Value-Added Taxes are Good, Actually

Today I’ll make the case for a VAT, or a value-added tax.

A VAT is a tax collected at every step of production (every time value is added). Compare this to a sales tax, which is only collected at the end point. While a VAT of X% would seem to collect the same revenue as a sales tax of X%, I much prefer a VAT for several reasons.

“The reasons why a VAT, levied using the credit (invoice) method, is harder to evade than a sales tax is well-known. Invoices provide a good audit trail… the base can be widened over time, to include more services, and to cover more items than a sales tax; and the use of invoices helps make the VAT self-enforcing to some degree, since a taxable buyer has an incentive to insist on an invoice.” (Source)

The importance of a broad base (meaning the tax applies to most things) cannot be emphasized enough, and it’s something I’ll be returning to later. The less broad the base, the easier it is to dodge taxes. So you want taxes as broad as possible.

That last line about self-enforcement may be a bit confusing, so let me explain. Say you have a VAT rate of 5%. That means that by the time the final product is sold, the government will have collected 5% of the final product’s value in taxes no matter what. So if a company in the production chain dodges the VAT, other companies will have to pay more VAT to account for it. Obviously, they don’t want to do that, so companies are incentivized to make sure everyone is paying the proper VAT.

Now one argument against VATs is that they are regressive. That’s because the VAT is a consumption tax, and as you get richer, you save more and consume less as a percentage of income. However, the rich still consume far more in dollar amounts: the top quintile consumes about 5 times as much on average as the bottom quintile. That means if a VAT is used to fund universal services, it ends up having progressive effects (lessening inequality) even though the poor pay more as a percentage of income. In other words, the poor get far more out than they pay in.

A graph showing the net benefit of a 10% VAT used to fund universal benefits. The bottom 60% gain money on net.

Lastly, it should be noted that the Nordic countries we hear so much about are all funded in large part by a VAT of 25%. This is for two reasons. One, a VAT raises a lot of revenue, and you need a lot of revenue to have a big welfare state. Two, a VAT is invisible: the tax incidence is on consumers, yet producers are responsible for paying it. Just like with the employer-side payroll tax, this decoupling of tax incidence and responsibility for paying is key for taxes that will effect most folks.

Economics and welfare knower.