VAT Taxes Are Good, Actually
How a "regressive" tax can actually be progressive
The VAT, or Value Added Tax, is a powerful and often misunderstood, revenue-generating tool. In America, politicians on both the left and right have derided the VAT for selfish political reasons. The rest of the world, on the other hand, has embraced its potential. I illustrate how the VAT works, why it is not truly regressive, and how it can be used to advance policies for the betterment of humankind.
Consumption Taxes are exactly what they sound like, taxes levied on the things one buys or consumes. Consumption taxes come in three primary flavors, Excise, Sales, and VAT. Excise taxes are levied on specific kinds of goods, often to counteract negative externalities. Think taxes on cigarettes or taxes on sugar-sweetened beverages, as I discussed here.
Sales and VAT, on the other hand, are more broad-based levies on a wide variety of goods and services. However, unlike a Sales Tax, where tax is collected only at the final sale, the VAT is collected at each stage in the lifecycle of the product, from production to consumption.
How the VAT works
Imagine a chair manufactured and sold in a jurisdiction with a 10 percent VAT. The lumber company sells the raw material to a manufacturer at $100, which becomes a purchase price of $110 after including the VAT. The $10 tax is remitted to the government.
The manufacturer then fashions the lumber into a chair, selling it to a retailer for $300, which becomes $330 with the VAT. But instead of remitting the full $30 tax to the government, the manufacturer can deduct the $10 tax they already paid, remitting $20 to the government. The retailer then sells the product to the end consumer for $500, or $550 with VAT. The retailer remits $20 to the government, the total tax collected less the $30 tax they already paid when they purchased the chair from the manufacturer.
The concept is simple and effective. VATs are superior to Sales taxes because they avoid Tax Pyramiding. Tax Pyramiding occurs when products are taxed multiple times during production and sale, resulting in a higher overall tax rate than intended. This cannot happen with a VAT due to its deduction mechanism.
In addition, the desire of each party at every stage to obtain that deduction, makes the VAT largely self-policing. This has the added benefit of making it easier and cheaper to collect, and much more difficult to evade. The VAT, therefore, is able to generate huge sums of revenue. In OECD countries, on average, about 1/3 of total government revenue comes from VAT alone.
Furthermore, when compared with other kinds of taxes, such as income tax, VATs are a more stable and reliable source of revenue. Corporate and household incomes can fluctuate wildly from year to year, but consumption fluctuations are much more muted. This makes the VAT a consistent source of revenue that most other taxes cannot compete with.
Too Good, Yet Flawed
Detractors on the political Left, however, denounce the one perceived drawback of the VAT: it’s regressive. Low-income individuals spend a greater proportion of their income on goods and services. As a consequence, the VAT would appear to have the greatest proportional impact on those with the least financial resources.
But the VAT isn’t truly regressive at all, at least not in the long term. When evaluating the VAT in the near term, indeed it appears regressive because wealthy individuals invest/save a greater proportion of their income, thus not incurring any of the levy (not consuming), relative to those with lower earnings.
Over a lifetime, however, those savings will ultimately be spent (consumed), thus incurring the VAT like everyone else. Indeed, studies have found that the VAT burden is ultimately proportional. That is, over a lifetime, the total VAT liability is proportional to income for everyone. The VAT is not regressive, even if it appears that way.
On the political Right, on the other hand, detractors denounce the VAT for a different reason: it’s too good. The VAT invisibly generates so much revenue that it would allow the size of the government to expand too easily. This seems like a fairly ridiculous "problem” to have. The only concern should be one of fairness (which was already addressed) and deadweight loss. But as I will discuss, a properly designed VAT would have little excess burden on the economy.
A Better VAT
To counter the VAT’s perceived regressivity, many governments lower the VAT rate or exempt certain goods and services, such as groceries, education, and healthcare. The creation of exemptions and varying tax rates, however, engenders administrative complexities and distorts consumer decisions. This is so problematic that VAT’s inventor, Maurice Laure, described exemptions as a “cancer.”
To that end, when designing a good VAT, we ought to resist the urge to exempt or apply varying tax rates, especially now that we understand that the VAT isn’t regressive in the first place. In addition, we should also strive to broaden the tax base to business sectors that were previously considered too complex to tax, namely financial transactions and housing.
Broadening the base of the VAT can address concerns about deadweight loss. Deadweight loss, or the lost economic activity without corresponding income, is a function of the tax rate squared. That is, doubling the rate quadruples the loss. Therefore, to minimize deadweight loss while maximizing revenue, taxes should be as low as possible, while the base as broad as possible, to keep revenue constant.
For financial transactions, we could levy a VAT on the spread between lending and borrowing interest rates, the implicit charge for financial services provided by banks. Similar levies could be used in insurance and other financial services. For housing, we could extend VAT treatment beyond a home’s first sale and include resales. This would not, however, include land values, which should be paid through an LVT.
If indeed perceived regressivity is still an issue, we can transform the VAT into a progressive policy measure by using the revenue raised to fund progressive policies, known as “progressive revenue recycling.” A 10-15 percent VAT on virtually all goods and services would generate substantial revenue. This revenue could be used to fund progressive programs, perhaps, as I explored in separate essays, a universal healthcare scheme, Negative Income Tax, or universal education system.
The VAT is a powerful tool. Used correctly, it becomes a near-perfect instrument of policy with few trade-offs. When combined with a Land Value Tax, we can design a pro-growth and inclusive economy that still raises enough revenue to fund common-sense social programs and forward-looking policies for the betterment of humankind.