re Volume 3 Value-Added Tax Office of- the Secretary Department of the Treasury November '1984 TABLE OF CONTENTS Volume Three Page Chapter 1: INTRODUCTION 1 Chapter 2: THE NATURE OF THE VALUE-ADDED TAX I. Introduction TI. Alternative Forms of Tax A. Gross Product Type B. Income Type C. Consumption Type 111. Alternative Methods of Calculation: Subtraction, Credit, Addition 7 A. Subtraction Method 7 8. Credit Method 8 C. Addition Method 8 D. Analysis and Summary 10 IV. Border Tax Adjustments 11 V. Value-Added Tax versus Retail Sales Tax 13 VI. Summary 16 Chapter -3: EVALUATION OF A VALUE-ADDED TAX 17 I. Introduction 17 11. Economic Effects 17 A. Neutrality 17 B. saving 19 C. Equity 19 D. Prices 20 E. Balance of Trade 21 III. Political Concerns 23 A. Growth of Government 23 B. Impact on Income Tax 26 C. State-Local Tax Base 26 Iv. European Adoption and Experience 27 Chapter 4: ALTERNATIVE TYPES OF SALES TAXATION 29 I. Introduction 29 11. Analytic Framework 29 A. Consumption Neutrality 29 E. Production and Distribution Neutrality 30 111. Value-Added Tax 31 IV. Retail Sales Tax 31 V. Manufacturers and Other Pre-retail Taxes 33 VI. Personal Exemption Value-Added Tax 35 VII. Summary 38 iii Page Chapter 5: MAJOR DESIGN ISSUES 39 I. Introduction 39 11. Zero Rating versus Exemption 39 A. Commodities 39 B. Transactions 40 C. Firms 40 D. Consequences of zero Rating or Exemption 41 E. Tax Credit versus Subtraction Method 42 111. The Issue of Regressivity 43 A. Adjustment of Government Transfer Payments 43 B. Zero Rating of Food and Other Necessities 43 C. Provision of a Refundable Credit 44 D. Personal Exemption Value-Added Tax 44 IV. Single versus Multiple Rates 44 V. Foreign Transactions 45 Chapter -6: IMPLEMENTATING A VALUE-ADDED TAX IN CERTAIN INDUSTRIES AND ACTIVITIES 41 I. Introduction 41 11. Taxation of Services 47 A. Services Clearly Suitable for Taxation 48 B. Financial Services 49 C. Governmental Activities for Which No Charge is Ma.de 53 D. Services that Cannot Effectively Be Taxed for Administrative Reasons 54 E. Problems in the Transportation Field 54 F. Services Involving Significant Social Policy Considerations 56 G. Summary 57 111. Taxation of Small Enterprises and Farmers 51 A. Small Businesses 57 B. Farmers and Value-Added Taxes 61 IV. Governments and Not-for-Profit Institutions 61 A. Governmental Units 61 B. Taxation of Nonprofit Institutions IO V. Housing and Construction 72 A. Housing: Homeowner versus Tenant 73 B. Commercial (Nonhousing) Construction 75 c. European Experience 76 D. Summary 17 VI. Taxation of Used Durable Goods 77 A. Consumption Goods 11 B. Sales of Used Business Assets 80 VII. Tax Treatment of Fringe Benefits 80 A. Forms of Fringe Benefits 81 B. summary 82 iv Page Chapter 7: VALUE-ADDED TAX BASE 85 Chapter 8: DISTRIBUTIONAL EFFECTS OF THE VALUE-ADDED TAX 89 I. Introduction 89 11. Some Underlying Assumptions 89 111. The Alternative Solutions 90 A. Adjustments in Transfer Payments 91 B. Zero Rating of "Necessities" 92 C. Reimbursement for Value-Added Tax 100 D. Personal Exemption Value-Added Tax 109 IV. Summary 109 Chapter 9: ADMINISTRATION OF A VALUE-ADDED TAX 113 I. Introduction 113 11. General Information 113 111. Recordkeeping 114 IV. Filing of Returns and Payment of Taxes 115 V. Imports 116 VI. Enforcement 117 A. Examination 117 B. Collection 121 C. Criminal Investigation 121 D. Appeals Procedures 122 VII. Pub1 i c Education St rategy 122 VIII. Returns Processing 123 IX. Data Processing Activities 123 X. Cost Estimates 124 XI. Summary 124 Appendix 9-A: Form 6400 Federal Value-Added Tax (VAT) Return 125 Appendix 9-B: Estimated Staffing and Annual Cost ,128 V Page TABLES 2-1 Comparison of Three Methods of Calculating Value-Added Tax Liability 9 2-2 Comparison of Value-Added and Retail Sales Tax 15 3-1 Federal, State, and Local Tax Revenue for Selected Countries as Percent of Gross Domestic Product, by Type of Tax, 1982 24 3-2 Taxes on Goods and Services as a Percentage of Total Taxes and Value-Added Taxes as a Percentage of Total Taxes, 1967-1982 25 6-1 Exemptions of Small Firms from Sales Taxes, Based on Sales Volume 59 6-2 Distribution of 1979 Nonfarm Sole Proprietorship Returns, 1980 Partnership Returns, and Amounts of Business Income by Gross Business Receipts Class 60 6-3 Farm Enterprises: Proprietorships, Partnerships, and Corporations. Number and Business Receipts by Size of Receipts 63 6-4 Illustrative Treatment of Farmers Under a 10 percent Value-Added Tax 66 7-1 Estimate of Value-Added Tax Base 86 8-1 Distribution of Value-Added Tax Burden: Broad-Based Tax and the Effect of Indexing Transfer Payments 93 8-2 Distribution of Value-Added Tax Burden: Broad-Based Tax and the Effect of Zero Rating Food and Other Expenditures 96 8-3 Distribution of Value-Added Tax Burden: Broad-Based Tax and the Effect of Income-Based Credits 107 8-4 Distribution of Value-Added Tax Alternatives as a Fraction of Economic Income by Income Class 111 9-1 Taxpayer Compliance Levels: Individual and Corporate Selected Years, 1976-1981 118 9-2 Audit Coverage and Staffing for Value-Added Tax by Categories of Taxpayers 120 Page FIGURES 8-1 Effect of Indexing Transfer Payments on the Distribution of Value-Added Tax Burden 94 8-2 Effect of Zero Rating Food and Other Expenditures on the Distribution of Value-Added Tax Burden 97 8-3 Comparison of Tax Burden Resulting from Broad- and Narrow-Based Value-Added Taxes 101 8-4 Effect of Income Based Credits on the Distribution of Value-Added Tax Burden 108 ix Chapter 1 INTRODUCTION Many observers of the American fiscal scene believe that the Federal government should introduce a national sales tax. At the very least, a national sales tax could be used to take pressure off the income tax; that is, it would allow lower income tax rates and these, in turn, would cause less disincentives to work, save, invest produc- tively, and innovate. In addition, a shift in the mix of taxation toward more reliance on taxes on consumption, rather than income, would reduce further the discrimination against saving found in current law. Some advocates of a national sales tax see it as a means of reducing the Federal deficit and its drain on the supply of national saving. Despite the potential advantages of a national sales tax, the Treasury Department does not recommend that such a tax be adopted at this time. A national sales tax has disadvantages, as well as advan- tages; though these are not previewed here, they are discussed at length in Chapter 3. The most compelling reason for not proposing a national sales tax results from the context in which the Treasury Department conducted its review of the tax system. As noted in Chapter 2 of Volume 1, Overview, the Treasury Department proposals are revenue neutral. This implies that any revenue obtained from a national sales tax would be used solely to reduce the income tax. Thus one must ask whether reducing pressure on the income tax would justify introduction of a whole new source of Federal revenue. The Treasury Department estimates that the process of introducing a Federal value-added tax would take roughly 18 months from the date of enactment. Thus, for example, even if a value-added tax were passed by Congress in mid 1986, it could not have an effec- tive date before January 1, 1988. When fully'in force, a value-added tax would require 20,000 additional personnel and cost about $700 million to enforce. The Treasury Department has concluded that the advantages of a national sales tax are not sufficient to justify this level of expenditure merely to reduce reliance on the income tax. This volume considers in greater detail the issues involved in deciding whether or not the United States should adopt a national sales tax. A value-added tax is the type of sales tax that would be most appropriate for use at the Federal level, if a decision were ever made in favor of a national sales tax. This volume therefore concen- trates on the description and evaluation of a value-added tax from an economic and administrative perspective. But it also discusses briefly other types of sales taxes. Chapter 2 provides a basic description of a value-added tax. Value added can be conveniently thought of as the difference between a firm's sales and its purchases from other firms. A value-added tax is -2- a multistage sales tax levied at each point or stage in the production-distribution process. The retail value or price of a product is equal to the total of the values added at each of these stages. Thus, a value-added tax that includes the retail level would have the same aggregate tax base and raise the same amount of revenue as a retail sales tax, assuming the two taxes apply to the same goods and services and are imposed at the same rate of tax. While there are different forms of value-added tax and alternative methods for calculating tax liability, the only form suitable for the United States would be a consumption-type value-added tax with tax liability determined under the credit method. This means that pur- chases of capital equipment would, in effect, be deductible in full in the year they are made and that a firm would calculate its tax lia- bility by subtracting value-added tax paid on its purchases from other firms from the tax due on its sales.