The VAT Tax

(via Ezra Klein) Many people think that taxes will have to go up in the future - wars, debt, health/climate reform, etc - but that raising the income tax won't be able to pick up the slack. So, be prepared to keep hearing about the value added tax (VAT) that is used in most European countries. Here's a great primer:

The value-added tax is also the darling of many economists for its bounce-a-quarter-off-its-abs efficiency. Its administrative costs to the government are generally low. It is also considered less of a drag on the economy over the long run than raising income taxes, which discourage people from saving money and thereby making capital available to businesses.

To understand why a value-added tax is considered so efficient, you have to understand how it usually works.

Imagine the production of a new dress, in three steps:

1) A fabric store sells a tailor enough silk to make one dress, at a total price of $10 before taxes;

2) The tailor sews a dress and sells it to Macy’s for $30 before taxes;

3) Macy’s then sells the dress to a shopper for $50, before taxes.

Let’s say the value-added tax is 10 percent. The government will collect some tax revenue in each step of the production process, from roll of fabric to cocktail-party scene-stealer, but each business in the chain gets credit for the tax already paid by other suppliers.

When selling the cloth to the tailor, the fabric store adds a tax of 10 percent, or $1 on the $10 of supplies the tailor purchases. The tailor pays the fabric store $11, and the store remits $1 to the government.

When the tailor sells his dress to Macy’s, he calculates the value-added tax as $3, or 10 percent of his $30 pretax price. Macy’s pays the tailor $33.

But instead of sending the full $3 to the government, the tailor gets to subtract the $1 of taxes he had already paid to the fabric store. So he sends $2 to the government.

When Macy’s sells the dress to a shopper, it adds another 10 percent, so the shopper pays $55, or $50 plus $5 in tax. That would be in addition to any state or local sales taxes consumers have to pay, depending on the locale.

Macy’s checks to see how much the previous companies in the supply chain — the fabric store and the tailor — have already paid the government in value-added taxes, and subtracts that from the $5. Macy’s ends up remitting just $2 to the government.

The government receives $5 total, or 10 percent of the final purchase price, but from three different businesses.

Although more complicated, value-added taxes are considered better than equivalent sales taxes — where the tax is levied only when the consumer buys a product — for two main reasons.

First, if a single business evades the value-added tax, the government does not lose a large portion of money, because it will collect taxes at other stages of production.

Since companies usually get credit for taxes already paid by their suppliers, companies will pressure other businesses in the production chain to prove they paid their taxes. That means the system is somewhat self-policing.

To some foes of big government, though, the efficiency of the tax is also its fatal flaw. Conservatives worry that it enables the government to raise money with such little effort that it will encourage Washington to spend even more.

On the other hand, liberals are wary of value-added taxes because they are regressive. Poor people spend a higher portion of their income buying things than the rich, meaning lower-income people would be disproportionately hurt.