Chapter

chapter 11 Effects of VAT on the Economy

Author(s):
Alan Tait
Published Date:
June 1988
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Life can be one of two ways. Either it can be all about vat or it can be all about God. It’s perfectly clear that he has a lower percentage of vat and a higher percentage of God than almost anyone else one knows.

—William Rees Mogg (about Cardinal Basil Hume, Archbishop of Westminster), February 1981

This chapter examines the effects of vat on distribution, efficiency, savings and investment, foreign trade, public sector size, and management of the economy.

Distribution

General

The common case against the vat is that it is regressive, reducing the real consumption of low-income households by a greater percentage than for high-income households. This general accusation depends on many particular assumptions about the taxes replaced, the exemptions and zero ratings, and any special compensatory features. However, the general view is that vat is a broad-based tax levied on essentials, and as such must be regressive.

The first point is that for many countries, especially those outside the EC, it is important not to consider the distributional effects of the vat in isolation but to determine whether the vat’s effects will be better or worse than any alternative measures used to raise revenue. Frequently, where income taxes are poorly administered and their revenue base limited, the alternative taxes to vat for revenue are potentially equally or more regressive, such as excises on alcohol or tobacco and customs duties.

Second, in any country, it is not particularly useful to consider the impact of one tax in isolation; it is the overall distributional effect that is important and, indeed, not only the distributional effect of taxes on households but also the impact of government expenditures. That is, it is the net budgetary incidence that matters.

Furthermore, regressivity is usually measured against current annual household income. Some claim this is inappropriate because if all income were consumed over a lifetime, a general single rate, tax on consumption would be proportional to lifetime income. Families save and accumulate capital; therefore, the sales tax would represent a higher proportion of a young family’s income than of older families. However, offsetting this is the fact that the cross-section information is only a “snapshot” at a particular time. Households will be temporarily in a particular income category and, for instance, in the lowest category may well spend more than they earn for a year or two until they move upward; in this case, the conventional cross-section data would overstate the regressiveness of the sales tax.

Another problem, common to all users of household budget surveys, is that the sample always understates income toward the bottom of the scale, resulting in apparent persistent dissaving by low-income households. Once again, this probably leads to the regressivity of vat being overstated. However, all in all, for most people and certainly for political presentation, the most understandable and most practical measure is annual household income. The professional economist can keep in mind that such a measure probably overstates the regressivity.

Let us look first at the evidence of regressivity, then at the effect of exemptions and zero rating, and finally at possible compensation schemes.

Evidence of Regressivity

The Dutch designed their introduction of vat to be distributionally neutral.1 The original rates of 4 percent and 12 percent approximated to the previous sales tax rates. The Central Planning Bureau computed that the change might have improved progressivity because services, which typically form an increasing proportion of household expenditure as income rises, were taxed under vat. Later surveys suggested that the Dutch vat is roughly proportional, and that some adjustments to the tax base have actually worsened the distributional impact, for example, transferring hotel and restaurant services to be taxed at the lower rate and household fuels at the higher general rate.2

In some contrast, a single rate vat at 10 percent in Korea proves to be regressive.3 The vat payments represented 5.6 percent of the lowest decile’s income and only 3.9 percent of the highest. Farm households paid less vat absolutely, but the regressivity appeared larger. These conclusions have been broadly confirmed in later studies.

Studies for France all found vat proportional or mildly progressive, measured in relation to the levels of consumption.4 In relation to income levels it was regressive, and certainly regressive compared with the exceptionally progressive income tax.

A calculation for the United States suggested that a 10 percent vat could constitute as much as “17.97 percent of the pretax income of the average family in the lowest quintile, but would amount to only 5.57 percent”5 in the highest quintile. The U.S. Treasury Report6 estimated that a 10 percent vat would lead to an 8 percent increase in consumer prices (assuming 80 percent of consumption expenditures liable and an accommodating money supply leads to a once and for all shift in prices); with no adjustments, this would require households in the lowest income class (up to $ 10,000 a year) to pay 14.2 percent of their income in vat, whereas those with incomes of $ 100,000—200,000 a year would pay about 3 percent.

In the United Kingdom, the vat is progressive mainly because of zero rating for food, housing, and children’s clothing.7 However, while the zero rating achieves progressivity, it does so at the cost of a great erosion of the tax base, large amounts of revenue forgone, and extraordinarily poor targeting of those groups supposed to be helped.

The Irish Tax Commission’s Third Report gives an excellent account of the problem.8 As Table 11-1 shows, because the zero rating of food benefits everyone who buys food, the richer households get an absolutely larger benefit (the top 10 percent of households gain the benefit of tax relief on £Ir 27.3 worth of food a week contrasted to only £Ir 15.8 spent by the bottom 10 percent, although, of course, these represent 9.9 percent and 48.4 percent of total household expenditures). This is a most inefficient way to help poorer households. As the Commission points out, “Expenditure on zero-rated food, clothing, and footwear amounted to almost £1,700 million in 1983. Taxation on this expenditure would raise a sum far in excess of what would be necessary to compensate the poor for the regressive impact of a general value-added tax” (p. 67; italics added).9

Table 11-1.Ireland: Proportion of Total Weekly Expenditure on Food and the Share of Every £Ir 100 Spent on Food in 1980 by Decile Adjusted by Equivalence Scales1
Decile Groups

(1)
Total Weekly

Expenditure

(In Irish pounds)

(2)
Expenditure on

Zero-Rated Food

(In Irish pounds)

(3)
Percent of

Total Expenditure on

Zero-Rated Food Items

(3) as Percent of (2)

(4)
Of Every

£Ir 100 Spent on

Zero-Rated Food Items,

Each Decile Spends

(In Irish pounds)

(5)
Decile 1 (highest)274.727.39.910.0
Decile 2201.231.315.511.5
Decile 3165.130.718.611.2
Decile 4151.030.920.511.3
Decile 5124.129.023.410.6
Decile 6116.430.626.311.2
Decile 797.128.829.610.5
Decile 876.925.733.49.4
Decile 958.322.939.48.6
Decile 10 (lowest)32.715.848.45.8
Source: Ireland, Third Report of the Commission of Taxation: Indirect Taxation (Dublin: Stationery Office, June 1984), p. 223.

Equivalence scales provide a means of converting total household expenditure to a common basis to allow for differences in household composition.

Source: Ireland, Third Report of the Commission of Taxation: Indirect Taxation (Dublin: Stationery Office, June 1984), p. 223.

Equivalence scales provide a means of converting total household expenditure to a common basis to allow for differences in household composition.

Compensation Schemes for VAT

It is clear that exemptions, zero rating, and multiple rates are inefficient ways to tackle the potential regressivity of the vat. It is also clear that if the tax were actually levied on the exempt commodities, the yield could certainly be used to compensate low-income households; but the question remains how to make sure that low-income households will be compensated. This has been recognized as a problem for many general sales taxes; some U.S. states (Hawaii, Idaho, Kansas, New Mexico, South Carolina, Vermont, and Wyoming) have experimented with credits to offset the cost of the state sales tax for particularly disadvantaged groups. Usually the credit is available against income tax for taxpayers with incomes under some Specified amount (the highest limit is $2,751 in South Dakota). Massachusetts and Nebraska used to have similar credit schemes, but canceled them in the early 1980s. The evidence is that under half of the eligible households took advantage of the New Mexico scheme, and about only one eighth claimed the property tax credit in Michigan.10 Obviously, it is possible to use tax credits to offset the regressivity of sales taxation, but the credits that have been used have been of debatable efficiency and they have not been used with the vat, although their possible use has been debated.11 What has been used is a form of negative income tax for poor people. New Zealand decided to compensate the poor for the price increase due to the vat by ensuring a form of minimum wage paid by the employer (as agent for the Commissioner of Inland Revenue). “The employer recoups himself out of tax withheld from the remuneration of other employees,” if he has “so many low paid employees that he is out of pocket as a result of paying out tax credits he recovers the balance from the Commissioner.”12 This wage supplement was adopted deliberately to avoid introducing vat exemptions for food and clothing; it was recognized that exemptions would be less efficient, more expensive to administer, and introduce problems of compliance.

There are three problems with credits for vat. Credits against income tax will only help those who have income tax liabilities. In fact, for these persons it would be more efficient to adjust the income tax structure than to work through the cumbersome method of tax credits. For such persons, a better alternative may be to organize a cash refund (see below). Second, other persons, who might not be taxpayers, could be compensated through the social security system—the old, those on supplemental assistance, and so on. Indeed, it is argued that those receiving transfers from the government are automatically protected against inflation if the transfers are indexed.13 However, this leaves a group who are still outside either category and who are likely to be many, especially in developing countries. Those with small rural incomes, the urban poor, and the old when there is no or only a rudimentary social security system, young workers, part-time workers, and all poor persons outside any social security system.

If credits can be organized to get to whom they are intended, they can be designed to leave households with exactly the same real purchasing power as before.14 Moreover, the cost of the credit system can be limited, by designing the scheme so that credits are paid only to households below some “poverty” limit. The criteria must be kept simple: for example, households with incomes less than $7,000 could be allowed a credit of $100 for an adult and $50 for a child. The administrative costs of such a scheme could be kept low. Simple credit schemes also create sudden jumps into higher marginal income tax rates above the threshold income where they are phased out. More important, practically, there is no realistic way in which such schemes could be operated in many of the countries using a vat. The idea of creating a vast transfer or credit system in countries such as Brazil or Mexico would not auger well for budgetary control—quite apart from the problems of monitoring even the most simple criterion, for example, the number of children in a household. It is striking that only New Zealand has tried a credit system directly tied to the cost of the vat to compensate lower-income households. Where some offsetting action has been deemed desirable (Denmark, Norway, and Israel), adjustments have been made to tax allowances and transfers when the vat is introduced.

In the final analysis, as pointed out earlier, it is not whether the vat itself is regressive or not (and in some cases, it seems it is not, for example, the United Kingdom and Italy15), but whether the entire tax and expenditure system is achieving the pattern of household income net of taxes and gross of transfers and government expenditures that society desires. The case for vat does not stand or fall on its regressiveness. The case for vat is that it is an efficient way of collecting a large and buoyant revenue for government; other parts of the budget should take care of progressiveness, and the vat should be kept as simple and efficient as it is intended to be—for that is its justification. The worst of all worlds is to end up with an eroded vat base, complicated rates and exemptions, and a tax that is expensive to administer, all in the name of equity; instead of simplicity and efficiency, you end up with complexity, expense, and evasion—and all for the wrong reasons.16

Efficiency and Neutrality

In fact, it may be more worthwhile to emphasize the effects the vat should not have. As first mentioned, the ideal vat is an efficient tax precisely because it does not distort consumer choice. A vat that taxes all goods and services (and the New Zealand vat is an example that is as near general as it is possible to be) leaves consumers only with the choices of unbought and, therefore, untaxed services (for example, leisure and do-it-yourself work) and all goods and services taxed equally. Unlike the income tax, the vat does not tax income from savings. In most countries, the income tax is riddled with distortions (in favor of owner-occupied house purchases, investment in government bonds, ownership of shares, development of certain industries or development areas, and so on), and in many cases the distortions arise because of an administration that is partial to certain persons and institutions. The vat is likely to involve fewer distortions than the income tax.17

It has been stated that the introduction of a flat rate vat in the United States, with an equal yield reduction in the personal income tax, estimated by using a general equilibrium model, would improve the efficiency of the economy; there would be “modest welfare gains.”18

Such estimates can yield results indicating the marginal social costs of raising additional revenue by different alternative taxes. The evidence shows that the vat has the lowest marginal social cost (only one third of a cascading wholesale manufacturer tax, for instance). In a U.S. study, the excess burden of raising extra revenue from a sales tax (on commodities other than alcohol, tobacco, or gasoline) was only a third to a quarter of raising the same amount by labor taxes on industry or by traditional income taxes.19

Of course, we must not compare a perfect vat to a known imperfect- income tax. Many vats are far from general and, as soon as exemptions and exceptions are allowed, the neutrality is lost.20 However, many vats show that is possible to tax food and nearly all goods, including new housing. Few tax medical and financial services and clearly this distorts the tax, but not in an unacceptable way. More serious distortions occur with the zero rating of food and housing and lower tax rates on, say, clothing. The same general equilibrium model for the United States indicated that adopting the sort of differentiated rates common in the European vats reduced the welfare gains from adopting vat by 25–40 percent. Nevertheless, the same study concludes that a flat rate vat, a differentiated vat, and a progressive expenditure tax are more efficient, at the margin, than the U.S. pre-1986 personal income tax and, further, that the flat rate vat appears to be far more efficient at the margin than an income tax surcharge.21

Savings and Investment

The usual case is a vat replacing a previous sales tax. The old European cascade taxes frequently taxed capital goods (for instance in Belgium, France, the Federal Republic of Germany, Italy, and the Netherlands), and as the vat is designed to give full credit for capital goods, and to be neutral as regards the choice between capital and labor or investment and consumption, the substitutions should favor capital over labor and investment over consumption. The indirect taxes replaced by the vat in Korea also taxed capital goods and it is considered that manufacturing, electricity, and gas sectors gained substantial benefits.

A broad-based vat taxes present and future consumption the same and is, therefore, neutral between consumption and saving. The net effect of a vat on saving and investment depends on the exact form of tax replacement discussed. A vat that simply increased revenue would be potentially deflationary, would reduce consumption, and probably would reduce the profitability of future investment. At the same time, such an increase in revenue could be used to reduce the fiscal deficit, reduce the public sector borrowing requirement, allow interest rates to fall, and thus stimulate investment. The vat could also lessen the danger of inflation from monetized deficits.22 This might reduce interest rates and the real cost of capital. The net outturn depends on numerous behavioral relationships, but it is by no means clear that vat harms investment and savings; there are several plausible arguments for the opposite.

The estimate for the substitution of a general consumption tax for an equal amount of the personal income tax in the United States is that it would increase saving by 6 percent of the yield.23 This is a relatively modest contribution to saving. Given the decline in U.S. personal saving, currently about 3.8 percent against a postwar average of 6.8 percent, some encouragement might be welcome.

In general, vat does not distort saving and investment behavior; if it replaces taxes that are distorting, economic efficiency should be improved.

Foreign Trade24

Though one of the main advantages of vat is to ensure that international trade takes place on a transparent basis (and that is why GATT accepts the border adjustments for vat), no one should claim that the net effects on foreign trade, as such, are likely to be large. Those that have thought foreign trade could be improved by, for example, substituting a vat for a corporate profits tax, may have based their judgment, as discussed below, on a too narrow and partial a view of the tax change.

All present vat systems are based on the destination principle, where fiscal frontiers must be maintained to ensure that exports are fully rebated for the vat paid in the exporter’s domestic market and where the vat rates appropriate to the importer’s home market can be applied. This is a major compliance cost, but the same cost would be involved by any sovereign nation trading across international boundaries.

There is the possibility of a minor distortion in foreign trade under vat. To the extent that countries exempt goods and services, the suppliers are unable to recoup their vat content. If these goods and services are used to produce taxable goods and services, then even though those activities can reclaim the vat at the point of export, that amount cannot include the earlier vat paid by the exempted activity. In this case, there could be differential amounts of hidden and unre-claimable vat on different traded goods and services, depending on the exempted sectors in each country. The same holds true for any small firms that are exempted and export goods or services. In general, vat removes distortions that existed in previous systems and the advantages to foreign trade of adopting vat are those of getting rid of the previous distortions.

Replacing a Sales Tax with VAT

Retail sales taxes and most wholesale taxes are not levied on exports and, therefore, vat offers an advantage only insofar as there is any cascading. Cascaded taxes are included in export prices and the tax content is different for different products or, indeed, for the same product, depending on the number of steps of production, the degree of specialization, and the amount of industry vertical integration. No matter how large the cascade content is in the export price, it cannot be rebated precisely for all products or for any one product without the danger of being unfair to other products. It was this arbitrariness of cascaded sales taxes that persuaded the EC to opt for the vat, whose use ensures that the tax content is clear at any time.

When the vat is substituted for a cascaded sales tax and the old export rebates are abolished, had the rebates involved an element of subsidy, the net position of the exporter might be worse. What happens then depends on the movement of exchange rates (they might depreciate), on the response of purchasers of the exports to the price change (which could well be small as the absolute price alteration is likely to be small), on the response of the exporters to the shift in producer prices and, finally, on the response of the domestic consumers to relative price shifts in favor of imported goods. Evidence from the Federal Republic of Germany25 and Korea26 suggests that perhaps the Government had inadequately compensated exporters under the old cascade taxes and that, therefore, the vat, by giving the correct (and larger) rebates for domestic taxes, favored exports. Every country is likely to have a different outcome, and forecasting it depends on elasticities that are most uncertain, especially when disaggregated for particular products or sectors. In any event, the final net change does not seem likely to be large. In general, if factor prices are fully flexible, or if the exchange rate is floating freely, the usual domestic consumption type vat will be neutral with respect to the allocation of resources.27

Replacing a Direct Tax by a VAT

The “vat is also advocated as a means of stimulating exports. Under … GATT, a country may adjust the price of an exported item by indirect taxes but not for direct taxes, such as income taxes and social security taxes. As a result, goods exported from countries using vat enjoy a comparative advantage; by contrast, goods exported from the United States bear the cost of high income and payroll taxes. By replacing such taxes, in part, with a vat, some argue, the United States would no longer be at a competitive disadvantage since it would rebate the vat on exports.”28 Some might argue this but it is based on a partial view of adjustment. To take the extreme view, if all direct taxes were rebated on exports, would that not give the greatest incentive? But the rebates on exports leave the government budget with a revenue shortfall. With a given government expenditure, the government must get its revenue from somewhere and what it gives with one hand it must recoup elsewhere. That is, the rate of vat would have to be raised to maintain domestic revenue; this raises domestic prices and lowers real wages. If that position were sustained, exports might indeed increase. However, if labor responds by demands for higher wages, domestic industrial costs rise and the competitive advantage is eroded. This argument that a vat would increase exports only works if a real cut in domestic factor returns can be engineered, and that is based on social and economic considerations probably little connected with the vat.

Even in the more limited case of substitution of vat for some corporate direct taxes, the same argument holds. In addition, the argument must consider whether corporate prices fully reflect the reduction in corporate taxation; second, there could be cross-subsidization of exports from domestic pricing structures; third, a sustained expansion of exports and containment of imports might be countered by exchange rate appreciation. Finally, it has to be proved that the elasticities of supply of exportables and demand for imports are such as to yield significant advantages.

A provocative analysis by Gary Hufbauer suggests using a 4 percent vat to eliminate the U.S. corporate income tax.29 He argues that corporate profitability would be improved and the cost of capital would be reduced. However, the improved profitability would probably be short lived and, as Henry Aaron argues, the “effect of the tax swap on saving is many fold too high.”30 The vat for corporate income tax swap would tend to increase domestic saving (because after-tax rates of return rise) and increase investment by U.S. businesses (because the cost of capital to the firm is reduced). At the same time, U.S. assets become much more attractive, and capital would tend to flow to the United States causing the dollar to appreciate and create an increased deficit on current account. In the longer run, the United States would have to run a larger current account surplus to finance the returns on the increased net holdings of U.S. assets by foreigners.31 Whether or not this complicated and subtle series of changes on current and capital account would be to the ultimate advantage of the United States is difficult to assess. It is certainly dangerous to be dogmatic about cause and effect when so many uncertainties are involved.

It is not thought that the introduction of vat had any significant effect on exports in Italy, Sweden, or the United Kingdom.32 In the Federal Republic of Germany, the increases in exports at the start of vat were associated more with constrained domestic demand and higher productivity (lowering labor costs per unit) than with the tax change. The evidence is that “fluctuations in exchange rates and world demand” make the effects of vat swaps (for personal income taxes—the United Kingdom and Sweden, or for social security contributions—Italy) “pall into insignificance.”33

Overall, the argument and the evidence is that it is the customs union that drives up international trade and not the vat; the vat makes the customs union possible, but is not the agent that stimulates trade. Indeed, the vat is designed to be neutral and not to give an edge to any one country. Any effect discussed above would be unlikely to be large and probably would be temporary.

There is, perhaps, a minor effect on international trade from using the vat. It has been argued that importers must pay vat as the goods physically enter the country, and that tax payment is deposited in the national treasury “for a fairly long period of time”34 and, of course, no interest is paid on it. The trader, it is claimed, is at some disadvantage. This is exaggerated. Generally, importers do not pay vat upon the entry of the goods, but are often allowed a month to pay. The “postponed accounting system”35 allows the recipient of the goods, not the importer, to pay the vat. Generally, this means an additional 15 days for which the tax payment can be postponed, and this synchronizes the import vat with the domestic vat. Unfortunately, the trend may be in the opposite direction, as countries such as the United Kingdom and Ireland, which used the postponed accounting system, have recently reverted to levying the vat on the physical movement of the goods at import (despite a predominant wish on the part of industry that the postponed accounting system continues36) thereby gaining for their treasuries a once and for all gain at the expense of the importer.

Size of the Public Sector

Some commentators argue that the vat allows the government to grow larger, including the President of the United States who, in his February 21, 1985 news conference said the vat “gives a government a chance to blindfold the people and grow in stature and size.”37 The tax may offer policymakers a tempting way to expand their influence. Any revenue shortfall can be met by an increase in the vat rates (and it is true that only in three countries, Chile, Costa Rica, and Peru, has the vat rate been reduced from that at which it was initially introduced). In this way, there will be a temptation to increase public expenditures, knowing the buoyant vat is waiting in the wings to help out. It is true that vat, particularly in developing countries, often creates a more varied and broader tax base, which allows countries to tap resources that previously were unavailable. Also, because the vat is levied on a wide range of goods and services, it automatically appropriates its “share” of consumption as the GNP grows and as prices rise.

In addition, it can be argued that since an ideal vat taxes all goods and services, the taxpayer cannot shift his consumption pattern to alternative untaxed goods and services; if the vat replaces a tax that has allowed taxpayers such a choice, then “tax distortion” is reduced. With no choice but to pay the tax, total tax revenues are likely to rise. At the same time, the vat may have replaced taxes with high marginal rates and such a switch may encourage taxpayers to work harder. It may also reduce evasion. In both cases the tax ratio may be raised and the size of the public sector may increase.

An interesting “event analysis” of the introduction of vat in 11 European countries suggests that the introduction of a vat “immediately increases the tax ratio, which then persists at [a] higher level.”38 However, this particular test assumed that government expenditure is determined independently of government revenue, an assumption directly at odds with some of the arguments just made.

Other evidence does not support the thesis that vat enables countries to have a larger public sector. Countries now using vat tended to have a larger public sector before they used vat than the countries that at present do not use vat. As Table 11-2 shows, it is correct that 6 of the 11 countries reviewed did increase their average annual growth of public expenditure as a percent of GDP after the vat, and that the group average reflects this.39 However, Table 11-2 also shows that in most cases, receipts did not grow as rapidly as outlays and that, naturally, the difference showed up as increases in the rate of growth of the deficit. It is not so much that vat triggers an increase in the rate of growth of the public sector, but rather that countries already with a large government expenditure look for efficient ways to finance that government outlay and gravitate to vat. They do so because they know that vat is able to support general rates above 10 percent, indeed, typically at 15 percent, whereas the evidence is that a retail sales tax runs into difficulties at rates over 10 percent (see Chapter 1).

Table 11-2.The Government Sector Before and After the Imposition of VAT
YearsAverage Annual

Growth in

Outlays as a

Percentage of

GDP
Average Annual

Growth in

Receipts as a

Percentage of

GDP
Average Deficit

or Surplus as a

Percentage of

GDP
Austria1965–720.290.40–0.01
1973–821.010.53–2.50
Belgium1965–700.840.90–3.56
1971–821.650.89–5.63
Denmark1965–661.802.301.56
1967–821.701.11–0.81
France1965–670.30–0.10–0.30
1968–820.750.59–1.36
Germany,1965–671.000.60–1.20
Fed. Rep of1968–820.740.54–2.39
Ireland1965–711.231.40–4.53
1972–811.760.62–9.10
Italy1965–720.610.11–4.34
1973–821.901.28–9.78
Netherlands1965–681.731.70–1.58
1969–821.480.96–2.83
Norway1965–691.421.633.36
1970–820.640.773.03
Sweden1965–682.232.002.95
1969–821.800.95–0.10
United1965–720.530.51–1.35
Kingdom1973–820.730.81–5.22
GroupPre-VAT1.091.04
averagePost-VAT1.290.82
Source: Terree Alverson “Does the Value-Added Tax Contribute to Increased Government Spending and Taxation?” Economic Outlook, Chamber of Commerce of the United States (Washington), April/May 1986, Table 3, p.14.
Source: Terree Alverson “Does the Value-Added Tax Contribute to Increased Government Spending and Taxation?” Economic Outlook, Chamber of Commerce of the United States (Washington), April/May 1986, Table 3, p.14.

Management of the Economy

The vat has been seen as a possible tool for economic management, but with “fine-tuning” going out of fashion, not much has been heard recently about using vat as a regulator. Some countries such as Korea have included a clause in the vat legislation to allow the Minister of Finance to vary the vat rate within 3 percent without immediate recourse to legislation. Some countries (for example, Italy) have used vat deliberately to try to contain domestic demand.

The Italian example demonstrates a danger in using vat in a too discriminatory way as a temporary surcharge; when a 4 percent vat surcharge was applied to automobiles and “white goods” such as washing machines and refrigerators and a 2 percent surcharge was applied to electronic and photographic goods, it appeared that firms would have to reprogram their computerized accounting systems to accommodate these special separate rates.40 The authorities allowed the surcharge to be merged with the existing vat rates (increasing the 18 percent rate to 20 percent or 22 percent). However, such sudden and temporary switches in rates are administratively disruptive and the vat is better left out of such short-run fiscal management.

It can also be argued that shifting to vat from income taxes is a desirable part of long-run economic management. The disincentive effects of income taxes on work effort, savings, and risk taking are emphasized; vat revenues replacing part of income tax could boost economic activity. According to one commentator, “It is a pity that the bad press accorded to the vat increase of 1979 had tended to inhibit any further shift from income and capital taxes toward vat.”41 On the other hand, it has been held that the composition of taxes for a given budget deficit critically affects the trade balance. “Under a value-added tax system, a budget deficit worsens the trade balance and raises the world interest rate; under an income-tax system, the same deficit improves the trade balance and lowers the world interest rate.”42

Brazil has used the state vat (icm) to stimulate exports and promote certain projects of “national interest.” Since 1975, such projects, including telecommunications, power, and steel, have not had to pay vat on their inputs. During 1971–77, the usual vat exemption for exports was supplemented by a subsidy (crédito prêmio); this was an extra vat credit expressed as a percentage of the firm’s export value. Other countries have toyed with the possibility of using vat as a tool of regional policy (basically impossible as the effects would rapidly spill over from the region—see Chapter 2). It might be feasible to create regional investment credits using the vat refund mechanism. Traders, identified by the codes in the registration number identifying their region, could be allowed to claim refunds for investment expenditures in excess of the amounts actually paid. Of course, this would be open to all the criticisms of such regional incentives and, in fact, the vat would only be used as a mechanism for distributing the capital subsidy.

Another suggestion has been to recognize that complying with vat represents a significant cost for many small employers. If such small traders were exempted from vat, this could remove an impediment to their survival and growth. As it is recognized that a substantial part of new employment takes place in small firms, it is argued that this concession could increase employment.”43 There is the added temptation that the exemption for small retailers would cost a relatively small proportion of the revenue and would release many vat inspectors and other staff to monitor the tax on firms where the potential revenue loss (or revenue saved) is much greater (see Chapter 6).

It is always possible to devise ways to adjust the vat and especially the vat credits to affect investment, exports, and particular forms of consumption, but all this goes against the grain of the basic rationale of the vat. The vat is designed to be neutral. To use it for economic management, other than for broad-based demand adjustment, involves creating nonneutrality and is unadvisable.

Cnossen (1981, p. 240).

Cnossen (1981, p. 241).

Heller (1981).

Lienard, Messere, and Owens (1987, pp. 180–81).

Greene and Fishbein (1986, p. 90).

United States, Department of the Treasury (1984, Vol. 3, pp. 89–93).

Hemming and Kay (1981, pp. 83–85).

Ireland, Commission on Taxation (1984, p. 67).

The same conclusion is drawn in McLure (1987a, pp. 12–14).

Murray (1979).

United States, Department of the Treasury (1984, Vol. 1. pp. 223–25, and Vol. 3, pp. 100–107)1 see also Canada, Tax Reform 1987: The White Paper (1987, p. 61).

Prebble (l987, p. 14).

United States, Department of the Treasury (1984, Vol. 3, pp. 91–92).

Ingenious schemes can be concocted to replace both corporate and individual income taxes with a low, flat rate tax of the vat type, but using personal exemptions—see Hall and Rabushka (1985) and McLure (1987b, pp. 89–91).

See discussions in Aaron (1981).

”There is presently more concern for the administrative problems of iva … The administrative mess and the huge evasion, which go hand in hand, are the truly outstanding and serious problems of the Italian iva today,” Castellucci (1987, pp. 234–35).

See McLure (1981, p. 149).

Ballard, Scholz, and Shoven (1987).

Ballard, Shoven, and Whalley (1985).

Hemming and Kay (1981).

Ballard, Scholz, and Shoven (1987).

Sinclair (1983, pp. 383–84).

Goode (1976, p. 67).

For a similar discussion, see Tait (1986).

It seems the Germans undercompensated their exporters by approximately 3 percent: see Cnossen (1986a).

Price Waterhouse (1980, p. 8).

Hufbauer (1987).

Aaron (1987, p. 211).

Aaron (1987, pp. 212–13).

Brecher and others (1982, p. 41).

Brecher and others (1982, p. 42).

Dekker (1985, p. 121).

See European Community, Proposal for a Fourteenth Council Directive.

Miles (1987, p. 2).

“Reagan Sees Tightening of Business Tax,” Washington Post (Washington), February 22, 1985, p. D3; see also Bannock (1986).

Nellor (1987, p. 1).

See Aiverson (1986); see also Stockfisch (1985).

“Italy: Tightening the Fiscal Beit,” World Tax Report (1987, p. 8).

Walters (1986, p. 78).

Frenkel and Razin (1988, p. 297).

See Samuel Brittan, “Don’t Let vat Kill Off Jobs,” Financial Times (London), February 18, 1985, p. 11.

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