Leading up to the ratification of the U.S. Constitution in 1789, a series of papers was published referred to as The Federalist Papers. It is interesting to note that Paper Number 21, allegedly written by Alexander Hamilton, talks about the benefits of a consumption tax.
"It is a signal advantage of taxes on articles of consumption that they contain in their own nature a security against excess. They prescribe their own limit, which cannot be exceeded without defeating the end proposed—that is, an extension of the revenue. When applied to this object, the saying is as just as it is witty that, "in political arithmetic, two and two do not always make four." If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them."
Almost all states and Washington, D.C. impose a sales tax which is a type of consumption tax. Only Delaware, Montana, New Hampshire and Oregon do not impose a sales tax. Alaska does not have a sales tax at the state level, but it is used at the local level.
A consumption tax is a tax on spending rather than on income; income is taxed when spent (consumed), not when it is saved.
Consumption tax formula—
Income = Consumption + Savings
Thus, Consumption = Income - Savings
Considering the above formulas and the current U.S. tax system, several observations can be made:
1) If income is taxed, that means that both consumption and savings are taxed. However, the U.S. tax system does not tax all income. Some types of income, such as most types of fringe benefits, are excluded from income, and various deductions, such as for home mortgage interest, limited medical expenses, and charitable contributions are allowed. In addition, the U.S. income tax system has various provisions to encourage savings, such as reduced taxation of capital gain income, exclusion of up to $250,000 gain from sale of a principal residence ($500,000 if married), and personal retirement savings deductions.
2) Ignoring possible deductions and exclusions, a tax base consisting of consumption is smaller than a tax base consisting of income. Thus, for a U.S. consumption tax to raise as much revenue as the current income tax, it would appear that the consumption tax rate would have to be higher than the current income tax rates.
3) If consumption is taxed, it can either be done at each point of consumption, such as with a sales tax, or by an annual calculation based on Income less Savings. There are two ways to measure consumption as Income less Savings: a) all income less savings ("cash-flow approach"), or b) earned income only ("tax prepayment approach"). Following are some simple examples using a 20% tax rate to illustrate the equality of the cash-flow and tax prepayment approaches to taxing consumption.
Cash flow approach: Individual earns $25,000 and saves $1,000 in an account earning 5%. The $1,000 savings deduction produces a tax benefit of $200 ($1,000 x 20% tax rate). One year later, Individual withdraws the $1,000 + the $50 interest, and includes $1,050 in his tax base producing an additional tax of $210 ($1,050 x 20%). The net proceeds of the transaction is $1,050 - $210 = $840. This approach is used in the USA tax proposal.
Tax prepayment approach: Same facts as above. Individual pays $200 tax on the $1,000 saved, and thus saves only $800. One year later, he withdraws $840 ($800 + 5% interest) and pays no tax on any of this amount, thus netting $840 as in the earlier example. This approach is used in the Armey flat tax.
Taxing consumption when it occurs: Instead of computing consumption as Income less Savings, a consumption tax can also be collected by applying the tax to every purchase of goods and services made by the final consumers - a sales tax. This is equivalent to taxing businesses on sales to nonbusinesses. And, under a sales tax, it is businesses that complete the tax forms - not the consumers who are the ultimate taxpayers. Currently in the U.S., most state sales tax systems also tax consumption by businesses. Thus, unlike a VAT, sales tax in the U.S. is a cascading tax (that is, since businesses pay sales tax, it gets factored into retail prices and sales tax gets paid on sales tax). Some states have partially alleviated cascading by exempting manufacturing and R&D equipment from the sales tax. However, the intent behind such rules typically is not to alleviate the cascading tax, but to provide an incentive for businesses to locate in the state. Also, in the U.S., no state taxes all types of consumption. Often, consumption of food, services, intangibles, and real estate, are exempt.
Indications that a tax is a consumption tax—An indication that a tax is a consumption tax is that it exempts savings, and for businesses, it allows investment in capital (such as land, building, and equipment) to be deducted when acquired, rather than depreciated over a period of years. Such expensing removes the expected future income from that investment from taxation (under an assumption that the cost of the asset reflects the net present value of its expected future income).
Key benefits of a consumption tax—A commonly cited economic benefit of a consumption tax over an income tax is that a consumption tax does not penalize a taxpayer who earns and saves in early years and then consumes in later years, relative to a taxpayer who does not postpone consumption. A consumption tax would treat taxpayers with either consumption pattern similarly. The unequal treatment of these taxpayers under an income tax stems from the fact that the early saver will pay tax on earnings from savings. Stated another way, the early consumer will have less income over his lifetime (less earnings from savings), which would impact lifetime income taxes, but not lifetime consumption taxes. Thus, the perceived benefit of a consumption tax relative to an income tax is that it will increase savings and investment.
Common questions under a consumption tax system—Who is the taxpayer or consumer? For example, who is the consumer of a college education or childcare? Is education a non-taxable investment or taxable consumption? Should any types of consumption be exempt? For example, should employer-provided health insurance be exempt, as it is under the current income tax system - don't the same reasons for exempting it under the income tax justify exemption under a consumption tax? [Under the Armey flat tax, discussed later, businesses may not deduct the costs of fringe benefits. Thus, such benefits are subject to tax.] Should rates be progressive or flat? How should regressivity concerns be addressed? [Consumption taxes are typically viewed as regressive meaning that they represent a larger percentage of a lower income taxpayer's income relative to a higher income taxpayer.]
There are three main forms of VAT:
a. Credit invoice VAT—This type of VAT is computed by charging VAT on all taxable purchases by businesses and consumers. A company's recordkeeping is fairly straightforward because it must just institute a procedure whereby it keeps track of sales invoices showing VAT collected and purchase invoices from other businesses showing VAT paid. At the end of the reporting period, a company merely totals each set of invoices and submits to the government, the excess of VAT collected over VAT paid. Or, if VAT paid exceeds VAT collected, the company would request a refund of the difference from the government. From the government's perspective, the audit trail is also straightforward because it consists of two types of records: sales invoices and purchase invoices. Under credit invoice systems, sellers are generally required to state the VAT charged on the face of the invoice.
b. Subtraction method VAT—Instead of tracking VAT paid and collected on a sale-by-sale and purchase-by-purchase basis, all sales are aggregated and reduced by the aggregate of taxable purchases for the period. The result is the amount of value added by the business on which is pays VAT. A subtraction VAT form looks very much like an income tax return except that no wage deduction is allowed (wages are value added). Also, interest income and expense are not reported and most taxes are not deducted.
c. Addition method VAT—This VAT adds up the value added by a business, such as wages paid and certain taxes paid, plus owner profit and multiples this by the VAT rate. It is the reverse of the subtraction method VAT in that instead of taxable sales less taxable purchases equals VAT base, the elements of the VAT base are added together.
See Appendix A for examples of how the three types of VAT operate and compare to a retail sales tax (RST).
If a retail sales tax were used instead of a VAT, the tax would just be collected by the retailer (most prior purchases would be exempt under a resale exception). When a VAT has no special rates or exemptions, it can raise the same amount of tax as a retail sales tax that is just imposed on the final retail sale.
Commonly cited benefits of a VAT over an RST include:
- Improved chances of collection because the VAT is collected at each stage of production and distribution, rather than just at the final sale to the retail consumer. Also, under a credit invoice VAT, each purchaser is likely to demand an invoice from a seller in order to claim a credit for the VAT paid. This mechanism can be a self-regulating feature of a credit invoice VAT that is not present with an RST.
- Elimination of the cascading effect of an RST caused by businesses paying the RST on items, such as manufacturing equipment, that are not held for resale. Tax authorities and businesses would no longer need to deal with sales tax exemptions that only apply to specific types of items.
- Elimination of the seller's burden to determine and document whether a buyer is exempt from sales tax. Under a VAT, unless the item transferred is zero-rated or the seller is exempt, VAT is charged on the sale of the good or service; it is up to the buyer to obtain a credit if they are entitled to one. Thus, a VAT can be an easier system for removing the tax on producer goods.
- The above advantages of a VAT may make it a better vehicle than the RST for taxing services.
• is easier to use multiple rates and exemptions;
• is known to be GATT compatible (not clear for a subtraction VAT)
• is not a hidden tax, particularly if the tax is separately stated on invoices provided to the final consumer;
• provides for separate recordkeeping and an audit trail of sales and purchases invoices all showing the VAT collected or paid;
• is a simpler mechanism for implementing a destination principle because it is easier to identify export transactions (invoices) and to rebate the tax on them;
• many examples exist of this tax in practice;
• because it is more widely used today than the subtraction VAT, arguably, it would be the more appropriate VAT to adopt when considering what is appropriate for businesses operating in a global economy;
• the tax can more easily be collected closer in time to the transaction; and
• for people most familiar with an income tax, the credit invoice method may be easier to understand than the subtraction method because they are less likely to raise the objections that typical income tax deductions, such as wages and interest expense, are eliminated.
• uses records already maintained for income tax and financial reporting purposes;
• would be more compatible with existing income tax recordkeeping, forms and filing procedures;
• less likely to cause direct interference with a state's RST because of how this VAT is calculated and assessed;
• would enable states to increase the RST collected because purchases would likely include the subtraction VAT (while this is also possible with the credit invoice VAT, it is more obvious and may be difficult for the states to implement) (would likely be viewed as a disadvantage of this VAT by taxpayers);
• likely involves lower compliance and administrative costs because there is no need for collection of VAT that will ultimately be refunded, as under the credit invoice VAT; and
• is typically viewed as less susceptible to the addition of special rates and exemptions.
A value-added tax (VAT) is a tax on the value added at each stage of production and distribution of goods and services. A VAT can be computed under one of three methods:
1) the credit invoice method (commonly used in Europe),
2) the subtraction method, or
3) the addition method.
In a system in which there are no special tax rates for any goods or services and no exemptions, a VAT will raise as much tax revenue as a retail sales tax would if imposed on the same goods and services. This feature is illustrated by the examples which follow.
Credit invoice method:
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* There would be no need to separately state the VAT on the invoice because the customer would not be entitled to a credit for the VAT paid.
Under the credit invoice system, a company's recordkeeping is fairly straightforward because it will use a procedure whereby it keeps track of sales invoices showing VAT collected and purchase invoices from other businesses showing VAT paid. At the end of the reporting period, a company merely totals each set of invoices and submits to the government, the excess of VAT collected over VAT paid. Or, if VAT paid exceeds VAT collected, the company would request a refund of the difference. From the government's perspective, the audit trail is also straightforward because it consists of two types of records: sales invoices and purchase invoices. Under credit invoice systems, sellers are generally required to indicate on the invoice, the amount of VAT charged, and business buyers want such an invoice so that they can request a refund of VAT paid.
Subtraction method:
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* Taxpayer's records will likely show purchases including the VAT. Thus, an alternative calculation would be to use the tax-inclusive rate of 9.0909%, rather than the tax-exclusive rate of 10% (rate applied to sales amount exclusive of the VAT):
Raw materials: ($110 - $0) x 9.0909% = $10
1st processor: ($132 - $110) x 9.0909% = $ 2
Distributor: ($154 - $132) x 9.0909% = $ 2
Retailer: ($198 - $154) x 9.0909% = $ 4Total $18
Addition method VAT: For this type of VAT, the tax rate is applied to the total of the taxpayer's inputs that were not purchased from other businesses, such as employee wages, interest and owner profit (that is, the value added by the business). This should result in the same tax as with the subtraction method. For example, if the retailer collected sales of $18,000 less cost of materials purchased of $14,000 less wages of $1,500, its financial statements would show net income of $2,500. Under the subtraction method, its tax base would be $18,000 - $14,000 = $4,000. Under the addition method, its tax base would also be $4,000 (wages of $1,500 + owner profit of $2,500).
Retail Sales Tax
: If a retail sales tax were used instead of a VAT, the tax would only be collected by the retailer (most prior purchases in the chain would be exempt under a resale exception), and the tax collected would also be $18 ($180 retail sale x 10%).For information about a specific VAT in the European Union - click here to learn VAT basics for consumers in the UK + UK guides for businesses
Copyright Annette Nellen 2000, 2003. Last updated November 4, 2009.
Last Modified: Feb 22, 2023