Taxable Base of the Value-Added Tax

Taxable Base of the Value-Added Tax

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Taxable Base of the Value-Added Tax
Maxim Shvedov
Analyst in Public Finance
October 6, 2009
Congressional Research Service
7-5700
www.crs.gov
RS22720
CRS Report for Congress
P
repared for Members and Committees of Congress
c11173008

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Taxable Base of the Value-Added Tax

Summary
The value-added tax (VAT) is a type of broad-based consumption tax, imposed in about 136
countries around the world. Domestically, it is often mentioned in policy discussions as a
potential new or supplemental funding source for such large-scale social programs as Social
Security, Medicare, national health insurance, etc. An example of such a proposal is H.R. 15. In
addition, the VAT figures prominently in most fundamental tax reform discussions.
The key determinant of the VAT’s revenue-raising potential is the size of its taxable base. This
report estimates its size under two frequently used “generic” policy options: a broad-based VAT
and a VAT with certain frequently mentioned exemptions. Under the assumption of the broad-
based VAT, the potential revenue base could be equal to $8.8 trillion in 2008. Exempting certain
expenditures, such as food, housing, healthcare, and others is estimated to reduce the taxable base
to $5.1 trillion in 2008.
These estimates are likely to overstate the size of the taxable base under either scenario as they
assume no behavioral responses and perfect compliance with the law. This report briefly
discusses these and other important caveats and their implications for revenue projections and
further policy analysis.
This report will not be updated.

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Taxable Base of the Value-Added Tax

Contents
Option 1. “Generic” Broad-Based Value-Added Tax.................................................................... 1
Option 2. Value-Added Tax with Certain Exemptions .................................................................. 3
Revenue Projection Using These Estimates ................................................................................. 4

Tables
Table 1. Taxable Base for Broad-based VAT, 2008....................................................................... 2
Table 2. The VAT Taxable Base After Certain Exemptions, 2008 ................................................. 3

Contacts
Author Contact Information ........................................................................................................ 5

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Taxable Base of the Value-Added Tax

value-added tax (VAT) is a type of broad-based consumption tax, even though it is levied
on a firm’s value added at all stages of the production chain. The value added by a firm is
A the difference between the total value of the firm’s sales and its purchases from all
suppliers.
About 136 countries around the world impose some form of the VAT.1 There are several
administratively different forms of the VAT, but the so called “credit method” is the most widely
used. While different in form, all methods are economically equivalent to each other, but may
vary in terms of simplicity, administrative costs, and compliance rates. For a detailed description
of the VAT, its alternative administrative forms, and other details please refer to CRS Report
RL33619, Value-Added Tax: A New U.S. Revenue Source?, by James M. Bickley.
In the United States, the VAT is often mentioned in policy discussions as a potential new funding
source for such large-scale social programs as Social Security, Medicare, national health
insurance, etc. For example, Representative John Dingell introduced H.R. 15, which proposes
levying a 5% VAT on most goods and services to pay for a national health care system. In
addition, the VAT figures prominently in most fundamental tax reform discussions. This report
estimates the size of the VAT’s taxable base—the key factor determining the tax’s revenue-raising
potential—under two frequently considered, “generic” policy options.
Option 1. “Generic” Broad-Based Value-Added Tax
Conceptually, the VAT is a type of a consumption tax imposed on sales of goods and services,
even though it is collected at all stages of the production chain. Thus, the VAT taxable base can be
estimated as the value of all consumption spending taking place in the economy. Table 1 presents
calculations of the broad-based consumption tax base.2
The size of the taxable base is estimated at $8.8 trillion ($8,772.5 billion) in 2008, using Bureau
of Economic Analysis (BEA) data.3 The largest contributor to the base, at $10.1 trillion
($10,129.9 billion), is “personal consumption expenditures” (PCE). Private real estate
investments in owner-occupied structures add an estimated $318.0 billion of additional
expenditures potentially subject to the VAT.
The deductions from the base include the imputed rental value of owner-occupied housing and
farm dwellings ($1,186.8 billion and $24.9 billion, respectively). These are the amounts
homeowners would have had to pay if they had rented an identical property from somebody else.
It is easier to understand this concept by considering a homeowner in a dual capacity: an owner of
the property and a tenant at the same property. The tenant-homeowner consumes housing services
provided by himself or herself. BEA includes this value in PCE, because from an economic

1 Organization for Economic Co-operation and Development, International VAT/GST Guidelines (OECD, Feb. 2006),
p. 1, visited on Sept. 21, 2008, at http://www.oecd.org/dataoecd/16/36/36177871.pdf.
2 The methodology follows, with modifications, Congressional Budget Office, Reducing the Deficit: Spending and
Revenue Options, March 1997, p. 391.
3 U.S. Department of Commerce, BEA, Table 3.3, State and Local Government Current Receipts and Expenditures,
revised Aug. 27, 2009; and Tables 2.4.5, Personal Consumption Expenditures by Type of Product, and 5.4.5, Private
Fixed Investment in Structures by Type, both revised Aug. 20, 2009, from http://www.bea.gov. BEA periodically
revises its estimates after their initial publication, which frequently results in changes in the reported amounts, typically
relatively small in magnitude.
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Taxable Base of the Value-Added Tax

standpoint this transaction is no different from a regular “explicit” housing rental. No actual
monetary exchange occurs in this case, however, and therefore, unlike a regular “explicit”
housing rental, these hypothetical transactions would be non-taxable.
State sales taxes ($443.9 billion) are also deducted from the base, because presumably a VAT
would be imposed on the price net of state sales taxes. PCE data report the amounts consumers
pay including the state sales taxes. The estimate also accounts for “Net foreign travel”—a
relatively small in size item, equal to the difference between expenditures in the United States by
nonresidents and foreign travel spending by U.S. residents.
Table 1. Taxable Base for Broad-based VAT, 2008
Description
2008
(billions of dollars)
The sum of:

Personal consumption expenditures (PCE)
10,129.9
Residential private fixed investment in owner-occupied structures
318.0
Owner-occupied nonfarm dwellings—space rent
-1,186.8
Rental value of farm dwellings
-24.9
Net foreign travel
-19.8
Sales taxes
-443.9
Taxable base of the broad-based VAT
8,772.5
Sources: Bureau of Economic Analysis data and CRS calculations.
Note: Totals may not add due to rounding.
This estimate has an important limitation: it does not incorporate the likely taxable base reduction
triggered by changes in taxpayers’ behavior. For example, taxpayers may choose to reduce or
somehow rearrange their consumption, so that the value of transactions subject to the VAT would
be smaller. This behavior, called tax avoidance, while legal, would reduce the size of the taxable
base. Some other taxpayers may evade the VAT illegally. The reduction would likely be more
pronounced if the VAT rate were higher. It would also depend on the comprehensiveness of the
taxable base and other specifics of the law.
To make the estimate more realistic, it would be necessary to account for taxpayers’ non-
compliance and tax avoidance. In the absence of a specific proposal and historic data on the VAT
in the United States, however, making reliable quantitative predictions about the magnitude of the
taxable base reduction is problematic. International experiences range widely and therefore
cannot serve as a proxy.
On the other hand, it would be reasonable to expect the size of the taxable base to grow with time
roughly in proportion to nominal economic growth. The estimates in this report do not
incorporate such growth. The rate of economic growth itself might also depend on the VAT’s
taxable base and rate, as well as on the eventual use of the collected revenues.
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Taxable Base of the Value-Added Tax

Option 2. Value-Added Tax with Certain
Exemptions
Another policy option would be a VAT with a narrower taxable base, which exempts, for
example, food, medical care, housing, higher education, and religious and welfare activities.4 In
selecting the set of potential exemptions, CRS attempted to choose the most frequently proposed
ones. Of course, any specific proposal does not have to incorporate all of them or might include
some additional ones. For example, H.R. 15 sets forth exemptions for food, housing, medical
care, exports, interest, governmental entities, and certain tax-exempt organizations.
Table 2 shows the estimated taxable base of this policy option. Given these exemptions, the VAT
taxable base would be $5.1 trillion ($5,095.0 billion) in 2008, or about 58% of the above-
estimated broad base.
Similar to the estimates of the previous section, non-compliance and tax avoidance would reduce
the taxable base in this case as well. In addition, as exemptions add complexity to the tax system,
the reduction in revenue might be somewhat more pronounced compared to the broad-based VAT.
In addition, the categories in Table 2 are quite broad. Depending on the implementation,
exemptions from the VAT under the actual law might encompass less than the whole segment of
the economy. For example, the housing exemption might apply only to owner-occupied housing,
but not to the housing rental payments. If so, the VAT taxable base would be larger than this
estimate indicates. On the other hand, if some additional categories, such as the financial sector,
were excluded from the base, it would be smaller.
Table 2. The VAT Taxable Base After Certain Exemptions, 2008
Description
Taxable base, 2008
(billions of dollars)
Broad-based VAT taxable base
8,772.5
Exemptions:

Food excluding alcoholic beverages
1,194.6
Health care
1,554.2
Housing (included in the broad base)
649.3
Higher education
135.0
Social services and religious activities
144.4
Total exemptions
3,677.5
Total after all exemptions
5,095.0
Sources: BEA data and CRS calculations.

4 For examples of similar, but not identical, estimates see Congressional Budget Office, Reducing the Deficit: Spending
and Revenue Options, March 1997, p. 391, or William G. Gale and C. Eugene Steuerle, “Tax Policy Solution,” in
Alice M. Rivlin and Isabel Sawhill, eds., Restoring Fiscal Sanity—2005 (Washington: Brookings Institution Press,
2005), p. 113.
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Taxable Base of the Value-Added Tax

Note: Totals may not add due to rounding.
Revenue Projection Using These Estimates
Revenues from VAT would equal, as a first approximation, the VAT rate multiplied by the taxable
base. There are, however, a number of issues that make revenue projection more complicated.
First, this simple calculation works reasonably well only for low VAT rates. As the rate gets
higher, the discrepancy between this simple projection and the real revenue yield would likely
grow due to various feedback effects. 5 In a more sophisticated analysis, the level of the VAT rate
affects the size of the taxable base through economic agents’ behavioral responses. Economic
theory suggests that there would be some kind of a revenue-reducing response to imposition of
the VAT, but its magnitude is highly speculative. Beyond the rate per se, it would depend to a
great extent on specifics of the VAT’s implementation.
Second, the estimates presented above are based on a single year of observation, 2008, and thus
depend on the specific economic situation that year. For example, to the extent housing values
were first above and then below their long-term trends in the last decade, the magnitude of all
estimates involving housing would be above or below the trend, too.
Third, any revenue calculations should take into account the reduction in corporate income or
other taxes that would likely occur after the imposition of the VAT. For example, the VAT would
become an additional new cost of doing business for companies, which might reduce their profits.
This, in turn, would reduce the corporate income tax revenues of the federal government. Thus
the net revenue gain from imposing the VAT would be smaller due to this feedback effect.
Fourth, any revenue projections should also account for any transitional or cash-flow issues,
which may be significant. There would also be some administrative costs involved.
Finally, estimates of the VAT taxable base size might serve as a starting point for calculating the
taxable bases of other consumption taxes, such as a national retail sales tax. It is important to
remember, however, that behavioral responses and other issues discussed in this section may be
even more pronounced with national sales tax or other consumption taxes. Any analysis
overlooking such feedback effects may yield a misleading picture of the revenue-raising potential
of a tax.6

5 Feedback effects reflect the fact that not only does the VAT taxable base depend on broad economic variables, such
as consumption expenditures, but also broad economic variables in turn depend on the VAT and its parameters. For
example, as a result of imposing the VAT, consumers might reduce their consumption expenditures. Feedback effects
are present whenever a bi-directional causal relationship exists between any pair of variables.
6 For an overview of the issues, please see CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail
Sales Tax: Overview of the Issues, by Jane G. Gravelle.
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Taxable Base of the Value-Added Tax

Author Contact Information

Maxim Shvedov

Analyst in Public Finance
mshvedov@crs.loc.gov, 7-4639

Congressional Research Service
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