A Value-Added Tax Contrasted With a National Sales Tax

A Value-Added Tax Contrasted With a National Sales Tax

Order Code RL33438
A Value-Added Tax Contrasted
With a National Sales Tax
Updated February 1, 2008
James M. Bickley
Specialist in Public Finance
Government and Finance Division

A Value-Added Tax Contrasted
With a National Sales Tax
Summary
Both a value-added tax (VAT) and a national sales tax (NST) have been
proposed by participants in the tax-reform debate as replacement taxes for all or part
of the nation’s current income tax system. In addition, there is congressional interest
in using a consumption tax to finance national health care.
A firm’s value added for a product is the increase in the value of that product
caused by the application of the firm’s factors of production. A VAT on a product
would be levied at all stages of production of that product. VATs differ in their tax
treatment of purchases of capital (plant and equipment). The type of VAT used by
developed countries — termed a consumption VAT — treats a firm’s purchases of
plant and equipment the same as any other purchase. A firm’s net VAT liability is
usually calculated by using the credit method. According to this method, a firm
determines its gross tax liability by multiplying its sales by the VAT rate. Then the
firm computes its net VAT liability by subtracting VAT paid on purchases from other
firms from the firm’s gross VAT liability.
In contrast to a VAT, a NST would be a federal consumption tax collected only
at the retail level by vendors. A NST would equal a set percentage of the retail price
of taxable goods and services. Retail vendors would collect the NST and remit tax
revenue to the federal government. Both a VAT and a NST are frequently assumed
to be ultimately paid by consumers. For calendar year 2005, it is estimated a
broad-based VAT or NST would have raised net revenue of approximately $50
billion for each 1% levied.
The operating differences between a consumption VAT and a NST have
important policy implications. On the one hand, the administrative cost of a VAT
would exceed that of a NST because a VAT would require more information to be
reported and audited. Also, an opportunity exists for a NST to be collected jointly
with state sales taxes, but a federal VAT offers no readily available joint collection
possibilities. A VAT would require more time to implement than a NST because a
VAT is more complicated, covers more firms, and is a new tax method. On the other
hand, a consumption VAT with the credit method more easily excludes inputs from
double taxation than does a NST. A consumption VAT would be easier to enforce
than a NST. It is in the self-interest of a firm to have accurate purchase invoices so
that it can obtain full credit for prior VAT paid. Tax authorities can double check the
accuracy of the VAT remitted by any firm because data are collected from producers
at all levels of production. For a given year, a VAT could have a broader base than
a NST because a VAT is easier to enforce. A VAT may be less visible to consumers
than a NST. A VAT is levied at all stages of production, and policymakers have the
option of not requiring the amount of VAT to be shown on retail sales receipts. As
of February 1, 2008, the following bills concerning a NST or VAT have been
introduced: H.R. 25, S. 1025, H.R. 1040, S. 1040, H.R. 4159, S. 1081, H.R. 15, and
H.R. 2600.
This report will be updated as issues develop or new legislation is introduced.

Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Concept of a Value-Added Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Types of VATs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Methods of Calculating VAT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
A National Sales Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Administrative Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Joint Tax Collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Avoiding Double Taxation of Intermediate Goods and Services . . . . . . . . . 4
Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Broadness of Tax Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Time Required to Implement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Visibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Experiences of Other Nations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Legislation in the 110th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

A Value-Added Tax Contrasted
With a National Sales Tax
Introduction
In Congress, both a value-added tax and a national sales tax have been proposed
by Members in the tax-reform debate as replacement taxes for part or all of the
nation’s current income tax system.1 In addition, there is congressional interest in
using a consumption tax to finance national health care.2 Both the VAT and the NST
are taxes on the consumption of goods and services and are conceptually similar.3
Yet, these taxes also have significant differences. This report discusses some of the
potential policy implications associated with these differences.4
Concept of a Value-Added Tax
The value added of a firm is the difference between a firm’s sales and a firm’s
purchases from all other firms.5 In other words, a firm’s value added is simply the
amount of value that a firm contributes to a good or service by applying its factors
of production (land, labor, capital, and entrepreneurial ability). A value-added tax
is a tax, levied at each stage of production, on a firm’s net value added.
Types of VATs
There are three types of VATs; they differ in their tax treatment of purchases of
capital inputs (plant and equipment). The consumption-type VAT treats capital
1 For an overview of proposals for tax reform, see CRS Report RL34343, Tax Reform: An
Overview of Proposals in the 110th Congress, by James M. Bickley.
2 Furthermore, on Dec. 20, 2007, the U.S. Treasury issued a report titled Approaches to
Improve the Competitiveness of the U.S. Business Tax System for the 21st Century. One
broad approach outlined in this report was replacing business income taxes with a business
activities tax (BAT), a subtraction-method VAT.
3 In Nov. 2005, The President’s Advisory Panel on Federal Tax Reform [established by
President Bush] issued its final report that included analyses of both a NST and a VAT.
This report is available at [http://www.taxreformpanel.gov/final-report/] visited Feb. 1,
2008.
4 A classic article on this topic is: Sijbren Cnossen, “VAT and RST: A Comparison,” The
Canadian Tax Journal, v. 35, no. 3, May/June 1987, pp. 559-615.
5 For a comprehensive analysis of the concept of a U.S. value-added tax, see CRS Report
RL33619, Value-Added Tax: A New U.S. Revenue Source?, by James M. Bickley.

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purchases the same way as the purchase of any other input (the equivalent to
“expensing” under an income tax). The other two types of VATs are the income
VAT and the gross product VAT. Under the income VAT, the VAT paid on the
purchases of capital inputs is amortized (credited against the firm’s VAT liability)
over the expected lives of the capital inputs. Under the gross product VAT, no
deduction for the VAT on purchases of capital inputs is allowed against the firm’s
VAT liability. The consumption VAT is the only type of VAT that is used in
developed nations and has been proposed for the United States; consequently, the
consumption VAT is contrasted with the NST in this report.
Methods of Calculating VAT
There are three alternative methods of calculating VAT: the credit method, the
subtraction method, and the addition method.6 Under the credit-invoice method,
a firm would be required to show VAT separately on all sales invoices.7 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. The credit-invoice method is calculated on a transactions basis.
Under the subtraction method, the firm calculates its value added by subtracting
its cost of taxed inputs from its sales. Next, the firm determines its VAT liability by
multiplying its value added by the VAT rate. Most flat tax proposals are modified
subtraction method VATs. Under the addition method, the firm calculates its value
added by adding all payments for untaxed inputs (e.g., wages and profits). Next, the
firm multiplies its value added by the VAT rate to calculate VAT to be remitted to
the government.
The credit-invoice method is used by 28 of 29 OECD nations with VATs. 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. This
method requires registered firms to maintain detailed records 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. Also, each
firm has a vested interest in insuring that the VAT shown on its purchase orders is
not understated so the firm can receive full credit against VAT liability for VAT
previously paid. Thus, the credit-invoice method would seem to be easier to enforce.
6 For a comprehensive explanation and analysis of methods to calculate VAT, see Value-
Added Tax: Methods of Calculation, by James M. Bickley, a CRS general distribution
memorandum available from the author.
7 An exception is the final retail stage where policymakers have the option of including or
excluding the VAT from the retail sales slip.

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Also, the credit-invoice method is probably the only feasible method if there are to
be multiple tax rates.
A National Sales Tax
A national sales tax (NST) would be a federal consumption tax collected only
at the retail level by vendors. The NST would equal a set percentage of the retail
price of taxable goods and services. Retail vendors would collect the NST and remit
tax revenue to the federal government. A buyer of intermediate products (that is,
inputs used to produce goods and services) would register and receive an exemption
certificate. This buyer would present the exemption certificate to the seller and thus
would be exempt from paying the retail sales tax.
The retail price of a good or service equals the sum of value added at all stages
of production. Consequently, a value-added tax and a national sales tax with the
same tax rate and tax base would yield the same amount of revenue. The operating
assumption of policymakers and economists is that both taxes are fully shifted
forward onto consumers; that is, the price to the consumer increases by the (full)
amount of the tax. William G. Gale of Brookings and C. Eugene Steuerle of the
Urban Institute estimate that each percentage point of a VAT could generate revenue
equivalent to 0.4% of gross domestic product.8 For calendar year 2005, U.S. gross
domestic product was $12.5 trillion.9 Thus, for 2005, according to the Gale/Steuerle
estimate, a U.S. VAT of 5% would have generated $250 billion in revenue.
Policy Implications
The operating differences between a VAT and a NST have many important
policy implications in eight areas: administrative cost, joint tax collections, avoiding
double taxation of intermediate goods and services, enforcement, broadness of tax
base, time required to implement, visibility, and experiences of other nations.
Administrative Costs
Under a VAT, all firms would have to report tax information and collect taxes.
Under a NST, firms without retail sales would not report or collect taxes. But the
substantial majority of all firms would collect the NST since they have some retail
sales. Under a VAT with a credit method of collection, each firm must keep invoices
on all sales and purchases from other firms, and these invoices would be subject to
audit by tax authorities. Hence, the value-added tax would require more information
8 William G. Gale and C. Eugene Steuerle, “Tax Policy Solutions,” p. 113. Available at
[http://www.brook.edu/ES/research/projects/budget/fiscalsanity/2005chapter5.pdf] visited
Feb. 1, 2008.
9 Bureau of Economic Analysis, U.S. Department of Commerce, [http://www.bea.gov/bea/
dn/dpga.txt] visited Feb. 1, 2008.

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to be reported and audited than a national sales tax, and, consequently, a VAT would
likely be more expensive to administer than a NST.10
Joint Tax Collection
Since 45 states and the District of Columbia have general sales taxes, an
opportunity exists for a NST to be collected jointly with state sales taxes.11 A federal
VAT could not be jointly collected with state sales taxes. States could convert their
sales taxes to a VAT with the federal tax base, but this is unlikely since it would
require that the states establish entirely new tax systems. Consequently, no
administrative costs saving would be expected from a VAT; therefore, the collection
costs of a VAT can be expected to be higher than a NST.
Avoiding Double Taxation of Intermediate
Goods and Services
Double taxation occurs if an input is taxed at the time of purchase and then a tax
is levied on the same input again when it becomes part of the output of the firm. A
consumption VAT, with the credit method of tax computation, easily excludes inputs
from taxation. The exclusion of inputs from a NST would be more difficult.
Usually, firms buying inputs would have to provide sellers with exemption
certificates before making their purchases. At the state level, procedures to exempt
input purchases from state retail sales taxes have worked imperfectly. It is therefore
reasonable to expect that excluding inputs from taxation would be more difficult with
a NST than with a VAT.
Enforcement
With a VAT, a firm would have a financial interest in ensuring that amounts of
VAT paid on input purchases are accurately reported on its purchase invoices since
the firm could receive credits against its VAT liability. In addition, the VAT would
provide the tax authorities with an opportunity to cross-check the amount of VAT
collected because data are gathered from producers at different stages of production.
Nonetheless, some enforcement problems do exist with a VAT. For example, firms
at different stages of production could collude to falsify invoices. But the NST lacks
both the self-enforcing procedure and the cross-checking opportunity of the VAT.
Hence, better compliance is expected from a VAT than with a NST.12
10 For an examination of the administrative costs of a VAT, see Sijbren Cnossen,
“Administrative and Compliance Costs of the VAT: A Review of the Evidence,” Tax Notes,
vol. 62, no. 12, June 20, 1994, pp. 1,609-1,626.
11 For a list of states with retail sales taxes and corresponding revenue yields, see Tax
Foundation, “State General Sales Tax Collections by State, Fiscal Year 2006,” available at
[http://www.taxfoundation.org/publications/show/286.html] visited Feb. 1, 2008.
12 Cnossen, VAT and RST: A Comparison, pp. 609-611.

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Broadness of Tax Base
Because of the potential for better enforcement of a VAT, it may be possible to
levy a VAT on more goods and services than a NST.13 This view is supported by the
fact that VATs of European nations, on the average, are levied on more goods and
services than most state sales taxes in the United States.14 For a given revenue yield,
tax economists prefer a broad tax base because the tax rate, needed to raise a given
amount of revenue, is lower. Lower tax rates reduce economic distortions and thus
raise economic efficiency. Thus, if a VAT has a broader base then a NST, then it
would be more efficient because a lower tax rate would be needed to raise a given
amount of revenue.
Time Required to Implement
A VAT would take more time to implement than a NST because a VAT is more
complicated and would cover more firms than a NST. Also, business executives are
not familiar with this form of taxation, hence, the U.S. government would face the
need to conduct an educational campaign.
Visibility
The value-added tax may be less visible to consumers than a national sales tax.
Policymakers and economists assume that 100% of both the VAT and the NST are
passed onto consumers. But the perceptions of many consumers may be different
about a VAT. Many consumers may believe that a VAT tax would at least partially
fall on firms because the VAT is collected at each stage of production. Since the
NST is levied only at the retail level, consumers may more readily believe that they
would pay the entire tax. Furthermore, policymakers have the option as to whether
the amount of a VAT should be stated on retail sales receipts.15 New Zealand gives
each retailer the option of whether or not to explicitly state the amount of VAT on
its retail sales receipts.16 The amount of a NST would be explicitly stated on sales
receipts.
The lower visibility of the VAT relative to the NST may be either desirable or
undesirable depending on one’s political ideology. It can be argued that taxes should
be visible so that the costs of taxation may be compared with the benefits of
government spending. Conversely, it can be argued that people generally do not like
the idea of paying taxes; consequently, in this view, to finance public sector
responsibilities, it is better to have taxes seem as painless as possible.
13 For an analysis of the tax base for a value-added tax, see CRS Report RS22720, Taxable
Base of the Value-Added Tax, by Maxim Shvedov.
14 Cnossen, VAT and RST: A Comparison, pp. 593-595.
15 Alan A. Tait, Value-Added Tax: International Practice and Problems (Washington:
International Monetary Fund, 1988), p. 357.
16 Ibid.

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Experiences of Other Nations
Currently, all developed nations except the United States have a VAT at the
national level. A VAT is a requirement for membership in the European Union
(EU).17 Sweden, Norway, Iceland, and Switzerland had retail sales taxes at the
national level but eventually switched to a VAT.18 According to the Organization for
Economic Co-Operation and Development (OECD)19
The spread of Value Added Tax (also called Goods and Services Tax — GST)
has been the most important development in taxation over the last half-century.
Limited to less than 10 countries in the late 1960s it has now been implemented
by about 136 countries; and in these countries (including OECD member
countries) it typically accounts for one-fifth of total tax revenue. The recognized
capacity of VAT to raise revenue in a neutral and transparent manner drew all
OECD member countries (except the United States) to adopt this broad based
consumption tax.20
Policy insights can be obtained by examining the experiences of other nations,
however, just because other nations exhibit a specific tax policy does not necessarily
mean that it is appropriate for the United States to adopt this policy.
Legislation in the 110th Congress
As of February 1, 2008, eight bills have been introduced in the 110th Congress
concerning the value-added tax or the retail sales tax.21 Representative John Linder’s
proposal (H.R. 25) and Senator Saxby Chambliss’s proposal (S. 1025) would replace
our current income-based tax system and estate/gift taxes with a national retail sales
tax. Representative Michael Burgess’s proposal (H.R. 1040) would allow taxpayers
to select a flat tax, a modified VAT based on the concepts of Robert E. Hall and
Alvin Rabushka, as an alternative to the current income tax system.22 Senator
Richard C. Shelby’s proposal (S. 1040) and Senator Arlen Specter’s proposal (S.
1081) would replace individual and corporate income taxes and estate and gift taxes
with a flat tax based on the Hall-Rabushka concept. Representative Phil English’s
17 Cnossen, VAT and RST: A Comparison, p. 583.
18 Cnossen, VAT and RST: A Comparison, p. 585 and OECD, Consumption Tax Trends
(OECD, March 2005), p. 11.
19 The OECD is an international organization dedicated to promoting international trade,
economic growth, and economic stability. The OECD consists of 22 European nations,
Turkey, the United States, Canada, Mexico, Australia, New Zealand, South Korea, and
Japan.
20 OECD, International VAT/GST Guidelines (OECD, Feb. 2006), p. 1. Available at
[http://www.oecd.org] visited Feb. 1, 2008.
21 For the most current information about pending legislation including copies of bills,
please consult the Legislative Information System (LIS) at [http://www.congress.gov].
22 For an analysis of the Hall-Rabushka concept, see CRS Report 98-529, Flat Tax: An
Overview of the Hall-Rabushka Proposal, by James M. Bickley.

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proposal (H.R. 4159) would replace the corporate income tax with a cash-flow
business tax (a subtraction-method VAT) and the individual income tax with a tax
on consumed-income.
In addition, in the 110th Congress, Representative John Dingell introduced H.R.
15, which would levy a VAT to finance national health insurance. Also,
Representative Bill Pascrell Jr. introduced H.R. 2600, Border Tax Equity Act of
2007, which would “authorize the imposition of a tax on imports from any country
that employees indirect taxes [particularly value-added taxes] and grants rebates of
the same upon export and to authorize compensatory payments to eligible United
States exporters.”