Q & A : Value-Added Tax--What It Is and How It Works
The crushing cost of health care has prompted the Clinton Administration to revive consideration of a controversial tax plan to finance a sweeping program of reform.
Alice Rivlin, deputy director of the Office of Management and Budget, this week called the value-added tax--better known as VAT--”a possible candidate” for financing health care reform, even though President Clinton earlier had denied that a VAT was in the offing.
Value-added taxes are a political hot potato, because they tax consumption. And consumption taxes generally hit poor people hardest, because they spend a greater portion of their income on essential goods and services.
Administration officials refused to discuss the VAT question on Thursday, noting that the health care task force headed by First Lady Hillary Rodham Clinton has not yet presented its recommendations to the President.
However, others note that VAT has a simple, compelling appeal for policy-makers: It raises vast amounts of money in a way that isn’t directly apparent to consumers. And vast amounts of money will be needed to pay for the universal health coverage President Clinton wants to offer.
How does the VAT affect consumers, workers and shareholders? Here’s a question-and-answer look.
Q. What is a value-added tax?
A. It’s a tax on the value that humans add to goods by processing them. For instance, unrefined rubber may be worth $100 a ton. But when processed, that ton of rubber may make 1,000 tires worth $100 each. A value-added tax would be levied on the difference between the $100,000 refined price of the tires and the cost of the goods, plus labor and other expenses required to make the final product.
Assume it cost $80,000 to make the tires. Add that to the $100 cost of the raw rubber. Subtract the sum, $80,100 from the $100,000 refined value. The VAT would be levied on the difference--$19,900, which represents the “added value.”
Q. How is the tax levied?
A. At each stage of the production process, a tax is imposed. For example, a tax is levied when a rubber farmer sells his plants to a refiner; again when the refiner sells his goods to a tire producer, and again when the tire manufacturer sells his tires to an auto maker. Businesses would add the tax to the invoiced price of goods they sell, then send the tax on to the federal government.
Q. Does that mean that heavily processed goods are taxed more than unprocessed items? In other words, does VAT tax cars more heavily than lettuce?
A. Instinctively, you’d think so, but it doesn’t work that way in practice in the 14 industrial nations that have VATs. That’s because producers get to deduct their costs from the taxable amount--and built into their costs are the taxes paid by earlier refiners of the raw materials. Theoretically, if the VAT was 3%, the final cost of any product would be increased simply by 3%, no matter how many times it was handled.
Q. Why do you say “theoretically?” Does a VAT increase the cost of consumer goods or not?
A. There is a cost, and somebody has to pay it. But it’s not always shouldered by the consumer. That’s because consumers simply refuse to pay higher prices on certain nonessential items. When the VAT is levied on essential goods, such as food and electricity, it usually gets passed on to consumers in the form of higher prices. But when it’s levied on luxury items, such as fur coats or cars, manufacturers may not be able to sell the goods if they attempt to pass on the higher cost.
Q. So who pays the VAT, if not the consumer?
A. Workers or company shareholders. If a company has higher costs and can’t charge more for its products, managers have two choices. They either can make shareholders pay the price in lower dividends and lower investment returns, or they can try to cut costs elsewhere. That often means layoffs or wage cuts. In the end, someone--workers, shareholders, consumers, or all of them--have less purchasing power.
Q. Why would government consider a value-added tax?
A. Some economists say that it is one of the least destructive ways to raise revenue, since a VAT penalizes neither working or saving, as income taxes do. At some point, income taxes discourage productive activity by taking away such a large portion of the reward for that activity, says Margo Thorning, chief economist at the American Council for Capital Formation in Washington. If anything, value-added taxes discourage spending.
Q. Is a VAT likely to hurt the poor?
A. That would depend on how it was implemented. Many countries that have VATs exempt certain items, such as food and housing, from the tax. That reduces the burden on low-income families that spend the bulk of their income on essentials.
Q. Is that what the U.S. would do if it implemented a VAT?
A. Possibly. But another idea has surfaced that may be more attractive: imposing the VAT on everything, and then giving a tax credit to poor families.
This would work something like the earned income tax credit, which essentially refunds Social Security taxes to families earning less than $22,000.
The reason some policy-makers like this idea is that it doesn’t subsidize wealthier families’ purchases of food and housing--so it would raise more revenue.
Q. How much would a VAT raise?
A. Estimates differ, especially since some policy analysts expect that certain items would be exempted. But a rule of thumb is that every 1% in VAT could raise about $30 billion in revenue annually.
Q. Would a VAT be imposed on imports? If so, how? If not, does that put American products at a competitive disadvantage?
A. Value-added taxes would be put on imported goods. But in those instances, it would work more like a conventional sales tax, because the VAT would be imposed on the final purchase price, according to Lawrence M. Stone, chairman of the tax department at Irell & Manella in Los Angeles.
On the other hand, when U.S. companies shipped their products overseas, the government would refund the VAT taxes they had already paid. The end result, says Stone, is that a VAT could make U.S. goods more competitive, not less.
VAT Rates in Europe
Standard rates of value-added taxes in Europe as of Feb. 1, 1993. Belgium: 19.5% Britain: 17.5% Denmark: 25% France: 18.6% Germany: 15% Greece: 18% Ireland: 21% Italy: 19% Luxembourg: 12% Netherlands: 17.5% Portugal: 16% Spain: 15%
Source: British Treasury, Associated Press
