Presentation to the President's Advisory Panel on Federal Tax Reform: The Value Added Tax (VAT)

1. Presentation to the President's Advisory Panel on Federal Tax Reform:The Value Added Tax (VAT) May 11, 2005 • Charles McLure • Senior Fellow • Hoover Institution • Stanford University

2. Overview • Overview of Credit-Method Value Added Tax (“VAT”) • Comparison of Credit-Method VAT, Subtraction-Method Business Transfer Tax (“BTT”), and Retail Sales Tax (“RST”) • Exempting and Zero-Rating under VAT, BTT, and RST • Taxation of Financial Services under a Credit-Method VAT • International Issues • Subtraction-Method BTT: Additional Considerations • What Liberals and Conservatives Fear – or Like – about the VAT

3. Overview • Appendix • Implications of three ways of implementing indirect consumption taxes • Extended evaluation of direct and indirect forms of consumption taxes • Subtraction-Method BTT: Additional considerations • Coordinating state and local RSTs with a federal VAT

4. Credit-Method Value Added Tax (“VAT”) • Credit-Method VAT is an indirect tax on consumption • Indirect taxes cannot be personalized for circumstances of purchasers • Flat Tax and Consumed Income Tax are direct consumption taxes • They can be personalized via exemptions, deductions, and graduated rates

5. Credit-Method Value Added Tax (“VAT”) • Credit-Method VAT is the most commonly used tax on consumption • Levied by approximately 150 countries worldwide, including all 25 members of the European Union (“EU”) • VAT has administrative and political advantages over other indirect consumption taxes, such as: • Subtraction-Method VAT • Business Transfer Tax (“Subtraction-Method BTT”) • Japan is only OECD country to use Subtraction-Method VAT • Retail Sales Tax (“RST”) • Levied by 46 U.S. states, including the District of Columbia, and 9 Canadian provinces • Not levied in any other major developed country

6. Three Forms of Indirect Tax on Consumption:An Illustration (Tax rate = 10%)

7. Three Forms of Indirect Tax on Consumption:An Illustration (Tax rate = 10%) • In their pure forms, BTT, VAT, and RST have identical effect: taxation of consumption • VAT and RST are “transactions-based” taxes: they are levied on each sale • BTT is an “accounts-based” tax: it is not/cannot be levied on each sale • BTT taxes “slices” of value added (sales minus purchases) • Under RST, tax collector gets only “one bite at the apple,” at the last stage • Under BTT and VAT much of tax is collected before the last stage • Under VAT invoices showing tax paid must support input credits See appendix slide 21 for further discussion.

8. Three Features of the Standard VAT • Credit-Method • Businesses are allowed input credits for VAT shown on invoices • Immediate credit for all tax on business purchases, including capital goods • Required for consumption tax • Simpler (no need for complicated “timing” rules for depreciation, etc.) • “Destination” treatment of foreign trade, due to “border tax adjustments” • Imports are subject to VAT (with input credit for registered businesses) • Imports are treated like domestic production • Exports are zero-rated • Exports enter world markets tax-free

9. Credit-Method VAT: Exempting and Zero-Rating of Last Stage (Tax Rate = 10%) • Input credits are allowed for zero-rated sales, but not for exempt sales • Exemption of last stage eliminates tax only on value added at that stage • Zero-rating of last stage eliminates tax on entire value of sales at all stages through credits at last stage • Zero-rating is common for exports

10. Credit-Method VAT: Exempting and Zero-Rating of Intermediate Stage (Tax Rate = 10%) • Zero-rating of intermediate stage has no effect on ultimate tax liability (Zero-rating produces lower input credits) • Exemption of intermediate stage breaks chain of credits and increases tax (Neither exempt seller nor customer is allowed input credit for VAT paid by exempt seller) • Exemption creates “cascading” of tax, incentives for self-supply, and other economic distortions; zero-rating does not • Producers of intermediate stage goods and services do not want to be exempt; this is politically important

11. Credit-Method VAT: Summary of Effects of Exemption and Zero-Rating

12. Choosing between Exemption and Zero-rating • Administrative differences • Exemption requires allocation of input taxes; zero-rating does not • Depends on the purpose • Zero-rating selected final sales eliminates tax; exemption does not • Exempting intermediate sales increases tax; zero-rating does not • Exports: only zero-rating eliminates tax at pre-export stages • Reducing regressivity (not an optimal way to do this, given EITC, etc.) • Avoiding taxation of (non-commercial) activities of non-profit organizations • Small business (for administrative business; probably not needed in US) • Zero-rating does not eliminate administrative burden; exemption does • Exemption increases taxation, except at final stage • Make registration and normal treatment optional • Financial institutions: discussed in detail later

13. Exemption and Zero-Rating of Last Stage Under BTT, VAT, and RST (Tax Rate = 10%) • Exemption of last stage under VAT or BTT eliminates tax only on value added at last stage • Zero-rating of last stage under VAT eliminates tax on entire sales price, like a retail sales tax exemption

14. Effects of Exemption of Intermediate Stage under VAT and BTT (Tax Rate = 10%) • Subtraction-Method BTT: exemption of intermediate stage reduces tax • politically vulnerable to requests for exemptions • Credit-Method VAT: exemption of intermediate stage increasestax • much less vulnerable: intermediate stages do not want to be exempt

15. Taxation of Financial Services under a Credit-Method VAT

16. International Issues • Border Tax Adjustments are relatively simple under VAT • Verify exports; valuation is not required (because zero-rated) • Valuation of imports is important only for purchases by households • Undervaluation of business imports yields lower credits • Using a VAT to lower income tax rates would have international repercussions • Destination-based VAT would, per se, be neutral • More excess foreign tax credits: • US income tax would have effects more like territorial tax • Investment in US might be encouraged • Pressures on foreign countries to lower income tax rates • Using a VAT (or a BTT or an RST) to replace the corporate income tax would cause massive international disruptions

17. Evaluation: Direct and Indirect Forms of Consumption Taxes See appendix slide 22 for further discussion.

18. Subtraction-Method BTT: Summary of Additional Considerations • Difficult to allow deductions only for purchases that have been subject to BTT • Accurate Border Tax Adjustments (BTAs) are not simple if not all pre-export stages are taxed • BTT does not – or should not – accommodate multiple rates See appendix slides 23 and 24 for further discussion.

19. What Liberals and Conservatives Fear – or Like – about the VAT • “The VAT is regressive” (burdening the poor relatively more than the affluent) • Exemption (or zero-rating) of necessities is not the solution • Exemptions do not have much effect on the distribution of income • Higher VAT rate would be required • Exemptions complicate administration and distort choices • There are other ways to reduce the burden on the poor (e.g., EITC) • Everyone should help pay for government in a democracy • “The VAT is a ‘money machine’” (that leads to bigger government) • Governments in the European Union spend more than those in the US • But they spent more before the switch from inferior sales taxes to VAT • Not clear whether there is an upward trend in the size of governments because of a VAT • Less constraint on spending if necessities are exempt or zero-rated • Indexing (of Social Security, EITC, welfare, etc.) to reflect VAT would reduce restraint

20. Appendix

21. Implications of Three Ways of Implementing Indirect Consumption Taxes

22. Extended Evaluation: Direct and Indirect Forms of Consumption Taxes

23. Subtraction-Method BTT: Additional Considerations • Border Tax Adjustments (BTAs) are not simple • Incentive to overvalue imports • Treatment of exports • Exempt only value added at export stage? • Incentive to shift activities to “export” stage • Incentive to undervalue exports • Would not eliminate BTT on exports • Eliminate all BTT on exports (as under Credit-Method VAT) • Calculation of tax base: zero minus purchases • What if not all pre-export activity has been taxed?

24. Subtraction-Method BTT: Additional Considerations • BTT does not – or should not – accommodate multiple rates • Invitation for lobbyists to gain low rates • Manipulation of transfer prices to shift income to low-tax activities • Accurate BTAs (eliminating all tax) are impossible • How much tax has been paid before the export stage? • How much tax has been paid on competing domestic products? • Deductions could, in theory, be allowed only for purchases from suppliers subject to BTT • Difficult to implement under accounts-based BTT • To be effective it would need to mimic credit-method VAT • Invitation for lobbyists to gain exceptions • Problems of multiple rates and BTAs remain

25. Coordinating State and Local RSTs with a Federal VAT • Four defects of state and local (S&L) RSTs • Many products (especially services) are untaxed • Many business purchases are taxed • Incredible complexity, due in part to lack of uniformity • Many interstate sales to households are untaxed • US Supreme Court’s decision in Quill, based on complexity • Potential benefits of coordinating S&L RSTs with federal VAT • More likely to tax services (taxed under VAT) • More likely to exempt business purchases (input credits under VAT) • Coordination could reduce complexity (greater uniformity of tax base and administration) • Federal legislation could override Quill (not needed with uniformity)

26. Coordinating State and Local RSTs with a Federal VAT • S&L counter-arguments • Federal VAT would “pre-empt” traditional S&L tax base • Coordination reduces state sovereignty over tax base and administration • S&L governments would retain sovereignty over tax rates • Sovereignty over base and administrative details is much less important • States have not acted responsibly: lack of uniformity