Value Added Tax: Distributional effects

In theory, the distributional burden of the VAT depends crucially on how household resources are measured. Typical distributional analyses are made with respect to current income. The VAT is regressive if households are classified by, and the tax burden is measured as a share of, current income. Because VAT is a proportional tax on consumption, and because lower-income households tend to spend a larger proportion of their income than higher-income households, it imposes higher burdens - as a share of current income - on lower-income households.  However, several other perspectives are also there. The VAT is a proportional tax if households are classified by current consumption since all households are taxed at the same rate on the amount they consume. Likewise, to the extent that current consumption mirrors average lifetime income, VAT is also proportional with respect to lifetime income.
ADMINISTRATIVE ISSUES: A broad-based VAT would cost less to administer than the income tax. For example, in the United Kingdom, administrative costs of VAT were less than half of those of income tax, measured as a share of revenue. Similarly, the New Zealand revenue department was required to intervene in just 3 per cent of VAT returns, compared to 25 per cent of income tax returns (GAO 2008).  VAT has compliance advantages over retail sales tax, which aims to collect all revenue at the point of sale from a business to a household. Since revenue collection for VAT is spread across stages of production, with producers receiving a credit against taxes paid as an incentive for compliance, VAT in practice is less likely to be evaded. Gale (2005) discusses administrative complications with a retail sales tax and the changes in tax rate resulting from an erosion of the tax base due to evasion. Theory and evidence suggest that the compliance burden would likely fall more heavily-as a per centage of sales - on smaller businesses. Most countries address these concerns by exempting small businesses from collecting VAT. It is worth noting that, to the extent administrative costs are fixed with respect to the VAT standard rate, the presence of such costs suggest thatVAT should be set at a relatively higher rate rather than a lower one.
As for the United States, some analysts (McLure, 2002) express concern that a national VAT would impinge on states' ability to administer their own sales taxes. In our view, a national VAT could help states significantly. State retail sales taxes are poorly designed - they exempt many goods and most services and collect more than 40 per cent of their revenue from taxing business purchases, which should be exempt.  McLure (2002) described the "nutty" world of state sales taxes. Mazerov (2009) estimated that most states could increase sales tax revenue by 20 to 40 per cent if "feasibly-taxed" services were added to the sales tax base. Durner and Bui (2010) described for the share of sales taxes paid by businesses.  
Converting their sales taxes to VATs and piggybacking on a broad-based federal VAT would offer states in the US several advantages. First, the states could raise substantial amounts of revenue in a less distortionary manner than current sales taxes. Second, administrative costs, which currently exceed 3.0 per cent of state sales tax revenue (PriceWaterhouseCoopers 2006), would decline.  Many states currently link their income tax to the federal income tax base, with obvious administrative and compliance advantages. Similar savings would accrue from linking federal and state VAT bases. Third, a national VAT would allow states and the federal government to tax previously difficult-to-tax transactions, such as interstate mail order and internet sales. If the U.S. experience followed that of Canada, the federal government could collect revenue on behalf of states and absolve states of the cost of administering consumption taxes altogether (Duncan and Sedon 2010).
In 2009, state and local sales tax revenue equalled 2.0 per cent of GDP (authors' calculations based on U.S. Census Bureau 2010). If the federal VAT had the broad base and demogrants described in Table 1, and the states and localities piggy-backed on that structure, an average subnational VAT of about 6.0 per cent would raise the same revenue as existing state and local sales taxes. Alternatively, states could maintain their sales taxes or create their own VAT bases. Following the implementation of a federal VAT in Canada, most provinces maintained their existing tax codes for several years. Some provinces have yet to fully harmonize with the federal VAT, while Quebec administers its own VAT (Duncan and Sedon 2010).
ANTICIPATED VAT AS STIMULUS: While a major tax increase would not be a good idea while the economy is still recovering slowly from recession, it is worth noting that there is potential for the announcement of a future VAT to be stimulative in the current period. By raising the price of consumption goods in the future, or by doing so gradually over time via a phased-in VAT, the announcement would encourage people to spend more now and in the near future, when the economy needs the stimulus. This effect may not be very big, there is little evidence, but it goes in the right direction.
WILL VAT FUEL EXPANDING GOVERNMENT:  VAT has been called a "money machine" in honour of its ability to raise substantial amounts of revenue. That is a helpful feature if the revenues are used to close deficits, but poses a problem if the boost in revenue simply fuels further unsustainable growth in spending.   Some analysts reject any source of extra revenue-including a VAT- on the grounds that less government revenue leads to smaller government. In general, this "starve the beast" theory does not apply to most taxes, nor does it reflect recent experience. Bartlett (2007) outlines the development of the "starve the beast" theory and shows how it failed to apply during the George W. Bush administration.  
Romer and Romer (2009), for example, find that tax cuts designed to spur long-run growth do not in fact lead to lower government spending; if anything, they find that tax cuts lead to higher spending. This finding is consistent with Gale and Orszag (2004), who argue that the experience of the last 30 years is more consistent with a "coordinated fiscal discipline" view, in which tax cuts were coupled with increased spending (as in the 1980s and 2000s) and tax increases were coupled with contemporaneous spending reductions (as in the 1990s). Given the widely recognised need for both spending cuts and revenue increases to balance the budget, it is likely that any new revenue stream would be accompanied by reductions in spending.
Some observers argue that the VAT is such an efficient and invisible tax that it has been and would be used to fuel government spending increases through a gradually increasing VAT rate. Bartlett (2010a, 2010b) addresses this claim by noting that increased VAT rates in OECD countries were common among early adopters, who operated a VAT in the high-inflation environments in the 1970s, but far less common among countries that adopted VAT after 1975. Among the 17 countries that instituted VAT during the post-1975 period of relative price stability, four have not changed their VAT rate and four have decreased the rate; the average rate increase across all late-adopters of the VAT is less than 1 per cent point. The average VAT in OECD countries has been roughly constant since 1984 at or just below 18 per cent.
MAKING VAT TRANSPARENT: A variant of the concern about spending growth is the notion that the VAT is "hidden" in prices. As a result, the argument goes, taxpayers won't notice the VAT the way they do income, sales, or payroll taxes. This issue is easily addressed. VAT doesn't have to be invisible: for example, Canada simply requires that businesses print the amount of VAT paid on a receipt with every consumer purchase. This is essentially identical to the standard U.S. practice of printing sales taxes paid on each receipt. The growing literature on tax visibility offers somewhat mixed results. Mulligan et al. (2010) finds that the proportion of payroll taxes paid by employees does not have a significant effect on the size of the public pension programme. Finkelstein (2009) finds that the adoption of electronic toll collection results in higher tax rates and reduced short-run elasticity of driving with respect to toll rates. Similarly, Chetty et al. (2010) finds that posting tax-inclusive prices reduce demand for certain goods.   Another way to make the VAT transparent is to link VAT rates and revenues with spending on particular goods. Aaron (1991) and Burman (2009) propose a VAT related to health spending. Under such a system, the additional health insurance coverage would help offset the regressivity of a VAT and make the costs of both the VAT and government spending more transparent.
INFLATION: The creation of an add-on VAT will create pressure on prices. (If, instead, the VAT were replacing a sales tax, there would be no pressure or need to adjust the price level.)  But there is no theoretical or empirical reason to believe that VAT would cause continuing inflation.. Research has found only a weak relationship between the VAT and continually increasing prices. In a survey on 35 countries that introduced VAT, Tait (1991) finds that 63 per cent exhibited no increase in the consumer price index (perhaps because they were replacing existing sales taxes) and 20 per cent had a one-time price rise. In the remaining 17 per cent of cases, the introduction of the VAT coincided with ongoing acceleration in consumer prices, but it is not likely - in Tait's view- that the VAT caused the acceleration.
This is the last of a five-part 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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