Value Added Tax and tariff system: Advanced country perspective

William G. Gale and Benjamin H. Harris (2010) of Brookings Institution and Tax Policy Centre in their paper noted that U.S. faces a large medium-term federal budget deficit and an unsustainable long-term fiscal gap. Left unattended, these shortfalls will hobble and eventually cripple the economy. The only plausible way to close the gap is through a combination of spending cuts and/or tax increases. The paper discusses why a federal Value Added Tax (VAT) should be part of a constructive solution to the fiscal problem. Under a VAT, businesses pay taxes on the difference between their total sales to other businesses and households and their purchases of inputs from other businesses. That difference represents the value-added by the firm to the product or service in question.
Tax can be administered in different ways. For example, under the credit invoice method, firms receive tax credits for the taxes they have paid on their purchases from other firms. Alternatively, under the subtraction method, firms can fully deduct all of their payments to other firms. The sum of value-added at each stage of production is the retail sales price, so in theory the VAT simply replicates the tax patterns created by a retail sales tax and is therefore a tax on aggregate consumption. In practice, the key distinction is that VATs are collected at each stage of production, whereas retail sales taxes are collected only at point of final sale. As a result, VAT is easier to enforce and is widely regarded as having a superior administrative structure to a retail sales tax.
Although it would be new to the United States, VAT is in place in about 150 countries worldwide and in every OECD (Organisation for Economic Cooperation and Development) country other than the United States. Experience suggests that VAT can raise substantial revenue, is administrable, and minimally harmful to economic growth. Additionally, it has potential advantages worth highlighting: a properly designed VAT might help the states deal with their own fiscal issues, and a pre-announced, phased in VAT might be able to accelerate the pace of economic recovery.
 Several concerns that have been raised about how VAT can be easily addressed. While VAT is regressive relative to current income, the regressivity can be offset in several ways. While VAT is not readily transparent in many countries, it would be easy to make it completely transparent to businesses and households by reporting VAT payments on receipts just like sales taxes are reported today. While VAT has led to an increase in revenues and spending in some countries, higher revenues are precisely why VAT is needed in the U.S, and efforts to limit spending should be part of an effort to enact a VAT.
 Making VAT transparent should also reduce the extent to which a VAT would fuel an increase in government spending, a concern that is sometimes overstated by critics in the first place. While VAT may lead to a one-time increase in prices, it is not the case empirically that VATs inevitably, or even usually, lead to continuing inflation.  None of this implies that VAT would unilaterally solve the country's fiscal problems; nor would it be painless. Nevertheless, the VAT is a relatively attractive choice, given the need to close the fiscal gap and the other options for doing so.
IMPACT ON REVENUE: Gale and Benjamin H. Harris (2010) paper claimed in the current fiscal context, a key attraction of VAT is its ability to generate significant amounts of revenue. Among non-U.S OECD members in 2006, the VAT raised almost 7.0 per cent of GDP (gross domestic product) in revenue, and accounted for almost 19 per cent of revenue raised at all levels of government.  As with any tax, revenue from VAT depends on the rate structure and the base.  The standard VAT rate, the rate charged on most goods and services, has remained relatively steady in recent years in non-US OECD countries. In 2007, it ranged from a low of 5 per cent in Japan to a high of 25 per cent in Denmark, Iceland, Norway, and Sweden. The average rate was 18 per cent (OECD 2008).  The VAT "yield ratio" measures VAT revenues as a share of GDP divided by the standard VAT rate. A ratio of 0.3, for example, implies that a 10 per cent VAT raises 3.0 per cent of GDP in revenues. Note that the yield ratio does not include the net costs of policies intended to compensate low-income households for VAT payments, nor do they include the offsetting effects that the VAT may have on other revenue sources. The yield ratio simply measures how much revenue is actually gained from the VAT itself.
In 2006, in non-U.S OECD countries, the yield ratio ranged from a low of 0.28 in Mexico to a high of 0.69 in New Zealand. Most countries fell within a range of 0.3 and 0.4 (OECD 2008). The yield ratio depends critically on the extent to which the VAT tax base is kept broad rather than eroded by preferential rates or exemptions on certain goods or services. In practice, most OECD countries apply preferential rates to some items.
Toder and Rosenberg (2010) estimate that the U.S. could raise gross revenue of $355 billion in 2012 through a 5.0 per cent VAT applied to a broad base that would include all consumption except for spending on education, Medicaid and Medicare, charitable organisations, and state and local government. This would represent about 2.3 per cent of GDP and produce a yield ratio of 0.45.  However, as discussed further below, governments often provide either subsidies or exemptions on VAT. One way to do so is to narrow the base, excluding some preferred items. For example, exempting rent, new home purchases, food consumed at home, and private health expenditures from VAT in the U.S. would reduce revenue by 38 per cent, cutting the yield ratio to 0.28.
Imposing the VAT would reduce net business income, which would in turn reduce other revenues. Toder and Rosenberg estimate that declines in other tax receipts would offset about 27 per cent of gross VAT revenues. This would reduce "effective" revenues after netting out the costs of cash payments and the loss in other revenues of 1.02 per cent of GDP for either base, resulting in an "effective" yield ratio of 0.2.  These figures imply after allowing for offsetting adjustments in other taxes and the costs of either cash payments or narrowing the base as described above that a 10 percent VAT would rise just over 2.0 per cent of GDP in revenues.
EFFICIENCY AND GROWTH : A broad-based VAT that is levied uniformly on all goods and services would not distort relative prices among consumption goods. Similarly, a VAT with a constant tax rate over time would not distort household saving choices and business's choices regarding new investments, financing instruments, nor organisational form. Relative to higher income tax rates which would distort all of the choices noted above, VAT has much to offer in terms of incentives. Like the income or payroll tax, however, VAT would distort household choices between work and leisure. VAT is border-adjustable; it would exempt exports and tax imports. While this is sometimes touted as providing economic benefits, it is actually a neutral treatment of these items.  A substantial literature, based on economic theory and simulation models, documents the potential efficiency gains from substituting a broad-based consumption tax for an income tax (Altig et al. 2001, Auerbach 1996, Fullerton and Rogers 1996). These gains arise from a combination of broadening the tax base, eliminating distortions in saving behavior, and imposing a one-time tax on existing wealth.
The tax on existing wealth merits additional discussion. As a tax on consumption, VAT can be regarded as a tax on the wealth and income that households use to finance current and future consumption: wealth that exists at the time of the transition to the VAT, future wages, and extra-normal returns to capital (Hubbard and Gentry 1997). In a risk-free world, the normal return to capital is just the risk-free rate of return. Earning the risk-free rate of return on saving does not raise the present value of consumption a household can obtain; it simply affects the timing of the consumption. Allowing for risk changes the normal return to a risk-adjusted return, but also changes the rate at which consumption is discounted, so the result continues to hold that earning the normal return (adjusted for the risk) on capital does not affect the present value (adjusted for risk) of consumption available to the household. In contrast, returns due to rents do affect the present value of consumption available to households and therefore would be subject to a consumption tax  
The tax on existing wealth is a lump-sum tax, since the wealth has been already accumulated. Lump-sum taxes are preferable to other forms of taxation on efficiency grounds, since they do not distort economic choices. In fact, the lump sum tax on existing wealth is a major component of the efficiency gains due to the creation of a consumption tax. Altig et al. (2001) shows that in the conversion to a flat tax, the taxation of old capital accounts for more than 60 per cent of the induced economic growth effect in the first five years, more than half of growth in the first decade, and about 40 per cent of the induced growth even after 50 years.
The efficiency and growth effects due to an add-on VAT would include: losses from the increased distortion of work/leisure choices; the substantial gains noted above from the one-time tax on existing wealth and substantial gains from deficit reduction. While short-term fiscal stimulus can boost an otherwise slack economy, as it has over the past year and a half, large and persistent deficits will have deleterious effects that can materialise gradually or suddenly. The sudden scenario has been emphasised in the past (Ball and Mankiw 1995, Rubin et al. 2004), under considerably more sanguine fiscal conditions than exist today, and has been highlighted recently by Burman et al (2010). Under this scenario, investors' fears about future deficits can reach a tipping point and trigger a financial crisis with potentially calamitous effects. Some analysts cite this potential sudden impact as the most important reason to avoid substantial ongoing budget deficits.
But even in the absence of a crisis, sustained deficits have deleterious effects, as they translate into lower national savings, higher interest rates, and increased indebtedness to foreign investors, all of which serve to reduce future national income. Gale and Orszag (2004a) estimate that a 1 per cent of GDP increase in the deficit will raise interest rates by 25 to 35 basis points and reduce national saving by 0.5 to 0.8 percentage points of GDP. Engen and Hubbard (2004) obtain similar results with respect to interest rates. Thus, relative to a balanced budget, a deficit equal to 6 per cent of GDP would raise interest rates by at least 150 basis points and reduce the national saving rate by at least 3 per cent of GDP.
 The IMF (2010) estimates that, in advanced economies, an increase of 10 percentage points in the initial debt/GDP ratio reduces future GDP growth rates by 0.15 percentage points. Hence, the projected increase in the debt/GDP ratio from about 40 per cent earlier in the decade to 90 per cent by 2020 (Auerbach and Gale 2010) would be expected to reduce the growth rate by a whopping 0.75 percentage points. By cutting deficits, the VAT would help spur economic growth.
Empirical research broadly confirms these notions (Caspersen and Metcalf 1994, Metcalf 1994, Toder and Rosenberg 2010). However, empirical analysis is complicated by the fact that alternative methods of distributing the burden of a consumption tax-such as distributing the burden to consumption versus wages and capital less investment-can produce drastically different estimates of progressivity, even though they are equivalent in theory (Burman et al. 2005).
As mentioned earlier, VAT imposes a one-time tax on existing wealth, a feature that is desirable on efficiency grounds but is more controversial with regard to fairness. We believe a one-time tax on wealth would be fair, and in fact would be quite progressive. There is concern that imposing a VAT would hurt the elderly, a group that has high consumption relative to its income. However, it is the case that Social Security and Medicare are the principal sources of income for a substantial proportion of low-income elderly households. Since those benefits are effectively indexed for inflation, low-income elderly households would be largely insulated from any VAT-induced increases in the price of consumer goods or health care services. Johnson et al. (2004) shows that for households in the bottom quintile and second quintile of the income distribution for the elderly, 80 per cent and 68 per cent, respectively, of their financial (i.e., non-Medicare) income comes from Social Security.   High-income elderly households, who receive much lower shares of their income in the form of indexed government benefits, would need to pay more in taxes but could afford to do so.
Concerns about the regressivity of VAT are complex, but they should not obstruct the creation of a VAT for two reasons. First, the validity of transfer system, not the distribution of any individual component of that system. Clearly, VAT can be one component of a progressive system.  Second, it is straightforward to introduce policies that can offset the impact of VAT on low-income households. The most efficient way to do this is to simply provide households either refundable income tax credits or outright payments. For example, if the VAT rate were 10 per cent, a $3,000 demogrant would equal VAT paid on the first $30,000 of a household's consumption. Households that spent exactly $30,000 on consumption would pay no net tax. Those that spent less on consumption would receive a net subsidy. Those that spent more on consumption would, on net, pay a 10 per cent VAT only on their purchases above $30,000. Toder and Rosenberg (2010) estimate that a VAT coupled with a fixed payment to families is generally progressive, even with respect to current income.

In contrast, many OECD governments and state government offer preferential or zero rates on certain items like health care or food to increase progressivity. This approach is largely ineffective because the products in question are consumed in greater quantities by middle-income and wealthy taxpayers than by low-income households. Congressional Budget Office (1992, p. xv) finds that "excluding necessities such as food, housing, utilities, and healthcare would lessen VAT's regressivity only slightly." Toder and Rosenberg (2010) find that excluding housing, food consumed at home, and private health expenditures from the consumption tax base can somewhat increase progressivity, but not as much as a per-person payment would.  
Furthermore, this approach creates complexity and invites tax avoidance as consumers try to substitute between tax-preferred and fully-taxable goods and policymakers struggle to characterise goods (for example, if clothing were exempt from the VAT, Halloween costumes classified as clothing would be exempt while costumes classified as toys would not).
 [The name of the author was inadvertently  mentioned as Syed Jamaluddin in the third instalment of the series published on Sunday, March 03, 2016. The mistake is regretted.]
This is a part of the Conference Paper titled "From Differential to Uniform Rate System: The Political Economy of Reforming Value Added Tax System in Bangladesh" presented at the Members Conference of the Institute of Chartered Accountants of Bangladesh. Mr Nojibur Rahman, Secretary, Internal Resources Division and Chairman of NBR, was the chief guest while Barrister Jahangir Hossain, member, VAT Policy, was the special guest. Jamaluddin Ahmed, PhD, FCA, is Chairman, Emerging Credit Rating Ltd.
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