Menu
Tax Notes logo

CRS Updates Comparison of VAT to National Sales Tax

JAN. 28, 2011

RL33438

DATED JAN. 28, 2011
DOCUMENT ATTRIBUTES
Citations: RL33438

 

James M. Bickley

 

Specialist in Public Finance

 

 

January 28, 2011

 

Congressional Research Service

 

7-5700

 

www.crs.gov

 

RL33438

 

 

Summary

The President and leading Members of Congress have stated that fundamental tax reform is a major policy objective for the 112th Congress. 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.

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. A firm's net VAT liability is usually calculated by using the credit-invoice method. According to this method, a firm determines its gross tax liability by aggregating VAT shown on its sales invoices. Then the firm computes its net VAT liability by subtracting VAT paid on purchases from other firms from the firm's gross VAT liability. This net tax is remitted to the government. The subtraction method can also be used to calculate the VAT. Under this 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. A flat tax, based on the proposal formulated by Robert E. Hall and Alvin Rabushka of the Hoover Institution, is a type of modified subtraction method VAT. A VAT has two special treatments of a product or a business: exemption and zero-rating.

In contrast to a VAT, an NST would be a federal consumption tax collected only at the retail level by vendors. an 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 an NST are frequently assumed to be ultimately paid by consumers. For 2011, the Urban-Brookings Tax Policy Center estimates that a 5% broad-based VAT would yield $277.2 billion ($55.44 billion per 1%).

The operating differences between a consumption VAT and an NST have important policy implications. On the one hand, the administrative cost of a VAT would exceed that of an NST because a VAT would require more information to be reported and audited. Also, an opportunity exists for an 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 an NST because a VAT is more complicated, covers more firms, and is a new tax method. On the other hand, a VAT with the credit-invoice method more easily excludes inputs from double taxation than does an NST. A VAT would be easier to enforce than an 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 an NST because a VAT is easier to enforce. A VAT may be less visible to consumers than an 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 January 26, 2011, one bill concerning an NST or VAT has been introduced in the 112th Congress: H.R. 25, or Fair Tax Act of 2011, would levy an NST.

This report will be updated as issues develop, new legislation is introduced, or as otherwise warranted.

                            Contents

 

 

 Introduction

 

 

 Concept of a Value-Added Tax1

 

 

      Methods of Calculating VAT

 

      Exemption and Zero-Rating

 

 

           Exemption

 

           Zero-Rating

 

 

 A National Sales Tax

 

 

 Policy Implications

 

 

      Administrative Costs

 

      Joint Tax Collection

 

      Avoiding Double Taxation of Intermediate Goods and Services

 

      Enforcement

 

      Broadness of Tax Base

 

      Time Required to Implement

 

      Visibility

 

      Experiences of Other Nations

 

 

 Contacts

 

 

 Author Contact Information

 

 

Introduction

The President and leading Members of Congress have stated that fundamental tax reform is a major policy objective for the 112th Congress. 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.1 A VAT or an NST with the same tax base and tax rate would yield approximately the same revenue. For 2011, the Urban-Brookings Tax Policy Center estimates that a 5% broad-based VAT would yield $277.2 billion ($55.44 billion per 1%).2

Both the VAT and the NST are taxes on the consumption of goods and services and are conceptually similar. Yet, these taxes also have significant differences. This report discusses some of the potential policy implications associated with these differences.3

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.4 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 each firm's value added.

Methods of Calculating VAT

There are three alternative methods of calculating VAT: the credit method, the subtraction method, and the addition method.5 Under the credit-invoice method, a firm would be required to show VAT separately on all sales invoices.6 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. 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 nations in the Organization for Economic Cooperation and Development (OECD) with VATs.7 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 in order for that firm to receive full credit against VAT liability for VAT previously paid. Thus, the credit-invoice method would seem to be easier to enforce. Also, the credit-invoice method is probably the only feasible method if there are to be multiple tax rates.

A flat tax, based on the proposal formulated by Robert E. Hall and Alvin Rabushka of the Hoover Institution, is a type of modified subtraction method VAT.8 Their proposal would have two components: a wage tax and a cash-flow tax on businesses. (A wage tax is a tax only on salaries and wages; a cash-flow tax is generally a tax on gross receipts minus all outlays.) It is essentially a modified VAT, with wages and pensions subtracted from the VAT base and taxed at the individual level. Under a standard VAT, a firm would not subtract its wage and pension contributions when calculating its tax base. Under this proposal, some wage income would not be included in the tax base because of exemptions. Under a standard VAT, all wage income would be included in the tax base.

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.9 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, of course). 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 fall 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 not pay VAT on the inputs used to produce that product nor charge VAT on the sale of that product.

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.

Policy Implications

The operating differences between a VAT and an 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 an 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-invoice 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 to be reported and audited than a national sales tax, and, consequently, a VAT would likely be more expensive to administer than an NST.10

Joint Tax Collection

Since 45 states and the District of Columbia have general sales taxes, an opportunity exists for an 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 an NST.12

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 VAT, with the credit-invoice method of tax computation, easily excludes inputs from taxation. The exclusion of inputs from an 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 an 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 an NST.13

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 an NST. 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 an 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 an NST because a VAT is more complicated and would cover more firms than an 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.

The Government Accountability Office (GAO) analyzed VATs in five developed nations: Canada, New Zealand, Australia, France, and the United Kingdom. GAO found that Australia, Canada, and New Zealand, all with relatively new VATs, took between 15 and 24 months to implement their VATs, even though they had preexisting consumption tax administrative structures.15 Another estimate reports a similar time table. Alan A. Tait, former Deputy Director of the Fiscal Affairs Department of the International Monetary Fund, wrote a "chronological schedule of work to be done to introduce a VAT in about eighteen months."16

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.17 New Zealand gives each retailer the option of whether or not to explicitly state the amount of VAT on its retail sales receipts.18 The amount of an 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.

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).19 Sweden, Norway, Iceland, and Switzerland had retail sales taxes at the national level but eventually switched to VATs.20 According to the Organization for Economic Co-Operation and Development (OECD)

 

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.21

 

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.

Author Contact Information

 

 

James M. Bickley

 

Specialist in Public Finance

 

jbickley@crs.loc.gov, 7-7794

 

FOOTNOTES

 

 

1 For an overview of proposals for tax reform, see CRS Report R41591, Tax Reform: An Overview of Proposals in the 112th Congress, by James M. Bickley.

2 Urban-Brooking Tax Policy Center, "5 Percent Broad Based Value Added Tax (VAT) Impact on Tax Revenue ($ billions), 2010-2019," November 12, 2009, p. 1.

3 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.

4 For a comprehensive analysis of the concept of a U.S. value-added tax, see CRS Report R41602, Should the United States Levy a Value-Added Tax for Deficit Reduction?, by James M. Bickley.

5 For a comparison of the credit-invoice method and the subtraction method as a partial replacement VAT, see Itai Grinberg, "Where Credit is Due: Advantages of the Credit-Invoice Method for a Partial Replacement VAT," presented at the American Tax Policy Institute Conference, Washington, D.C., February 18, 2009, 41 p.

6 An exception is the final retail stage where policymakers have the option of including or excluding the VAT from the retail sales slip.

7 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.

8 For a comprehensive analysis of the H-R flat tax proposal, see CRS Report 98-529, Flat Tax: An Overview of the Hall-Rabushka Proposal, by James M. Bickley.

9 For a current examination of exemptions, see Walter Hellerstein and Harley Duncan, "VAT Exemptions: Principles and Practice," Tax Notes, August 30, 2010, pp. 989-999.

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 tax rates, see Tax Foundation, "State Sales, Gasoline, Cigarette, and Alcohol Tax Rates by State, 2000-2010," available at http://www.taxfoundation.org/news/show/245.html, visited January 26, 2011.

12 The authors of a study of the Canadian VAT (goods and services tax) concluded that "the introduction of a federal VAT in the U.S. would not create any great technical problems for either the states or business." See Richard M. Bird, Jack M. Mintz, and Thomas A. Wilson, "Coordination Federal and Provincial Sales Taxes: Lessons from the Canadian Experience," National Tax Journal, vol. 49, no. 4, Dec. 2006, pp. 889-903.

13 Cnossen, VAT and RST: A Comparison, pp. 609-611.

14 Cnossen, VAT and RST: A Comparison, pp. 593-595.

15 U.S. Government Accountability Office, Value-Added Taxes: Lessons Learned from Other Countries on Compliance Risks, Administrative Costs, Compliance Burden, and Transition, GAO-08-566, Apr. 2008, p. 5.

16 Alan A. Tait, Value-Added Tax: International Practice and Problems (Washington, International Monetary Fund, 1988), pp. 409-416.

17 Ibid., p. 357.

18 Ibid.

19 Cnossen, VAT and RST: A Comparison, p. 583.

20 Cnossen, VAT and RST: A Comparison, p. 585 and OECD, Consumption Tax Trends (OECD, March 2005), p. 11.

21 OECD, International VAT/GST Guidelines (OECD, Feb. 2006), p. 1. Available at http://www.oecd.org.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
Copy RID