A Value Added Tax and Factors
Affecting Its Economic Impact*
by CHARLOTTE E. RUEBLING
A VALUE ADDED TAX (VAT) has at times
been mentioned as a substitute for an existing tax or
Table
as a source of new revenues in the United States.
European Countries Employing a VAT
While a VAT is not currently used in this country, it
Year Introduced
is employed by many U.S. trading partners in Europe.
Belgium
1971
Denmark
1967
One purpose of this article is to provide a general
France
1954-55
description of a VAT. A second purpose is to point
Gc,rmany
1968
Ireland
1972
out that some consequences often expected as the
Italy
1973
result of adopting any tax are conditioned by aspects
Luxembourg
1970
Netherlands
1969
of the economic environment which can vary from
Norway
1970
time to time. For example, discussions of a VAT have
Sweden
1969
Un.tad Kingdom
1973
centered on its possible effects on prices, income dis-
tribution, economic growth, and the balance of pay-
Value added for a given period is conceptually
ments. To evaluate adequately the consequences of
equivalent to all income — wages and salaries, rent,
a VAT or any other tax, circumstances such as the use
interest, and profits — generated in the production of
of revenues and accompanying monetary develop-
aggregate output. A VAT nevertheless differs from
ments must be considered.
a general tax on incomes in that firms, rather than the
individuals who ultimately receive income, are re-
FEATURES OF A VAT
sponsible for paying the tax to the government.
The Concept of Taxing Value Added
A VAT is often considered to be essentially a retail
A tax often takes its name from the base on which
sales tax. However, a VAT differs from a retail sales
it is computed. For example, personal income taxes are
tax in that it is collected at each stage of the produc-
levied against a base of personal income, and retail
tion and distribution process, not solely at the stage
sales taxes are a proportion of final sales. Value added
where a product is sold to the consumer,
taxes are no exception, being levied, in principle, on
the value of newly produced goods and services.
Methods of Computing a VAT
tThe author appreciates helpful comments provided by Pro-
There are three methods for computing an individ-
fessor Charles %V. Meyer on an earlier draft of this article,
ual firm’s VAT. These are the addition, the subtrac-
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FEDERAL RESERVE BANK OF ST. LOUIS
SEPTEMBER 1973
tion, and the credit or invoice methods. The ad-
less unfavorable, to investment expenditure than the
dition and the subtraction methods involve different
other two.~The total dollar amounts of tax base re-
approaches to computing the tax base. The credit
ductions are ultimately the same under both the in-
method calculates the tax liability itself, without re-
come and consumption types. However, under the
quiring explicit measure of a firm’s value added. In
consumption type, the firm purchasing capital ob-
practice these three computational procedures are
tains a reduction of the base in the period in which
1
only approximately equivalent.
the capital is purchased. With the income type, the
reduction is spread over the depreciation period.
The addition method of computing the VAT base
Thus cash available to the firm
in the early years of
is to sum the firm’s payments of wages, salaries, in-
the capital’s use is greater than under the income
terest, rent, and profits. These payments represent
type. In general, European countries have adopted
the firm’s contribution to the value of the economy’s
the consumption type.
output in the period, or its “value added.” This base
multiplied by the tax rate indicates the amount owed
Rate Variations and Exemptions
the government in value added taxes. The subtraction
method computes each firm’s value added as sales less
Many VAT systems can be described as having a
purchases of material inputs from other businesses.
basic rate, special rates for some goods and services,
The credit method computes the tax by applying the
and exemption status for certain economic activities
tax rate to sales and then subtracting taxes paid on
4
T
or specific goods and services.
These features influ-
purchases of components. \ alue added taxes in Euro-
ence the nation’s aggregate effective tax base,
pean countries are usually computed by the credit
method.
In language used with a VAT, to be “exempt”
means that there is no tax payable on sales and that
The Treatment of Capital
taxes paid on purchases in order to provide a good or
service are not recoverable from the government.
Three variations of VAT also arise through different
Various categories of economic activity have been
treatments of capital goods. The variations described
exempted in European countries either to simplify
here are in terms of the subtraction method of corn-
administrative procedures, as when very small busi-
puting the VAT base. A gross product type VAT does
nesses are exempted, or to achieve special effects on
not allow purchases of capital goods to be subtracted
prices and the distribution of real income in the eco-
from a firm’s sales to determine its tax base. Any part
nomy. Banking and financial institutions offer services
of the VAT assessed to the capital producer’s value
to which the value-added concept is generally diffi-
added which he is able to pass on as a higher price is
cult to apply; consequently, these firms and services
not recoverable by the purchaser through a tax base
are commonly exempted from a VAT. Government
reduction matching the purchase price of the capital.
and educational services, medicine,
transportation,
and communications products and services are also
An income type VAT reduces the firm’s tax base in
each period by the amount of its capital depreciation
in that period or by some proportion of the capital
given interest rate, the tax on the goods produced with capital
raises the amount of net income finns must derive from a
purchase price. This type is analogous to net national
capital asset in order to justify its purchase. In other words,
product, a measure of output which subtracts capital
the tax reduces the demand for funds, and other things re-
maining the saune, the interest earned by savers. See Charles
consumed or used-np in producing the gross output
E. McLure, Jr., and Norman B. Ture, Value Added Tax.’
or “value added” for the period.
Two Views (Washington, D.C.: American Enterprise Institute
for Public Policy Research, Noveunber 1972), pp. 88-92.
T
:s5ee Carl
Shoup, “Theory
and Background
of the
Value
A consumption type \ AT excludes from the tax
Added Tax,” National Tax Association Proceedings of the
base the entire amount of capital expenditures in the
Forty-Eighth Annual Conference, 1955, pp. 11-18, for ex-
2
tax period.
This type is somnewhat more favorable, or
planation of an ‘interest-exclusion
variant” of the income
type which is equivalent to the consumnption type. Also dis-
1
played is a proof demonstrating that the consumption type
See Alan A. Tait, Value Added Tax (London: McGraw-Hill,
does not discriminate in favor of or against capital as opposed
1972), pp. 1-5.
to a situation of no tax.
2
4
Norman Ture maintains that
this variation has been mis-
See
Tax Policy
(October-December,
1972)
especially
the
named. The name promotes the view that it is a tax exclu-
selections:
B.
Kenneth Sanden,
“The
Value-Added
Tax —
sively on consumption. Flis analysis develops the proposition
What It Is; How It Works — Experience in Foreign Coun-
that under certain conditions, this type of VAT is a propor-
tries,” pp. 1-19; John S. Nolan, “How VAT Should Operate
tional tax on incomes of owners of productive facilities in
in the United States,” p. 20-26; William I. Stoddard, “Effect
the forms of both labor and capital. Savers, who directly or
of
VAT
on Service Industries,”
pp.
59-65;
and Gordon
indirectly are owners of capital, do not escape the tax, be-
lnsley, “The Value-Added
Tax and Financial Institutions,’
cause value added by capital is subject to the tax. For a
pp. 72-78.
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FEDERAL RESERVE BANK OF ST. LOUIS
SEPTEMBER 1973
often exempted. In some countries these and/or other
tax policy often considers — namely, those relating to
goods and services, considered “necessities,” are in-
inflation, economic growth and stability, income dis-
stead taxed at a rate lower than the basic rate, while
tribution, and the international balance of payments.
some items, defined as luxury goods, are taxed at
While monetary policy and the government budget
rates higher than the basic rate.
are not the only influences on these matters, both
are significant.
If a firm’s sales are subject to a “zero” or “nil” rate,
then not only are sales free from tax liability, but the
Inflation
firm also is entitled to a refund of taxes listed on the
invoices of purchased inputs. Exports are typically
The possibility of increases in the average price of
subject to a zero rate in VAT laws and proposals.
goods and services upon enactment of a VAT has
The zero rate means that exporters do not pay tax on
been a concern of Europeans, even though for some
their sales abroad and receive refunds for taxes paid
countries the VAT replaced a similar tax known as a
on purchases.
turnover tax. For example, in the past year France
reduced its VAT rates, along with other measures,
reportedly for the purpose of combatting inflation.
ISSUES CONCERNING THE EFFECTS•
Imposition of a VAT or a change in any tax rate,
OF A VAT
by itself, cannot be considered inflationary or defla-
The consequences of adoption of a VAT, or any
tionary. Even if sellers were able to raise prices to
tax change, for inflation, income distribution, resource
cover the tax they pay, this would constitute a one-
allocation, economic growth, and a nation’s balance of
time increase in their prices, but would not neces-
payments depend on the specific form of the tax and
sarily lead to inflation, which is a continuous increase
the accompanying circumnstances. This section of the
in the average of prices over time.
paper describes possible effects of a VAT, noting some
of the specific aspects of the tax and some of the con-
Even associating a one-time increase in the level
of prices with a tax change would be accurate only
ditions in the economy which must be considered in
order to reach valid conclusions about whether those
under special circumstances. A tax on a single good
effects will or will not follow the imposition of the
could often be expected to raise the price of that
tax. The general categories of considerations discussed
good and perhaps affect prices of related goods and
5
are relevant for analysis of the effects of any tax
services.
However, a rise in the general price level
change, not merely one involving a VAT.
cannot be mnaintained unless there is a rise in the
dollar amount of goods and services demanded rela-
One inevitable change in circumstances accom-
tive to output. Assuming no decline in output, this
panying any tax change and bearing on subsequent
would require either expansion in the money stock or
economic developments is the possible use of new
decline in the public’s holdings of real money bal-
revenues. New tax revenues may be used by the
ances.° If there were neither a rise in the money
government: (1) to purchase goods and services; (2)
stock nor an increase in the rate of money turnover,
to reduce or replace another tax; (3) to retire out-
buyers would be unable to make all of their previous
standing debt; or (4) to hold balances in commercial
purchases at higher prices. A result of a widespread
or central banks.
attempt to raise prices would be reduction in the
real amount of goods and services sold, rollbacks in
Monetary conditions also influence the effects some-
some prices, and/or adjustments in production and
times associated with tax policy. Monetary policy and
employment. Consequently, if a rise in the price level
tax policy are often considered separately from each
is sustained with the imposition of a VAT or other
other. Commentators assessing the impact of one or
tax change, it is largely because of one or more of the
the other often implicitly assume definitions of these
following: the tax has induced the monetary authori-
terms which keep them distinct. One should keep in
mind, however, the following relationships between
tmFor a formal analysis, see Arunen A. Alehian and William 11.
monetary and tax policy. A decline in money can
Allen,
University Economics,
3rd edition
(Belmont,
Cali-
result from one use of tax revenues
fornia:
Wadsworth Publishing Company,
Inc.,
1967), pp.
—
increasing Treas-
324-328.
ury balances in commercial or Federal Reserve Banks.
6In the framework of the quantity equation, MV = PT,
Also, increases in the money stock can finance gov-
familiar to some readers, the reduction of average cash bal-
ances is equivalent to a rise in transactions
velocity
(V)
ernment expenditures. Additionally, changes in the
which, in the presence of constant money stock (M) and full
money stock have influences over objectives which
employment (constant T), would produce a rise in prices (P).
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FEDERAL RESERVE BANK OF ST. LOUIS
SEPTEMBER 1973
ties to increase the money stock; the tax has induced
the possible consequences of a VAT on growth? Once
the public to attempt to reduce their holdings of
again it depends to some extent on the policy actions
money balances; or the tax has acted as a disincentive
accompanying the VAT and responses to these ac-
to production.
tions. In general we need to ask whether the private
sector responds to a given tax substitution or increase
Income Distribution
by: (1) reducing consumption; (2) reducing invest-
ment; or (3) increasing the supply of productive re-
Many believe a VAT to be a regressive tax — one
sources to the market. Response (3) appears condu-
which takes a larger proportion of lower incomes than
cive to growth. However, for the growth impact of
high ones. An appropriate analysis of the effects of a
response (3) to be lasting, there must be balance
tax on income distribution requires consideration of
between demand and the resulting increase in the
the specific form of the tax — including its rates and
supplies of goods. Slack in demand resulting in ac-
exemptions — and the use of the revenues, Considera-
cumulations of unsold goods is a signal for a produc-
tion of how these in turn affect income distribution is
tion cutback (and/or a price decline) in a market
rather complex.
economy. In general, policies conducive to growth are
To illustrate, Great Britain replaced selective em-
those which increase supplies of productive resources
ployment and special purchase taxes with a VAT,
and investment and those which foster conditions in
effective April 1, 1973. This VAT has a basic rate of
which an essential balance between aggregate sup-
10 percent and a zero rate on some items, including
plies and demands can he maintained.
food, housing, fuel, power, and passenger transport.
The combination of responses (1), (2), and (3) to
Under the special purchase taxes which were re-
placed, some luxury items were taxed at a rate of 25
adoption of a VAT is influenced by how the VAT, the
accompanying use of funds, and monetary conditions
percent while many items purchased more universally
8
affect prices of current versus future consumption
were taxed at rates lower than 10 percent. The effect
and the conditions which lead resource owners to
of this tax substitution on income distribution is con-
hold or release their resources to the market. If mone-
tingent on how prices of commodities respond to the
tary conditions (rates of money stock growth and
elimination of one tax and the imposition of the other.
money turnover) do not change, relative prices will
The substitution would usually be considered regres-
reflect the impact on prices of the tax for which the
sive if prices of items purchased predominately by
VAT was substituted or the spending undertaken by
lower income households rise relative to prices of
the government. A lowering of the relative price of
purchases made by higher income households. The
future consumption would in many circumstances be
assumption, often made, that prices respond in direct
7
conducive to growth of production in the economy.
proportion to the tax change is usually unwarranted.
The income distribution effect of adoption of a
Balance of Payments
consumption type VAT in the U.S. would depend on
a number of circumstances including, of course, its
A VAT, as opposed to some other taxes, is consid-
rates and exemptions. The use of revenues — for ex-
ered advantageous to an individual country’s balance
ample, whether they were used to reduce or eliminate
of trade. Provisions of the General Agreement on
corporate income taxes, social security taxes, or prop-
Tariffs and Trade (GATT) foster this effect. GATT
erty taxes, or whether they were used to increase
permits a rebate of indirect taxes, such as a VAT or
government spending — would help determine the
sales tax, on exports so that the destination price of
distribution of real income after the tax change. In
the export svill exclude the tax, but does not permit
addition, accompanying monetary conditions would
the effect of direct taxes, such as the corporate income
influence the behavior of prices, which, in turn, affects
tax, to be excluded from the export price. In addition,
the distribution of real income.
GATT allows a border tax on imports equivalent to
the importing country’s indirect tax. If direct taxes
Economic Growth
have a positive effect on the prices of commodities,
One objective apparent in discussions concerning
which is reversed with elimination of the tax, the
taxation is that the tax system encourage or at least
tFuture eonssnnption implies saving and huying capital which
not impair the economy’s potential for and achieve-
will yield a larger stock of consumption goods at some time
ment of economic gi-owth. What, then, are some of
in
the
future
than
one
is
capable
of acquiring
in tIme
present. Interest rates, influenced by physical productivity of
capital and monetary conditions, measure the trade-off he-
~Alebian and Allen, pp. 324-328.
tween present versus future consumption.
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FEDERAL RESERVE SANK OF ST. LOUIS
SEPTEMBER 1973
substitution of an indirect tax, such as a VAT, for a
amount of one or more of the possible uses of the
direct tax would tend to increase a nation’s exports
revenues must be considered.
and reduce its imports, given that other factors affect-
Two basic points made in this article are: (1) the
ing trade remain substantially the same. This is be-
consequences
for
income
distribution,
economic
cause the price to foreigners could be more attractive
growth, and the international balance of payments of
within a framework imposing a VAT than one involv-
a VAT substitution in the tax structure depend largely
ing a direct tax,
on what happens to prices; (2) the effects on prices
of the imposition of a VAT in place of another tax
SUMMARY
depend to a considerable extent on monetary condi-
This article has discussed the concept of a value
tions — the rate of growth of the money supply and
added tax. Its main pus-pose, however, has been to
the velocity of money — and on the price-impact of
illustrate some of the necessary, but often overlooked,
an alternative tax or other use of funds. In contrast
ingredients for analysis of any tax proposal. To ana-
to some widely alleged consequences of a VAT, it is
lyze the consequences of any tax change, the accom-
noted that a VAT need not be followed by inflation
panying monetary conditions and the change in the
or greater inequality of income distribution.
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