While no new formal proposals are in the books, the prospect of implementing a value-added tax has elicited both support and opposition across the political spectrum.
Although many liberals support the idea as a means to pay for social programs and helping reduce the soaring budget deficit, they see it as a highly regressive tax that hits low- and middle-income taxpayers more severely than those in the top brackets. Meanwhile, conservatives are leery of the hidden nature of the tax, which once in place can be changed without the direct involvement of the end user, who is also the end payer.
The VAT, a tax that was put into practice in Europe in the 1950s, is applied at each level of production. Persons or entities adding value to a product pay tax on the amount of increase in value. They then recover a credit on their cost of materials and services used to add value.
Paul Volcker, the former Federal Reserve Board chairman and current chair of President Obama's Economic Recovery Advisory Board, said recently that a VAT could be part of the solution to the deficit. Even though he later admitted that the tax was too unpopular to be considered for the time being, both politicians and tax policy experts have continued to weight in with opinions.
One day after President Obama labeled VAT a "novel idea," Treasury Secretary Tim Geithner quickly assured the nation that the president was not actually in favor of a VAT but reiterated the need to find ways to bring the deficits down: "The president does not support [it], but we all recognize that our deficits are too high and we've got to bring them down."
Both House Speaker Nancy Pelosi and John Podesta, chief executive of the progressive think tank Center for American Progress, have come out in support of a VAT. The Senate, on the other hand, recently voted overwhelmingly in a non-binding resolution to oppose the creation of a VAT.
THE PROS OF A VAT
There are a number of factors that make a VAT particularly attractive to governments in need of increased revenue, according to Harley Duncan, managing director of KPMG's National Tax Practice.
"First, they get their money up front, since it is paid at each stage of production, with the burden on the taxpayer to go back and get a credit," he said. "Second, because of the need to go back and get a credit, there is a self-enforcing aspect to it compared to sales taxes, which inspire widespread evasion."
The reason for the growing interest in a VAT is the current fiscal position of the United States, said Duncan. "We have large and growing deficits," he said. "The goal of the president's deficit reduction commission is to reduce the deficit to 3 percent of gross domestic product by 2015. In order to achieve this by addressing only expenditures, you would have to reduce all entitlements by 25 percent or all federal spending by 15 percent. If you do it solely through tax, you would have to increase rates by 30 percent. Something needs to be done both to increase revenue and decrease expenditures."
The optimum system is to have a balance between income-based and consumption-based taxes, noted Duncan. "In the U.S. we rely almost exclusively on income-based taxes, so it's natural to look at consumption tax options," he said. "More and more countries use a tax like this, so it's natural to look at consumption tax options."
A GLOBAL SHIFT
The economic realities of budget shortfalls faced by governments worldwide will move them toward VATs and other indirect taxes, agreed Frank Sangster, a principal in KPMG's U.S. indirect tax practice.
"The slow economy and falling direct-tax rates are causing many governments worldwide to tighten their existing indirect-tax regimes or introduce new ones," he said. "Finance and tax directors must be proactive in considering how their organizations are responding to the global VAT changes, which are already affecting their markets, operations and internal systems."
"Here in the United States, we're seeing VAT discussed more as a potential means to raise revenue and help reduce the federal deficit," said Sangster.
"A key issue would be carefully coordinating existing state and local sales taxes with a federal VAT," he said. "We've seen examples of how a federal VAT works in other countries in concert with sales taxes in a country's provinces or states, so this matter can be addressed effectively."
A VAT is preferable to a national sales tax, noted Duncan. "A VAT and a well-designed or pure retail sales tax achieve the same result, but when you look at our retail sales tax, it's far from pure," he said. "A VAT applies to transactions involving goods and services, whereas our sales tax applies to sales of goods. And a retail sales tax relies a lot on the taxation of business input. Each step pyramids a tax onto the base, with a variety of harmful economic effects. A VAT doesn't tax business inputs like a sales tax and it deals better with services than a retail sales tax."
The experience of Canada in implementing its goods and services tax illustrates the benefits of a well-designed VAT, according to David Robertson, a tax partner with Toronto-based law firm Fasken Martineau.
Canada's introduction of its GST in 1991 essentially replaced a 13.5 percent manufacturers' sales tax with a value-added goods and services tax of 7 percent, Robertson observed. And the majority of provinces have now abolished their provincial sales and use tax systems to harmonize them with the federal government's GST and create the HST, or harmonized sales tax.
"Our VAT gives us a nice competitive advantage to doing business in Canada and to export from Canada," he said. "A key advantage from a business perspective is that with a VAT you pay tax on everything you purchase, but if a business purpose is involved, the government gives it back. An entrepreneur in the U.S. gets taxed up front by a sales tax and pays it as a business expense before he ever makes a penny, which creates a disincentive to take risks. With a VAT, you pay the tax but the government gives it back as a tax credit, frequently on a monthly basis - you can elect to file monthly, although you're only required to report annually."
"By switching to a single, national value-added tax, Canada has significantly reduced the tax burden and embedded tax costs of the goods and services that our businesses and manufacturers export to the United States and around the world, and that has contributed to the economic success that Canadian businesses and Canada have enjoyed over the past decade," he said.
And it is not a given that a VAT increases the overall tax burden of a country, Robertson pointed out. "When I started my practice, Canada was a high-tax jurisdiction for business. Now, some 20 years later, we're becoming a low-tax jurisdiction. We're doing this by moving toward exclusively using a VAT, which doesn't tax business inputs, and dropping the corporate income tax rates," he said.
At the same time that Canada and most of its provinces were implementing a VAT, the government introduced spending cuts. As a result, after three decades of deficits, Canada posted its first annual budget surplus in 1998, Roberson noted. "In the mid-1990s, our debt-to-GDP ratio was close to 70 percent, one of the highest in the G-7," he said. "Since then we've been paying it down and now the debt to GDP ratio is 30 percent, the lowest of all the G-7 countries."
There are ways to deal with the regressive aspects of a VAT, according to Duncan.
"It is a tax on consumption, so even if you leave necessities like food and shelter out of the tax base, it will hit low-income households in greater proportion than upper-income ones," he said. "One of the ways to solve this is through rebates to low-income households through the income tax system. It's one of the political issues that will have to be dealt with."
A solution to projected U.S. deficits just does not mesh with the way Congress has developed budgets in the last 20 years, he observed. "It will be very difficult with the existing revenue and expenditure options. So a VAT has to be considered part of the answer."
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