from 15 to 24 months to
implement their VATs.5
Exemption and Zero-Rating
A VAT has two special treatments of a product or a business: exemption and zero-rating.
Exemption
A VAT may exempt either a product or a business from taxation. An exempt business would not
collect VAT on its sales and would not receive credit for VAT paid on its purchases of inputs. An
exempt business would not register with tax authorities and, consequently, would not be part of
the VAT system. Hence, an exempt business would not have the usual VAT compliance costs and
would not impose administrative costs on the government (except verification of its exemption).
An exempt business’s costs, however, include any tax paid on inputs, because it receives no credit
for previously paid taxes. A business might be exempt because it only produces an exempt
product. Also a business might be exempt because its total sales fell below some threshold. A
business that sells both exempt and non-exempt products would be required to allocate its tax
payments between the two kinds of sales.
Zero-Rating
A business or product could be zero-rated. A zero-rated business would not collect VAT on its
sales but would receive credit for VAT paid on its inputs. This is equivalent to the business being
charged a zero tax rate. A zero-rated business would be a registered taxpayer and, consequently,
would involve the usual compliance and administrative costs. A zero-rated business, however,
would receive a refund of any VAT paid on its inputs, therefore, its costs would not include VAT
paid at earlier stages. The producer of a zero-rate product would neither pay VAT on the inputs
used to produce that product nor charge VAT on the sale of that product.
Revenue Yield
The revenue yield of a VAT would depend on the size of the tax base and the tax rate. In
estimating a VAT’s revenue yield, 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

(...continued)
presented at the American Tax Policy Institute Conference, Washington, DC, February 18, 2009, 41 p.
5 U.S. Government Accountability Office, Value-Added Taxes: Lessons Learned from Other Countries on Compliance
Risks, Administrative Costs, Compliance Burden, and Transition, report no. GAO-08-566, p. 41.
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Value-Added Tax as a Revenue Option: A Primer

(or any other major tax increase) would have a contractionary effect on the economy unless offset
by other economic policies. Consequently, a revenue estimate is generally made under the
assumption that the Federal Reserve would use an expansionary monetary policy to neutralize the
contractionary effects of a VAT. A VAT would lower the amount of products purchased by
consumers and thus reduce total demand in the economy. In response, the Federal Reserve could
reduce short-term interest rates by increasing the money supply. This decline in short-term
interest rates would stimulate consumer spending and private investment, and, consequently, raise
total demand in the economy. Thus, an appropriate monetary policy would cause these effects on
total demand to offset each other.
Because a VAT, as a new revenue source, would lower income and payroll tax revenues, the
Congressional Budget Office (CBO) reduces the gross VAT revenue amount by 25% in order to
calculate the net revenue amount. Also, a revenue estimate does 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. Finally, the revenue yield would be affected by the degree of tax
compliance.
For FY2011, the Urban-Brookings Tax Policy Center estimated that a 5% broad-based VAT
would yield $277.2 billion ($55.44 billion per 1%).6 The VAT base excludes education
expenditures, rent, housing, and religious and charitable services.7 This estimate assumes a 15%
non-compliance rate and a 25% revenue offset from lower income and payroll taxes.8 For
FY2014, the Congressional Budget Office estimated that a 5% broad-based VAT would yield
$240 billion ($48 billion per 1%).9
International Comparison of Composition of Taxes
One argument frequently made for a U.S. VAT is the relatively heavy reliance on consumption
taxes by other developed countries. For 2007, for taxes on general consumption (e.g., VATs and
sales taxes), the United States (federal, state, and local governments) had a lower reliance (7.7%
of total tax revenues) than any other OECD nation.10 Also for 2007, 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.11 This lower U.S. reliance on
consumption taxes may result from all other OECD nations having a VAT at the national level.
Policy insights can be obtained by examining the experiences of other nations; however, simply
because other nations have enacted a specific tax policy does not necessarily mean that it is
appropriate for the United States to adopt this policy. Economic analysis of optimal taxation
suggests that those choices depend on issues of efficiency, equity, and administrative and
compliance costs, and should be made in the context of the overall tax and spending structure.
These considerations may vary from one country to another.

6 Urban-Brookings Tax Policy Center, 5 percent Broad Based Value Added Tax (VAT) Impact on Tax Revenue
($ billions), 2010-19, Table T09-0442, November 9, 2009.
7 Ibid.
8 Ibid.
9 U.S. Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options, March 2011, pp. 189-190.
10 OECD, Revenue Statistics: 1965-2008 (Paris: OECD Publishing, 2009), p. 89.
11 Ibid.
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VAT Rates in Other Countries
Standard VAT rates vary substantially among the 29 countries with VATs in the OECD and Chile,
which will become the 31st member of the OECD during 2011. Japan and Canada have the lowest
rate of 5%. Iceland has the highest rate of 25.5%, and four nations have a 25% rate. The
unweighted average of standard VAT rates has risen from 16.0% in 1976 to 18.0% in 2010.12 This
high average rate is one reason for the robust revenue yield of VATs. Most countries have reduced
VAT rates on certain goods and services.
Equity
A major topic concerning any proposed tax or tax change is the distribution or equity of the tax
among households. There are two types of equity: vertical and horizontal. Vertical equity
concerns the tax treatment of households with different abilities-to-pay. Horizontal equity
concerns the degree to which households with the same ability-to-pay are taxed equally. Both
vertical and horizontal equity may be affected by the measure of ability-to-pay and the tax period.
Vertical Equity
If disposable income over a one-year period is the measure of ability-to-pay, then a VAT would be
viewed as 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 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 tend to have
net savings over their lifetimes; consequently, they would pay a lower proportion of their
disposable incomes in VAT than would lower-income groups. But the use of these highly stylized
life-cycle models are controversial.13
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.
Policy Options to Alleviate Regressivity
Some supporters of progressive taxation oppose the VAT primarily because they believe that it is
regressive. No mechanism is likely to introduce progressivity at higher income levels. But critics

12 OECD, VAT/GST Rates in OECD Member Countries, 2010.
13 Marin Browning and Thomas F. Crossley, “The Life-Cycle Model of Consumption and Saving,” Journal of
Economic Perspectives, vol. 15, no. 3, Summer 2001, pp. 3-22.
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are especially concerned about the absolute burden of a VAT on low-income households. The
degree of regressivity on lower-income households, 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).
Horizontal Equity
If disposable income is the measure of ability-to-pay, the horizontal equity of a VAT would
depend on the time period. For a one-year period, a VAT would be very inequitable because
households with the same level of disposable income would have widely differing levels of
consumption and, consequently, payments of VAT.
For a lifetime period, the VAT would have a high degree of horizontal equity. For low- and
middle-income households, almost all income is consumed over these households’ lifetimes;
consequently, households with the same lifetime incomes would have the same levels of
consumption and the same VAT payments. Over their lifetimes, high-income households with
equal incomes differ in their levels of consumption and, consequently, VAT payments.
Neutrality
In public finance, the more neutral a tax is, the less the tax affects private economic decisions
and, consequently, the more efficiently the economy operates. 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.
A VAT would not alter choices among goods and would not affect the relative prices of present
and future consumption. But a VAT cannot be levied on leisure, consequently, a VAT would affect
households’ decisions concerning work versus leisure. 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), goods to produce, or domestic versus foreign investment.
Inflation
If the Federal Reserve implemented an expansionary monetary policy to offset the contractionary
effects of a VAT, then there would be a one-time increase in the price level. For example, an
expansionary monetary policy to accommodate a 5% VAT on 60% of consumer outlays might
directly cause an estimated one-time increase in consumer prices of approximately 3%. There
would also be 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.
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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 imported products would be the same. The VAT rate on a particular
good would still vary among nations.
In early 1973, the United States and its major trading partners formally shifted to a flexible
exchange rate system. Under this system, 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 be
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 indicates that a VAT offers no
advantage over other major taxes in reducing a deficit in the balance-of-trade.
National Saving
National saving consists of government saving, business saving, and personal saving. A VAT, or
any other tax, that reduces the budget deficit would be expected to reduce government dissaving,
and, consequently, raise national saving.
A second issue concerns the effect on the personal savings rate of levying a VAT compared to
increasing income taxes. A VAT would tax 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 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.
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Administrative Costs
The value-added tax would likely 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.
Compliance
In comparison to other broad-based consumption taxes such as the retail sales tax, a VAT can
produce relatively good compliance for four reasons. First, a VAT collected using the credit-
invoice method offers the opportunity to cross-check returns and invoices. Second, each firm has
an incentive not to allow suppliers to understate VAT on their sales invoices. A firm is able to
credit VAT paid on inputs against VAT collected on sales; consequently, a firm’s net VAT liability
will increase if VAT shown on its purchase invoices was understated by suppliers. Third, tax
auditors can compare information about a VAT with information about business income taxation,
which will increase compliance with both types of taxes. Fourth, some firms legally required to
remit VAT may not register. But these firms receive no credit for VAT paid on inputs. Hence,
these firms are only partially able to evade the VAT because of the compliance with the VAT by
suppliers.
Although compliance with a VAT is seen as higher than other broad-based consumption taxes, the
level of noncompliance can be significant. As previously discussed, some firms legally required
to remit VAT may not register. Furthermore, firms may evade VAT by altering or omitting
information.
Intergovernmental Relations
For the United States, a federal VAT raises two primary intergovernmental issues: the federal
encroachment on the state sales tax, and the joint collection of a VAT.
Encroachment on a State Tax Source
It has been claimed that broad-based consumption taxation has traditionally been a state source of
revenue while income taxation has been a federal revenue source; consequently, a federal VAT
would encroach on a primary source of tax revenue for the states. Most states, however, adopted
their individual income taxes before they adopted their general sales taxes. No constitutional
restriction prevents the federal government from levying a VAT. Precedents exist for the federal
government to levy a new tax that many states already levy. The federal government relies
primarily on income taxes, but taxation of income by states has risen steadily over the years.
Hence, it can be argued that the states have encroached on the primary source of revenue of the
federal government.
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States could continue to levy their retail sales taxes while the federal government levies a VAT. In
Canada, the federal government levies a VAT, and the provinces continue to collect their retail
sales taxes.
Joint Collection
States could piggy-back on a federal VAT. To do this, states would have to replace their retail
sales taxes with a VAT and adopt the federal tax base. Because a federal VAT would probably
have a broader base than any state sales tax, more revenue would be yielded for each 1% levied.
Also, the VAT would eliminate duplication of administrative effort, permit the taxation of
interstate mail order sales, permit the taxation on Internet sales, and lower total compliance costs
of firms. But, states may decline the opportunity for joint collection because of their desire to
maintain greater fiscal independence from the federal government.
Size of Government
In the public policy debate over a VAT, one of the more divisive issues concerns the size of the
public sector.14 There is an hypothesis that a VAT is a “money machine” because the higher
revenue yield per 1% levied could allow the government to finance a growing public sector by
periodically raising the VAT rate. It can be argued that the VAT is a partially “hidden” tax because
consumers pay a small amount of VAT with each purchase and are not fully cognizant of the
aggregate VAT paid for a year. Furthermore, the tax authorities have the option of prohibiting the
VAT from being shown on retail sales slips.
Most experts generally agree that these concerns are unproven. After all, the tax rate for any tax
can be increased at the margin. Furthermore, there is no proof that taxpayers are any less
cognizant of a tax paid in small amounts than in one lump sum. (Although, even if taxes are
visible, for taxpayers to compare the cost of the tax with the benefits from the tax, the benefits
would have to be similarly visible). Some empirical studies have found that tax increases lead to
increased spending, but other empirical studies have found that public demands for a larger public
sector lead to tax increases. The President’s [George W. Bush] Advisory Panel on Federal Tax
Reform found
sophisticated statistical studies that control for other factors that may affect the relationship
between the size of government and the presence of a VAT yield mixed results. The
evidence neither conclusively proves, nor conclusively disproves, the view that supplemental
VATs facilitate the growth of government.15

14 The optimal size of government is a value judgment. A larger public sector is neither inherently better nor worse than
a smaller public sector.
15 President’s Advisory Panel on Federal Tax Reform, Simple, Fair, & Pro-Growth: Proposals to Fix America’s Tax
System (Washington: U.S. Department of the Treasury, November 1, 2005), p. 203.
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Conclusions
The VAT has numerous positive characteristics such as a robust revenue yield, relative neutrality,
good enforcement, border-adjustability, and reasonable administrative costs. Some critics are
concerned about the VAT’s regressivity; proponents say policies are available to reduce or
eliminate this regressivity. The prevailing view of tax professionals is that an optimal VAT would
have the following characteristics: a broad base, a single rate, the credit-invoice method of
collection, the application of the destination principle, and a significant sales threshold for
registration. The United States is the only developed nation without a VAT. In conclusion, the
option of levying of VAT may warrant inclusion in the debate over the solution to the nation’s
long-term fiscal problems.

Author Contact Information

James M. Bickley

Specialist in Public Finance
jbickley@crs.loc.gov, 7-7794

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