Over in the far off distant world of Europe, they don’t use the income tax system that the American government uses.  Instead the Euro folks are big fans of the Value Added Tax (VAT).  The VAT is a tax on consumption, like the sales tax and fair tax.  But it’s technically a tax on profits too, making it similar to the corporate income tax here in the states.  So in essence, the VAT is a hybrid.

So how does it work?  Pretend you want to buy a pen for $1.50 in both the United States and Germany.  The US has a 10% sales tax and Germany has a 10% VAT.

In the US, the transaction would look like this:
The manufacturer pays $1.00 for the raw materials, certifying it is not a final consumer.
The manufacturer charges the retailer $1.20, checking that the retailer is not a consumer, leaving the same profit of $0.20.
The retailer charges the consumer $1.65 ($1.50 + $1.50×10%) and pays the government $0.15, leaving the same profit of $0.30.
Total revenue to US government is $0.15.

In Germany, the transaction goes as follows:
The manufacturer pays $1.10 ($1 + $1×10%) for the raw materials, and the seller of the raw materials pays the government $0.10.
The manufacturer charges the retailer $1.32 ($1.20 + $1.20×10%) and pays the Government $0.02 ($0.12 minus $0.10), leaving the same profit of $0.20.
The retailer charges the consumer $1.65 ($1.50 + $1.50×10%) and pays the government $0.03 ($0.15 minus $0.12), leaving the profit of $0.30 (1.65-1.32-.03).
Total revenue to German government is $0.15.

In both cases the final consumer pays the same price of $1.65 and the government collects their cut of $0.15.  (Thanks to Wikipedia for the example)

Now that you’ve seen a simple example of how it works, let’s look at at the good and bad associated with the VAT.

What are the pros of the Value Added Tax?
Paying taxes costs money.  Best Buy, Starbucks, and (someday) Amazon are all responsible for paying the government the sales tax they charge you as the consumer.  They must have dedicated staffs to make sure they pay the right amount in each state.  This is an expense to the company.  Toshiba, in its relationship as a manufacturer providing products to Best Buy, doesn’t have to pay a sales tax.  Why should Best Buy have to bear the expense of taking care of sales tax, when there’s two sides of every transaction?  Employing the VAT would force all parties to bear the brunt equally.

The VAT is also a consumption tax, so there is incentive for you to limit your spending.  Like the Fair Tax, if you spend less than you make, you’ll pay less in taxes (all else equal).

Deployment of the VAT, unlike the Fair Tax, has shown itself to be successful in other countries.  VAT is very popular in Europe, and has served to help unite the countries of the EU. Britain also employs a value added tax, as do many countries representing other continents.  Using the VAT in the United States would assist in unifying tax codes all over the world, improving the efficiency of commerce.  Someday, we’ll all be a part of a large organization which is driven by standards.  The standards for taxes will probably follow a VAT system.

Because everyone is taxed at every transaction, the VAT is able to capture more revenue that may previously had been missed.  Imagine a mechanic fixing your car for you.  You pay him under the table, so you avoid taxes and so does he.  But because he did have to order parts, taxes were paid in that transaction.  In the current US environment of a sales tax, this wouldn’t have been caught because the parts dealer sold them wholesale.

What are the cons of the Value Added Tax?
Like the Fair Tax again, the VAT is a regressive tax.  Regressive taxes tend to benefit the wealthy and punish the poor.  Why?  Someone making $1 million a year may only spend 10% of their income, so only 10% is taxed.  Their impoverished little brother though makes only $35,000 a year and spends it all supporting his kids.  So he is taxed on 100% of his income.

In most countries the VAT has produced less revenue than expected.  This is because of the hefty costs to the government required to make sure everyone is paying.  At some point it costs the government more to chase after the evaders than the expected revenue from catching them.  The end result is those that do pay, end up having to pay more for compensating the cheaters.  A system that punishes those following the rules can result in bad public opinion.

Because the value added tax and fair tax are so related, their problems are similar.  However the VAT is a more complicated system than the fair tax, making fraud much easier.  A move from the current tax system to the VAT would take a very long time.  Because the government prefers to use tax law as an economic stimulus, it is likely the tax code would end up being just as bloated as it is today.  The auditing industry would surely survive, but only after a long and painful transition.  Because Americans don’t like change, it’s difficult to conceive we would ever make the move to another complicated taxing system.

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categories: government