How Does a 'Value Added Tax' Work, Anyway?

I think a VAT would be a perfectly wonderful idea. I just have one question. How the heck would it work?

One of the most important pieces in the federal revenue picture is a consumption tax, William Gale told me today. That's makes him between the thousandth and ten-thousandth tax expert I know who says we need to join the rest of the industrialized world in the category 'Rich Countries With a Value Added Tax.' But what is a VAT, exactly, and how does it actually work?

In Part One of our interview, Gale explained to me why we should learn to love the IRS. In Part Two, he explained why good tax policy today and good tax policy tomorrow are completely different things. Now in the final installment of our Tax Transformation Trilogy -- AKA "this morning's chat" -- we discussed the VAT over the phone, with follow-ups via email.

We need a tax that is broad-based and low rate to raise revenue for the government. One obvious candidate is a value added tax (VAT). So what's the rationale behind backing a VAT, which is somewhat like a sales tax?

The VAT is like a retail sales tax, but it's collected in pieces along the production chain. The reason we need to do it is we need to raise several percentage points in GDP in revenue in the next 10 years. There are not a lot of ways to do that without a new tax. It's hard to do with an income tax because you can't raise that much from closing loopholes and deductions, politically.

Quick diversion: former CBO Director Rudy Penner suggested that dramatically reforming tax expenditures could go even further than a VAT in terms of closing our deficits. What do you think?

That's very difficult, politically. You technically can close all the loopholes and jack up rates. But no country has ever done that. Every country has subsidies in its tax system. But most industrialized countries also have an income, payroll, and consumption tax. I know we like to think we're special and different in the US, but it's not like like our tax and fiscal policy has been so darn good that we have nothing to learn from these other policies.

I'm only slightly embarrassed to admit I don't understand exactly how a VAT works at each stage "along the production chain"? Can you give me an example?

Sure. The example I always use is a loaf of bread you buy in a store for a buck -- so you have a farmer, a baker, and a supermarket along the production chain. Let's put the VAT at 10 percent.

1) The farmer grows the wheat and sells it to the baker for 20 cents. The VAT is 2 cents. The baker pays the farmer 22 cents, and the farmer sends 2 cents in VAT to the government.

2) The baker makes a loaf and sells it to the supermarket for 60 cents. The VAT is 6 cents. Now the supermarket pays the baker 66 cents, of which 6 is VAT. The baker sends the government 4 cents -- he pays 6 cents in VAT but receives a two cent credit from the government.

3) The store sells the loaf to me for a dollar. I pay $1.10. The store sends the government 4 cents total - the 10 cents it collected in VAT on its sales, minus the 6 cents it paid to the baker in VAT, which it gets back in a credit. In total, the government gets 2 cents from the farmer, 4 cents from baker, 4 cents from the store. That's 10 cents on a final sale of a dollar -- for a 10 percent VAT.

{Editors' note: If you prefer to think in terms of equations:

Net VAT payment for each merchant =
[VAT(price you sold product for) - VAT(price you paid for product)].

The VAT sounds complicated, with various tax payments along the production line, and tax credits to offset taxes. Why isn't it easier to just implement a one-time retail sales tax?

It's easier to collect than the retail sales tax because it's got these various stages in it, built in paper work. A retail sales tax would have been very easy to avoid because there's no counterparty to the transaction. Look at the baker in the VAT. The baker wants to avoid paying VAT, but he knows the grocery store will report the purchase. The government can go to the baker and say "you forgot to report your 60 cents of sales." That's the counter-mechanism. There's no counter-mechanism in the retails sales tax. A lot of history suggests that sales taxes are difficult to enforce when you get to rates above 6 to 10 percent because people find ways around them.

So how should a VAT be implemented?

We need to do two things. We need to raise revenues, and we need to stimulate the economy right now. We need Americans to spend more now and less later. We need Americans to save less now and save more later. What we want to do is to announce the future implementation of that VAT that starts relatively low, at 5 percent. But we don't want too low a rate because there are fixed costs at setting it up -- it's going to take a couple years to set up the machinery. So we'll say it's gonna start at 5 and rise to 10 percent in the next five years. It's probably raising 3-4 percent of GDP in revenues, so we put fiscal responsibility in hailing distance for the next 10 years. We're not going to solve our fiscal problem in one fell swoop.

So for example, the supermarket in the scenario above pays 4 cents net because: 0.1($1) - 0.1($.6) = $0.4