Eric Toder, a fellow at the Urban-Brookings Tax Policy Center, addressed the following questions regarding the possibility of a federal value-added tax. Urban-Brookings is a joint venture of the Urban Institute, which calls itself a nonpartisan research organization, and the Brookings Institution, which bills itself as an independent research organization.
Please explain how a value-added tax works. It’s basically a consumption tax, like a retail tax. But it’s collected from every business along the production chain, with each business getting a rebate for the tax paid at the previous stage. Take the sale of bread.
Imagine the farmer is selling a quantity of wheat at $300, plus a 10 percent value-added tax. The miller pays $330 to the farmer. The miller incurs $400 in costs to grind the wheat, so the 10 percent VAT adds $40. The baker incurs another $300 in costs, resulting in $30 of VAT, so the final cost of bread to consumers becomes $1,100: $1,000 for the loaves, $100 for the VAT.
Why is a VAT being touted as a way to reduce our enormous deficits? Given the government’s commitments to provide retirement and health benefits, the spending cuts required to balance the budget would be draconian. On the revenue side, we have a flawed income tax with lots of preferential treatment and high taxes on corporate income.
If we are serious about deficit reduction, we will have to retain an income tax along with any VAT. But some VAT revenues could be used to reduce income tax rates or to increase exemptions so that fewer taxpayers file income-tax returns.
Would a VAT stifle spending when the economy needs it most? We don’t want to raise taxes now, given the high unemployment rate. But that will change, and we have very-long-term debt problems.
FRAUD AND THE VAT?
Curtis Dubay, a senior analyst in tax policy at The Heritage Foundation, an independent and conservative think tank, wrote this year: “If Congress implements a VAT as an additional tax, businesses and individuals would try to avoid it through fraud, severely limiting a VAT’s ability to close budget gaps.” He wrote that “fraud persists with the VAT” … mostly in four forms: false claims of taxes paid, credit claimed for noncreditable purchases, bogus traders and hidden sales. His report can be found at tinyurl.com/25odmgf.