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Would European Value Added Tax Work For The United States?

By Richard Cornelisse, Big4.com Guest Blogger


Methods of governments to balance their budgets are a shift from direct to indirect taxation, increase of VAT rates and tax authority scrutiny.

“The global spread of Value Added Taxes (sometimes referred to as Goods and Services Taxes) has been the most remarkable development in taxation over the last 50 years. Operated in less than 10 countries in the late 1960s, VAT now raises one fifth of the world’s tax revenue and still more countries are adopting it. The increasing importance of VAT as a source of government revenue is likely to continue as countries deal with fiscal consolidation pressures in the wake of the economic crisis while seeking to restore growth.”  Jeffrey Owens Director, Centre for Tax Policy and Administration at the Organisation for Economic Co-operation and Development

From an economic point of view the question is what the impact will be on the economy in the downturn. Increase of prices and often the same or even lower available consumer’s budgets will result in less spending.

Levy of VAT and Impact on shareholder value:

“(UK) Budget 2012: Greggs shares fall on VAT blow. More than £20m was wiped off the value of bakery company Greggs on Thursday, following the Government’s announcement that all hot takeaway food would be subject to VAT.” The Telegraph

US Value Added Tax is considered

The effectiveness of indirect tax revenue is – based on considerable amount of tax literature and Reuters‘ article of March 14, 2012 (by Stella Dawson and its quotes are used) – also seen in the United States. Several prominent commentators, politicians past and present have suggested that the introduction of a VAT or GST may be the “least worst” option open to the US government to raising revenue and to combat the deficit.

“Very large changes are necessary. They need to be structural, they need debating, and this is the year to start the process,” Paul Volcker, former head of the Federal Reserve

” About tax reform: the one thing that unites people right now. It is not only central to reducing the budget deficit and increasing growth, but also vital to economic fairness and social cohesion in a society that has largely lost faith in the political system. The richest 1 percent cannot expect a tax cut, and the U.S. budget deficit cannot be reduced by cutting spending alone. A creative approach to taxes must be part of the solution. We should be open to every possibility”  Larry Summers, former U.S. Treasury Secretary and Democrat.

“a value added tax should be on the table. We need a combination of tax increases and spending cuts. But we need quality rather than quantity,” Larry Lindsey, a Republican and former Fed governor

“Growth-oriented tax reforms would generally involve shifting revenue from corporate and personal income taxation or social security contributions onto consumption and property taxes, including housing taxation.” Recent OECD analysis of growth- oriented tax reforms concluded that “A revenue-neutral tax reform that shifts the balance of taxation more toward consumption and recurrent residential property taxes could […] strengthen the growth of output over the medium term.” as “… corporate taxes are the most harmful type of tax for economic growth, followed by personal income taxes and then consumption taxes, with recurrent taxes on immovable residential property being the least harmful.” (OECD (2010), Tax Policy Reform and Economic Growth, OECD Publishing).

Some highlights of European Union Value Added Tax system

What does it actually mean: an ‘European’ Value Added System?

In its most elementary form a business will charge VAT (‘output tax’) on its sales (‘supplies’), but will be entitled to deduct the VAT (‘input tax’) that it has paid on its costs and purchases (a multi-stage tax). We note that VAT can only be deducted if the invoice meets the invoice requirements (the conditions for this are summarized in national VAT Act) and is reclaimed in the right country (e.g. Italian VAT must be reclaimed in Italy) in the correct period. If these requirements are not met there is a substantial risk of additional VAT assessments increased with penalties and/or interest as a result of e.g. a VAT audit.

In the European VAT system one of the basic principles is that input VAT (VAT paid) can be off sett against output VAT (VAT charged). In case of a surplus of input VAT a refund of tax is claimed and often paid by the authorities.

Neutrality can only be achieved – better is the word earned – if certain formal and material requirements are met.

That means in practice that input VAT deduction and output VAT has to be managed separately to avoid substantial VAT assessments, penalties and interest payments. It is risky business to monitor only the balance between output VAT and input VAT.

Allowing businesses the opportunity to collect and retain large amounts of tax can leave the system open to fraud and manipulation by dishonest taxable persons.  VAT fraud is for a while a key issue for all European Member States.

“11 percent of VAT revenue is lost annually through fraud – principally ‘missing trader’ or ‘carousel fraud’ – which equates to in the region of €100 billion” PwC report

Macroeconomic effects – National Retail Organization reports

The National Retail Organization published their report about introduction of a VAT system and the macroeconomic effects.  It was on their request written by Ernst & Young LPP, Tax Policy Advisers LLC and Baker Institute for Public Policy and Economic Department, Rice University.

The executive summary:

    • “As a consumption-based tax, an add-on VAT would be shifted forward to consumers through higher consumer prices. As a result, private consumption would fall. By increasing consumer prices, the VAT also reduces real or inflation-adjusted wages, which would cause labor supply to fall as well.
    • An add-on VAT would have particularly adverse effects on the retail industry. There would be an especially pronounced reduction in retail spending because nearly all retail goods would be subject to double-digit VAT rates, while many other consumer purchases would be exempt under a narrow-based VAT. In addition, some consumers would evade the tax – experience in other countries suggests 12 percent non-compliance with the VAT – driving up the VAT rate.
    • Moreover, an add-on VAT leaves the economy considerably worse off than a similarly-sized reduction in government spending on income transfers. With an add-on VAT, GDP would initially be lower and the economy would lose jobs; by comparison, GDP and employment would increase with a reduction in spending. Although lower deficits and debt would have positive long-run economic effects for the economy, most middle income Americans who are working age or older at the time of enactment of the VAT would be worse off.
    • Perhaps the most troubling aspect of a deficit-reducing VAT is that, if enacted in the near future, its negative effects on GDP, consumer spending, and employment would occur in the face of the current economic climate of weak economic growth, high unemployment, and low consumer confidence. The near-term drop in output, loss of jobs, and sharp decline in consumer spending described by this report would raise additional economic worries, rather than shoring up the weak economy. With the CBO projecting unemployment to not fall below 7 percent until 2013, the initial reduction in employment from a VAT, estimated to be roughly equivalent to 850,000 jobs, would make full economic recovery much more difficult.” – National Retail Organization –

      The NRO complete report

Timing

Is the time right?

Some quotes from Reuters article:

“While tax reform as part of a budget overhaul is unlikely immediately after the November elections, progress needs to be made in crafting solutions” Larry Summers, former U.S. Treasury Secretary and Democrat.

“There is a realistic chance that Republicans and Democrats after the election would be ready to strike a bipartisan accord on the budget deficit and taxes” Robert Rubin  former U.S. Treasury Secretary and Democrat”

  • Based on the macroeconomic data is it smart to introduce a VAT system in the downturn?
  • Is the first priority not to realize economic growth, establish trust in the market and therefore should the focus not be on findings ways to increase consumer spending?
  • Is the introduction of a VAT system not counterproductive?

“Raising the standard VAT rate has often been considered as the easiest way to increase revenues from the tax, particularly at a time when many governments are seeking ways to address large fiscal deficits. Some countries have even explicitly linked rate increases to the objective of fiscal consolidation. For instance the Slovak Republic has temporarily increased its VAT rate until the deficit will be reduced to below 3% and in Poland the VAT rates will automatically increase if the public debt to GDP ratio increases above a certain level.” Jeffrey Owens Director, Centre for Tax Policy and Administration at the Organisation for Economic Co-operation and Development

How do you see this?

Lobby groups

When somebody wins, somebody else must lose. Without any doubt indirect tax is the right and maybe only way to combat the deficit, unless of course the US government is going to cut their spending substantially. I don’t consider that likely.  Do you?

Who might feel a loss and what do politicians need to manage to make it happen?

Besides the end consumer, companies might consider it a loss. The implementation and compliance costs (e.g. managing ongoing the VAT numbers) and associated tax risks are bottom line costs of companies and a decrease of corporate income tax is above the line.  The question is whether the shift from direct (e.g. lowering corporate income tax) to indirect tax introduction is seen still as a positive.

The retail industry in general will face substantial costs and it is not a real surprise that the negatives are highlighted in the executive summary of the report of National Retail Organization. It seems that the lobby against has already started. The drop of Greggs share value is a good war story to use in that quest.

Public support for a VAT introduction – assuming it exists – will likely be lost when anti-fraud/tax evasion legislation causes disruption to daily business and is the cause effect of substantial implementation costs.

How do you see this?

Richard’s other Big4 publications

Richard Cornelisse is CEO of the KEY Group and worked previously as Big4 Partner in the Tax Performance Advisory and Indirect Tax Practice and blogs on Tax Function Effectiveness and Tax Control Framework developments.

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