Called “Best and Worst of Taxes,” VAT is a Subtler Sales Tax. It Garners Big Revenue for Governments, but Can Dampen Consumption – and Stifle Economic Growth.

Is VAT – the “value-added tax“-- the miracle levy that can solve budget squeezes with minimal political pain?  Many people seem to think so.  It functions like a sales tax, but less obtrusively.  Both are paid by consumers at the cash register, but the VAT operates in a more complex manner that enables governments to manipulate rates more easily in accordance with their political agendas.

In Europe, it has proved to be the best of taxes and the worst of taxes, depending on your viewpoint. But there is no doubt that it is prized by governments. It has spread throughout the European Union, where it generates roughly one-fifth of government revenues in these nations (and more in some). As a national levy, it seems to be more easily accepted by consumers as an unvarying tax built into the system so thoroughly that it does not draw attention to itself on each and every transaction. And it has subtler uses:  for example, Germany, a nation famously committed to budgetary rigor, has on occasion raised its VAT rates to help pay for its social safety net and, at the same time, to use to make German-made goods more competitive. This advantage arises from the fact that imported goods have to pay the VAT without getting the rebates available to domestic manufacturers. It also made German products cheaper to export, especially because the VAT rise was coupled with tax cuts on companies. The French government is currently seeking similar room to maneuver in its own use of this special tax, VAT.

This ingenious (or diabolical) idea of VAT was the brainchild of a French tax official in the 1950s. The then-head of the French tax authority, Maurice Laure, conceived it as an alternative and supplement to income tax (and payroll taxes). Its attractions arise from the way it works.  In a “VAT” system, the amount of tax due on each particular item is calculated at every step of the process of manufacturing a product or providing a service.  Then, at each stage, the partial producers (for example, suppliers of raw materials or subcontractors along the way) pay their “VAT” (calculated on their profit) and pass along that amount in the price they charge their customers. At the same time  they turn around to the tax authorities for reimbursement of the “VAT” they paid on the services or parts they bought to do their work.  Ultimately, the finished product carries the full cumulative VAT, and it is paid by the final customer.  So the consumer pays the whole tax, and each intermediary is only taxed on his individual profit.  The tax involves considerable bureaucracy, because of the multiple collection and refunding, but the tax is hard to evade because it creates a very clear paper trail. 

The crucial feature – which makes VAT different from a sales tax – is that the tax gets levied at each step of the way, reducing the tax bill of each sub-contractor while still putting the final tax bill on the consumer. So, for example, a furniture manufacturer pays the VAT on his raw materials (such as wood he has to buy) and then gets it refunded. In turn, when he bills his client (perhaps a furniture store), his price includes the tax amount for his "added value," which is billed to the customer and then passed onto the government. In this way, each producer and supplier only pays tax on the “added value” (and profit) of his share of the work in producing the object or the service. This is true of each sub-contractor, supplier etc in the chain of manufacturing or providing a service. Ultimately, the whole cumulative tax has to be paid at the moment of sale to the end customer.

It is a Consumption Tax

So, in practice, it is a tax on consumption.  Many critics of VAT (notably Americans on the political right) oppose the system as a brake on consumption and economic growth.  Perhaps, but the VAT has the advantage of making the tax into a level national charge (in contrast to the widely varying sales taxes levied by American states) and also of distributing  the burden in ways intended to reduce the tax burden on the production process of good and services.

The success of this approach is attested by the relatively high rates that governments can apply in charging VAT. In Europe, for example, the basic rates range from 15 percent in Luxembourg to 25 percent in Sweden. Within countries, governments modulate their VAT rates in order to take account of its societal impact, and products deemed to be “basic necessities” (such as food or pharmaceuticals) are taxed at lower VAT rates than luxury goods. For example, the Czech Republic charges 10 percent on food instead of the normal across-the-board 20 percent.  Poland charges as little as three percent on unprocessed foodstuffs and as much as 22 percent on the construction of new residences. (Americans and other foreigners can get a clear idea of VAT’s existence when they collect their partial VAT refunds) at the airport on purchases they are taking with them and “exporting” from the EU.)

From an economist’s standpoint, the VAT system has obvious attractions: It enables the tax authorities to avoid distortions in competition between local sales tax rates and it is not very vulnerable to massive evasion. And it has the added political attraction of being relatively “painless” to the tax-payer – or at least to the taxpayers’ perceptions. In most countries with VAT, consumers see price tags labeled “tax included.” Compared to income tax or payroll taxes (which are listed separately on paychecks), VAT is a sugar-coated pill.

It is a Modular Tax

Another advantage is that a VAT system favors the competitiveness of a country’s manufactured goods, particularly when compared to rival products imported from low-wage countries. In contrast to payroll taxes and other social charges which are simply factored into the sales price of locally-manufactured goods, a VAT tax is levied at the same rate against all goods in the same category, local and imported – with the difference that local employers benefit from the system of refunds that makes them pay only their “added value” share. In contrast, foreign products pay the whole difference between cost and sale price to the importing country’s tax system.  This explains one of the reasons why Germany decided to raise its normal VAT rate by three percent in 2006 while simultaneously lowering the social charges levied on manufacturers and workers. In making this change, Berlin had two goals in mind:

• Increase government revenue to pay for welfare and health care, which are running big deficits in Germany as everywhere else in the EU.
• Improve the competitiveness of German products against similar items imported from countries with lower social charges.
• Increased government revenue to pay for welfare and health care, which are running big deficits in Germany as everywhere else in the EU. It is a precious opening for disguised flexibility in the current situation in Europe where national exchange rates can no longer be changed individually in the eurozone. But governments can resort to a tactic involving VAT: when the VAT rate is raised and at the same time taxes on employers are decreased, a nation’s companies gain lower domestic labor costs and their products become more competitive against the products of foreign competitors. This competitive effect of a higher VAT is reinforced by discouraging competitive imports because the same rate is imposed on all products of the same kind, whether foreign-made or domestic. Germany did exactly that in 2006 when it increased its VAT by three percentage points and lowered its federal unemployment insurance.

Alongside these advantages, VAT has some drawbacks.

It is a regressive tax in the sense that it affects everyone the same, regardless of income levels. In France, for example, where the normal VAT rate is 19 percent, the tax accounts for 10.5 percent of the spending of the poorest 10 percent of households and 11.5 percent of the expenditure of the richest 10 percent of households.  In other words, the less well-off carry an “inequitably” high share of the burden – and would shoulder even more if it were not for the fact that a reduced rate of five percent is applied to “basic necessities”:  water, food, most pharmaceuticals and – recently – hotels and restaurants. In practice, as these figures show, the adjustment of the rate to make exceptions has a limited impact on reducing the overall tax burden on poorer families.

It is a "Regressive" Tax

Put another way, this “regressive” nature of VAT emerges from statistics showing that VAT does not have an effect of “wealth redistribution” like a progressive income tax or even like social charges which are proportional to wages, at least up to a point. So VAT is “regressive” and does not promote egalitarian agendas. It only applies to spending, not to saving. As statistics show, the better off people are, the more of their incomes they tend to save – and in doing so avoid taxes penalizing their accumulation of wealth. (France also has a “wealth tax”, but that is a different story.)  So VAT absorbs more of the income, proportionately, of poorer people than of better-off citizens – and conversely less and less of incomes as you go up the salary scale.

Another disadvantage is that the VAT is not very “elastic” in absorbing the impact of change when a government lowers the rate in order to stimulate consumption in a specific sector. A recent case in point involved the VAT rate in hotels and restaurants in France : a few months ago, the governments slashed the old VAT rate to five percent, but so far only a small part of the savings  were passed on to consumers – an example of what economists call the “ratchet effect.”  In France, when the government recently cut the VAT on restaurant meals from nearly 20 percent to just over 5 percent, only a small portion of this reduction (statistically, only 1.7 percent) was passed on to customers as lower prices. Most of the tax cut was kept by restaurants as profit or as extra revenue to cover wages and other rising labor-related costs.

The reduced VAT tax for the restaurant industry in France, despite showing little to no indications of success, will not be further reduced according to Hervé Novelli, secretary of commerce in France. An estimated 40,000 new jobs were expected to be created as a result of the tax break for the industry, but instead, only 5,700 new jobs were created since its inception in 2009. Backlash from the failure of the reduced task has cost the French government over three million euro since 2009. The VAT tax is under scrutiny after this disappointment that has caused some public outcry.

As a result, the much-ballyhooed VAT rate-cut in 2009 has backfired against the government. Instead of generating 40,000 additional jobs (as the restaurant industry promised in lobbying for the cut), it has only added fewer than 6,000. And French government coffers are poorer by three billion euros a year as a result of the tax cut. It is conceivable that the authorities could restore the old VAT rate on restaurants as part of some future package of austerity measures. The lesson? Manipulations in VAT rates are harder to target than fiscal mandarins sometimes imagine.

A final difficulty with VAT arises in the context of the EU’s single market, where the rates vary widely among member states. The result, naturally, is for consumers – including companies – to try to save money by shopping for goods and services in countries with lower VAT rates.  As a rule, customers pay the tax according to the rate in the country of purchase. So when an Italian wants to buy a camera on the web from a supplier in Germany, the German rate (19 percent) is added into the price and not the Italian rate (20 percent). None of the mechanisms that have been set up so far have succeeded in harmonizing this tax across borders. (And none probably will, short of actually getting the rates to be the same in all EU countries.)

In conclusion, what should people understand about VAT?  As famously said about any radical change, it can be viewed as producing the best of worlds or the worst of worlds.

It Generates Half of France's Tax Revenue

For European governments, it is obviously considered a good approach. It generates very substantial tax revenues: in France, for example, roughly half of total tax revenues. That flow means that it brings in three times as much as the national income tax. (France has a comparatively small number of people who pay any income tax – slightly less than half the country’s households.) Politically, the VAT does not cause a backlash, at least not a big one, in terms of public complaints among tax-payers and voters.

Seen through the eyes of consumers and some economists, VAT is a very crude tool. While it often seems to exist only in the background of people’s minds, it actually adds constantly to people’s cost of living – without making any adjustment for varying income levels. At a macro-economic level, VAT functions as a brake on consumer spending. Governments recognize this fact: Britain, for example, decided to cut its VAT by 2.5 percent in 2009 as an economic stimulus-measure. At roughly the same time, Germany, for example, nudged its VAT rate upward to boost manufacturing against foreign competitors. In other words London wanted to stimulate consumption while Germany wants to raise corporate earnings and avoid any cheaper imports.

These different examples illustrate a rule about the system: in Europe, a country’s handling of VAT choices are a sure guide to the government’s political priorities. Does it favor more consumption and spending? Or does it want to emphasize its international competitiveness?  And how much importance does it attach to wealth redistribution via a progressive tax system?  For all these often-conflicting goals, VAT can be a tool for better or for worse.

Sylvain Gouz is a Paris-based journalist who can be reached at sylvain@mediagouz.fr