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.

Hopefully, we have pre-sold much of a shipment so within a few days the goods are in the hands of dealers (I sell a little to end users, but mostly I sell to people who sell on). Let’s say I sell the whole shipment to one customer. If I sell on for $130,000, I have to add 16% on top, so I invoice $150,800. I’ve paid $16,000 to the government and now I’m waiting for my customer to pay $130,000 for me, and $20,800 for the government.


And here’s the sticking point: I have to account for the VAT on the day of invoice, which means if I give the customer 60 days to pay, I’m out of pocket by $16,000 for 60 days.

In effect, I’ve lent my money to the government on an interest-free loan. When (or if) my customer pays I will have collected $4,800 for the government — and I had to do all the administration. It’s even worse if the goods are not pre-sold, because I end up loaning the money to the government until the stocks are sold.

Once a month, my company’s bookkeeper has to figure out the previous month’s incomings (invoices written but not necessarily paid to customers) and outgoings (VAT payments at the ports and other local purchases). This report is submitted and any payment necessary to balance the books is made. Sometimes I am required to appear in person at the VAT office to show particularly large or unusual invoices, not one of my favorite business tasks.

Retailers have it the other way around: they end up being huge net holders of VAT because they buy and pay VAT to their suppliers, usually on credit. They sell for cash including VAT, which they can hold for up to four weeks until they submit their next monthly VAT report and pay to the government.

What about, say, a small manufacturing company started by an entrepreneur with a clever idea to make a better widget than GE? He has to pay VAT on any equipment he buys, and he has to pay VAT on any goods and services he buys along the way. He can claim it back in a monthly cycle as he goes along, but he’ll pretty quickly find that part of any capital he raises will be held in trust by the government instead of working for him. And that is before he makes a dime in profit.


Do you enjoy the process of claiming a federal tax refund today? Would you like to deal with that every single month? And what about audits and loopholes?

The net result, barely mentioned outside of obscure economics texts: businesses give an interest-free loan to the government directly from their working capital and must act as unpaid tax collectors. That is one of the dirty little secrets of what VAT would mean for businesses in the U.S.


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