JURIST Guest Columnist João Gonçalves of the Universidade de Lisboa, Faculty of Law discusses the advantages of VAT for an economic system…
Europe may seem the worst class of students for the US to find for fiscal lessons, but as the necessity for a new revenue strengthens and a call for a tax reform, even if minor, grows louder, it is time to adopt the Value-Added Tax (VAT). Curiously enough, the US is the only country in the OECD that has not adopted the VAT—yet. Ironically, the first form of VAT [PDF] appeared in the State of Michigan in 1953. In 1954, in order to recover from the war, the French implemented the VAT in such a way that it convinced everyone else. Prior to that, all European countries had turnover taxes. This means, in very broad terms, that at that time, instead of having a 20 percent tax on consumption, the government taxed every stage of production, charging a previous VAT. In other words, it would be 20 percent plus 40 percent plus 60 percent—only to be deducted on the last stage. So if this system brings in more money, why did everyone adopt VAT? For two reasons: one is that the VAT system, where everyone asks for invoices, is an intrinsic, built-in anti-fraud system. This system ensures that the players in the chain of production are paying their taxes. If something goes wrong, the money is only lost on the last transaction—the rest has already been collected by the government. Reason number two is the fact that a turnover tax is intrinsically a non-neutral tax. Decisions of economic operators are going to be influenced by the fact that any tax that they are charged with represents a cost to them and they are going to try to minimize the costs, thus making decisions based on tax, rather than based on any other economic reason. In its pure form, VAT is neutral. And we want neutrality because when a player starts to make tax-based decisions, such decisions render allocation of resources less effective. Yet it needs to be applied uniformly to all goods and services in an economy because it raises the prices of everything proportionally. Therefore, no product or service gains an artificial comparative advantage over another. This is why VAT exemptions or low rates are not welcome—it would dissipate the VAT advantage.

So is VAT the best money-making machine system? Yes, it absolutely is. In Europe, the acquis communautairewas not the only thing responsible for adopting VAT—the International Monetary Fund influenced everyone [PDF], even outside of Europe, by establishing VAT as a sure way to generate revenue. In addition, it will not distort competition and therefore will not hamper economic growth. However, some could point out the Laffer Curve where, if you raise taxes high enough, at some point consumption and revenue are going to start decreasing. If you push the VAT rate sufficiently high, consumption will retract and revenue will come down. But every time VAT rates increase, the optimal point seems to go up also. Revenue always increases. Either there is no such thing as a Laffer Curve, or we have not reached it yet. And Europe has put this theory to the test, over and over again—Denmark went up 10 percent, Germany, Italy and Turkey went up 8 percent. If the US were to have a 20 percent VAT, it would raise 8 percent of GDP; just under €1,7 trillion in higher taxes in 2019. A tax increase of this magnitude would raise the federal tax burden between 33 and 44 percent above its historical average. Also, in the fiscal year of 2011, if the US had had a VAT tax of 20 percent, it would have had more revenue than corporate income tax and individual income taxes altogether.

Now let us address specifically why the US does not have the VAT? There are several reasons. First of all, because of the transitional costs—the costs of moving from one tax to another. There is a huge administrative burden from moving from one tax that only requires a check on one transaction to a tax that has to check every transaction, although its administrative costs would be derisive given VAT financial gain. Another reason is that the VAT is not a good way to redistribute wealth. While for personal income taxes one can take into account personal circumstances, the VAT is by nature a regressive tax. This means that it does not take into consideration the household income. Some economic experts may say it is not regressive, but when taking into consideration the margin of utility, there is little room for doubt. If household A spends €1000 per month on groceries, they will have a VAT of, for example, 20 percent—that equals €200. Whereas household B, which spends only €200, will be taxed on the same percentage resulting in €20. But those €20 mean much more to the latter than the €200 means to household A. A way to go around this problem is by adding VAT to the US currency system, allowing for a balance of some of the regressivity with the income tax.

VAT is more important, more so now, than direct taxation. This is because there is more unemployment, and this causes a downward pressure on the employed income. This is why personal income taxes have been decreasing in revenue. Concerning corporate income taxes rates around the world, since the 1960’s no country has increased corporate income taxes. This has to do with mobilization and mobility of income; mobility of capital leads to tax competition. In the US, it is worth mentioning the Delaware effect—Delaware was lacking an industry and decided to have almost no regulation for companies, no minimum capital for company establishment and very attractive corporate income tax rates. The effect refers to all the other states that tried to return companies to their home states by creating similar conditions, also known as the race to the bottom. So, because tax competition is a global phenomenon, particularly intensive within the US and Europe, there is a downward pressure on corporate income taxes. Countries are constantly under pressure to decrease their rates of corporate income tax. At the same time, during the down term, profits decrease. Reduced rates are a bad idea, alongside with exemptions as aforementioned. Rather than being worried about reducing the rate for, for example educational school books, one can just give a personal income tax credit for school books. These are ways that are more effective in protecting low income households. Also, from a legal standpoint, reduced rates establish an enticement to engage in aggressive tax planning—its consequences include double deductions (i.e., the same loss is deducted both in the state of source and residence) and double non-taxation (i.e., income which is not taxed in the source state is exempt in the state of residence) and the application of different rates of VAT to similar products. Also, there would have to be a uniform high rate for general goods, in order to avoid new consumption trends and businesses trying to manipulate their own merchandise like Marks and Spencer did when they applied a standard rate for their teacakes therefore giving them a competitive disadvantage to other companies in the markets that applied a VAT reduced rate. They said that, a) in order to have costumers buy their products, they had to artificially decrease the price of sale; b) If they had not paid the standard rate of VAT, they could lower the prices and/or have a bigger profit margin and in this way they lost market share because they had a standard rate of VAT for 20 years. Because of this, the key criteria to define what is a cake or a biscuit is by what happens when they go stale: if it stays hard, it is a cake; if soft, it is a biscuit.

Congress should consider the following: more is not always better. After the credit crisis, everyone understood the necessities for an interchangeable mindset of spending/saving. And although consumption also makes the economy thrive, increased taxation will not hinder the economy—while high spending creates a short-lived economic high, saving and investing mage for longer-term sustainable growth, because businesses use capital to expand their operations, and entrepreneurship use them to begin businesses. Taxing saving and investment reduces their attractiveness to individuals and increases the cost of raising capital for businesses. And, like everything, the rate change is easy and convenient and it should be intertwined with the current economic situation.

João Gonçalves is a curricular intern at Liberum Law Firm, where he developed a special interest in the areas of corporate and tax law. João is currently a 3L at the Faculty of Law, University of Lisbon.

Suggested citation: João Gonçalves, Why the US Should Adopt VAT, JURIST – Student Commentary, June 3, 2015, http://jurist.org/student/2015/06/Joao-Gonçalves-VAT-US.