Beware the (Other) Hidden Tax
(Queue Jaws theme music in your head. By the way, it’s Shark Week on Discovery Channel… no affiliation on my part obviously, I just love it.)
No, this article is not about the indirect hidden tax – inflation -- we are so fond of discussing. It’s about a particularly insidious, direct, hidden tax that has already swept across Europe and (we think) is now bound for the U.S.
We’re talking, of course, about the “value-added tax” or VAT.
Former Deputy Treasury Secretary Roger Altman and former Fed Chair Alan Greenspan both (along with many others in Congress) recently expressed the opinion that the VAT tax is coming to the U.S. fairly soon.
Here’s what Greenspan said: “I don’t like the value-added tax, but I agree with Roger [Altman]. I think that there is a fairly significant probability that the least worst solution to the problem will end up to be a value-added tax, because it’s the only thing that raises revenues in significant quantities without significantly impacting on the economy.”
Before we get into the “hidden” nature of the VAT and the real-world impacts of it, let’s provide some background.
What Is a VAT?
A value-added tax (VAT) is a fee that is assessed against businesses by a government at various points in the production of goods or services – usually any time a product is sold, resold, or value is added to it.
For tax purposes, value is added whenever the value of a product increases as a result of the application of a company’s factors of production, such as labor and equipment.
Every company that handles a product during its transformation from raw materials to finished goods must pay a VAT. For example, tax is charged when a manufacturer sells to a wholesaler and again when a wholesaler sells to a retailer.
The total VAT accrued during the production of a good is reflected in the price of the item sold to final consumers, because each reseller along the way passes through its VAT costs. In this way, VAT is quite similar to a national sales tax. In other ways, it is quite different.
Perhaps a comparative example will help clarify.
Consider the manufacture and sale of the economist’s staple hypothetical good – the widget.
Scenario 1: Manufacture and sale of one widget without any sales tax
A widget manufacturer spends $10.00 on raw materials and combines these materials with labor to make a widget.
The widget manufacturer then sells the widget wholesale to a widget retailer for $12.00, leaving the manufacturer with a $2.00 profit.
The widget retailer then sells the widget to a widget consumer for $15.00, making the retailer a profit of $3.00.
Scenario 2: Manufacture and sale of one widget with a North American (Canadian Provincial and U.S. State) sales tax of 10%
The widget manufacturer spends the same $10.00 on raw materials to build a widget, but it must certify that it is not a final consumer.
The widget manufacturer charges the retailer the same $12.00, first checking that the retailer is not an end-consumer, leaving the manufacturer (again) with a $2.00 profit.
The widget retailer then sells the widget to a widget consumer, but this time for $16.50 [$15.00 x (1 + 10%)] and pays the government $1.50, leaving the same profit of $3.00.
Scenario 3: Manufacture and sale of one widget with a VAT of 10%
This time, the widget manufacturer pays $11.00 [$10.00 x (1 + 10%)], and the seller of the raw materials pays the government $1.00 in VAT.
The widget manufacturer charges the widget retailer $13.20 [$12.00 x (1 + 10%)] and pays the government $0.20 in VAT ($1.20 less $1.00 paid in first stage), leaving the manufacturer with the same $2.00 profit ($13.20 sale price less $11.00 cost of materials less $0.20 VAT in second stage equals $2.00).
The widget retailer charges the widget consumer $16.50 [$15.00 x (1 + 10%)] and pays the government $0.30 ($1.50 less $1.20 already paid in first and second stages), leaving the retailer with the same $3.00 profit ($16.50 sale price less $13.20 purchase price less $0.30 VAT in third stage equals $3.00).
So, you see, the total tax paid to the government in both scenarios 2 and 3 is $1.50, and the entire tax burden is ultimately placed on the end consumer, who must pay $16.50 for a widget that would only cost $15.00 absent the sales tax or VAT.
Hidden Nature of VAT
Remember, the total tax, regardless of the stage of production at which it was collected, ends up being added to the final sales price.
No matter how many steps there are in the production process, a fixed percentage of the final price of the product would represent the value-added tax, just as a retail sales tax is a fixed percentage of the final product price. Unlike a sales tax, however, the cost of the VAT to consumers would be hidden because it is baked into the advertised retail prices of goods and services.
Many consumers, of course, would recognize that the VAT existed, but it is not likely that they would realize the magnitude of the levy. For instance, gasoline consumers generally understand that gas taxes exist. But because gas taxes are incorporated in the advertised retail price of gasoline, few are aware that taxes comprise a substantial share of the retail price. (The average gasoline tax in the U.S. is about $0.46 per gallon. That’s $9.20 in taxes to fill a 20-gallon tank.)
Real-World Impact of VAT
Many countries already impose VATs (over 130, in fact), and the results of this real-world experiment have been dismal.
VATs are associated with both higher overall tax burdens and more government spending. In 1966, before the VAT swept across Europe, the average tax burden for advanced European economies (the EU-15) was 28.4% of GDP, fairly similar to the U.S., where taxes consumed 25% of economic output, according to data from the OECD Factbook 2009:Economic, Environmental, and Social Statistics,an annual publication of the Organization for Economic Cooperation and Development (OECD).
European nations began to impose VATs in 1967, and now the EU requires all members to have a VAT of at least 15%.
What are the results? Scary, to say the least.
By 2007 (the most recent data available), calculations using OECD data determined that the average tax burden for EU-15 nations has climbed to 39.9% of GDP. That’s a 40% increase since 1966. The tax burden also has increased in the U.S., but at a much slower 13.2% rate, rising to 28.3% of GDP for the year 2007.
Furthermore, according to European Commission figures, government spending during 1965 in EU-15 nations averaged 30.1% of GDP, roughly comparable to the 28.3% of economic output consumed by U.S. government spending. By contrast, in 2007, government spending consumed 47.1% of economic output in the EU-15, significantly higher than the 35.3% burden of government spending in the U.S.
Another argument for the VAT concedes it will increase the overall tax burden but lead to lower taxes on personal and corporate income. The evidence from Europe indicates otherwise. Taxes on income and profits consumed an average 9.1% of GDP in the EU-15 during 1966, which gave Europe a competitive advantage over the U.S., where they ate up 12.4% of GDP.
By 2007, calculations using OECD data show that the tax burden on income and profits climbed to 14.1% of GDP in the EU-15, slightly higher than the 13.9% figure for the U.S.
Conclusion – What Else?
Other than triggering more government spending and higher aggregate tax burdens, what other effects does a VAT have?
VATs slow the economy and destroy jobs. By taking resources from the productive members of society and transferring them to the government (which produces nothing and creates no wealth), VATs slow economic growth and undermine job creation. The economic damage caused by a VAT is made worse due to the increase in the aggregate tax burden.
VATs impose heavy administrative costs on businesses and taxpayers. VATs force businesses to serve as tax collectors for the government. Under this system, every company and entrepreneur is forced to keep records on every purchase and sale throughout the production process and submit detailed, time-consuming, costly forms to the government.
(Queue Jaws theme music in your head. By the way, it’s Shark Week on Discovery Channel… no affiliation on my part obviously, I just love it.)
No, this article is not about the indirect hidden tax – inflation -- we are so fond of discussing. It’s about a particularly insidious, direct, hidden tax that has already swept across Europe and (we think) is now bound for the U.S.
We’re talking, of course, about the “value-added tax” or VAT.
Former Deputy Treasury Secretary Roger Altman and former Fed Chair Alan Greenspan both (along with many others in Congress) recently expressed the opinion that the VAT tax is coming to the U.S. fairly soon.
Here’s what Greenspan said: “I don’t like the value-added tax, but I agree with Roger [Altman]. I think that there is a fairly significant probability that the least worst solution to the problem will end up to be a value-added tax, because it’s the only thing that raises revenues in significant quantities without significantly impacting on the economy.”
Before we get into the “hidden” nature of the VAT and the real-world impacts of it, let’s provide some background.
What Is a VAT?
A value-added tax (VAT) is a fee that is assessed against businesses by a government at various points in the production of goods or services – usually any time a product is sold, resold, or value is added to it.
For tax purposes, value is added whenever the value of a product increases as a result of the application of a company’s factors of production, such as labor and equipment.
Every company that handles a product during its transformation from raw materials to finished goods must pay a VAT. For example, tax is charged when a manufacturer sells to a wholesaler and again when a wholesaler sells to a retailer.
The total VAT accrued during the production of a good is reflected in the price of the item sold to final consumers, because each reseller along the way passes through its VAT costs. In this way, VAT is quite similar to a national sales tax. In other ways, it is quite different.
Perhaps a comparative example will help clarify.
Consider the manufacture and sale of the economist’s staple hypothetical good – the widget.
Scenario 1: Manufacture and sale of one widget without any sales tax
A widget manufacturer spends $10.00 on raw materials and combines these materials with labor to make a widget.
The widget manufacturer then sells the widget wholesale to a widget retailer for $12.00, leaving the manufacturer with a $2.00 profit.
The widget retailer then sells the widget to a widget consumer for $15.00, making the retailer a profit of $3.00.
Scenario 2: Manufacture and sale of one widget with a North American (Canadian Provincial and U.S. State) sales tax of 10%
The widget manufacturer spends the same $10.00 on raw materials to build a widget, but it must certify that it is not a final consumer.
The widget manufacturer charges the retailer the same $12.00, first checking that the retailer is not an end-consumer, leaving the manufacturer (again) with a $2.00 profit.
The widget retailer then sells the widget to a widget consumer, but this time for $16.50 [$15.00 x (1 + 10%)] and pays the government $1.50, leaving the same profit of $3.00.
Scenario 3: Manufacture and sale of one widget with a VAT of 10%
This time, the widget manufacturer pays $11.00 [$10.00 x (1 + 10%)], and the seller of the raw materials pays the government $1.00 in VAT.
The widget manufacturer charges the widget retailer $13.20 [$12.00 x (1 + 10%)] and pays the government $0.20 in VAT ($1.20 less $1.00 paid in first stage), leaving the manufacturer with the same $2.00 profit ($13.20 sale price less $11.00 cost of materials less $0.20 VAT in second stage equals $2.00).
The widget retailer charges the widget consumer $16.50 [$15.00 x (1 + 10%)] and pays the government $0.30 ($1.50 less $1.20 already paid in first and second stages), leaving the retailer with the same $3.00 profit ($16.50 sale price less $13.20 purchase price less $0.30 VAT in third stage equals $3.00).
So, you see, the total tax paid to the government in both scenarios 2 and 3 is $1.50, and the entire tax burden is ultimately placed on the end consumer, who must pay $16.50 for a widget that would only cost $15.00 absent the sales tax or VAT.
Hidden Nature of VAT
Remember, the total tax, regardless of the stage of production at which it was collected, ends up being added to the final sales price.
No matter how many steps there are in the production process, a fixed percentage of the final price of the product would represent the value-added tax, just as a retail sales tax is a fixed percentage of the final product price. Unlike a sales tax, however, the cost of the VAT to consumers would be hidden because it is baked into the advertised retail prices of goods and services.
Many consumers, of course, would recognize that the VAT existed, but it is not likely that they would realize the magnitude of the levy. For instance, gasoline consumers generally understand that gas taxes exist. But because gas taxes are incorporated in the advertised retail price of gasoline, few are aware that taxes comprise a substantial share of the retail price. (The average gasoline tax in the U.S. is about $0.46 per gallon. That’s $9.20 in taxes to fill a 20-gallon tank.)
Real-World Impact of VAT
Many countries already impose VATs (over 130, in fact), and the results of this real-world experiment have been dismal.
VATs are associated with both higher overall tax burdens and more government spending. In 1966, before the VAT swept across Europe, the average tax burden for advanced European economies (the EU-15) was 28.4% of GDP, fairly similar to the U.S., where taxes consumed 25% of economic output, according to data from the OECD Factbook 2009:Economic, Environmental, and Social Statistics,an annual publication of the Organization for Economic Cooperation and Development (OECD).
European nations began to impose VATs in 1967, and now the EU requires all members to have a VAT of at least 15%.
What are the results? Scary, to say the least.
By 2007 (the most recent data available), calculations using OECD data determined that the average tax burden for EU-15 nations has climbed to 39.9% of GDP. That’s a 40% increase since 1966. The tax burden also has increased in the U.S., but at a much slower 13.2% rate, rising to 28.3% of GDP for the year 2007.
Furthermore, according to European Commission figures, government spending during 1965 in EU-15 nations averaged 30.1% of GDP, roughly comparable to the 28.3% of economic output consumed by U.S. government spending. By contrast, in 2007, government spending consumed 47.1% of economic output in the EU-15, significantly higher than the 35.3% burden of government spending in the U.S.
Another argument for the VAT concedes it will increase the overall tax burden but lead to lower taxes on personal and corporate income. The evidence from Europe indicates otherwise. Taxes on income and profits consumed an average 9.1% of GDP in the EU-15 during 1966, which gave Europe a competitive advantage over the U.S., where they ate up 12.4% of GDP.
By 2007, calculations using OECD data show that the tax burden on income and profits climbed to 14.1% of GDP in the EU-15, slightly higher than the 13.9% figure for the U.S.
Conclusion – What Else?
Other than triggering more government spending and higher aggregate tax burdens, what other effects does a VAT have?
VATs slow the economy and destroy jobs. By taking resources from the productive members of society and transferring them to the government (which produces nothing and creates no wealth), VATs slow economic growth and undermine job creation. The economic damage caused by a VAT is made worse due to the increase in the aggregate tax burden.
VATs impose heavy administrative costs on businesses and taxpayers. VATs force businesses to serve as tax collectors for the government. Under this system, every company and entrepreneur is forced to keep records on every purchase and sale throughout the production process and submit detailed, time-consuming, costly forms to the government.
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