The Disadvantages of Value Added Tax

More than 150 countries have adopted a value-added tax (VAT) as a way to balance their budget. The value-added tax works like a sales tax, but it's applied at every step of the production chain. If a farmer sells grain to a baker who sells bread to a restaurant who sells the bread to a customer, each transaction involves a small tax.

How VAT Works

The value-added tax works like sales tax except that every person in the chain that leads to the final purchase pays tax. For example, suppose there's a 10% VAT tax in effect.

  • An iron mine sells $200 worth of iron to a foundry. The foundry pays $220 (200*1.10), and the mine sends the $20 to the tax agency.
  • The foundry uses the iron to make $500 worth of wrought-iron ornamental railings. It sells them to a home improvement chain for $500. The chain pays $550 (500*1.10), and the foundry sends in $50.
  • A home improvement store sells the railing to a homeowner for $700, plus $70 in VAT (calculated as 700*.10). The store sends in $70.

This gets more complicated when you factor in that each intermediate player gets to subtract the value-added tax they paid. Rather than send in $70, the store would get a credit for the $50 in VAT it paid the foundry and only send in $20. The exception is the final purchaser, whose $70 payment is not deductible.

VAT vs. Sales Tax

One question about the advantages and disadvantages of VAT that crops up a lot: Why bother? One of the limitations of VAT is that the end result of a 10% VAT tax is no different than a 10% sales tax. So why not just go with sales tax?

VAT advocates say that because VAT involves more parties, it's much harder to cheat. If a sales tax gets to the 10% level, customers start looking for ways to avoid paying. With VAT, if the home improvement store avoids paying the tax, the foundry won't go along because that would leave it on the hook for the $50 in VAT the store didn't pay.

Advantages and Disadvantages of VAT

The value-added tax is common around the world, but to date, it hasn't taken root in the United States. Like so many policy issues, you can find people who think we should implement it immediately and others who think the limitations of VAT outweigh the benefits.

Advantages of VAT:

  • Value-added taxes are broad-based. Everyone pays, so nobody feels they've been singled out.
  • Even if the rate stays fairly low, VAT can still generate a lot of revenue.
  • It's politically easier to impose a VAT than hit the rich or corporations with higher taxes.
  • Instituting a new tax can raise more money than just closing tax loopholes.
  • Some nations are able to raise a third of their tax revenue through VAT, whereas U.S. sales tax revenue is less than 20%. 
  • Increasing tax revenues to pay the deficit down could make it unnecessary to attempt to cut spending.

VAT advocates point out that multiple other countries have successfully levied a VAT, so it's not some radical experiment in economics.

Limitations of VAT

One of the big limitations of VAT is that, like any new tax, it's controversial. If the federal government tried to impose VAT, the opposition would undoubtedly be intense. VAT critics also say that when you weigh the advantages and disadvantages of VAT, the disadvantages win.

  • Critics of government spending say VAT would be bad precisely because it makes it easy to raise revenue. Instead, they want the government to reduce its spending.
  • Like sales taxes, the value-added tax is regressive. If a rich person and a poor person each buy a $40 item with a 10% VAT, they both pay a $4 tax. That money is a higher percentage of a lower-income person's pay than a millionaire's.
  • The paperwork is a lot more complicated than a sales tax.

VAT supporters say some of these problems can be overcome. For example, adjusting income tax rates could make up for the regressive nature of the tax.