The Value-Added Tax

WHAT DOES IT REALLY MEAN?

The Value-Added Tax

In the discussion of economic questions, even in the nonspecialist press, many terms are used which until quite recently were employed only by economists or others professionally concerned. This series of articles is designed to explain the economists' shorthand.

Bjorn Matthiasson

NUMBER OF countries have in recent years A adopted a new tax called the value-added tax. Its spread has been very rapid; only ten years ago there Timetable of Value-Added fax Adoption and Baste Rate (Per Cent) was but one country, France, that used it. Then, with the inception of the Common Market, it was decided to France 1955 23 2 align some of the taxes levied in the member countries. Denmark 1967 12.50 This decision involved the initiation of value-added Germany, Federal Republic of 1968 11 taxes in the member countries, which in turn has in- Sweden 1969 11.11 spired a number of other European countries to fol- Netherlands 1969 12 low suit in their efforts to associate themselves later on Belgium 1971 20 with the European Economic Community. At present Luxembourg 1970 8 there are nine countries in Europe (see timetable) that Italy 1972 3 have either put the value-added tax into operation or Norway 1970* 20 passed legislation for its introduction in the near fu- ture.1 A number of other European countries, includ- 1 Based on price excluding tax. 2 As of January 1,1970. 1 Three other European countries—Finland, Greece, and 4* Tentative date of adoption. Turkey—have a form of value-added tax that extends over Legislative adoption in process. only some of the stages of the production-distribution process. The production taxes in many French-speaking countries are similar.

©International Monetary Fund. Not for Redistribution ing the United Kingdom, have also given the value- From this oversimplified description we see that added tax serious consideration, and it may be expected each link in the production-distribution process acts as that in a decade it will be a predominant instrument of a tax collector for the Treasury and the tax paid at taxation in Europe. each juncture is passed on next time the product changes hands, until the final product lands in the Structure and Coverage hands of the consumer who in the end bears the whole The value-added tax is a sales tax levied in the value tax. It is thus conceived not as a tax on the producer, added to a product or service each time it changes but rather as a tax on the product, borne by the con- hands. To illustrate this, the chart shows how a sumer. We can also see that the proceeds collected by value-added tax is imposed on a steel product as it pro- the Treasury come to exactly $50, or 10 per cent of gresses from iron ore in the mine to the final transaction the final net price. when an article incorporating it is handed to the con- This illustration presents a simple hypothetical out- sumer over the counter. The tax rate is in this instance line of the tax. In practice the matter is of course more 10 per cent of the price as it was before the tax is complicated. In our illustration the mining company levied. got its ore for nothing and hence its sales price for the The mining company brings the iron ore out of the ore was all value added. In reality we would have to ground and sells it to the steel mill for $50. For sim- drop this assumption. The company's value-added tax plicity's sake we shall assume that the mine got the liability is in fact the difference between the value-added iron ore for nothing and paid nothing for its capital tax collected and the value-added tax paid out to equipment and intermediate goods. The "value added" others by the company. Thus, if it collected $100,000 of the ore at the time of sale to the steel mill would in value-added tax on its sales in one tax period and thus be all of the $50 and the steel mill would pay $5 paid $40,000 in tax on its mining equipment and min- to the mining company in value-added tax, which the ing rights to others, its tax liability for that period mining company would in turn remit to the Treasury. would be $60,000. The steel mill then processes the ore in its blast fur- The value-added tax is levied on almost all goods naces and rolls it into sheets, selling it for $150 to a and services in domestic trade. Exemptions from the manufacturer. The manufacturer pays the steel mill tax are usually few, but vary between countries. Bank- $15 in value-added tax. But the mill passes on only ing and insurance, postal services, medical services, $10 to the Treasury. The other $5 received from the newspapers, and services and goods used exclusively by manufacturer compensates the steel mill for the tax the government are most frequently exempted. Some- that it paid on the iron ore. The manufacturer shapes times a good or service is subjected to a special excise the steel into an appliance and sells it for $300 to the tax and at the same time exempted from the value- retailer, collecting $30 in value-added tax. Of this added tax. In France, for instance, entertainment in amount $15 goes to the Treasury, the other $15 is a theaters, cinemas, etc., is subject to an entertainment compensation for the tax paid by the manufacturer to tax, but is exempted from the value-added tax. the steel mill. The retailer sells the appliance to the Exports are always exempted from the value-added consumer for $500 and the consumer pays the retailer tax. In theory the export firm pays the value-added tax $50 in value-added tax, $20 of which the retailer re- on its taxable intermediate goods and services, but gets mits to the Treasury, the other $30 being a compensa- a refund from the tax authorities. France, the country tion for the tax he paid to the manufacturer. with the longest experience in value-added taxation,

©International Monetary Fund. Not for Redistribution Mining Company Steel Mill Manufacturer Retaller Consumer

Price

Tax

Tax Payments

Tax Payments Collected by the Treasury

©International Monetary Fund. Not for Redistribution has eliminated this procedure for the most part and al- correct its uneven impact on the final consumer. Such lows exporters in practice to accept goods and services a turnover tax (at one time levied in Germany and for export production or delivery tax free, with the sup- still levied in Austria) is levied at a low rate and its plier in turn not remitting value-added tax on such de- impact on the final product price is often not even livery to the Treasury. This avoids the system of known. collection of value-added tax on supplies to export The value-added tax gets away from these problems. producers with a later refund of the same tax proceeds It simply allows the value-added tax paid on all capital to the exporter. and intermediate products and services bought by the firm to be credited against the value-added tax collected Some Merits of the Tax on its sales. For example, if a company collected a value-added tax of $50,000 on its sales in a tax period, All countries that have so far adopted the value-added but bought at the same time equipment on which it tax have done so in place of a sales tax of some paid a value-added tax of $10,000 in addition to its other kind. These have either been a multiple stage tax on normal inputs of $25,000, the company's tax gross turnover tax (as in the Federal Republic of Ger- liability would be $15,000. Thus, double taxation is many) or single stage sales taxes at the manufacturer eliminated. and/or wholesale level (Denmark) or at the retail level The second advantage of the value-added tax is its (Sweden). neutrality toward transactions in goods and services The advantages of the value-added tax lie primarily and allocation of resources. Under the gross turnover in the fact that it eliminates some of the knotty prob- tax system, as it existed in Germany before the value- lems of misallocation, double taxation, and unfair tax added tax, there was a strong tendency to minimize the exemption that have undermined the success of other tax by integrating firms vertically—for example, a steel sales taxes. There are many sources of such troubles. mill might amalgamate with a steel-using manufacturer. A manufacturer who buys machinery subject to sales This reduced the number of times the product changed tax and in turn has to pay for the machinery out of hands and thereby the number of opportunities the au- taxable sales revenue can do one of two things. If he thorities had to levy the turnover tax. In Germany, one has any measure of control over his own sales price study estimated that for steel bars the cumulative tax (i.e., if he is not unduly restricted by competition from burden in the nonintegrated production-distribution increasing his prices), he can shift a part of or the full process was about twice as high as in a highly integrated price of the machinery, including the sales tax, onto his system. To counteract these integrative tendencies, sales. The sales price of the final product thus has Germany resorted to devices creating an artificial more than the share of sales tax included in its price transaction within a firm for tax purposes (to cancel than the tax percentage by itself would indicate. If he the integration advantage) and it also let some transac- has no control over the final sales price the manufac- tions between affiliated companies forming a "com- turer must bear the sales tax, in addition to any in- munity of interest" to go tax free so as not to give come tax, out of his profits. He is thus placed in an them incentive to merge. inequitable position vis-a-vis any other manufacturer The single-stage sales taxes have somewhat fewer who can at least partly control his sales price. The drawbacks in this respect, but are nevertheless not neu- same is true if a raw material or semifinished product tral either. With a manufacturer/wholesale tax, as in the is made subject to sales tax. United Kingdom, difficulties arise in determining what Most systems of single-stage sales taxation have the actual price to the retailer is, should the transaction sought to eliminate this double taxation effect by ex- between manufacturer or wholesaler on the one hand empting capital goods and goods going into production. and retailer on the other be eliminated. Then a notional The difficulty in doing so is twofold: first, it is difficult wholesale price has to be arbitrarily determined, a to eliminate all taxation of capital and intermediate matter of great complexity. The United Kingdom has goods, especially for small manufacturers and crafts- had its sales tax system (called the Purchase Tax) un- men who may need such goods only in small quanti- der continuous review over the years for this and other ties. Secondly, the broader the exempted range of capi- reasons, but the difficulties and inequities of the tax tal and producer goods, the easier it is to have such have not by any means disappeared. The tax has not, goods bypass the production process altogether and let however, been so disadvantageous that the authorities them land tax free directly in the hands of the final would have wished to replace it with a retail sales tax. consumer. Many such goods can alternatively be used as production inputs or as final consumer goods. Fewer Complications For multi-stage gross turnover taxes this problem of cumulation (often referred to as the cascade effect) The value-added tax gets away from most of these simply has to be tolerated and few amends are made to complications. As was seen in the example above of

©International Monetary Fund. Not for Redistribution the travel of a product from the mine to the final con- Some Disadvantages sumer, the value-added tax stays always in proportion to the final sales price. The tax would not be any less While these advantages are appealing and persua- if the number of stages that the product went through sive, the value-added tax is not without disadvantages. had been any fewer, unless such integration had led to For the individual firm, particularly for small firms greater efficiency, the benefits of which had been with limited bookkeeping, it is often complex. In a passed to the consumer in the form of lower prices. country that switches from a single-stage sales tax to Nor do valuation problems for tax base purposes arise, the value-added tax, the number of taxpayers prolifer- as with a tax at the wholesale/manufacture level. The ates, often tripling or quadrupling. This makes the ad- tax base of each company becomes simply the value ministration of the tax both expensive and cumber- added of that company in the tax period. The defini- some. In fact, the British Government commission tion problems of value added are, of course, also investigating the value-added tax cited administrative somewhat complex when one gets right down to detail, expense as one of the main reasons why it thought it but they are not nearly as vexing as definition prob- inadvisable to adopt a value-added tax in place of the lems with other sales taxes. purchase tax at the wholesale or manufacturing level.3 The third main advantage has to do with tax en- German and French concern over administrative ex- forcement. For single-stage sales taxation the incentive pense was less, since both countries already had an ex- to evade taxes is considerable, particularly if the rate is tensive tax administration machinery in existence at the high. This is especially true of a high retail sales tax. time of the adoption of the value-added tax. Denmark There the problem of tax administration is compounded and Sweden, however, had both only single-stage sales by the number of taxpayers being much larger than taxes prior to the value-added tax and neither viewed if the tax had been levied at the wholesale level or the increase in administrative expense as a particular manufacturing level and by the fact that retail book- problem. keeping is often poor. The value-added tax has a Another special characteristic of the value-added tax built-in advantage in this respect. It automatically pro- is that it does not lend itself easily to exemptions of in- vides opportunities for cross-checking because each dividual products or services. It functions best when all taxpayer is legally liable for the full amount of the tax goods and services in domestic trade are subject to it. and can reduce that tax liability only by proving that Under the single-stage sales tax, the division of a taxa- tax has been paid on his purchases. The burden of ble firm's sales into tax-free and taxable sales was sim- proof is here placed on the taxpayer, which automati- plified because it could be done at one stage in the cally makes it his interest to maintain records of his production-distribution process. Under the value-added purchases and thereby of someone else's sales. It is system it would have to be done in perhaps twice as thus much harder for the seller to let some sales go many places. Also, since the calculation of the value- unreported, knowing that some purchaser will as a added tax involves the deduction of previously paid tax matter of course submit records of these to the tax au- against total tax liability the calculation of the tax is thorities. Only at the retail stage does some danger of further complicated by the necessity of disallowing evasion exist. It is in any event less than with single- some of the previously paid tax as a counterpart of the stage retail taxation (given equal tax rates) since only tax-free sale. Therefore, the value-added tax is generally a fraction of the total tax proceeds on a product pass broader and has fewer exemptions than previous sales through the hands of a retailer under the value-added or turnover taxes. tax, whereas in the case of a retail sales tax he handles While this inflexibility of the value-added tax is all of the tax proceeds alone and none is levied at other viewed as a drawback, it should not be forgotten that stages. It is also viewed as an advantage against it is a blessing (perhaps in disguise) for lawmakers. It evasion that the tax is collected in fractions at the dif- gives them a convenient excuse to resist pressure from ferent stages of production and distribution (often re- special interest groups seeking exemptions of particular ferred to as the fractional payments system) and thus products and services for reasons that are less than there is less of a temptation to evade it. French busi- sound. On the other hand, the impact of the value-added ness reported to the British Richardson Committee that tax on such things as previously exempt food prod- somehow the value-added tax seemed less onerous than ucts (e.g., in Denmark) has led to a sharp price in- a one-stage tax. "A tax of 10 units on one's product is crease in basic necessities that cut into the living felt to be less burdensome, if one pays 8 units with standard of lower income groups. This cut has in some one's left hand to one's supplier as an addition to his cases been compensated for by increasing social security price, leaving only 2 units of tax to be paid with one's allowances and similar benefits. Finally, the value- right hand to the government." 2 added tax, like other sales taxes, is regressive but has 2 Chancellor of the Exchequer, Report of the Committee on Turnover Taxation (London, March 1964), p. 37. 'Ibid., p. 8.

©International Monetary Fund. Not for Redistribution at least the advantage over other sales taxes that its investments.5 The profoundness of this change rests burden is proportional to taxable consumption. therefore to a considerable degree upon the way in which investments were handled under sales taxes prior Other Issues to the imposition of the value-added tax. But the structural investment problem is not the There are a number of important side effects stem- only one. A substantial transitional problem can also ming from the imposition of the value-added tax that arise as a country goes over to a value-added tax, be- also carry both advantages and disadvantages. The is- cause investors are apt to postpone their investments if sue that gets mentioned most in the newspapers nowa- they anticipate that under the value-added tax they will days is the so-called border tax controversy between escape the sales taxes previously levied on their invest- countries in the European Economic Community al- ments. Germany, Belgium, the Netherlands, and Swe- ready levying a value-added tax and countries outside, den all made arrangements to ease the transitional principally the United States. This issue arises because effects. Germany levied a special nonrefundable tax on the United States has a relatively low load of indirect investments that decreases gradually from 8 per cent in taxes and uses direct taxes as the main source of gov- 1968 to 2 per cent in 1972, disappearing altogether at ernment revenue. Indirect taxes are generally refunded the end of that year. This tax is separate from the value- on exports in all countries,4 but direct taxes are not. added tax under which the tax on investments is The relief from indirect taxes in the United States on immediately creditable toward tax received on sales. In exports is therefore a relatively smaller proportion of Belgium and the Netherlands, the credit of value-added total taxes than in Europe with its heavy indirect taxes. tax paid on investments is limited to a certain percent- Before the value-added tax, e.g., in Germany, the re- age of actual tax paid, the percentage increasing as fund of indirect taxes was complicated by the fact that time goes on. the actual tax load on the final export product was difficult to calculate due to the complexity of the gross turnover tax system. The refund was therefore proba- Does It Help Growth and the External bly lower than the actual tax load. This changed when the value-added tax came along. Balance? With it the tax burden on an export product became In the last analysis it is of profound importance quite explicit at the stage before the export was re- what effect the value-added tax has on economic funded in full. The amount of total export refunds rose growth. It is a far-reaching tax and is meant to be one thereby and the countries with no value-added tax of the mainstays of government revenue in all the claimed that this was a devaluation in disguise. For ex- countries that have adopted it. Thus, it is.important ample, at the time that Germany imposed a value-added that it should not hamper economic growth in any way tax it was estimated that the devaluation implicit for through its effects on the price mechanism and the al- merchandise trade was between 1 per cent and 3 per location of real resources. The simplicity of the tax cent. may lead superficial observers to the conclusion that it A second major impact of the value-added tax is as- must be conducive to growth and that there are no ad- sociated with investment. As was said above, the payer verse economic effects to be feared from it. In the lit- of the value-added tax figures his tax liability by calcu- erature on value-added taxation this is quite widely lating the gross tax on his sales and subtracting the tax disputed and arguments pro and con are presented in already paid on his intermediate products and capital complex detail. goods. The significance of this method of taxation is The argument that the substitution of a value-added that the value-added tax is primarily a tax on consumer tax for a general sales tax of the types discussed above purchases including housing, but production capital will stimulate growth are centered upon two main is in effect exempted from the tax through the right to points: (1) that the exemption of exports, while im- deduct the value-added tax paid on it. ports are taxed, will benefit the balance of payments; The consequences of changing to a value-added tax (2) that the tax will stimulate growth through its ex- will largely depend on what tax the value-added tax is emption of productive investment and taxation of con- replacing. If it is replacing a retail sales tax with iden- sumption. tical coverage and full exemption of production capital The skeptics have raised a number of points about and intermediate goods, then theoretically there will be the value-added tax in criticism of these simple prem- no change. In practice, however, this is not so. In all ises. An adverse impact of the value-added tax, they instances, so far, the value-added tax has replaced tax claim, can result from its effect on the price level. If its systems that in one measure or another taxed 5 The only country that came close to exempting its pro- 4 Their imposition on exports is even prohibited in the United ductive investment under the system prevailing prior to the States by its Constitution. value-added tax was Denmark.

©International Monetary Fund. Not for Redistribution \j imposition raises prices by a substantial amount,6 then the economy in an overinvestment-underconsumption it can unleash a wage/price spiral, particularly in coun- situation. tries with a weak income policy. The beneficial effect It seems from the foregoing that the benefit for from the tax exemption on exports can thus quickly be growth and the external balance derived from adopting canceled through higher wage costs placing export in- the value-added tax is subject to certain conditions fall- dustries in a more difficult position than they were in ing in two broad categories: (1) that adoption of a before. Higher money incomes could at the same time value-added tax will not set off a wage/price spiral accelerate the pace of imports, further weakening the leading to adverse effects on the balance of payments, balance of payments. The weakened balance of pay- and (2) that a likely increase in investment at the ments would thus necessitate a restriction in domestic expense of consumption will find outlet for its produc- demand for goods and services, thus dampening the tive capacity. growth rate. In evaluating the second point, skeptics have tended Conclusion to question whether investment is dependent on the The value-added tax is a unique taxation instrument level of taxation to such an extent that an exemption in the sense that it leads to fewer misallocations of re- of productive investment from the value-added tax will sources than most other taxes. Therefore, it deserves materially stimulate it. Empirical studies have long wide consideration among countries that are dependent found that investment was notoriously fickle in reacting on an efficient economic mechanism to achieve a satis- to a change in interest rates and similar variables. factory rate of growth. It has not been shown to be Thus, it is by no means certain that investment would without qualifications or disadvantages, so that its ben- rise under the value-added tax, but if it should rise efit is subject to conditions, as shown above. In the (and this is at least likely), one great limitation placed opinion of this writer the adoption of the tax could on the expansion of investment stems from the possible materially benefit the tax structure in most industrial- curtailment of consumption which can also be expected ized countries. The administrative complexity of the to result from the value-added tax. Such a curtailment tax may make it less wise to apply it in less developed could limit the need for new investment and thus place countries where long experience in tax administration is not available. "A value-added tax with an identical rate to a previous re- Finally, it is to be hoped that the value-added tax tail sales tax should not raise prices for goods previously could lead to further restructuring of taxes in a direc- covered, but the value-added tax is in effect always broader than prior sales taxes, especially in respect of services, and tion more conducive to growth, equity, and the alloca- hence has tended to accentuate price increases. tion of resources.

Bjorn Matthiasson returned to Iceland last year to join the staff of the Central Bank. He was previously an economist in the European Department of the Fund. He is a graduate of the University of Iceland, and of Swarthmore College and Yale Uni- versity in the United States.