CRS REPORT ESTIMATES REVENUES FROM HYPOTHETICAL U.S. VAT IN FISCAL 1994.

                          James M. Bickley

The potential revenue 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 base, the lower the tax rate necessary to raise a given amount of revenue. There are two primary justifications for excluding specific commodities from taxation. First, data are not readily available on the sales of many commodities. Second, some commodities are excluded on equity grounds, since these commodities claim disproportionately large percentages of the incomes of lower income families.

Updating two well-known sources of broad and narrow bases for a VAT and formulating a third set of VAT bases yielded a range of revenue estimates. For fiscal year 1994, it is estimated that, for each one percent levied, a broad-based VAT would yield between $33.2 billion and $34.6 billion. Also, for fiscal year 1994, a narrow-based VAT, for each one percent levied, would yield between $17.2 billion and $20.9 billion.

TABLE OF CONTENTS

VAT BASE

CALCULATION OF REVENUE ESTIMATES

BIBLIOGRAPHY

VALUE-ADDED TAX: REVENUE ESTIMATES FOR FY94

Recent and projected large deficits in the Federal budget have sparked congressional interest in possible sources of additional revenue. A value-added tax (VAT) has been frequently discussed as a possible new tax source. ¹ The value added of a firm is the difference between that firm's sales and its purchases from other firms. A VAT is levied on firms' value added at all stages of production. In order to narrow the scope of this report, it is assumed that the VAT is the consumption-type which has been adopted by all European nations with VATs. A consumption VAT treats all purchases, including capital purchases, as deductible in calculating a firm's value added. The consumption VAT base, therefore, is the value-added included in consumer goods, which is the same as their retail price. Hence, a consumption VAT does not tax capital and simplifies the calculation of value added.

Economists and public officials use the operating assumption that a VAT is fully shifted onto final consumers in the form of higher prices for products. The revenue estimates in this report also are based on the assumption that the VAT is fully shifted onto final consumers. A VAT (or any other major tax increase) would have a contractionary effect on the economy unless offset by other policies. Consequently, the revenue estimates in this report are made under the assumption that the Federal Reserve would use an expansionary monetary policy to neutralize the contractionary effects of a VAT. The 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 not.

The analysis in this report estimates that, for each one percent levied, a broad-based VAT would yield between $33.2 billion and $34.6 billion for fiscal year 1994 (FY 94). A narrow-based VAT, for each one percent levied, would yield between $17.2 billion and $20.9 billion for FY 94.

VAT BASE

The potential revenue per one percent rate from a VAT would vary with the comprehensiveness of the tax base. The Government can exclude a commodity from taxation by levying a zero-tax rate, i.e., zero-rating the commodity. A broad-based VAT would have limited exclusions, while a narrow-based VAT would have numerous exclusions. Obviously, the broader the tax base, the lower the tax rate necessary to raise a given amount of revenue.

Furthermore, the broader the VAT base, the more efficient is the tax system. The exclusion of commodities from taxation changes their prices relative to taxed commodities. Changes in relative prices cause economic distortions. Consumers tend to substitute lower priced commodities for higher priced commodities.

There are two primary justifications for excluding specific items from taxation. First, the VAT would be difficult to collect because some sellers of goods and services could easily avoid reporting their sales. For example, VAT would be difficult to collect on expenditures for domestic services and expenditures abroad by U.S. residents. Second, some items are excluded on equity grounds, since these items claim disproportionately large percentages of the incomes of lower income families.

For this report, two well-known formulations of broad and narrow tax babes for a VAT were updated using current data. A third set of VAT bases was formulated by CRS as a means of evaluating the other bases. These VAT bases are used in the next section to estimate revenue yields of a VAT.

In the first source, Professor Charles E. McLure constructed broad and narrow tax bases for a consumption value-added tax using 1984 Department of Commerce data. CBS used 1991 Department of Commerce data to update McLure's calculations. McLure used his own judgment in determining which items to exclude in order to establish a broad-based and narrow-based VAT. His broad-based VAT would have limited exemptions, and his narrow-based VAT would have liberal exemptions, as shown in table 1. McLure's broad-based and narrow- based VATs would be levied on 76.3 percent and 44.8 percent of personal consumption expenditures, respectively. ²

   TABLE 1. ESTIMATED BASE OF CONSUMPTION-BASED VALUE-ADDED TAX WITH

/b/ Includes only purchased meals, beverages, and tobacco products.

/c/ Excludes standard clothing issued to military personnel.

/d/ Includes only purchases of new houses.

/e/ Excludes domestic services.

/f/ Excludes domestic services and household utilities except telephone.

/g/ Excludes physicians' services.

/h/ Excludes services furnished without payment by financial intermediaries except life insurance companies and expenses of handling life insurance.

/i/ Excludes bridge, tunnel, ferry, and road tolls; and mass transit systems.

/j/ Excludes clubs and fraternal organizations.

/k/ Excludes foreign travel and expenditures abroad by U.S. residents but includes expenditures in United States by foreigners.

Table updated from McLure, Charles E. The Value-Added Tax: Key to Deficit Reduction. American Enterprise Institute, Washington, DC, 1987. p. 21.

Source: U.S. Department of Commerce, Survey of Current Business (July 1992). p. 59, 78.

Furthermore, the Musgraves identified items which were FREQUENTLY excluded from State sales taxes. Examples of frequently excluded items are home-consumed food, household utilities, and private education. They derived a narrow-based NST by excluding items that are either generally or frequently excluded from State sales taxation. This narrow-based NST would be imposed on 38.4 percent of consumer expenditures. ⁴ All items generally or frequently excluded from State sales taxation are listed in table 2.

Both of these formulations of VAT bases have some problems in the choice of exactly which items might be taxed; obviously, many of these decisions about a real-world VAT are subjective. Table 3 presents another selection of consumer expenditure items, based on a review of the literature. In these alternative formulations, a broad- based VAT would be based on about 77 percent of consumer expenditures and a narrow-based one would cover about 47 percent.

The remarkable thing about all these bases is how close the total maximum and minimum tax bases actually are, despite the differences in the items chosen for exclusion. This suggests that the revenue estimates presented in the next section are reasonable approximations of the maximum and minimum revenues that might be expected from a one percent value-added tax.

           TABLE 2. ESTIMATED BASE OF A VALUE-ADDED TAX, 1991

Data Resources, Inc. (DRI) forecasts that total personal consumption expenditures will be $4,488 billion in current dollars for fiscal year 1993 (October 1, 1993 -- September 30, 1994). ⁵ This aggregate level of personal consumption expenditures and the tax bases formulated by McLure, the Musgraves, and CRS may be used to estimate revenue yields per one percent VAT. As shown in table 4, a 1-percent VAT, based on McLure's work, would yield $34.0 billion (.01 x .796 x $4,488 billion) with a broad base or $20.1 billion with a narrow base for fiscal year 1994. Broad and narrow VAT bases formulated from the Musgraves' analysis would yield $33.2 billion and $17.2 billion, respectively. The VAT bases formulated in table 3 would yield $34.6 billion with a broad base and $20.9 billion with a narrow base for each one percent rate for fiscal year 1994.

          TABLE 4. ESTIMATED REVENUE FROM A VALUE-ADDED TAX /a/

Source: CBS computations based on tables 1-3 and aggregate personal consumption figures from Data Resources, Inc. Forecast Summary. Review of the U.S. Economy. October 1992. p. 13.

Barham, Vicky, S. N. Poddar, and John Whalley. The tax treatment of insurance under a consumption type, destination basis VAT. National tax journal, v. 40, no. 2, June 1987. p. 171-182.

Beaman, Walter H., et al. Technical problems in designing a broad- based value-added tax for the United States. A report of the Special Committee on the Value-Added Tax Section of the American Bar Association. Tax lawyer, v. 28, no. 2, Winter 1975. p. 193-220.

Data Resources, Inc. Review of the U.S. economy, October 1992. p. 13.

Due, John F. Some unresolved issues in design and implementation of value-added taxes. National tax journal, v. 43, no. 4, December 1990. p. 383-394.

Focus on the value-added tax. Coopers & Lybrand. Washington, 1986. 34 p.

Gillis, Malcolm, Carl S. Shoup, and Gerardo P. Sicat, eds. Value- added taxation in developing countries. Washington, World Bank, 1990. 237 p.

Henderson, Yolanda K. Financial intermediaries under value-added taxation. New England economic review, Federal Reserve Bank of Boston, July/August 1988. p. 37-50.

Hoffman, Lorey Arthur, S. N. Poddar, and John Whalley. Taxation of banking services under a consumption type, destination basis VAT. National tax journal, v. 40, no. 4, December 1987. p. 547- 554.

McLure, Charles E. The value-added tax: key to deficit reduction. American Enterprise Institute, Washington, 1987. 184 p.

Musgrave, Richard A., and Peggy B. Musgrave. Public finance in theory and practice. 4th ed. New York, McGraw-Hill, 1984. 824 p.

Tait, Alan A. Value-added tax: international practice and problems. International Monetary Fund, Washington, 1988. 450 p.

Taxing consumption. Paris, Organization for Economic Co-operation and Development, 1988. 335 p.

Turner, William J. Designing an efficient value-added tax. Tax law review, v. 39, no. 2, Summer 1984. p. 435-472.

U.S. Treasury. Office of the Secretary. Tax reform for fairness, simplicity, and economic growth. v. 3, Value-added tax. Washington, November 1984. 128 p.

² McLure, Charles E. The Value-Added Tax: Key to Deficit Reduction, American Enterprise Institute, Washington, D.C., 1987. p. 20-23.

³ Musgrave, Richard A., and Peggy B. Musgrave. Public Finance in Theory and Practice. 4th ed. New York, McGraw-Hill, 1984. p. 437- 438.

⁴ Ibid.

⁵ Data Resources, Inc. Forecast Summary. Review of the U.S. Economy, October 1992. p. 13.