October 3, 2023

The word “Taxes” is engraved on May 10, 2021 at the headquarters of the Internal Revenue Service (IRS) in Washington, DC, USA.

Andrew Kelly | Reuters

This is how VAT works

Sales tax is similar to retail sales tax, except that there is a levy at every step of the production process, not a levy at the end.

For example, let’s say a farmer grows wheat for $ 100 and sells it to a baker. If the sale is subject to 20% sales tax, the baker pays $ 120 and the farmer pays $ 20 to the government. If the baker sells $ 5 bread, he pays an additional $ 1 per loaf for sales tax.

When the baker files his tax return, he transfers the $ 1 VAT payments for bread and requests a $ 20 credit for the VAT he paid to the farmer. However, the VAT paid by the consumer is not taken into account.

The VAT system creates a “self-disclosure mechanism” where each company documents another’s activity, resulting in a higher level of compliance, said Wojciech Kopczuk, economics professor at Columbia University.

A “workhorse” for other tax systems

Another reason VAT works so well is the relative stability of the tax base, said Daniel Bunn, vice president of global projects at the tax foundation.

“The government will not see large fluctuations in tax revenues from year to year,” he said.

The pandemic may of course have been the exception.

“But even in a pandemic, your excise tax revenue doesn’t fluctuate as much as your income,” said Bunn.

According to a report by the Brookings Institution and Urban-Brookings Tax Policy Center, VAT is the third largest source of income for other member countries in the Organization for Economic Co-operation and Development after income taxes and social security program levies.

“It was a workhorse of European tax systems,” said Gale.

Value added taxes are also effective in developing countries, as these taxes are easier to manage and enforce than income taxes, he added.

However, there are unique challenges with the introduction of VAT.

Many countries exclude certain products or services from VAT, such as groceries, medicines or other necessities, Kopczuk said. There can be inconsistencies between excluded products that are a burden for some companies.

In addition, there are cases of tax evasion, especially on cross-border purchases, when someone receives a tax credit for VAT paid outside their home country.

There are also cases where companies create fake invoices to claim VAT credits for purchases down the supply chain that never took place, he said.

“In China, for example, that’s a big problem,” said Kopczuk.

Despite these issues, sales taxes collect a lot of revenue and appear to be working pretty well, he said.

Why there is no sales tax in the USA

Although sales taxes are lucrative elsewhere, the levy faces political hurdles in the United States, Bunn said.

Some Democrats view sales tax as regressive as it hits families regardless of income, while Republicans may struggle against a large-scale tax hike, he said. Plus, it can also be a tough sale to lawmakers in states with no sales tax, Bunn added.

The logistics of a VAT can also cause setbacks in the business world, Kopczuk said.