VAT: The Nightmare Tax Gets Proposed, Again

For years politicians in the U.S. have floated the idea of a national sales tax modeled on the European value added tax to raise more federal funds. Usually this is couched in terms of reducing income taxes (personal or corporate) to replace them with a tax on consumption because this is somehow more "fair": let Americans keep more of what they earn and only tax when they spend. Soon after Obama’s election, his team floated the balloon and almost as quickly pulled it back down. But it keeps coming back: here is former South Carolina Senator Fritz Hollings in the Huffington Post calling to cancel the 35% corporation tax and to replace it with a 6% VAT scheme. He seems to think that just because the rest of the world has this, especially Europe, it can’t be all that bad.

That might seem clever -- after all, 6% is less than 35%, right? -- but there is a hidden cost to VAT that is paid by both profitable and unprofitable businesses. And remember, before almost any startup makes a profit, it makes a loss. VAT doesn’t care about profitability.

So what does VAT mean in Europe (or more precisely, “Credit Invoice VAT”)?

If you’ve ever traveled to Europe you might have come across VAT. I say "might" because unless you bothered to ask, VAT was mostly hidden from you with a cosmetic sleight-of-hand forcing retailers to only display prices after the tax is applied. Your hotel bill will have separated the VAT out if you checked it carefully. It’s also possible you were offered a way to reclaim VAT on larger purchases in tourist spots.

VAT should not be seen as state sales tax for Europeans. It is something completely different. While the overall effect to the final consumer of a product or service might appear the same, the overall effect on an economy is not. And I’m not just talking about the ludicrous rates it has now risen to in many parts of the EU (20% in the UK and up to 25% in Sweden and Norway).

In the European model, VAT is a tax applied to almost every transaction. If you buy raw materials for a business, pay for legal, accounting, or other services, import goods from outside the EU -- all of these attract VAT. When all is added up, businesses do not pay the VAT, only the final users of a product or service pay. But along the way, businesses are the unpaid tax collectors working for the government. (I’m in Israel, with a similar VAT system to the EU countries, though its rate is currently at 16% which puts Israel below all EU countries except Luxembourg.)

There are all sorts of distortions: children’s clothes are VAT-free in the UK (handy if you’re a very small woman: I’m not joking). Take-out hot food versus food consumed on the premises attracts different rates -- the price for McDonald's is completely different for eat-in versus take-out. (Here is a link to a government decision from the UK deciding what is or isn’t a cake for VAT purposes!)

So how does it work? My company imports goods from the U.S. Most of what we import was originally made in China (of course), but when we buy from the U.S. I have a warm fuzzy feeling that I’m purchasing from reputable companies residing in a jurisdiction that clings to the rule of law. I sleep better at night after wiring $100,000 to a U.S. corporation than after I buy in China.

When the goods arrive at a port, I pay my shipping company three charges. One is for the cost of shipping, one is a fee for performing the customs clearances (a painful experience if you try to do it without help), and the third is a VAT on the invoice value of the shipment. If I ship $100,000 of goods to Israel, I hand over $16,000 to the government at the port to get the goods.