Value Added Tax as a Reform Option for the Federal Income Tax Essay
Value Added Tax as a Reform Option for the Federal Income TaxAbstractA Value Added Tax is a form of taxation that nearly every other advanced country has already adopted as a revenue source. In contrast, the United States has not yet resorted to a Value Added Tax. This paper will discuss a Value Added Tax as a reform option for the federal income tax. It will consider why the United States has not followed the other major economies in the world by adopting a Value Added Tax. This paper will also address the features of a generic Value Added Tax, its potential to change the current federal tax structure in a positive way, the problems that the enactment of a Value Added Tax in the United States might present, and how to minimize those problems.
Finally, some proposed solutions are presented.IntroductionIn a famous test conducted in 1997, Money magazine asked forty-six tax professionals to perform a moderately complex calculation of the tax liability of a hypothetical family. The forty-six different answers they calculated—ranging from $34,420 to $68,192—show how complex the Internal Revenue Code has become (Slemrod and Bakija, 2004).
Along with these test results, other data demonstrate the same complexity. The instruction booklet for Form 1040 of tax year 2006 is 143 pages long (Keating, 2004). Tax law complexity presents many disadvantages. It causes individual taxpayers to spend more time and money preparing tax returns. It raises administrative costs for the government. It invites tax evasion and a variety of loopholes, which create the possibility of economic distortions. It provides the IRS with more opportunities to invade taxpayer privacy. It drives business entities out of the country.
Furthermore, it makes taxpayers believe that the tax law is unfair. Given these serious consequences of tax law complexity, it is imperative to simplify the tax law.Simplifying tax law is not simple, however. It is very complex, because there are several conflicting and often mutually exclusive goals that tax law must achieve. Often, attaining one goal means failing to achieve another. For example, the Code’s complex structure arose in great part out of concerns of equity; that is, a concern that the tax burden be distributed according to each taxpayer’s ability to pay. Consider the different definitions, phase-ins and phase-outs of each exclusion, above-the-line deductions, and credits. Simplifying tax law by repealing exclusions, deductions and credits may frustrate tax law fairness, because such an oversimplification would not allow for a fair distribution of the tax burden according to each taxpayer’s ability to pay.
Simplifying the code, therefore, must be considered in the context of other tax law goals.To achieve simplification and equity simultaneously, it may be worth considering a different tax regime, because the complex features germane to the income tax may sometimes be an obstacle to making meaningful progress. This paper will take a detailed look at a value added tax (VAT) as a measure to reform the federal tax environment for individuals.
It will examine the extent to which a federal VAT has the potential to simplify and positively reform the current structure. It does not contend that there is only one perfect solution.A VAT to Simplify the Tax CodeWhat a VAT can do in relation to the current federal tax structure for individual taxpayers, in which the federal income tax plays an essential role? Generally, advocates of the VAT, as a consumption tax, claim that the VAT is a better tax system than an income tax in several respects, including economic efficiency and fairness (equity) (Christan, 1989).
However, economic efficiency and fairness arguments are generally not the strongest grounds to consider a completely new system, because they necessarily involve value-judgments or theoretic limitations that are not always applicable to real-world situations. Here, the paper will discuss such VAT’s merits: the capacity to simplify the federal income tax and to reduce tax evasion under the regime of a generic VAT. Hopefully, these features will support a reform of the federal tax system using a VAT.Before considering further the potential application of a VAT as a reform of the current income tax system, a threshold question that must first be resolved is whether the current income tax system should be completely scrapped so as to remove all of its drawbacks. It is no wonder that some critics argue that the federal income tax must be completely replaced. However, is a world without an income tax the place in which we should hope to live?Income tax was created to respond to a public outcry for a “fair” tax system, imposing more tax upon those with more money (ability-to-pay norm).
The income tax system, believed to be “fair” at that time, is inevitably based upon individual financial evaluations of how much taxable income a taxpayer earns during each tax year, the determination of which necessarily entails a variety of evaluation methods making the system extraordinarily complex. If there were no income tax, it would be very likely that there would be almost no substantial means to distribute tax burdens according to each taxpayer’s ability to pay (Goldberg, 2007).Although consumption tax proponents maintain that income is not the best indicator of a taxpayer’s economic ability, income still best represents a yearly wealth that a taxpayer can base her tax on for a tax year. This is why an idea as extreme as completely repealing the income tax can be a dangerous approach, since it would involve abandoning a major norm of ability-to-pay. Based upon this understanding, unless the general public believes that ability to pay should not be a standard to calculate a taxpayer’s tax on, an income tax should remain. This is still the case in nearly all other developed countries in the world (Slemrod and Bakija, 2004).
Taking an income tax as an essential and necessary element of our tax structure, the next step is to consider how to supplement, not replace, the income tax, which is the focus of this paper. More specifically, the goal here is to determine how to use a VAT to supplement the income tax. It is true that commentators in the United States react differently to a VAT. Some do not agree with the notion of implementing a VAT in the United States for several reasons, not the least of which is the fear of a VAT’s capacity to make the government bigger or to make tax laws regressive or more complicated (Fleming, 1995). Some simply do not believe that a VAT is necessary.
In contrast, others support and would welcome certain features of a VAT, valuing highly a VAT’s potential to supplement an income tax. They believe that, with a VAT, an income tax can achieve its goals more easily and efficiently. This is why this paper studies a VAT as an avenue of reform of the current federal income tax. Neither an income tax alone nor a VAT alone can efficiently achieve the policy goals of tax law. An income tax alone can hardly minimize economic inefficiency nor solve the complexity problem of tax law. Similarly, a VAT can hardly distribute tax burdens to taxpayers according to one’s ability to pay. The weaknesses of each system taken separately can be overcome by blending the two systems together (Oldman & Schenk, 2001).The idea of reforming the income tax by having a different form of taxation may sound somewhat preposterous at first, because reforming an income tax seems to require that the income tax itself be changed in a certain way.
However, adding a VAT to the income tax will better achieve tax policy goals, which were set at the inception of the income tax. More specifically, adding a VAT to a simplified income tax would solve many problems that exist in the current federal income tax.Value Added TaxThe VAT has been mentioned over several decades as a new revenue source for governments, especially the federal government. In 1984, the Treasury Department prepared a report on tax simplification and reform, which analyzed a VAT as a new federal tax (Treasury Report, 1984). The report was prepared for President Reagan. In 2005, the President’s Advisory Panel on Federal Tax Reform again considered a VAT as a tax reform idea (President’s Advisory Panel, 2005).
In addition to these two reports, many articles have considered a VAT as a new tax regime in the United States. When we look outside of the United States, the VAT looks even more popular (Sheppard, 1993, p. 61).A large number of countries today have already enacted their own VATs. As of January, 2005, among thirty OECD member countries, twenty-nine countries adopted a VAT. Indeed, the United States is now the only major country that does not have a VAT as a national tax (OECD, 2006). These facts imply that a VAT is worth serious consideration. To consider a VAT a new option, we must first understand what a VAT is, what a VAT can do, what a VAT’s drawbacks are.
A value added tax (VAT) is “a tax imposed on and paid by business entities … in proportion to the value they add to the goods and services they produce and sell” (Christian, 1989, p.
23). The value added is the amount that a business entity receives through its business transactions minus the amount that it pays to other businesses during a certain period of time (value sold minus value purchased). While this is one of the simplest definitions of a VAT, many more elements must be considered to evaluate a VAT fully.
Types of VATsDepending upon the treatment or deductibility of capital equipment, three different types of VAT may be thought of. To simply put, a gross product type of VAT has the broadest tax base. It allows only a narrow range of deductions, i.e., cost of raw materials. As a result, it taxes purchases of capital investments. An income type VAT allows more deductions. It deducts depreciation of capital goods as a net investment purchase (gross investment minus depreciation).
A consumption type VAT deducts the entire capital investments (Schenk and Oldman, 2001, pp. 34-5).These three distinctions come from the breadth of tax-bases of each VAT.
The income type of VAT has the same, or nearly the same, tax base as a general income tax and works in much the same way. This means that the income type of VAT will invite the same complexity in regulating distinctions and methods of depreciation in the area of the VAT (Treasury Report, 1984, pp. 6-7).Since the gross product type of VAT does not exclude taxing the purchase of capital goods, it imposes a heavy burden upon purchases of capital goods and may cause disincentive to capital investment (just like an income tax; this is why an income tax has treatments of depreciation of capital investments), because capital investment is taxed twice under this VAT. The tax is imposed when the capital goods are purchased and when the output of the capital goods is sold (Treasury Report, 1984, p.
6). This heavy burden is likely to affect saving adversely, to disfavor capital intensive methods of production, and to delay capital advancement.Considering these characteristics of each type of VAT, there is almost no reason to regard any type of VATs in this article other than a consumption type of VAT. Under the consumption type of VAT, all business purchases would be deducted or excluded in reaching a business entity’s value added. This type will result in a tax base of totally private consumption (Treasury Report, 1984, p.
7). A VAT will become a consumption tax on the condition that the VAT takes this type. Not surprisingly, almost all of the opinions regarding a VAT are based upon the understanding that the VAT is a consumption type. “Except when the income form is used as a transition to VAT, VATs in use today almost always are consumption VATs” (Schenk & Oldman, 2001, p. 35).Can Adoption of a Federal VAT Help Simplifyan Individual’s Federal Tax Structure?[1]Simplicity is almost always on the list when one discusses tax policy goals these days.
This implies that today’s arcane tax law is already a headache to most people and that taxpayers desperately hope for relief in this matter. However, simplifying the federal tax system for individuals is not simple. The adoption of a new system always brings some confusion, which may discomfort scholars and taxpayers. Some scholars warn that a VAT is not inherently simple and that its adoption will require cautious use of the revenue derived from the VAT (Fleming, 1995, p. 390).
Two perspectives are required to consider a VAT as a means of simplifying the current federal tax structure. The first is whether a VAT in itself is simple, and the second is whether a VAT can simplify the current federal tax environment. These two perspectives are already problematic. The first involves at least two problems, while the second presents at least one. The two problems in considering whether a VAT is simple in itself have to do with the concept of such a tax and with the difficulty of comparison.
“Complex” and “simple” are relative concepts, which vary depending upon who judges them and how. A rocket scientist might think a first degree equation easy, while a seven-year-old child might think it complex. There is no applicable objective measurement or standard. Some people might see the current income tax law as simple, while others might see the same law differently. The other difficulty with regard to the first question arises when comparing a VAT with other tax laws (Alm, 1999).There is a general tendency when considering the simplicity of a VAT to compare it with other tax systems. Such a comparison is not always justified. Some might say that, just because a VAT is simpler than the federal income tax, does not mean that the VAT is simple, because the federal income tax is one of the most complex tax laws in the world (Sheppard, 1993, p.
1040). It is almost inevitable, however, to compare the complexity or simplicity of one system with those of another, because the concept of simple is relatively decided in most cases. As a result, the determination of the extent to which a VAT is a simple tax system is problematic.Considering the second question of whether a VAT can simplify the current federal tax environment also requires overcoming an obstacle. The extent to which the income tax will be simplified when a VAT is enacted in the future is unknown. How much simpler the reformed federal tax environment will be after the adoption of a VAT cannot be judged until the following information is garnered: how complex or simple the new VAT will be; the extent to which the income tax will be simplified; and whether the added complexity, created by the enactment of a new VAT, is greater than the complexity removed within the income tax. Strictly speaking, there is not enough information at present to permit any of these three inquiries to be answered intelligently.
Notwithstanding these difficulties, it is nevertheless useful to examine elements that make a generic VAT simple and factors that can make the federal tax environment simpler, for the purpose of later use in drafting a simple and effective VAT law.How Can a VAT Make the Federal Tax Environment Simpler?To the already uncertain issue of whether a VAT is a simple tax may be added a more complicated and uncertain discussion when considering the question of whether the adoption of a VAT will make the federal tax environment simpler. The difficulty is that there is no way to predict the extent to which the federal tax environment, mostly the income tax, will be simplified by adopting a VAT. Addressing this question requires a direct comparison between a VAT and the income tax. This is not to say that such a comparison is not necessary when examining a VAT’s simplicity in isolation.
The necessity of a comparison at that time comes from the conceptual nature (relativity) of simplicity. Here, however, a direct and essential comparison is required to address this question.Of course, it may ultimately be fruitless to divide the discussions, but they are theoretically separate. To discuss the simplicity of a VAT in itself can bring focus into a simple draft of a VAT, while discussing the simplicity of the overall federal tax environment can focus attention on, for example, the overall simplification of the federal tax system, including income tax simplification and how the revenue made by a VAT should be used. If the adoption of a VAT will not materially change any other income tax structure, it will definitely make the federal tax environment more complex instantly or over time.
This scenario is not very likely, however, because political dynamics may not allow such a proposal without an urgent and unavoidable need acceptable to the general public (Goldberg, 2007).As is the case in most other countries, substituting a VAT for any existing tax (mostly income tax) is also not highly likely due to the VAT’s regressive nature (Sheppard, 1993, p. 1040). As Slemrod (2004) puts, “Dumping the income tax entirely would be unprecedented.
Most countries adopted the VAT to replace inefficient turnover taxes, rather than income tax revenues” (p. 1334). But he further opines that “the United States may be in the unique position of being able to replace the income tax entirely, and stay within the range of VAT collections that has proven viable in other countries” (Slemrod, 2004, p. 1335). Professor Slemrod bases his idea upon the fact that the U.
S.’s overall revenue collected by tax is much lower than other developed countries.The only likely situation, then, will be the adoption of a VAT with a reformed (simplified) income tax. In that situation, whether the adoption of a VAT will simplify the federal tax environment will depend upon “how the VAT yield will be used” (Fleming, 1995, p. 399).
A three-step analysis will be helpful to the adoption of a VAT as a partial replacement of the current income tax or in addition to a simplified version of the income tax. The first step is to determine how complex a newly-enacted VAT will be (Complexity of the VAT). The second step is to determine the extent to which the income tax will be simplified (Simplification of the Income Tax). The third step is to see whether the Complexity of the VAT is greater than the Simplification of the Income Tax, since, if the former is not greater than the latter, the new VAT and relevant income tax simplification will be characterized as a simplification measure.This three-step analysis will not work well, however, until the provisions of the proposed VAT and the proposed simplified income tax are known. Thus, here again, there is no conclusive answer to the current abstract question whether the adoption of a VAT will simplify the federal tax environment. Nevertheless, it is still helpful to address which part of a VAT is generally considered complex, which part of an income tax should be simplified with the adoption of a VAT, and by which method these two parts should be combined (Fleming, 1995, pp. 393-402).
As noted above, it may be accepted that a VAT is, or at least can be, generally simpler than an income tax, and that a newly adopted VAT would simplify the current income tax so long as the former, partially or completely, replaces the latter or the revenue derived from the VAT were used to simplify the income tax (Fleming, 1995, pp. 393-402). Thus, for the purpose of simplifying the income tax, the United States should adopt a VAT and, at the same time, partially repeal or substantially simplify the income tax.
The revenue created by the VAT should, at least at first, be used to simplify the income tax.However, a simplification ought not be directed simply to lessen the burden of the rich. Doing so would contravene the essential idea of the ability-to-pay norm and the efficiency of tax administration. These objectives are summarized as follows: (1) Income tax should be substantially simplified or partially repealed to affect the majority of taxpayers, but in a way that does not lessen the tax burden of the rich; (2) A VAT should be enacted to supplement the revenue loss created by the simplification or partial repeal of the current income tax; (3) The new VAT should be simple.The proposal by Professor Michael J.
Graetz (2002) is a good example of how a VAT adopted in addition to an income tax can simplify the whole structure. With a new “family allowance” of up to $100,000 to replace the current law’s standard deduction, personal exemptions, and most personal tax credits, Professor Graetz substantially simplifies the income tax by keeping almost 90 percent of all income tax filers off of the income tax rolls (2002, pp. 295-96). The actual numbers may be adjusted based upon levels of inflation and economic conditions (p.
286). His proposal, which is summarized below, also includes a simple VAT to replace the reduced revenue portion of the income tax. His simple VAT idea excludes multiple rates, but includes an exemption for small businesses whose annual gross receipts are below a certain level to minimize a VAT filing burden to small business owners (Graetz, 2002, pp. 287-88).Professor Graetz’s VAT proposal can substantially simplify the federal tax structure. For individuals who do not run a business, the proposal provides an absolute solution to simplify the federal tax structure, because almost 90 percent of them will not need to file an income tax return.
Table 1: Outline of Professor Graetz’ Reform IdeaOUTLINEOBJECTIVES1. Create a “family allowance” as a replacement of standard deductions, personal exemptions, some itemized deductions, and most personal tax credits so that it eliminates almost 90% of all filers from the income tax rolls. (Income in excess of the greater of the family allowance or itemized deductions would be taxed at a flat rate of 25% or, alternatively, the family allowance might be phased out.
)To substantially simplify the current income tax situation.2. Enact a consumption type and credit-method VAT at a rate of 10 to 15% with a broad tax base.To finance the income-tax elimination.3. Exempt small businesses (22 to 50% of the total number of businesses) from the VATTo reduce administrative and compliance costs of the new VAT4. Provide Social Security payroll tax offsets (as a replacement for the current EITC*) to low-wage workers for the increased amount of tax and for the expenditures on education and health care.
To protect low-income taxpayers from an increased burden of tax owing to a new VAT* EITC: Earned Income Tax CreditAlso, for individuals running a business, the proposal significantly simplifies the structure, because a VAT filing is not required from those whose annual gross receipts are below a certain level. According to Professor Graetz’s plan, if a VAT is coupled with a small business VAT exemption, only 50 percent or (alternatively) 22 percent of them would be required to file new VAT returns, which is not a great burden compared to the number of people freed from having to file an income tax return (2002, pp. 291-2). This is an example of a VAT’s potential to simplify the federal income tax and the federal tax structure significantly.Professor Fleming explains this issue by comments on four situations: a VAT replacing the individual and corporate income taxes; a VAT used to pay for deficit reduction, income tax cuts, or spending program; a VAT financing corporate integration; and dropping taxpayers out of the system by using an expanded standard deduction. The professor concludes that the first three situations are not likely or helpful in simplifying the federal tax structure. On the fourth, he says that it would clearly achieve impressive simplification for large numbers of taxpayers except for situations that taxpayers having positive income tax liabilities must still file returns to get the credit refund. (Fleming, 1995, pp.
399-405)ConclusionAs shown above, a VAT, if adopted, can simplify or nearly eliminate the complicated income tax return process for a majority of taxpayers, while at the same time being able to maintain a similar revenue stream and tax-burden distribution across the board as existed before the change. As hundreds of different versions of income tax reform plans and VAT drafts are possible in theory, this issue can be addressed in many ways.For example, a simple VAT plus income tax with an expanded standard deduction or exemption is one way of simplifying the federal tax system. The method of a VAT with a raised income-tax exemption can be tailored to maintain the same or similar revenue stream by adjusting the VAT rate and the level of the exemption point of the federal income tax. This method does not seriously change tax burdens across the board, because most of the low-income taxpayers’ income is composed of consumption, due to the slim size of their savings (The income and consumption flow of low-income taxpayers might be quite different from that of high-income taxpayers).
Thus, a VAT, if designed properly and used in combination with a simplified income tax, for example, can significantly simplify the federal income tax environment and, at the same time, maintain the progressivity—which is almost always the hurdle to an adoption of a consumption tax—in the federal tax system. For example, professor Graetz’s idea (10% – 15% VAT and $100,000 income exemption for income tax) is expected to relieve 100 million American families of federal income tax returns. This method might even make the structure more progressive, because high-income taxpayers will be subject to income tax plus a VAT. As this example shows, a VAT may be considered as a good method to both simplify the tax environment and to distribute tax burdens progressively. Other than those ideas of simplifying the federal tax system that do not ensure the maintenance of progressivity (many ideas of enacting consumption-like taxes and repealing current income tax) or “theoretical constructs,” a combination of VAT and income tax can be a good plan that will contribute to simplifying the federal tax structure.ReferencesAlm, James. (1999). What is an ‘Optimal’ Tax System? in Tax Policy in the Real World, Joel Slemrod, (Ed).
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Report of the President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System.[1] Here, “an individual’s federal tax structure” means chiefly the federal income tax under the current law. The phrase would be broadened, however, to include not only an income tax, but also a VAT after its adoption in the area of individual taxation.
