How Value Added Taxes Work & How They Would Affect Small Businesses

Another detrimental effect is the disincentive to operate a small business. larger companies would have a great incentive to become even larger by 'vertically integrating'. That is, why wouldn't the retailer begin it's own farming and baking? Then ,since the entire chain is all part of XYZ Corp., they can save the VAT at each step - plus likely save on some accounting costs. That means, to be remotely attractive to a corp. as an outside supplier, you would need to undercut the VAT plus a little more. The negative effect on entrepreneurship would be devastating.

Another thing, if you look at the examples from Europe, which is where I live and you correctly state VAT is used it is hardly a "hidden cost".

On every receipt that you get, no matter if its for 1 US coffe cup or 100000 US car purchase it is written automatically and as required by law "total price 1 US" and under that "of that VAT 22% = 22 c" so you are quite well informed for each transaction you make how much goes to the state.

In fact, for many European people, the US system is quite confusing and involves hidden costs as you come up to the cash register with what was 100 US of goods but they then charge you somewhere between 106 and 115 depending on which part of of the States you are in. The people who are from that state are used to the fact that another 6-14% will be charged, but people from other places may not be.

The VAT systems makes it so that if it sais 50 US on a product you have to cash out exactly 50 US. Which is arguably more important to your everyday activites, and it takes a little effort to read the receipt if you want to know how much of that went to the gov't which will be writen somewhere on it.

Your conclusion is quite wrong. Using your $1 loaf of bread example, the farmer made 20c, the baker 40c, the store 40c, and the taxman got 10c. All this from the $1.10 paid by the consumer.

You'll note, this breakdown is not at all different from a 10% sales tax on the final product. There's nothing inherent about a VAT-based system that will affect final consumer pricing, it's still driven by the assessed tax rate.

The main difference between VAT and traditional sales tax is that the tax is assessed where value is added. If the farmer and baker are in Iowa, and the grocery store is in California, then the taxes are split between the two states, rather than all of it going to the final point of sale in CA.

Matt, why exactly do you think we should use it? simply explaining that you are a liberal doesn't really explain why you think increasing the tax burden of small businesses is a good thing...

As was said in the article, the VAT would be fine if it was a replacement for another tax, such as the income tax. Taking the hypothetical of replacing the income tax with a VAT, it would actually convey MORE economic freedom, as I have no choice about paying an income tax (unless I want to quit my job), but with a VAT I could choose to not spend as much money at a given time and control the amount of taxes I'd pay. Also, because this would give me more disposable income (the money that was going to income tax) I would be more likely to want to spend money, thus meaning more consumption and that would likely lead to more jobs being created, as while taxes would be higher at the sales end, the money would ultimately flow through more hands before being sucked up by the Gov, thus potentially creating more growth.
Just throwing a VAT on top of what we have now is just a tax increase and to be frank I doubt many people could afford it.

The real problem with a VAT is that it's a tax on poor people. Instead of progressive, it's the worst case of a regressive tax. Though they're saying all sorts of nice things, remember that in most of Europe, the 6-8% VAT has crept up to 20%. This is a horrible tax on poor people.

Dear Lucky Texan,

Your interpretation on vertical integration is not correct. Large corporations may be able to integrate an entire chain of supply and processing into one company but they will not save on VAT because their product when sold is taxed at 10% and without the credits.
It's no more cost effective tax wise whether company XYZ or small entrepreneur provides the steps necessary for a complete product.

Having been born and raised in Europe I find it better to have the full price listed on the item (product+tax) as opposed to finding the tax at the register which then truly feels like an added tax.

@Matt: Unbiased? Huh?!

The article spends an entire paragraph trying to commit the following bit of befuddlement:

"Depending on the complexity of the product in question - and therefore the number of steps involved - the total amount of value added tax paid could be astronomical."

Some readers might misinterpret that as saying that more manufacturing steps would make the tax higher. As if in the bread example the total tax might be more than 10%.

10% added to a $500 iPad's value in a 100 steps doesn't get you to $600 any more than sales tax of 10% in one step does.

not to be a downsider, but do you think the government will just simply replace the well known income tax? No they are looking to see how much money they can get from the citizens of the US before we break. Right now my faith in the government to hold up to their words is next to nothing which i currently have in my pocket. So you have a sales tax, vat, and income which means the government gets more money to grow and become more powerful. Is that what you want a government that can walk over the US people? hmm something to think about.

This is generally not the case with value added taxes [..] since it’s essentially built in ahead of time and doesn’t show up on a receipt like a sales tax would."

That is just false. In Europe for instance, all invoices state price, vat and total.
For instance, something being sold for 105€ with vat 5% would show up on any sales receipt:
cost: 100€
vat: 5€
total: 105€

So I can only assume that the author is ignorant of how VAT actually works.

It is also false that people need to charge higher prices along the chain. They charge exactly the same price, added of VAT.

VAT actually has a very positive impact in economy, as it allows taxes to be paid in small parts during the chain, not just when the item is sold.

For the final consumer, the result is EXACTLY the same. You still pay your 10% on top of the price. It just happens that out of those 10%, the seller already paid part of it when acquiring the product.

@income tax

It is wrong to compare VAT with income tax, and claim its not progressive thus hurtfull to poor people. VAT does not replace nor is it intended to replace income tax.

VAT is a tax used to replace (and should be compared to) SALES taxes. The progressive impact depends on different tax rates, for example using smaller rates on stuff like bread while larger on luxury items makes it more progressive and helps low income people. This ofcourse is left to every government to decide if it will use.

Income tax is different, it is used to tax income of a person (your wage) and as far as I know it is used everywhere cummulative with VAT or SALES tax.

So it is highly unlikely that income tax would be removed, and it is (for various other reasons) even quite bad for the general state of a society.

BUT ultimatley replacing Sales tax of 10% with VAT of 10% would NOT increase any prices for consumers (IPAD 500 + 10% whichever tax = 550 out of your pocket) while as some other commentators noted there are additionaly benefits to VAT in regard to reduction of illegal/untaxed economy.

The biggest disadvantage to VAT is cost of doing business. Cost of goods sold is all pass-through taxation and will just impact the consumer. But, all the other components that make a business work will be taxes with VAT as well.

For example, we sell things worldwide from various global locations. Our customers purchase from non-VAT treaty countries to save on costs. England buys from Canada, Canada buys from the US, etc.

Most likely, the US will enter into a VAT treaty with the EU, Canada, and Hong Kong, which means you will pay taxes everywhere.

This is, in large part, a way to impose an internet sales tax.

if you are going to use the VAT tax in america we need to replace the income tax with it thats the real solution or something we like to call the fairtax the more you consume more the more tax you pay, the more lavishly your consume the more lavishly you pay taxes as well its alot more fair than our current income tax system. check it out www.fairtax.org

Prices go up because almost no business (aside from drug dealers) ever sell 100% of their inventory. The cost of their goods have gone up due to the VAT, and the only way they can guarantee the ability to recuperate that cost is by raising their prices. Hence the authors example of the iPad costing 600 instead of 500. The VAT would raise the price to $550 and the company would add the other $50 as a form of insurance.

Couple things...

Matt is a troll. Contrary to popular opinion, liberals dont just like taxes (fun!)

This seems to provide complexity to a system that doesn't need it. So now every wholesaler has to deal with monthly taxes? Why?

Also, I own a bar. As you will find at many bars, we absorb the price of the tax into the price of the drink to keep things simple. So a beer costs $4 on your final bill. (rather than $4.12) any time taxes go up, we are forced to raise our prices (we round to the quarter) vs just adding it to the tax column. This sucks for us!

The only point I see any validity for is "capturing" all the taxes. I dont see a lot of taxes being lost however as most product based business have to operate legally and it is usually the service industries; hairdresseres, construction, etc where taxes are avoided...

@Anon

Huge fallacy in your post. The only business that sells 100% of their inventory isn't drug dealers. It is, indeed, Apple.

Also, I believe it's mainly because of the already implemented sales tax as to the reason why the iPad would become $600.00

In Canada we have the GST, which is a VAT, as well as PST, and we're moving to an HST. Confused yet? Good.

GST (our VAT) was introduced in 1984. Or thereabouts. And the government that introduced it was wiped out so enthusiastically that even it's name disappeared.

The real idea behind a VAT is to move taxes off rich people and onto poor people where they belong. Replace taxes on wealth, like (progressive) income taxes and capital gains taxes, and put them on the things poor people buy, like bread and milk. People who have lots of money can pay less of this because they drink very little milk compared to the amount of money they have. That was the plan. Worked great. Corporations now rake in even more. Everyone else... well, you know.

If you need to raise tax revenues- and you do- capital gains and financial transaction (Tobin) taxes are the way to go. Not getting money from the little guy.

Essentially, a VAT is a ponzi scheme where everyone gets credit wit hthe IRS against what they pay. Except for the end-consumer who, by law, is forced to eat it from the bottom of the pyramid.

nice.

http://congress.blogs.foxnews.com/2010/04/16/vat-the-next-big-tax-increase/

April 16, 2010 | 11:04 AM ET
VAT: The Next Big Tax Increase?

(AP Photo)

The Senate voted 85 to 13 late Thursday to oppose the idea of a value-added tax (VAT). The resolution sponsored by Sen. John McCain, R-Ariz., isn’t binding, but it is a sign that many lawmakers are worried about what's coming.

“The value added tax is becoming a hot topic because people are realizing that the deficit is so big that if politicians aren’t willing to cut spending, the regular ways of raising taxes,” such as raising tax rates on the rich “won’t provide enough, ” says Brian Riedl of the Heritage Foundation.

In fact, the U.S. is spending so much money it doesn’t have, some say the VAT is the only real alternative if large amounts of new revenues are needed.

..........

First, if the farmer has to pay $.02 for every $.20 sold, then the farmer, protecting his bottom line, will increase the cost of the goods to compensate for the new tax levied against him. Since the baker now must pay more for the raw product of the farmer, they too will charge more to protect their bottom line. It's important that you realize a business owner, small or large, will do whatever they can to protect their profits and any increase in cost due to government taxation, regulation or other will be passed to their consumer; ultimately, us.

Also, it is my understanding that the VAT is another form of tax IN ADDITION TO the sales tax. This means we'll pay our standard point-of-sale tax, as well as pay for the taxation of the product every step of the way. Sales taxes are used as revenue for the states while the VAT is used as a revenue for the Federal government.

@Fran
That's a different problem that has nothing to do with VAT. That comes from companies not including the tax when they advertise the price. If they included the tax now, that problem would be solved. That has nothing to do with VAT

I completely agree with Morpse, Fran, and Jamie. The VAT would need be in place of income tax. But if done correctly, this would be very beneficial for the economy. As Jamie mentions, the reason VAT is better than standard sales tax is because it allows for each individual state to realize tax revenues if an activity was performed in that state to add value to a product. So when a supply chain spans multiple states, it is not simply the state where the final sale takes place who will receive the entire tax. As Fran mentions, WYSIWYG (what you see is what you get) pricing is a great benefit for consumers. And as Morpse mentions, a consumption-based tax such as VAT replacing an income-based tax could provide the government with higher tax revenues while in parallel increasing consumption as well as closing massive income-based tax loopholes and controversies. One thing I want to add is that if the VAT is done correctly, we could tax essential goods (groceries, heating, etc) differently than discretionary goods (prepared food, electronics, etc).

To speak to 1 Lucky Texan's comment about larger companies and vertical integration, I would say consider this: Would it be worth it for a company to venture into completely different industries, spreading out their resources and income to invest in vertical integration all in an effort to avoid paying a tax that they get reimbursed for?

"That is, why wouldn't the retailer begin it's own farming and baking? T
Because, if a product is being sold at 100usd with VAT of 10%, the retailer would then be responsible for paying the whole 10%, instead of splitting it along the chain."

This was a good point. My gut reaction was that take Apple for example would bring things in house, but obviously if they can limit their tax burden they will.

Sense you filled in the flaws of my thinking perhaps you can advise me on another issue.

It is my understanding that a low corporate tax rate gives corporations capital that they can invest and in turn hire more employees who in turn will pay more in taxes than the corporation would have.

Would this same logic not apply to health care costs. If corporations were relieved of the burden of paying for health costs could they not in turn invest more capital and hire more employees who would in turn pay more taxes than the corporation was paying for healthcare. I understand the argument about government increasing it's power and generally not doing things well, and won't argue about that, but from a purely economic perspective wouldn't that make government run health care pay for itself?

As this comment board is rare in that everyone isn't arguing and shouting over one another I have an economic-policy question to pose to the board. In the news all I hear is the two sides shouting at each other and not a rational explanation of why they feel a given way.

It is my understanding that a low corporate tax allows the corporation to invest more capital and also hire more employees who will pay more in taxes than the corporation alone would have.

If that assumption is correct then does that fact corporations pay a good chunk of money for employee health care not act as a tax. If that burden were taken away doesn't the same logic process flow that the net tax revenues would be greater than the amount the corporations were paying allowing for government run health insurance in large part pay for itself?

I understand the argument about the loss of liberty in that the government has more power and generally doesn't do things well. I won't argue that point, but I also feel a loss of freedom in that I rely on my employer for my health and that of my family.

Opposing views?

@Fran @ Conrad

We already have a sales tax which is paid to the state. The VAT would be an additional federal tax. So while it is arguable of whether or not to replace a sales tax with a VAT tax, that is not what is at stake.

The iPad example would cost you $550, plus tax. My region has a 7% sales tax. Therefore, I would pay an additional 7% sales tax on (I presume) the $500.00 product value. So while I currently pay $535.00 for my shiny new iPad, with a VAT I would pay $35.00 in sales tax plus an additional $50.00 VAT tax. My iPad purchase comes to $585.00. Different regions have different sales taxes.

My understanding was that the Fed Gov wanted to implement the VAT, and since States apply the sales tax I was picking a tax that the Fed Gov currently implements in my previous scenario. The previous comment that this was a tax on poorer people as well as everyone else is correct, thus it is also more fair. I'm not sure what the current stat is, but last time I looked roughly 40% of the population doesn't pay income tax now (for what ever reason). While it's nice for those who don't pay income tax, that also means that a large percent of the population doesn't have to care about tax policy. That can lead to a lot of weirdness with people voting for who's going to take the most goodies from 'rich' people and give them to 'poor' people rather than who they think would run the country best. By moving from income to a VAT tax everyone would be taxed the same, thus everyone would want taxes to be low. If they were collecting VAT off everyone the rate could be low too, as what ever the current percentage is that doesn't pay income taxes currently would be paying VAT, thus a low rate could produce the same amount of funds. At first this would look something like tax raises on poor people and tax breaks for the rich, but I would look at it more as a reset and putting everyone on the same playing field. Right now there is an entire industry to help people figure out their taxes because the laws are so confusing, isn't that just a bit messed up?
Again, the thing I find appealing about the idea is that I could somewhat control the amount I'm taxed by controlling what I buy. Do I honestly expect that to happen? No, but it's fun to think about.

First of all, taxes are taxes, no matter how you call them.
If I remember correctly, foreign countries would not have to send VAT to another foreign country. I.e., the % of sales tax or VAT being the same, there would be less tax income on product sales when either raw materials or components or complete products are imported into the United States. Import tariffs still exist, but they are rather low and phase out with free trade agreements.
The bureaucracy is higher when VAT needs to be collected or exempted every step of the manufacturing way.

Is there actually a bill in congress about introducing a VAT in the US?

VAT is a type of Sales Tax. It cant replace Income Tax. For the mere reason that it will be handled by IRS (Or some other Federal agency). Sales Tax (or VAT) is charged on Sales and Income Tax on earnings(profits). Suppose A and B sell one product. There will be no difference of Sales Tax or Vat on the consumer. But there profits may differ due to their strategies and expertize. Suppose A earns $10 by selling a product for $ 100 and B earns $12. If there is no Income Tax, the higher gainer will get more benefits.

Though we have two types of Income Tax(State and Federal). Federal Govt can decide to charge a hight Income Tax and abolish State income tax. Later Federal and state govts can decide how to share Income Tax with states or for a national cause. This will simplify the process of Income Tax. However VAT being a direct tax, effects the local consumer, regardless the status of consumer. It must be handled by States. Since the tax collected by states should be spent for the welfare of the people of that state only.

@Tajinder
VAT absolutely could replace an income tax. It's just a different type of tax. It's just an economical debate of how people should be taxed, whether it's for what they earn or by what they spend.

Not only that, but the federal government would also earn money on international transactions or visiting consumers who are not citizens (including illegal immigrants who are not paying an income tax).

Also, not all states have an income tax. Florida, for example, does not have a state income tax. The federal government has no right (currently at least) to control state taxing. States have their own plenary power to tax.

@Duglarri

I don't know the details of the VAT situation in Canada, but in Europe most countries use three VAT rates. For instance in the Netherlands:

Luxuries 19% (jewelry, electronics, etc)
Basics 6% (food, books, etc)
Necessities 0% (prescriped medication, medical assistence, education, etc)

In this system rich people do pay more taxes.

to 1 lucky texan:

To my understanding vertically integrating the business model will have no impact on the VAT. the XYZ corp would essentially have to pay "more" taxes. Whether they make the whole loaf or just part of it, the tax percentage is the same. i think if anything it would cause corporations to move away from vertically integrating - Specialize instead to use the power of Economies of Scale to offset the "increase" of the VAT.

Would we even be able to implement this?

We just got this up here in Canada. The way we learned in tax law classes, VAT theoretically encourages small business activity and exporting of goods.
Based on the example above, say that instead, the good is a car or specialized equipment needed for production. If a small business owner were to need to buy that car or equipment, under sales tax, you pay the nominal amount + tax. Under VAT, since the good is directly related to the running of the business, the small business owner pays no taxes on it. Rather the tax is passed onto the consumer.

Likewise, since none of the domestic businesses responsible in the value chain actually pay any tax (as all tax is passed onto the consumer), this also has the effect of making our businesses more competitive globally.

Historical track record in eastern provinces of Canada and Europe shows that VAT on average encourages productivity due to the benefits stated above to small businesses.

You Americans have all the fun.

We Swedes have 25% VAT on most goods and on top of that the second highest tax pressure in the world (even without including VAT). It's kind of crazy.

Reference (in glorious Swedish, but you can watch the bar diagram or use Google Translate):
http://www.ekonomifakta.se/sv/Fakta/Skatter/Skattetryck/Skattetryck-i-Sverige...

"The real problem with a VAT is that it's a tax on poor people. Instead of progressive, it's the worst case of a regressive tax. Though they're saying all sorts of nice things, remember that in most of Europe, the 6-8% VAT has crept up to 20%. This is a horrible tax on poor people."

Horrible lies and misunderstanding.

If everyone pays a 17.5% standard VAT on the items they buy, it means those who spend more (i.e. the rich) will pay more into the system. With the most essential or beneficial items such as books and food not applicable to VAT.

It's a fair system. So of course you stupid Americans are afraid of it. Instead, you prefer a system which adds a hidden tax at the till..

The first part about the mechanics of the tax are fine, but the "conclusions" don't follow.

1) The number of steps is immaterial to the total tax due to the crediting. The production chain can be 1000 steps, but it's the total value added, not the number of steps, that determines the amount of the tax. From the article's example, there's a 10% tax on a $1 good- that 10 cents in tax could be from 1, 4, or 10 producers- it's still 10 cents in the end.

2) The total tax burden is not necessarily greater. That completely depends on the tax rate. Again, from the example in the article, we have a $1 loaf of bread. A 'regular' 10% sales tax: 10 cents in tax. A 10% VAT: 10 cents in tax.

3) There's nothing inherently hidden about a VAT. In the US, the sales tax is normally itemized separately, but that's convention- the food cart I grab lunch from just rolls the sales tax into his listed prices. And I've had receipts in Europe where the VAT listed.

Atually iPad will cost $499+$34.93 tax (7% indiana). If comparing the price of a good on two different tax system you need to mention the after tax price on both. So based on what the article is saying it should be. "if a VAT were in place, that iPad you just bought would be $600 final total instead of $533.93 final total on the current tax system."

I'm concerned that the government does not want to replace the income tax with the VAT, but have the VAT in addition to income tax. Notice how bad things are in EU countries where VATs are implemented.

@rgb
There is no direct correlation. Several European countries with both high VATs and high income taxes are doing quite well. Others are not. Generally it's a function of fiscal prudence, in other words, something most of the world is failing to display.

A high aggregate tax level, however, does seem to slow economic growth over the long run.

There are two other major benefits to VAT that have not been mentioned.
1) VAT makes increases the likelihood that taxes are paid. Since the entire US tax is collected at last sale only, people can sell goods "inofficially" to consumers with no tax at all being paid. This is especially problematic with high tax items such as cigarettes, alcohol, gasoline. However under VAT, a good fraction of the tax is captured by the government very early on, "at the production plant" or at the refinery.
2) VAT generally protects domestic production over imports. When e.g. goods are imported to China, a VAT (17%) is applied (and in addition an import duty of between 7-22%). The purchaser from a domestic source only has to pay the VAT on the value added on the last step, but has to pay VAT on the entire value of the import.

Actually you are quite wrong on point "Higher prices"

In your own example, if the Bread costs 1 US; it is no different if its taxes with 10% VAT to a final price of 1.1 US or with a 10% sales tax amounting to 1 US +10% tax again 1.1 US. As you correctly noted earlier in the text, the only difference being that it is paid in steps (2c + 4c +4c) instead of at the end.

There would be a difference only if the tax rate would be changed, but thats a moot point as it is natural that a 10% tax is more then a 6% tax, whichever the method of taxation.

That is, why wouldn't the retailer begin it's own farming and baking? T
Because, if a product is being sold at 100usd with VAT of 10%, the retailer would then be responsible for paying the whole 10%, instead of splitting it along the chain.

If anything, this does the exact opposite point, by encouraging companies to deal more with other companies rather than doing it all themselves.

Well now that I know what VAT is, I think we should use it (being the liberal that I am), but nonetheless I found this to be an informative and (considering the topic discussed) surprisingly unbiased article.

thanks very much.