Value-Added Tax: A New U.S. Revenue Source?
Value-Added Tax: A New U.S. Revenue Source?
Updated January 3, 2008
James M. Bickley
Specialist in Public Finance
Government and Finance Division
Value-Added Tax: A New U.S. Revenue Source?
President George W. Bush has stated that tax reform is one of his
Administration’s top priorities. Some form of a value-added tax (VAT), a broad-
based consumption tax, has been frequently discussed as a full or partial replacementth
for the U.S. income tax system. As of January 3, 2008, in the 110 Congress, four
proposals for fundamental tax reform include some form of a VAT: H.R. 1040,th
H.R. 4159, S. 1040, and S. 1081. In addition, in the 110 Congress, Representative
John Dingell introduced H.R. 15, which would levy a VAT to finance national health
A VAT is imposed at all levels of production on the differences between firms’
sales and their purchases from all other firms. For calendar year 2005, a broad-based
VAT in the United States would have raised net revenue of approximately $50 billion
for each 1% levied. Most other developed nations rely more on broad-based
consumption taxes for revenue than does the United States. A VAT is shifted onto
consumers; consequently, it is regressive because lower-income households spend
a greater proportion of their incomes on consumption than higher-income
households. This regression, however, could be reduced or even eliminated by any
of three methods: a refundable credit against income tax liability for VAT paid,
allocation of some of VAT revenue for increased welfare spending, or selective
exclusion of some goods from taxation.
From an economic perspective, a major revenue source is better the greater its
neutrality — that is, the less the tax alters economic decisions. Conceptually, a VAT
on all consumption expenditures, with a single rate that is constant over time, would
be relatively neutral compared to other major revenue sources. A VAT would not
alter choices among goods, and it would not affect the relative prices of present and
future consumption. But a VAT cannot be levied on leisure; consequently, a VAT
would affect households’ decisions concerning work versus leisure.
The imposition of a VAT would cause a one-time increase in this country’s
price level. But a VAT would not necessarily affect this country’s future rate of
inflation if the Federal Reserve offset the contractionary effects of a VAT with a
more expansionary monetary policy. If the United States continued its policy of
flexible exchange rates, then the imposition of a VAT would not significantly affect
the U.S. balance-of-trade. There is no conclusive evidence that a VAT would change
the rate of national saving more than another type of major tax increase. The high
revenue yield from a VAT would cause administrative costs to be low, measured as
a percentage of revenue yield. In comparison to other broad-based consumption
taxes, VATs have produced relatively good compliance rates. Whether or not a
federal VAT would encroach on the primary source of state revenue, the sales tax,
is subject to debate. A federal-state VAT could be collected jointly, but a state would
lose some of its fiscal discretion.
This report will be updated as issues develop, new legislation is introduced, or
as otherwise warranted.
In troduction ......................................................1
Concept of a Value-Added Tax.......................................2
Types of VAT................................................2
Methods of Calculating VAT.....................................3
Exemption Versus Zero-Rating...................................4
International Comparison of Composition of Taxes.......................7
Policy Options to Alleviate Regressivity...........................10
Exclusions and Multiple Rates..............................10
Earmarking of VAT Revenues...............................12
Encroachment on a State Tax Source.............................19
Appendix A. Credit-Invoice, Subtraction, and Addition Methods...........22
Appendix B. Economic Effects of a Special VAT Treatment..............25
Appendix C. General Consumption Taxes in OECD Countries.............26
Appendix D. VAT Rates by Country.................................28
Related CRS Products.............................................32
List of Tables
Table A1. Credit-Invoice Method....................................23
Table A2. Subtraction Method......................................23
Table A3. Addition Method........................................24
Table B1. Economic Effects of a Special VAT Treatment.................25
Table C1. Data on General Consumption Taxes in OECD................26
Table D1. Value-Added Tax Rates by Country.........................28
Value-Added Tax: A New U.S. Revenue
President George W. Bush has stated that tax reform is one of his top priorities.
His President’s Advisory Panel on Federal Tax Reform analyzed different reform
options including a “Partial Replacement VAT,” or value-added tax. Although the
Panel did not recommend the VAT option, it viewed this option as worthy of further1th
discussion. In the 110 Congress, some Members of Congress are expressing
interest in examining the feasibility of levying some form of a value-added tax as a2
way to reform the tax code or finance national health care. Representative Burgess
introduced H.R. 1040, which would allow taxpayers to select a flat tax, a modified
VAT based on the concepts of Robert E. Hall and Alvin Rabushka, as an alternative
to the current income tax system.3 Representative Phil English’s proposal (H.R.
4159) would replace our corporate income tax with a subtraction-method VAT and
our individual income tax with a consumed-income tax. Senator Richard C. Shelby’s
proposal (S. 1040) and Senator Arlen Specter’s proposal (S. 1081) would replace
individual and corporate income taxes and estate and gift taxes with a flat tax basedth
on the Hall-Rabushka concept. In addition, in the 110 Congress, Representative
John Dingell introduced H.R. 15, which would levy a VAT to finance national health
insurance. Furthermore, some advocates of a VAT argue that this tax is needed to
meet the long-term revenue requirements of the federal government.4
1 The President’s Advisory Panel on Federal Tax Reform, Simple, Fair, & Pro-Growth:
Proposals to Fix America’s Tax System (Washington: U.S. Department of the Treasury,
Nov. 1, 2005), pp. 191-192. This report is available at [http://www.taxreformpanel.gov].
For an analysis of the Panel’s proposals, see CRS Report RL33545, The Advisory Panel’s
Tax Reform Proposals, by Jane G. Gravelle.
2 For an overview of fundamental tax reform proposals, see CRS Report RL33443, Flat Tax
Proposals and Fundamental Tax Reform: An Overview, by James M. Bickley.
3 The combined individual and business taxes proposed by the typical flat tax can be viewed
as a modified value-added tax (VAT). The individual wage tax would be imposed on wages
(and salaries) and pension receipts. Part or all of an individual’s wage and pension income
would be tax-free, depending on marital status and number of dependents. The business tax
would be a modified subtraction-method VAT with wages (and salaries) and pension
contributions subtracted from the VAT base, in contrast to the usual VAT practice. For a
comprehensive analysis of the flat tax, see CRS Report 98-529, Flat Tax: An Overview of
the Hall-Rabushka Proposal, by James M. Bickley.
4 For example, see Committee for Economic Development, A New Tax Framework: A
Blueprint for Averting a Fiscal Crisis (Washington, 2005), 45 p.
Arguably, the primary reason for congressional interest in the VAT is its high
potential revenue yield.5 For calendar year 2005, a VAT imposed on most goods and
services would have raised a net revenue of approximately $50 billion for each 1%
Other aspects of a VAT that often raise interest or concern include international
comparison of composition of taxes, equity, neutrality, inflation, balance-of-trade,
national saving, administrative cost, compliance, and intergovernmental relations.
This report considers the experiences of the 29 nations with VATs in the 30 member
Organization for Economic Cooperation and Development (OECD), relevant to the
feasibility and operation of a possible U.S. VAT. Currently, the OECD consists of
Japan, Mexico, and South Korea. In order to examine different aspects of a VAT,
it is important to understand the concept of a value-added tax, including the types of
VATs, the different methods of calculating VATs, and exemption versus zero-rating.
Concept of a Value-Added Tax
A value-added tax is a tax, levied at each stage of production, on firms’ value
added. The value added of a firm is the difference between a firm’s sales and a
firm’s purchases of inputs from other firms. In other words, a firm’s value added is
simply the amount of value a firm contributes to a good or service by applying its7
factors of production (land, labor, capital, and entrepreneurial ability). Another
method of calculating a firm’s value added is to total the firm’s payments to its
factors of production.
Types of VAT
There are three types of VATs that differ in their tax treatment of purchases of
capital inputs (plant and equipment). Under the consumption VAT, capital purchases
are treated the same way as the purchase of any other input: the purchase price is
deducted at the time of purchase. This tax treatment of capital purchases is
equivalent to expensing. Under the income VAT, the VAT paid on the purchases of
capital inputs is amortized (credited against the firm’s VAT liability) over the
expected lives of the capital inputs. Under the gross product VAT, no deduction for
the VAT on purchases of capital inputs is allowed against the firm’s VAT liability.
5 The revenue for a VAT would vary depending on the tax base. For a discussion of this
issue, see CRS Report RS22720, Taxable Base of the Value-Added Tax, by Maxim Shvedov.
6 CRS figure derived from VAT revenue estimates in the following source: William G. Gale
and C. Eugene Steuerle, “Tax Policy Solution,” in Alice M. Rivlin and Isabel Sawhill, eds.,
Restoring Fiscal Sanity — 2005 (Washington: Brookings Institution Press, 2005), p. 113.
7 These factors of production have specific meanings to an economist. Labor consists of
all employees hired by the firm. Land consists of all natural resources including raw land,
water, and mineral wealth. Capital is anything used in the production process that has been
made by man. The entrepreneur is the decision maker who operates the firm.
All 29 OECD nations with VATs use the consumption type. The consumption
VAT is the type usually advocated for this country. Indeed, most VAT advocates
intend to shift tax burdens from capital income to consumption. Furthermore, a
consumption VAT is simpler to compute because firms do not have to separate
expenditures for capital from other expenditures.
Methods of Calculating VAT
There are three alternative methods of calculating VAT: the credit method, the
subtraction method, and the addition method.8 Under the credit-invoice method, a
firm would be required to show VAT separately on all sales invoices.9 Each sale
would be marked up by the amount of the VAT. A sales invoice for a seller is a
purchase invoice for a buyer. A firm would calculate the VAT to be remitted to the
government by a three-step process. First, the firm would aggregate VAT shown on
its sales invoices. Second, the firm would aggregate VAT shown on its purchase
invoices. Finally, aggregate VAT on purchase invoices would be subtracted from
aggregate VAT shown on sales invoices, and the difference remitted to the
government. The credit-invoice method is calculated on a transactions basis.
Under the subtraction method, the firm calculates its value added by subtracting
its cost of taxed inputs from its sales. Next, the firm determines its VAT liability by
multiplying its value added by the VAT rate.10 Most flat tax proposals are modified
subtraction method VATs. Under the addition method, the firm calculates its value
added by adding all payments for untaxed inputs (e.g., wages and profits). Next, the
firm multiplies its value added by the VAT rate to calculate VAT to be remitted to
The credit-invoice method is used by 28 of 29 OECD nations with VATs. Tax
economists differ in their classifications of the Japanese VAT. Both the credit-
invoice and the subtraction methods have been discussed for the United States. The
prevailing view of economists is that the credit-invoice method is superior. This
method requires registered firms to maintain detailed records that are cross indexed
with supporting documentation. A VAT shown on the sales invoice of one firm is
the same as the VAT shown on the purchase order of another firm. Hence, the credit-
invoice method allows tax auditors to cross check the records of firms. Also, each
firm has a vested interest in insuring that the VAT shown on its purchase orders is
not understated so the firm can receive full credit against VAT liability for VAT
previously paid. Thus, the credit-invoice method would seem to be easier to enforce.
Also, the credit-invoice method is probably the only feasible method if there are to
be multiple tax rates.
8 Numerical examples with explanations of these three methods of calculating VAT are
shown in Appendix A.
9 An exception is the final retail stage where policymakers have the option of including or
excluding the VAT from the retail sales slip.
10 For a comprehensive explanation and analysis of methods to calculate VAT, see Value-
Added Tax: Methods of Calculation, by James M. Bickley, a CRS general distribution
memorandum available from the author.
Supporters of the subtraction method maintain that it would have low
compliance costs because all necessary data could be obtained from records kept by
a firm for other purposes. Still, a firm would have to make calculations based on
these data. For example, deductible expenses would have to be separated from
nondeductible expenses, and some data expressed on an accrual basis would have to
be converted to a cash flow basis.
The credit-invoice method would have substantial compliance costs because the
amount of VAT would have to be shown on every sales invoice (and, conversely, on
every purchase invoice). On the plus side, however, the credit-invoice method
would yield an additional data base to firms. Some firms might find these additional
data useful in decision making. For example, records of purchase invoices and sales
invoices may improve some firms’ control over their inventories. Compliance costs
of the credit-invoice method might be partially offset by the value of the VAT data
base to firms, but this value has never been quantified.
The credit-invoice method would have greater administrative costs than the
subtraction method because of its requirements for additional data, computations, and
record-keeping. Although there are data on the administrative costs of a VAT
calculated by the credit-invoice method, empirical data are not available on the
subtraction method; consequently, a quantitative comparison of costs currently is not
feasible. The subtraction method would not work administratively if many goods are
exempt or if multiple tax rates are levied. Unless specified otherwise, this report will
assume that the credit-invoice method is used and that the VAT is the consumption
Exemption Versus Zero-Rating
None of the VAT proposals would require all firms to collect the VAT. The two
fundamental methods of giving special tax treatment to businesses in an industry
under a VAT are exemption and zero-rating. An exempt business would not collect
VAT on its sales and would not receive credit for VAT paid on its purchases of
inputs. An exempt business would not register with tax authorities, and,
consequently, would not be part of the VAT system. Hence, an exempt business
would not have the usual VAT compliance costs and would not impose
administrative costs on the government (except verification of its exemption, of
course). An exempt business’s costs, however, include any tax paid on inputs,
because it receives no credit for previously paid taxes.
A zero-rated business would not collect VAT on its sales but would receive
credit for VAT paid on its inputs. This is equivalent to the business being charged
a zero tax rate. A zero-rated business would be a registered taxpayer, and,
consequently, would involve the usual compliance and administrative costs. A zero-
rated business, however, would receive a refund of any VAT paid on its inputs, so
its costs would not include VAT paid at earlier stages. The effects on final prices and
total VAT collected by the government caused by exempting or zero-rating firms
would vary with the stage of production.
An exempt retailer would not charge any VAT on its sales but it would not
receive any credit for VAT previously paid on its inputs, so its price to the final
consumer would include all VAT paid except that on its own value-added. The
government would have collected a tax on all the value added in the product except
A zero-rated retailer would not charge any VAT on its sales, but it would
receive credit for all VAT previously paid on its inputs. A zero-rated retailer would
not remit VAT to the government, but it would receive a refund for VAT previously
paid by suppliers. Hence, the price of the commodity would not include any VAT,
and the government would receive no revenue.
Exempting or zero-rating a retailer would not affect the linkage (or chain) of
VAT collections and credits between different stages of production because retailers
are the final stage of production and distribution. But exempting or zero-rating an
intermediate stage, such as manufacturing of wholesaling, would break the chain
between firms at different stages of production.
Exempting, however, causes a far more serious break than zero-rating. For
example, an exempt manufacturer would not collect VAT on sales to a wholesaler
and would not receive credit for VAT paid on inputs. A nonexempt wholesaler
would not receive credit for the VAT paid on the manufacturer’s inputs included in
the price it paid the manufacturer. But the wholesaler would remit VAT collected
on all of its sales, so some of the value added in the product would be taxed twice.
Consequently, exempting a manufacturer or any other intermediate producer would
increase total VAT collected by the government and the final retail price of the
A zero-rated manufacturer would not collect VAT on sales but would receive
credit for VAT paid on inputs. The price paid by the wholesaler, therefore, would
contain no VAT. The nonexempt wholesaler would collect VAT on sales and would
not be eligible for any VAT credits, but the total VAT at that point would exactly
equal what it would have been had there been no untaxed stage. Subsequent stages
of production would charge VAT on sales and would receive credit for VAT paid on
inputs as though there had been no break in the chain. Hence, zero-rating a
manufacturer or other intermediate stage would change neither total VAT remitted
nor the retail price on the commodity.11
If both zero-rated firms and exempt firms operate at the same level of
production in the same industry, the zero-rated firms would have a competitive
advantage, because their costs are less by the amount of the VAT.
Policy makers may be faced with a decision to either zero-rate or exempt a
Zero-rating is desirable when the objective is to exclude the consumption of the
product completely from tax, where an exemption is warranted when it is not
11 Table B1 in appendix B summarizes the selective economic effects of exemption and
zero-rating, which were discussed in this section.
regarded as feasible or desirable to tax the activity but some tax on final
consumption is considered desirable....
There are two major objections to exemption. First, cascading results as the
exempt firms and their business customers cannot receive input tax credit.
Secondly, firms producing both exempt and taxable (including zero-rated) items
must allocate inputs between exempt and non-exempt categories, and this is12
difficult to accomplish in any non-arbitrary way and to control.
In estimating a VAT’s revenue yield, economists and public officials use the
operating assumption that a VAT would be fully shifted to final consumers in the
form of higher prices of goods. A VAT (or any other major tax increase) would have
a contractionary effect on the economy unless offset by other economic policies.
Consequently, a revenue estimate is generally made under the assumption that the
Federal Reserve would use an expansionary monetary policy to neutralize the
contractionary effects of a VAT. Also, a revenue estimate does not take into account
the possible shifts in consumption patterns that might be expected if some items are
taxed and others are excluded from taxation.
The potential revenue per 1% rate from a VAT would vary with the
comprehensiveness of the tax base. A broad-based VAT would have limited
exclusions, while a narrow-based VAT would have numerous exclusions.
Obviously, the broader the tax base, the lower the tax rate necessary to raise a given
amount of revenue.
Furthermore, the broader the VAT base, the more efficient it is. The exclusion
of goods from taxation changes their prices relative to taxed goods. Changes in
relative prices cause economic distortions. Consumers tend to substitute lower-
priced goods for higher-priced goods.
There are three primary justifications for excluding specific items from taxation13
under a VAT. First, the VAT would be difficult to collect because sellers of some
types of goods and services could easily avoid reporting their sales. For example,
VAT would be difficult to collect on expenditures for domestic services and
expenditures abroad by U.S. residents. Second, some goods are excluded on equity
grounds, since these goods claim disproportionately large percentages of the incomes
of lower-income families. (Data on spending patterns do not, however, suggest that14
exclusions can have a very powerful effect on the distribution of a VAT.) Third,
12 John F. Due, Some Unresolved Issues in Design and Implementation of Value-Added
Taxes, National Tax Journal, vol. 43, no. 4, Dec. 1990, p. 385.
13 This classification of justifications for exclusion from VAT taxation was derived from the
following source: Alan A. Tait, Value-Added Tax: International Practice and Problems
(Washington, International Monetary Fund, 1988), p. 56.
14 U.S. Congressional Budget Office, Effects of Adopting a Value-Added Tax (Washington,
some goods may be excluded because they are merit goods, that is “goods the
provision of which society (as distinct from the preferences of the individual
consumer) wishes to encourage.”15 Some items may be justified for exclusion for
more than one reason.
William G. Gale of the Brookings Institution and C. Eugene Steuerle of the
Urban Institute estimate that each percentage point of a VAT with only a few
exclusions could generate net revenue equivalent to 0.4% of gross domestic product
(GDP).16 For calendar year 2005, U.S. gross domestic product was $12.5 trillion.17
For calendar year 2005, each 1.0% rate for a VAT could have raised net revenue of
approximately $50 billion with a broad base. Thus, for 2005, according to the
Gale/Steuerle estimate, a U.S. VAT of 5% would have generated $250 billion in
revenue. In comparison, for FY2005, the individual income tax yielded $927
The VAT’s high revenue yield at a low tax rate not only makes it a possible
source revenue for tax reform but also has generated concerns among some that VAT
revenues may finance a larger public sector. The issue of VAT and the size of
government is examined in a later section of this report.
International Comparison of Composition of Taxes
One argument frequently made for a U.S. VAT is the relatively heavy reliance
on consumption taxes by other developed countries. For 2005, for taxes on general
consumption (e.g., VATs and sales taxes), the United States (federal, state, and local
governments) had a lower reliance (8.0%) of total tax revenues than any other OECD19
nation. Also for 2005, the United States’ (federal, state, and local governments)
general consumption taxes as a percentage of gross domestic product (2.2%) were20
lower than any other nation in the OECD.
This lower reliance on consumption taxes may result from all other developed
nations having a VAT at the national level. A VAT is a requirement for membership
U.S. Govt. Print. Off., Feb. 1992), pp. 22-26.
15 Richard A. Musgrave and Peggy B. Musgrave, Public Finance in Theory and Practice.
16 William G. Gale and C. Eugene Steuerle, p. 113.
17 Bureau of Economic Analysis, U.S. Department of Commerce,
18 U.S. Executive Office of the President, Office of Management and Budget, Historical
Tables, Budget of the United States Government, Fiscal Year 2007 (Washington: GPO,
19 OECD, Revenue Statistics: 1965-2006 (Paris: OECD Publishing, 2007), p. 89. For data
by country, see table C1 in appendix C.
20 Ibid. For data by country, see table C1 in Appendix C.
in the European Union (EU).21 Sweden, Norway, Iceland, and Switzerland had retail
sales taxes at the national level but eventually switched to a VAT.22 According to the
The spread of Value Added Tax (also called Goods and Services Tax — GST)
has been the most important development in taxation over the last half-century.
Limited to less than 10 countries in the late 1960s it has now been implemented
by about 136 countries; and in these countries (including OECD member
countries) it typically accounts for one-fifth of total tax revenue. The recognized
capacity of VAT to raise revenue in a neutral and transparent manner drew all
OECD member countries (except the United States) to adopt this broad based
Policy insights can be obtained by examining the experiences of other nations;
however, just because other nations exhibit a specific tax policy does not necessarily
mean that it is appropriate for the United States to adopt this policy. Economic
analysis of optimal taxation suggests that those choices depend on issues of
efficiency, equity, and administrative and compliance costs, and should be made in
the context of the overall tax and spending structure. These considerations may vary
from one country to another.
A major topic concerning any proposed tax or tax change is the distribution or
equity of the tax among households. There are two types of equity: vertical and
horizontal. Vertical equity concerns the tax treatment of households with different
abilities-to-pay. Horizontal equity concerns the degree to which households with the
same ability-to-pay are taxed equally. Both vertical and horizontal equity may be
affected by the measure of ability-to-pay and the tax period.
The most common measure of ability-to-pay is income.24 Proponents of income
as a measure of ability-to-pay argue that saving yields utility by providing households
with greater economic security. Federal data are more readily available on different
measures of income than different levels of consumption. For example, the federal
government reports levels of disposable income, which equals consumption plus
21 Sijbren Cnossen, “VAT and RST: A Comparison,” Canadian Tax Journal, vol. 35, no. 3,
May/June 1987, p. 583.
22 Cnossen, VAT and RST: A Comparison, p. 585 and OECD, Consumption Tax Trends
(OECD, March 2005), p. 11.
23 OECD, International VAT/GST Guidelines (OECD, Feb. 2006), p. 1. Available at
24 For an overview of the incidence of the VAT using income as a measure of ability-to-pay,
see U.S. Congressional Budget Office, Effects of Adopting a Value-Added Tax (Washington:
Feb. 1992), pp. 31-47.
saving. Thus, tax economists can more easily calculate tax incidence if income
instead of consumption is the measure of ability-to-pay.
Some arguments for the consumption tax base suggest that personal
consumption is the best measure of ability-to-pay because consumption is the actual
taking of scarce resources from the economic system. Some economists argue that
consumption may be a better proxy for permanent income than is current income (see
Tax incidence usually is measured by using a one-year period. Data on
consumption and income are readily available in one-year increments and the concept
of a one-year period is easily understood. But many economists believe tax incidence
is more accurately determined by measuring consumption and income over a
household’s lifetime. Lifetime income and consumption are affected by the life cycle
concept and transitional components of income. According to this life cycle concept,
a household makes current consumption decisions based on its expected future flow
of income, averaging its consumption over its lifetime.
For example, a common life cycle is low income in the household’s early years,
high income in the household’s middle years, and low income in the household’s
retirement years. A young household may save a small percentage of its income in
order to acquire consumer durables. In its middle years, this household may save a
high percentage of its income while its income is highest. Finally, during its
retirement years, this household may save a small percentage of its income in order
to maintain its consumption level. Thus, annual consumption tends to be more stable
than annual income over the household’s life cycle.
Although many economists prefer the concept of lifetime income, federal data
are not collected on a lifetime basis. Consequently, economists have developed life-
cycle models in an attempt to measure equity, but the distributional results from these
models are subject to widespread debate.
If disposable income over a one-year period is the measure of ability-to-pay,
then a VAT would be viewed as extremely regressive; that is, the percentage of
disposable income paid in VAT would decrease rapidly as disposable income
increases. In most discussions of tax policy, both a one-year period and annual
disposable income (or some other annual income measure) are used; consequently,
the VAT is viewed as being extremely regressive. For example, CBO calculated the
annual incidence of a 3.5% broad-based VAT for 1992. CBO found that all families
would have paid 2.2% of their income in VAT. The burden on family income was
25 For a comprehensive analysis of the vertical equity of a VAT, see Erik Caspersen and
Gilbert Metcalf, “Is a Value-Added Tax Progressive? Annual Versus Lifetime Incidence
Measures,” National Tax Journal, vol. 47, no. 4, Dec. 1994, pp. 731-746; and U.S.
Congressional Budget Office, Effects of Adopting a Value-Added Tax, pp. 31-47.
4.8% on the lowest quintile, 3.2% on the second quintile, 2.8% on the middle
quintile, 2.3% on the fourth quintile, and 1.5% on the highest quintile.26
If disposable income over a lifetime is the measure of ability-to-pay, a VAT
would be mildly regressive. For lower- and middle-income households, it appears
that nearly all savings are eventually consumed.27 Thus, it may be that for the vast
majority of households, lifetime consumption and lifetime income are approximately
equal. High-income households tend to have net savings over their lifetimes;
consequently, they would pay a lower proportion of their disposable incomes in VAT
than would lower-income groups. But these highly stylized life-cycle models are
If consumption is used as a measure of ability-to-pay, a single-rate VAT with
a broad base would be approximately proportional regardless of the time period. In
other words, the percentage of consumption paid in VAT by households would be
approximately constant as the level of household consumption rises.
Another equity issue concerns the burden of a VAT on different age groups. If
older individuals on the average consume more out of savings than younger
individuals, then a VAT would fall more heavily on the old than the young.
Conversely, an increase in the personal income tax would fall more heavily on the
young than the old.
Policy Options to Alleviate Regressivity
Some supporters of progressive taxation oppose the VAT primarily because they
believe that it is regressive. No mechanism is likely to introduce progressivity at
higher income levels. But critics are especially concerned about the absolute burden
of a VAT on low-income households. The degree of regressivity on lower-income
households, however, can be reduced by government policy. Three often-mentioned
policies are exclusions and multiple rates, income tax credits, and earmarking of
some revenues for increased social spending (including indexed transfer payments).
Exclusions and Multiple Rates. The incidence of the VAT depends on its
tax base; therefore, the regressivity of the VAT can be reduced or eliminated by
excluding (zero-rating or exempting) those goods that account for a
disproportionately high percentage of the incomes of lower-income households. The
26 U.S. Congressional Budget Office, Effects of Adopting a Value-Added Tax, p. 35.
27 Franco Modigliani, a Nobel Laureate in economics, estimated that at least 80% of all
savings by households are eventually spent on consumption. See Franco Modigliani, “The
Role of Intergenerational Transfer and Life Cycle Saving in the Accumulation of Wealth,”
Journal of Economic Perspectives, vol. 2, no. 2, spring 1988, pp. 15-23.
28 For examples of life-cycle models, see Don Fullerton and Diane Lim Rogers, “Lifetime
Effects of Fundamental Tax Reform,” in Economic Effects of Fundamental Tax Reform,
Henry J. Aaron and William G. Gale, eds. (Washington: Brookings Institution Press, 1996),
pp 321-352; and David Altig, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters,
and Jan Walliser, “Stimulating Fundamental Tax Reform in the United States,” The
American Economic Review, vol. 91, no. 3, June 2001, pp. 574-595.
exclusion of many necessities on equity grounds from retail sales taxes has been
politically popular at the state level. All members of the European Union (EU)
exclude some goods from VAT on equity grounds. Also, most EU nations have
multiple tax rates on equity grounds. Reduced rates are applied to necessities and
premium rates are levied on luxuries.
Despite the existing policies in the EU, most tax economists oppose exclusions
and multiple rates to reduce regressivity for three reasons. First, the administrative
costs, compliance costs, and neutrality costs are substantial.29 If a VAT is to raise a
given amount of revenue, then revenue lost from excluding goods must be offset by
higher VAT rates. These higher rates increase the distortion in relative prices, and
consequently, reduce the neutrality of the tax system. Second, the possible reduction
in regressivity from exclusion and multiple rates is declining because consumption
patterns for different income levels are becoming more similar.30 Third, for a one-
year time period, the reduction in regressivity is limited, particularly for low-income
households. Money saved for exclusions is largely offset by higher tax rates (needed
for revenue neutrality) on taxed goods.31
Tax Credits. The federal government could allow either a flat tax credit or a
credit that diminishes as income rises, in order to overcome the regressivity of a
VAT. This credit method could be operated in two ways. First, an individual could
apply the credit against his federal income tax liability, thus lowering his liability on
a dollar-for-dollar basis. If the tax credit exceeded the individual’s tax liability, he
could apply for a refund of the excess credit. A taxpayer already due a tax refund
could increase the size of his refund by the amount of the tax credit. A household not
subject to income taxation could apply for a tax refund equal to the credit. An
income tax credit that declines as income increases could reduce regressivity more
sharply than a flat income tax credit.
Second, a stand-alone credit system could be established which would not
require an eligible household to file an income tax return in order to obtain a refund
for VAT paid. An eligible household would have to submit a simple form in order
to receive a refund. A stand-alone credit system may be more effective than the
income tax credit in encouraging low-income households to file for a refund, but
administrative and compliance costs would be higher.
As stated previously, the President’s Advisory Panel on Federal Tax Reform
examined a proposal for a partial replacement VAT. The Panel believed that
29 For an examination of increased administrative and compliance costs resulting from
exclusions and multiple rates, see Liam Ebrill, Michael Keen, Jean-Paul Bodin, and
Victoria Summers, The Modern VAT (Washington, D.C.: International Monetary Fund,
30 Alan A. Tait, Value-Added Tax: International Practice and Problems (Washington, D.C.:
International Monetary Fund, 1988), p. 218.
31 Edith Brashares, Janet Furman Speyrer, and George N. Carlson, “Distributional Aspects
of a Federal Value-Added Tax,” National Tax Journal, vol. 41, no. 2, June 1988, p. 165.
compared to current law “it would be possible to develop an approximately
distributionally neutral tax credit and rate structure.”32
But a federal credit system would incur some administrative costs, which would
increase the total administrative costs of a VAT. Furthermore, households incur
implicit taxes if their credits are phased out (or income tested transfers reduced).
At the federal level, studies have concluded that the refundable earned-income
tax credit (EITC) has had “a significant positive impact on participation in the labor
force.”33 But compliance with EITC provisions has been an ongoing issue.34
Earmarking of VAT Revenues. A third option to reduce or eliminate
regressivity is to earmark some of the revenue from a VAT to finance an increase in
income tested transfers. Aaron estimated that an increase in benefits of
approximately $5 billion for a VAT yielding $100 billion could fully protect low-
income families from paying the VAT.35
For example, a 10 percent increase in food stamp entitlements would
approximately offset the effect on households eligible for the full food stamp
allotment of a VAT that raised $100 billion in revenue. This estimate is based
on the fact that $100 billion will be approximately three percent of consumption
in 1989 and that food is estimated to absorb about 30 percent of the budget in36
estimates of poverty thresholds.
Many households with low taxable incomes do not currently receive transfers
and would not be protected by Aaron’s proposal.
If disposable income is the measure of ability-to-pay, the horizontal equity of
a VAT would depend on the time period. For a one-year period, a VAT would be
very inequitable because households with the same level of disposable income would
have widely differing levels of consumption and, consequently, payments of VAT.
For a lifetime period, the VAT would have a high degree of horizontal equity.
For low- and middle-income households, almost all income is consumed over these
households’ lifetimes; consequently, households with the same lifetime incomes
32 The President’s Advisory Panel on Federal Tax Reform, Simple, Fair, & Pro-Growth, p.
33 CRS Report RL31768, The Earned Income Tax Credit (EITC): An Overview, by Christine
Scott, pp. 14-15.
34 Ibid., pp 16-17.
35 Henry J. Aaron, “The Political Economy of a Value-Added Tax in the United States,” Tax
Notes, vol. 38, no. 10, March 7, 1988, p. 1,113.
would have the same levels of consumption and the same VAT payments.37 Over
their lifetimes, high-income households with equal incomes differ in their levels of
consumption and, consequently, VAT payments. For example, assume that two
households have $10 million in lifetime income, but the first household spends $4.5
million on consumption and the second household spends $9 million on
consumption. The second household would pay twice as much in VAT as the first
household. Thus, for a lifetime period, the VAT is not horizontally equitable for
In public finance, the more neutral is a tax, the less the tax affects private
economic decisions and, consequently, the more efficient is the operation of the
economy. Conceptually, a VAT on all consumption expenditures, with a single rate
that is constant over time, would be relatively neutral compared to other major
For households, two out of three major decisions would not be altered by this
hypothetical VAT. First, this VAT would not alter choices among goods because all
would be taxed at the same rate. Thus, relative prices would not change. In contrast,
other taxes, such as excise taxes, which change relative prices, would distort
household consumer choices by encouraging the substitution of untaxed goods for
taxed goods. But a hypothetical income tax on all income would be neutral in this
Second, a VAT does not affect the relative prices of present and future
consumption. In contrast, the individual income tax affects the relative prices of
present and future consumption because the income tax is levied on income which
is saved, and then the returns on saving are taxed.
A household’s work-leisure decision, however, would be affected by a VAT or
any other tax on either consumption or income.38 Since leisure would not be taxed,
any tax increase would fall on the returns to work.
A VAT would have conflicting effects on the number of hours worked by each
household. A household would have an incentive to substitute leisure for work
because of the relative rise in the value of leisure to work (substitution effect).
Conversely, a household would have an incentive to increase its hours worked in an
attempt to maintain its current living standards (income effect). Thus, a VAT could
decrease, increase, or not change a household’s hours worked.
For a firm, the VAT would not affect decisions concerning method of financing
(debt or equity), choice among inputs (unless some suppliers are exempt or zero-
37 Henry J. Aaron, “The Value-Added Tax: Sorting Through the Practical and Political
Problems,” The Brookings Review, summer 1988, p. 13.
38 In economics, leisure is any time spent not working.
rated), type of business organization (corporation, partnership, or sole
proprietorship), or goods to produce. Other types of taxes may affect one or more of
these types of decisions.
But a VAT cannot be levied on all consumer goods; consequently, prices of
taxed goods will rise relative to untaxed goods. Furthermore, most nations with
VATs have more than one rate.39 Multiple VAT rates alter relative prices of taxed
goods. Finally, VAT rates in most nations have tended to rise over time. Despite
these deviations from a pure form of VAT, a broad-based VAT is relatively neutral
compared to most other taxes. This neutrality is greater if the tax rate is relatively
low. But the relative neutrality of a VAT compared to an increase in the personal
income tax is uncertain.40
If the Federal Reserve implemented an expansionary monetary policy to offset
the contractionary effects of a VAT then there would be a one-time increase in the
price level. For example, an expansionary monetary policy to accommodate a 5%
VAT on 60% of consumer outlays might directly cause an estimated one-time
increase in consumer prices of approximately 3%. There would also be some
secondary price effects. Some goods would rise in price because their factors of
production, especially labor, are linked to price indexes. Yet, if the Federal Reserve
disregarded these secondary price increases in formulating monetary policy, these
secondary price increases would tend to be offset by price reductions in other sectors
of the economy.
An examination of VATs in the OECD has found only an initial effect of a VAT
on the price level. But it is difficult to empirically isolate the effect of a VAT from
other possible causes of a change in the price level.
It has been suggested that the federal government exclude the VAT from price
indexes. Hence, existing indexing would not have an inflationary effect.41 But such
an approach might prove unpopular and it might be contested in court.
In summary, the proper monetary accommodation for a VAT would probably
cause a one-time increase in the price level but not affect the subsequent rate of
inflation (i.e., cause continual increases in the general price level).
39 For a list of standard and reduced VAT rates for selective countries, see Appendix D.
40 See U.S. Congressional Budget Office, Effects of Adopting a Value-Added Tax, pp. 56-60;
and Jane G. Gravelle, “ Income, Consumption, and Wage Taxation in a Life-Cycle Model:
Separating Efficiency from Redistribution,” American Economic Review, vol. 81, no. 4,
Sept. 1991, pp. 985-995.
41 Aaron, “The Political Economy of a Value-Added Tax in the United States,” p. 1,113.
Currently, all nations with VATs zero-rate exports and impose their VATs on
imports. This procedure for taxing trade flows is referred to as the destination
principle because a commodity is taxed at the location of consumption rather than
production. An alternative would be to apply the origin principle by having all
nations levy their VATs on exports but not imports. All experts on the VAT
recommend that nations adopting a VAT use the destination principle in order to be
consistent with existing practices of other countries.
The destination principle creates a level playing field because imported
commodities rise in price by the percentage of the VAT, but exported commodities
do not increase in price. For a particular nation, the VAT rate on domestically
produced and imported products would be the same. The VAT rate on a particular
good would still vary among nations.
A simple example demonstrates this concept of a level playing field. Assume
nation A has a 10% VAT and nation B has a 20% VAT. Exports from nation A to
nation B would not be taxed by nation A. But nation B would levy a 20% VAT on
imports from nation A. Thus, consumers in nation B would pay a 20% VAT
regardless of whether their purchased goods were domestically produced or imported.
Furthermore, exports from nation B to nation A would not be taxed by nation B.
Nation A would levy a 10% VAT on imports. Hence, consumers in nation A would
pay a 10% VAT on both domestically produced and imported commodities.
In 1962, the rules applicable to taxation were included in the General Agreement
on Tariffs and Trade (GATT). Under these GATT rules, indirect taxes were
rebatable on exports but direct taxes were not rebatable. Taxes which are not shifted
but borne by the economic entity on which they are levied are classified as direct
taxes. From 1962 through 1972, a fixed exchange rate system prevailed and the
United States ran deficits in its balance-of-payments. U.S. officials complained that
the GATT rules favored nations with VATs because their exports were zero-rated.
In contrast, corporate income taxes were not rebated on exports.
In early 1973, the United States and its major trading partners formally shifted
to a flexible exchange rate system. Under this system, the supply and demand for
different currencies determine their relative value. If a country has a deficit in its
balance-of-trade, this deficit must be financed by a net importation of foreign capital.
But net capital inflows cannot continue indefinitely. Thus, over time, this country’s
currency will tend to decline in value relative to the currencies of other nations.
Consequently, this country’s balance-of-trade deficit will eventually decline as its
exports rise and imports fall. Hence, economic theory indicated that a VAT offers
no advantage over other major taxes in reducing a deficit in the balance-of-trade.
Thus, U.S. officials ended their complaints about the effects of GATT tax rules on
Since early 1973 there have been periods when exchange rates have been
“managed” by mutual agreement among governments. Central banks have
coordinated purchases and sales of different currencies in order to stabilize their
relative values to promote international economic stability.
Even if there were a fixed exchange rate, a U.S. VAT would have slight impact
on the balance-of-trade because the proposed VAT rate of 5% or less is a low tax
rate. During the last 25 years the value of the dollar has fallen relative to an index
of major currencies, yet a serious U.S. balance-of-trade deficit persists. In summary,
a U.S. VAT offers no major advantage over other major tax increases in reducing the
U.S. balance-of-trade deficit.
Any large U.S. tax increase, which reduces the federal deficit, could reduce the
U.S. balance-of-trade deficit. The U.S. Treasury would reduce its borrowing on
financial markets, interest rates would decline, and foreign capital would flow out of
the United States. This capital outflow would reduce the demand for dollars relative
to other currencies. This decline in the value of the dollar would raise exports,
reduce imports, and, consequently, reduce the U.S. balance-of-trade deficit.
National saving consists of government saving, business saving, and personal42
saving. A VAT or any other tax that reduces the budget deficit would be expected
to reduce government dissaving, and, consequently, raise national saving.
A second issue concerns the effect on the personal savings rate of levying a
VAT compared to increasing income taxes. A VAT would tax savings when they are
spent on consumption, allowing savings to compound at a pre-tax rate. But an
income tax is levied on all income at the time it is earned, regardless of whether the
income is consumed or saved. The income tax is also levied on the earnings from
income saved. Consequently, some proponents of the VAT have argued that
choosing a VAT, rather than an income tax, to raise revenue would increase the
return from saving and, consequently, raise the savings rate.
The rate of return on savings, however, has never been shown to have a
significant effect on the savings rate because of two conflicting effects. First, each
dollar saved today results in the possibility of a higher amount of consumption in the
future. This relative increase in the return from saving causes a household to want
to substitute saving for consumption out of current income (substitution effect).
But a higher rate of return on savings raises a household’s income;
consequently, the household has to save less to accumulate some target amount of
savings in the future (income effect). Thus, this income effect encourages
households to have higher current consumption and lower current saving.
42 For an explanation of the components of national saving, see CRS Report RL30873,
Saving in the United States: How Has It Changed and Why Is It Important?, by Brian W.
Cashell and Gail Makinen.
A CRS study compared the long-run effects on the capital stock and
consumption of a $60 billion VAT and a $60 billion increase in individual income
taxes. This study’s results suggest that selecting a VAT instead of an increase in
individual income taxes would raise the capital stock by less than 2% and
consumption by only a quarter to a third of a percent after 50 years.43
An empirical study by the Congressional Budget Office analyzed the economic
effects of replacing a quarter of the current income tax with a 6% VAT on all
consumption. CBO estimated that this tax substitution would, in the long-run,
increase the saving rate by 0.5%, raise the capital stock by 7.9%, increase output by
1.5%, and raise consumption by 1.2%.44 These CBO findings of only slight
economic effects in the long-run are consistent with the estimates of the CRS study.45
The value-added tax would require the expansion of the Internal Revenue
Service. But the high revenue yield from a VAT could cause administrative costs to
be low measured as a percentage of revenue yield. The administrative expense per
dollar of VAT collected would vary with the degree of complexity of the VAT, the
amount of revenue raised, the national attitude towards tax compliance, and the level
of the small business exemption.
For tax year 1995, the Government Accountability Office (GAO) estimated the
cost of administering a U.S. VAT at $1.221 billion if the VAT had a single rate, a
broad base, and an exemption for businesses with gross receipts of less than
$100,000.46 For tax year 1995, Professor Sijbren Cnossen estimated that the overall47
administrative cost of a hypothetical single rate U.S. VAT at $1billion. He assumed
that “the administration of the VAT would be fully integrated with the administration48
of the federal income taxes.” The OECD found that evidence suggests “a lower
cost per dollar on revenue collected for VAT than for income tax.”49
43 CRS Report 88-697 S, Economic Effects of a Value-Added Tax on Capital Formation, by
Jane G. Gravelle, p. 2. (Archived report available on request).
44 CBO, Effects of Adopting a Value-Added Tax, pp. 52-53.
45 For a comprehensive analysis of the issue, see CRS Report RS22367, Federal Tax Reform
and Its Potential Effects on Savings, by Gregg A. Esenwein and CRS Report RL30351,
Consumption Taxes and the Level and Composition of Savings, by Steven Maguire.
46 U.S. General Accounting Office, Value-Added Tax: Administrative Costs Vary with
Complexity and Number of Businesses, Washington, May 1993, p. 63.
47 Sijbren Cnossen, “Administrative and Compliance Costs of the VAT: A Review of the
Evidence,” Tax Notes, vol. 62, no. 12, June 20, 1994, p. 1,610.
49 Organization for Economic Co-Operation and Development, Taxing Consumption (Paris:
OECD, 1988), p. 203.
Although considerable research has been conducted over the past 15 years on50
income tax compliance, research on VAT compliance has been limited. For tax
year 1995, Professor Sijbren Cnossen estimates the compliance costs of a single rate51
U.S. VAT would equal approximately $5 billion. He emphasizes that compliance
costs “can be reduced by broadening the base of the VAT, imposing a single rate, and52
increasing the threshold for registration.” Agha and Haughton summarized
estimates of VAT evasion for five European countries.53 These five countries and
their percentage of revenue lost through evasion were Belgium (8%), France (3%),
Italy (40%), Netherlands (6%), and United Kingdom (2%-4%).54 In comparison to
other broad-based consumption taxes such as the retail sales tax, a VAT has produced
relatively good compliance for four reasons.
First, a VAT collected using the credit-invoice method offers the opportunity
to cross-check returns and invoices. For example, VAT shown on a sales invoice of
a wholesaler will appear on the purchase invoice of a retailer. A tax auditor can
examine both invoices to cross-check the accuracy of the tax returns of both the
wholesaler and the retailer.
Second, each firm has an incentive not to allow suppliers to understate VAT on
their sales invoices. A firm is able to credit VAT paid on inputs against VAT
collected on sales; consequently, a firm’s net VAT liability will increase if VAT
shown on its purchase invoices was understated by suppliers.
Third, tax auditors can compare information about a VAT with information
about business income taxation, which will increase compliance with both types of
taxes. For example, the sales revenue figure reported on business income tax forms
may be checked for consistency with gross VAT collected as shown on VAT forms.
Also, a check of cash receipts during a VAT audit may identify the under reporting
of sales. Firms may attempt not only to evade the VAT but also to evade the55
business income tax.
50 For a current examination of VAT compliance from the approach of behavior economics,
see Paul Webley, Caroline Adams, and Henk Elffers, “Value Added Tax Compliance,” in
Behavioral Public Finance, eds. Edward J. McCaffery and Joel Slemrod (New York:
Russell Sage Foundation, 2006), pp. 175-205.
51 Sijbren Cnossen, “Administrative and Compliance Costs of the VAT: A Review of the
Evidence,” p. 1,609.
52 Ibid., p. 1,615.
53 Ali Agha and Jonathan Haughton, “Designing VAT Systems: Some Efficiency
Considerations,” Review of Economics and Statistics, vol. 78, no. 2, May 1996, pp. 304-305.
54 Ibid., p. 305.
55 Organization of Economic Co-Operation and Development, Taxing Consumption, pp. 199-
Fourth, some firms legally required to remit VAT may not register. But these
firms receive no credit for VAT paid on inputs. Hence, these firms are only partially
able to evade the VAT because of the compliance with the VAT by suppliers.
Although compliance with a VAT is higher than other broad-based consumption
taxes, the level of noncompliance is significant. As previously discussed, some firms
legally required to remit VAT may not register.
Furthermore, firms may evade VAT by altering or omitting information as
indicated in the following 10 major types of evasion. First, a registered firm may not
record resales of goods purchased from unregistered suppliers. Second, a seller of
both exempt and taxable goods may divert purchased inputs on which VAT is
claimed against taxed sales to help produce and sell exempt goods. Third, a firm may
claim credit for purchases that are not creditable. For example, a firm’s owner may
claim credit for VAT paid on an automobile but then use it for nonbusiness purposes.
Fourth, a firm may illegally import goods, charge VAT on their sale, but not report
this VAT. Fifth, a firm may simply under-report sales, which is the most common
type of evasion. Retailers are the most frequent users of this type of evasion. Sixth,
a firm may collect VAT on sales and then disappear. This type of evasion is
particularly common to small firms in the construction industry. Seventh, in those
nations with multiple rates, a firm may illegally reclassify goods into categories with
lower tax rates. Eighth, the owners of some small firms, particularly retailers, may
consume part of their firms’ production but not record their consumption. Ninth, a
firm may submit completely false export claims in order to obtain illegal VAT
refunds. And tenth, two firms may barter goods in order to evade the VAT.56
For the United States, a federal VAT raises two primary intergovernmental
issues: the federal encroachment of the state sales tax and the joint collection of a57
Encroachment on a State Tax Source
It has been claimed that broad-based consumption taxation has traditionally
been a state source of revenue while income taxation has been a federal revenue
source; consequently, a federal VAT would encroach on a primary source of tax
revenue for the states.58
56 For a detailed discussion of these 10 types of evasion, see Alan A. Tait, Value-Added Tax:
International Practice and Problems (Washington: International Monetary Fund, 1988), pp.
57 For an overview of state tax officials’ concerns related to the enactment of a broad-based
federal consumption tax, see U.S. General Accounting Office, State Tax Officials Have
Concerns About a Federal Consumption Tax, Washington, March 1990, 77 p.
58 For an examination of this issue, see Robert P. Strauss, “Administrative and Revenue
Most states, however, adopted their individual income taxes before they adopted
their general sales taxes. Thirty-nine states levy both individual income taxes and
general sales taxes. Twenty-three of these states adopted their individual income
taxes in an earlier year then they adopted their general sales taxes. Three states
adopted both taxes in the same year. Thirteen states adopted their general sales taxes
in an earlier year than they adopted their individual income taxes.59
No constitutional restriction prevents the federal government from levying a
VAT. Precedents exist for the federal government to levy a new tax that many states
already levy. For example, the federal government levied the personal income tax
after many states had already imposed this tax. Also, both the federal government
and the states impose many of the same excise taxes.
The federal government relies primarily on income taxes, but taxation of income
by states has risen steadily over the years.60 For FY2003, 33.3% of state tax
collections consisted of individual income taxes and 5.2% consisted of corporation
income taxes.61 Thus, total state taxes on income accounted for 38.5% of all state
taxes collected. In comparison, for FY2003, general sales taxes accounted for 33.8%
of state taxes collected.62 Hence, it can be argued that the states have encroached on
the primary source of revenue of the federal government.
States could continue to levy their retail sales taxes while the federal
government levies a VAT. In Canada, the federal government levies a VAT, and the
provinces continue to collect their retail sales taxes.
States could piggy-back on a federal VAT. To do this, states would have to
replace their retail sales taxes with a VAT and adopt the federal tax base. Because
a federal VAT would probably have a broader base than any state sales tax, more
revenue would be yielded for each 1% levied. Also, the VAT would eliminate
duplication of administrative effort, permit the taxation of interstate mail order sales,
permit the taxation on Internet sales, and lower total compliance costs of firms.
Implications of Federal Consumption Taxes for the State and Local Sector,” State Tax
Notes, vol. 16, March 15, 1999, pp. 831-868.
59 For data on the dates of adoption of major state taxes by state, see Tax Foundation, Facts
and Figures on Government Finance, 38th Edition (Washington: Tax Foundation, 2004), p.
60 For historical data on state tax collection by source, see Tax Foundation, Facts & Figures
on Government Finance, 38th Edition (Washington: Tax Foundation, 2004), pp. 188-189.
Historical data on federal receipts by source is available from the following source: Office
of Management and Budget, Budget of the U.S. Government, Historical Tables, Fiscal Year
61 Tax Foundation, Facts & Figures on Government Finance, p. 189.
62 Current data on sales tax rates by state are available at [http://www.taxfoundation.org/
But, states may decline the opportunity for joint collection because of their
desire to maintain greater fiscal independence from the federal government. In 1972,
federal legislation permitted states to adopt the federal individual income tax base
and have the federal government collect its state income tax, without cost to the
states.63 No state delegated collection of its income tax to the federal government.
The law was repealed in 1990.64
In Canada, differences in tax bases for retail sales taxes in the provinces and the
federal VAT have resulted in unexpectedly high administrative and compliance costs.
Different tax bases have caused products to fall in four different tax categories: taxed
by both political jurisdictions, taxed at the provincial level but not at the federal level,
taxed at the federal level but not at the provincial level, and not taxed by either
political jurisdiction. The federal government has tried to persuade the provinces to
adopt the same tax base but they have refused.65
63 The Federal-State Tax Collection Act was enacted as Title II of the legislation that created
the federal revenue sharing program. U.S. Congress, Joint Committee on Internal Revenue
Taxation. State and Local Fiscal Assistance Act and the Federal-State Tax Collection Act
of 1972, H.R. 14370, 92d Congress, Public Law 92-512, JCS-1-73, Feb. 12, 1973,
Washington, GPO, 1973, pp. 51-72.
64 Provisions of the Federal-State Tax Collection Act of 1972 (subchapter 64(E), sec. 6361
through 6365 of the Internal Revenue Code) were repealed by the Omnibus Budget
Reconciliation Act of 1990, P.L. 101-508, sec. 11801(a)(45).
65 Michael Rushton, A Value-Added Tax for the United States: Lessons from Canadian
Experience, National Tax Association — Proceedings of the Eighty-Sixth Annual
Conference, 1993, p. 98.
Appendix A. Credit-Invoice, Subtraction, and
This appendix provides numerical examples of the three methods of calculating
a VAT: credit-invoice, subtraction, and addition methods. The tax rate for a VAT
may be price inclusive (included in the sales price) or price exclusive (added to the
sales price). Most developed nations levy their VAT rates on a price exclusive basis.
The credit-invoice method of calculating a VAT is demonstrated in Table A1.
The rate for the value-added tax is assumed to be 10% on a price-exclusive basis.
The product manufactured and sold is a widget. The production of widgets involves
firms at four different stages of production: raw material producer, manufacturer,
wholesaler, and retailer. The operating assumption is that the VAT is fully shifted
forward to the next stage of production; consequently, the consumer pays the entire
VAT.66 The seller indicates the amount of VAT on each sales invoice.
At the first stage of production, the simplifying assumption is made that the raw
material producer provides all of his own inputs. The raw material producer has sales
of $200 plus VAT on sales of $20 (10% of $200). Sales plus VAT equal $220 ($200
+ $20). Because the raw material producer purchased no inputs, he receives no credit
for prior VAT paid. Hence, the raw material producer remits $20 to the government.
At the second stage of production, the manufacturer has sales of $500 plus VAT
on sales of $50 (10% of $500), which is shown separately on the sales invoice. Sales
plus VAT equal $550 ($500 + $50). The manufacturer purchased $200 in raw
material plus $20 was paid in VAT as listed on the purchase invoice. The
manufacturer credits the $20 paid in VAT on inputs against the $50 in VAT collected
on sales and remits the difference of $30 to the government.
At the third stage of production, the wholesaler has sales of $750 and adds a
VAT of $75 (10% of $750). Sales plus VAT equal $825 ($750 + $75). The
wholesaler purchased inputs for $500 and paid an additional $50 in VAT.
Consequently, the wholesaler credits $50 in VAT paid on inputs against $75 in VAT
collected on sales and remits $25 in VAT to the government.
Finally, the retailer has sales of $1,000 and adds VAT of $100 (10% of $1,000).
Sales plus VAT equal $1,100 ($1,000 + $100). The retailer purchased $750 in inputs
and paid an additional $75 in VAT. The retailer credits the $75 in VAT paid on
inputs against the $100 in VAT collected on sales and remits $25 to the government.
The VAT remitted by the four firms was $100. The consumer paid $100 in
VAT on top of $1,000 in retail sales. The last line of figures in Table Al indicates
the value added at each stage of production. The sum of all firms’ value added is
$1,000, which equals the sales price exclusive of the VAT.
66 This simplifying assumption is based on the fact that the VAT is a broad-based
consumption tax levied on most goods and services.
Table A1. Credit-Invoice Method
(Data in dollars, price-exclusive VAT rate assumed at 10%)
Stage of Production of Widgets
Transaction Raw Manu- Whole- Tot a l
Sales (Excluding VAT)$200$500$750$1,000
VAT on Sales205075100
Purchases of Inputs0200500750
VAT on Inputs0205075
Credit, VAT on Inputs-0-20-50-75
VAT to be Remitted20302525100
a. As a simplification, the raw material producer is assumed to provide all of his inputs.
The subtraction method is demonstrated in Table A2. In order to simplify a
comparison with figures in Table Al, a tax inclusive VAT rate of 9.091% is
assumed. This tax inclusive rate is equivalent to a tax exclusive rate of 10%.
Table A2. Subtraction Method
(Data in dollars, price-inclusive VAT rate assumed at 9.091%)
Stage of Production of Widgets
Transaction Raw Manu- Whole- Tot a l
P r oducer Remitted
Sales (Including VAT)$220$550$825$1,100
VAT to Be Remitted20302525100
a. As a simplification, the raw material producer is assumed to provide all of his inputs.
The raw material producer has sales including VAT of $220. Because he has
no purchases of inputs, his VAT base (sales including VAT less purchases of inputs)
is $220. His VAT to be remitted is $20 (9.091% of $220).
The manufacturer has sales including VAT of $550 and purchases including
VAT of $220. His VAT base is $330 ($550 less $220). His VAT to be remitted is
$30 (9.091% of $330).
The wholesaler has sales including VAT of $825 and purchases including VAT
of $550. His VAT base is $275 ($825 less $550). His VAT to be remitted is $25
(9.091% of $275).
Lastly, the retailer has sales including VAT of $1,100, purchases including VAT
of $825, and his VAT base is $275 ($1,100 less $825). He remits VAT of $25
(9.091% of $275). The total VAT remitted to the government by all four firms is
$100 ($20 + $30 + $25 + $25). This $100 in VAT equals 9.091% of $1,100.
The addition method is shown in Table A3. The raw material producer
calculates its value added by adding all payments for factors of production which the
firm owned and applied to the production process. Thus, the raw material producer
had value added of $200 (wages of $100, rent of $50, interest of $30, and profit of
$20). Next, the raw material producer calculates its VAT by multiplying its value
added by the tax rate. Thus, the raw material producer must remit $20 ($200 x 0.1)
to the government. This procedure applies to all other stages of production and total
VAT remitted is $100.
Table A3. Addition Method
(Data in U.S. dollars, VAT rate assumed at 10%)
VAT Materiala Manuf acturer Wholesaler Re tailer Total
P r oduct i on P r oducer
Wages $100 $150 $110 $80
Interest 30 25 35 30
V a lue-added 20 30 25 25 100
a. As a simplification, the raw material producer is assumed to provide all of his inputs.
Appendix B. Economic Effects of a Special
Table B1. Economic Effects of a Special VAT Treatment
Special VATBreak in Chain ofPrice ofCommodity PlusTotal VAT
Exempt RetailerNoDecline Equal to aDecline
Fraction of Initial
Zero-rated RetailerNoDecline Equal toDecline (VAT
Exempt Yes Rise Rise
Zero-ratedYes No ChangeNo Change
Appendix C. General Consumption Taxes in
Table C1. Data on General Consumption Taxes in OECD
(All levels of government)
Total tax revenue aGeneral General consumption
Countryas a % of GDP at market pricesconsumptiontaxes as a % of taxes as a % of
(2005)GDP (2005) total tax revenues (2005)
Australia 30.9% 4.1% 13.4%
Austria 42.1 7.9 18.9
Belgium 45.4 7.3 16.1
Canada 33.4 5.0 15.0
Denmark 50.3 10.0 19.9
Finland 44.0 8.7 19.8
France 44.1 7.6 17.1
Germany 34.8 6.3 18.0
Gr eece 27.3 6.0 22.2
Hungary 37.2 10.5 28.1
Iceland 41.4 11.5 27.7
Ir eland 30.6 7.7 25.1
It aly 41.0 6.0 14.6
K orea 25.5 4.5 17.5
Luxembourg 38.6 6.2 16.1
Mexico 19.9 3.8 19.1
Netherlands 39.1 7.6 19.5
Norway 43.7 7.9 18.1
Poland 34.3 7.7 22.5
Portugal 34.8 8.3 23.8
Total tax revenue aGeneral General consumption
Countryas a % of GDP at market pricesconsumptiontaxes as a % of taxes as a % of
(2005)GDP (2005) total tax revenues (2005)
Spain 35.8 6.2 17.5
Sweden 50.7 9.4 18.5
Switzerland 29.7 4.0 13.4
T urkey 32.3 7.1 21.8
Source: Adapted by CRS from OECD, Revenue Statistics 1965-2006, Paris, 2007.
a. GDP is an abbreviation for gross domestic product, which is a measure of total domestic output of
goods and services.
Appendix D. VAT Rates by Country
Table D1. Value-Added Tax Rates by Country
CountryStandard RateReduced Rate
Austria20%12% or 10%
Belgium21%12% or 6%
Finland22%17% or 8%
France19.6%5.5% or 2.1%
Greece19%9% or 4.5% (reduced by 30% to 13%, 6%
and 3% on islands
Ireland21%13.5% or 4.8%
Italy20%10%, 6%, or 4%
Lithuania18%9% or 5%
Luxembourg15%12%, 9%, 6%, or 3%
Netherlands 19% 6%
Poland22%7% or 3%
Portugal21%15% or 5%
Spain16%7% or 4%
Sweden25%12% or 6%
CountryStandard RateReduced Rate
Arge ntina 21% 10.5%
Bosnia and Herzegovina17%
Canada6% GST (5%4.5%b
effective 1 Jan.
People’s Republic of Chinac17%6% or 3%
Iceland 24.5% 7% d
Indiae12.5%4% or 1%
Israel f 15.5% g
Republic of Macedonia18%5%
Norway25%14% or 8%
Switzerland7.6%3.6% or 2.4%
Trinidad or Tobago15%
Turkey18%8% or 1%
Source: Adapted by CRS from Wikipedia, the free encyclopedia available at
[ http ://en. wikip e d ia.o r g/wiki/VAT ] .
a. HST is a combined federal/provincial VAT collected in some provinces. In the rest of Canada, the
GST is a 6% federal VAT, and if there is a Provincial Sales Tax (PST) it is a separate non-VAT
b. No real “reduced rate,” but rebates generally available for new housing effectively reduce the tax
c. These taxes do not apply in Hong Kong and Macau, which are financially independent as special
d. The reduced rate was 14% until March 1, 2007, when it was lowered to 7%. The reduced rate
applies to heating costs, printed matter, restaurant bills, hotel stays, and most food.
e. VAT is not implemented in 2 of India’s 28 states.
f. Except Eilat, where VAT is not raised.
g. The VAT in Israel is in the process of being gradually reduced. It was reduced from 18% to 17%
on March 2004, to 16.5% on September 2005, and was set to its current rate on July 1, 2006.
There are plans to further reduce it in the near future, but they depend on political changes in
the Israeli parliament.
h. The value-added tax levied by the States of Jersey is effective January 1, 2008.
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