A value-added tax (VAT) is a type of consumption tax that is collected at each stage of a commodity's production and distribution. Although a VAT is typically administered by taxing the total value of a business's sales of a particular product or service, the business can claim a credit for the taxes it paid on the "inputs"--such as materials and equipment--it used to make the product or provide the service.
More than 140 countries--including all members of the Organisation for Economic Co-operation and Development (OECD), except for the United States--have adopted VATs. However, the tax bases and rate structures differ greatly among countries. Most European countries have implemented VATs that have a narrow tax base, with certain categories of goods and services--such as food, education, and health care--either exempted from the tax or taxed at lower rates than other goods and services. In Australia and New Zealand, the VAT has a much broader tax base, with exemptions generally limited only to those goods and services for which it is difficult to determine a value. As of January 1, 2010, the average VAT rate for OECD countries was 18 percent, ranging from 5 percent in Japan to 25.5 percent in Iceland. All OECD countries that impose a VAT also collect revenues from taxes on income and profits.
This option would impose a 5 percent VAT in one of two ways. The first alternative would apply the VAT to a broad base that would include most goods and services. Because their value is difficult to measure, certain items--such as financial intermediation services, existing housing services, primary and secondary education, and other services provided by government agencies and nonprofit organizations for a nominal or no fee--would be excluded from the base. (Existing housing services encompass the monetary rents paid by tenants and rents imputed to owners who reside in their own homes.)
Although existing housing services would be excluded under this alternative, the broad base would include all future consumption of housing services by taxing the purchase of new residential housing. The broad base would also exclude government-reimbursed expenditures for health care (primarily costs paid by Medicare and Medicaid).
The option would become effective on January 1, 2013--a year later than most of the revenue options presented in this volume--to provide the Internal Revenue Service sufficient time to set up and administer a VAT. The first approach would increase revenues by $950 billion from 2012 through 2016 and by $2.5 trillion over the 2012-2021 period. (Because a VAT reduces the tax base of income and payroll taxes, the imposition of a VAT would lead to reductions in revenues from those sources. The estimates shown here reflect those reductions.)
Under the second alternative, the 5 percent VAT would apply to a narrower base. In addition to those items excluded under the broad base, the narrow base would exclude purchases of new residential housing, food purchased for home consumption, health care, postsecondary education, and all other financial services. This approach would increase revenues by $530 billion from 2012 through 2016 and by $1.4 trillion over the 2012-2021 period.
One argument in favor of imposing a VAT, as an alternative to increasing income tax rates, is that such action would raise revenues without discouraging saving and investment. Through tax credits, deductions, and exclusions, the individual income tax provides incentives that encourage saving, but those types of provisions--each with their own eligibility rules and income phaseouts-- make the tax system more complicated. By taxing consumption only, a VAT would exempt saving in a simpler, more direct fashion.
A drawback of the option is that it would require the federal government to establish a new system to monitor and collect the tax. As with any new tax, a VAT would impose additional administrative costs on the federal government and additional compliance costs on businesses. Because such costs are typically higher for smaller businesses, many countries, including the United Kingdom, exempt some small businesses from the VAT. A study conducted by the Government Accountability Office (GAO) in 2008 showed that all of the countries evaluated-- Australia, Canada, France, New Zealand, and the United Kingdom--devoted significant resources to addressing and enforcing compliance. However, the GAO study also found that a VAT might be less expensive to administer than an income tax. For example, the tax administration agency in the United Kingdom estimated administrative costs for the VAT to be 0.55 percent of revenue collected, whereas the cost of administering the income tax was 1.27 percent.
Another argument against imposing a VAT is that it might increase the prices consumers have to pay for goods and services relative to the after-tax price sellers would otherwise receive for providing those goods and services. Therefore, adopting a VAT would cause an initial jump in the overall consumer price index because that index is computed on a tax-inclusive basis. The increase in the price level, however, would not necessarily lead to further inflation. If the Federal Reserve adjusted the money supply in a way that maintained current-dollar income, little inflation, beyond the initial price jump, would occur. (If there was an initial increase in the price level, federal spending for mandatory programs with benefits
that are affected by inflation, such as Social Security, could increase; parameters of the tax system that are indexed to inflation could also be affected. However, the estimates shown here correspond to the standard estimating convention of holding macroeconomic aggregates-- such as gross domestic product and the overall price level--unchanged.)
Yet another drawback of imposing a VAT is that the tax is regressive when its burden is measured on an annual basis. In any given year, lower-income families--who consume a greater share of their income than higher- income families--would pay a larger share of their annual income in consumption taxes than other families. A VAT appears to be less regressive when its burden is measured over a longer period.
The choice between the two alternatives--a broad base and a narrow base--presents certain trade-offs. A VAT could be made less regressive by adopting a narrow base and thus granting tax preferences for the goods and services that command a relatively larger proportion of budgets for low-income individuals and families. Those preferences, however, would substantially increase the costs of enforcement and compliance, and they would reduce revenues. In addition, a narrow-based VAT with exemptions would distort economic decisions to a greater degree than would a VAT with a broader base.
Policymakers could offset some of the regressive impact of a VAT by allowing additional exemptions or refundable credits under the federal income tax for individuals and families with lower income. That approach could be specifically targeted to lower- and middle-income families, but such provisions could add to the complexity of the individual income tax.