Sunday, August 8, 2010

Value Added Tax

       A value added tax should be enacted in the United States since it will lead to significant increases in machinery and equipment investment, is a highly efficient tax that will help the government balance budgets, and has been successful in many developed countries worldwide.  The value added tax is the tax of choice in most industrialized countries.  Like a sales tax, it is a tax on consumption in which a single percentage rate is applied to goods and some services.  Unlike a sales tax, which is levied at the final retail stage only, a VAT taxes each stage of production calculating the increasing value of a good or service as it moves through the production process towards distribution.  In other words, businesses only get taxed on the difference between their sales receipts and the cost of their inputs purchased from other businesses (Farrell).  A VAT could help eliminate the US's debt and lead to long-term economic stability.

     One major advantage of implementing a value added tax in the United States is that it will likely lead to substantial increases in machinery and equipment investment.  During the 1990s, four Canadian provinces implemented a VAT, while five other provinces continued to use a retail sales tax (RST) similar to that used in almost all US states.  Research conducted in Canada during the 1990s shows the effects of having a VAT over a retail sales tax very accurately.  This is because both methods of taxation were used at the same time allowing the provinces that continued using a retail sales tax to act as a "control group".  In provinces that adopted the value added tax, machinery and equipment investment rose approximately 12 percent above trend levels in the years following the sales tax reform.  However, no significant difference was observed in both residential and non-residential construction in provinces that hadn't switched to a VAT (Smart and Bird).  The correlation between slow construction growth in non-reforming provinces can be attributed to the excessively high tax rates on business inputs including capital goods.  In accordance with economic theory, eliminating such taxes by replacing a RST with a VAT will have substantial effects on business investment.  It is likely that the effects observed in reforming Canadian provinces will be observed in US states that implement a VAT since the RSTs currently in place in many US states are similar to those currently being used in non-reforming Canadian provinces.  As seen from Canada's experience, replacing RSTs with VATs gives businesses a drastic incentive to increase machinery and equipment investment.  

     Contradicting the evidence that a value added tax is beneficial to society as a whole is the viewpoint that it's regressive.  Opposers of a VAT believe that it's regressive since it's a tax on consumption meaning that it will hit low-income households in greater proportion than upper-income ones.  This is due to the fact that poor people spend a greater percentage of their annual income on consumption meaning that a greater percentage of their income would be spent on the VAT tax (Caspersen and Metcalf).  

     At its very core, a VAT is in fact regressive because poor people spend a greater percentage of their income on consumption.  At the same time, you can't ignore the fact that 47% of US households don't pay income tax (Leonhardt).  Implementing a VAT would require all US consumers to make a contribution of some amount to the government.  To minimize the regressiveness of a VAT, food, housing, and medical expenditures could be exempt from the tax.  If a value added tax is designed and implemented with delicacy, its regressiveness can be minimized to an insignificant minimum.

      Another advantage of implementing a value added tax in the United States is that it's highly efficient tax that will help the government balance budgets.  Based on panel data from the Organization for Economic Co-operation and Development (OECD), governments with a VAT raise more revenue than those that don't, all else equal.  A VAT can achieve stellar efficiency due to significant reductions in administrative costs when raising any given amount of revenue.  This is because most of the cost of collecting tax is borne by business, rather than by the state.  A significant cause of the budget deficit can be linked to combating the costs of the current recession.  In addition, with the approximately 76 million baby boomers born between 1946 and 1964 getting ready to retire, enormous strain will be placed on the budgets of Social Security, Medicare, and Medicaid.  If over the next 25 years, the nation's total tax burden remains at its current 18% of the GDP, the United States will have to borrow to pay interest on the interest resulting in the national debt going straight up (Farrell).  Obviously, the income tax rate must be drastically increased or an efficient revenue raiser such as the VAT must be enacted.  The efficiency of a VAT can minimize compliance problems and help the government make ends meet.

     Many conservatives fear a VAT because of their belief that it will increase government size since governments with the tax raise more revenue than those that don't, all else equal.  Although statistical analysis of OECD data seems to show increased government size in countries with a VAT, deeper more thorough analysis reveals that the revenue a VAT raises is to some extent offset by reduced revenues from other taxes (Keen and Lockwood).  This shows that the purpose of a VAT is not to finance bigger government, but raise revenue with greater effectiveness.  The intent of a value added tax is to minimize wasteful spending and increase government revenue while easing the burden on taxpayers.  In essence, a VAT reduces the use of less effective tax instruments maximizing efficiency.

     One of the biggest reasons a value added tax should be implemented in the United States is that many developed countries worldwide have had success with it.  For example, the VAT is the tax of choice among OECD countries.  In the European Union, each member country's VAT legislation must comply with the provisions set forth in Directive 2006/112/EC which sets the basic framework for the EU VAT.  The VAT Directive requires certain goods and services to be exempt from the tax including postal services, medical care, lending, and insurance.  New Zealand has a value added tax called the Goods and Services Tax (GST) which is notable for its relatively few tax exemptions.  For example, New Zealand taxes all types of food at the same rate unlike most countries with a VAT.  Its few tax exemptions include rents collected on residential rental properties, donations, and financial services. Critics fear that if the federal government enacts a VAT, the states will lose their preferred tax base.  To get around this problem, Canada created a Harmonized Sales Tax (HST) which merged its Goods and Services Tax (GST) with its Provincial Sales Tax (PST) into one single value added tax.  Based on the experiences of countries worldwide, the US will likely have success with a VAT if it is designed and implemented well.

     As seen from Canada's experience, enacting a value added tax in the US will likely increase machinery and equipment investment substantially.  In addition, it would be much more efficient than the RSTs currently being used in many US states because most of the cost associated with collecting tax would be borne by business, rather than by the government.  Enacting a value added tax will not make the government bigger, but raise revenue with greater effectiveness.  Its intent is to minimize wasteful spending and increase government revenue all while easing the burden on taxpayers.  Using a similar approach to Canada's HST, a VAT could generate revenue for both state and federal governments.  With the national debt spiraling out-of-control and the baby boomer generation starting to retire, the US must either drastically increase its income tax or implement an effective tax such as the VAT.  If quick action isn't taken, the nation will see itself paying interest on the interest.  While not perfect, a VAT is the US's best approach to economic recovery and long-time stability.  It is for these reasons that a value added tax should be enacted in the United States. 

Works Cited

Caspersen, Erik, and Gilbert Metcalf. "Is a value added tax regressive? Annual versus lifetime incidence measures." National Tax Journal 47.4 (1994): 731-746. General OneFile. Web.

"Why a VAT Tax Is Where It's At; Adoption of a value-added tax in the U.S. would be a fair, efficient way to help restore the country's financial health, argues Bloomberg Business Week columnist Chris Farrell." Business Week Online 8 Mar. 2010. Business Economics and Theory. Web. 

Keen, Michael, and Ben Lockwood. "Is the VAT a money machine?" National Tax Journal 59.4    (2006): 905+. General OneFile. Web. 

LEONHARDT, DAVID. "Yes, 47% of Households Owe No Taxes. Look Closer." The New York     Times 13 Apr. 2010: Print. 

Smart, Michael, and Richard M. Bird. "The impact on investment of replacing a retail sales tax with a value-added tax: evidence from Canadian experience." National Tax Journal 62.4 (2009): 591+. Business Economics and Theory. Web.

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