In Defense of the VAT
How a regressive tax can be progressive
The VAT, or Value Added Tax, is a powerful revenue-generating tool. In America, politicians on both the left and right have derided the VAT for various political reasons. The rest of the world, on the other hand, has embraced its potential. I illustrate how the VAT works, 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 taxes levied 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 when including 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 VAT. But instead of remitting the full $30 tax to the government, the manufacturer can deduct the $10 tax they already paid, remitting just $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.
Economists agree that VAT is superior to Sales Taxes because it avoids 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.
The desire of every 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.
Additionally, when compared with other kinds of taxes, such as income tax, VAT is a more stable and reliable source of income. 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.
Detractors, particularly on the left, however, denounce the one 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 has the greatest proportional impact on those with the least financial resources. On the right, 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.
A Better VAT
To counter VATs 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 rates to goods and services. We should also strive to broaden the VAT to business sectors that were previously considered too complex to tax, namely financial transactions and housing.
Broadening the VAT also has another effect: reduced 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 and broad as possible.
For financial transactions, we could levy 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.
While this alleviates VAT distortions and raises more revenue, it leaves regressivity an open issue. But the VAT can be progressive if the revenues raised are used to fund progressive policies, a process 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 risk-adjusted vouchers for a universal healthcare scheme or a Negative Income Tax, as I explored.
The VAT is a powerful tool with only one flaw. But used correctly, it becomes a near-perfect instrument of policy. We shouldn’t allow politics to trump practicality. We can design a tax system that works for the people, grows the economy, and funds forward-looking policies for the betterment of humankind.