Taxes on Goods and Services

1. PA 546 Constantine Hadjilambrinos Taxes on Goods and Services Lecture 7 October 11, 2005

2. Advantages Can have a broad base—significant source of revenue Can diversify the tax base—minimizes efficiency and equity problems Can extract payments from individuals with high economic capacity regardless of current income Can be used on specific goods and services to internalize externalities Possibly enhance economic efficiency—levied on what consumers take from the economy rather than what they contribute to it. Encourage saving and investment PA 546 Constantine Hadjilambrinos

3. PA 546 Constantine Hadjilambrinos Types • General: Applies to all transactions • Specific (unit tax): Applies to physical units • Single-stage: Applies only once in production & distribution process • Direct: Apply to total consumption Cons.=Income - Savings • Selective (excise): Applies only to specific transactions • Ad valorem: Applies to value of transaction • Multi-stage: Applies to each stage of production & distribution process • Indirect: Apply to proxy to total consumption Retail sales tax, VAT

4. PA 546 Constantine Hadjilambrinos Some design issues • Multi-stage taxes can increase price of goods by an amount that is greater than the collected tax. Example: Sales tax rate: 10% Product markup: 20%

5. PA 546 Constantine Hadjilambrinos Some design issues • Integrated firms may be advantaged by multi-stage taxes: fewer embedded tax costs • Should producer purchases be excluded from tax? If not: • Tax will not be transparent to ultimate payers • Tax will raise cost of goods and services more than the revenue it will produce • Tax will affect different goods/services differently and will change economic behavior

6. PA 546 Constantine Hadjilambrinos Solutions • Direct-use rule: Anything used directly in production is excluded. • Component part rule: Producer purchases that become part of products are exempt.

7. PA 546 Constantine Hadjilambrinos Taxation of services Most states only tax a few services—This can be a problem in a service economy. • Need to make distinction between “retail” services and worker employer relationships • Need to avoid taxing services delivered almost exclusively to businesses • Social policy considerations may make it best to avoid taxing medical, legal, etc. services

8. PA 546 Constantine Hadjilambrinos Commodity exemptions Sales taxes are generally regressive—higher income groups tend to save and invest greater portions of their income. Exempting certain commodities (food, prescription medication, sometimes clothes) purports to address this regressivity. Higher income groups tend to spend more on food, clothes, etc, so, again, they benefit more from exemptions. Rebates may be better option.

9. PA 546 Constantine Hadjilambrinos Use Taxes Some jurisdictions do not levy sales tax (Andorra, Oregon, Delaware, NH, tribes). Neighboring jurisdictions can loose significant tax revenue. Most jurisdictions (all states with sales tax) levy use taxes on the storage, use, or consumption of taxable property on which no tax has been paid. Use tax is extremely difficult to enforce.

10. PA 546 Constantine Hadjilambrinos Remote Vendors Vendors are the collectors of sales tax for the state. What about purchases from out-of-state vendors? • Purchases from a local storefront. State can compel vendor to collect tax. • Purchases from a remote vendor with physical presence in the state. State can compel vendor to collect tax. • Purchases from a remote vendorwithout physical presence. State cannot compel vendor to collect tax.

11. PA 546 Constantine Hadjilambrinos Value-Added Tax (VAT) VAT taxes every incremental increase in value in each step of the production-distribution process. At each step, each business pays tax on its sales, but subtracts tax it paid to its vendors. VAT exemptions—Relieve seller from collecting VAT on sales, but not from paying VAT on purchases. Businesses, if exempt, cannot recover VAT paid.

12. PA 546 Constantine Hadjilambrinos Advantages of VAT • Combats tax evasion & lack of vendor cooperation in sales tax collection. • Collects tax from products imported, removes it from products exported. • VAT provides more complete exclusion of business purchases than retail sales tax.