Tax creates unhappy business owners

By Raymond Keating

Dolan Media Newswires

LONG ISLAND, NY--In case you haven't heard, the political drums are beating for imposing a value-added tax, or VAT, on U.S. businesses.

In October of last year, for example, House Speaker Nancy Pelosi, D-CA, declared a VAT was "on the table." In February, the two leaders of President Barack Obama's budget commission, Erskine Bowles, chief of staff to former President Clinton, and retired Wyoming Sen. Alan Simpson, a Republican, said a VAT would be under consideration. And earlier this month, Paul Volcker, the former Federal Reserve chairman who now heads up the president's tax reform commission, was talking up a VAT.

A VAT is a consumption-based tax imposed at each stage of production. As goods and services move through various stages of production and distribution, a company pays taxes on the value it adds.

While increasingly touted by the political class seeking to expand government, a VAT would be a nightmare for everyone else. Two new reports from the Small Business & Entrepreneurship Council (for whom I serve as chief economist) spell out the troubles.

On the economics, a study I authored - "Renewing the Great Tax Debate: Tax Increases, Tax Relief and Tax Reform" - evaluates the current tax code and three major reform proposals according to eight criteria. The most prominent reform proposals would replace much or all of the current tax system with a flat tax, a retail sales tax or a VAT. Here are the criteria for evaluating each: progressive versus proportional taxation, how capital is taxed, how inflation is treated, clarity, simplicity, bureaucracy and intrusiveness, impact on tax avoidance and impact on government spending.

While today's tax system scored worst and the flat tax best, followed closely by a retail sales tax, the VAT sat in the middle of the pack. Potential pluses for a VAT include at least the possibility for a low, proportional (flat) tax rate and that the returns on capital are not taxed.

However, a VAT is anything but clear, as consumers have no idea what the ultimate tax burden is. Businesses would still face an intrusive tax collection bureaucracy. In addition, rather than being simple, a VAT is a model of complexity (more on this below).

But perhaps worst of all, due to it being hidden from the eyes of consumers, the VAT turns out to be relatively easy to increase. As a result, it could serve as a powerful boost to government spending.

But it's crucial to understand that the current VAT happy talk is not about real reform, i.e. replacing the current tax system. Instead, it's about using the VAT as an add-on levy. So, businesses, and ultimately consumers, would face an ugly, costly income tax and an ugly, costly VAT.

In addition to faulty economics are the day-to-day problems of a VAT. In their analysis of how a VAT would work, two tax professionals - Leonard Steinberg, principal of Steinberg Enterprises, and Paul Nagel, assistant professor of business at City University of New York - explain the three ways the tax could be collected.

Most widely used in VAT nations is the credit method. Steinberg and Nagel offer an example of how this would work: "ABC Manufacturing assembles and sells $50,000 worth of products. The VAT rate has been set at 5 percent. ABC Manufacturing purchased parts from Supplier A for $10,000 and parts from Supplier B for $20,000. Supplier A would have paid a VAT of 5 percent of $10,000 ($500). Supplier B would have paid a VAT of 5 percent of $20,000 ($1,000). ABC Manufacturing's VAT tax is calculated at $50,000 times 5 percent, which is equal to $2,500. ABC would be entitled to a credit of $500 from Supplier A plus a credit of $1,000 from Supplier B for VAT previously paid. The net VAT that must be paid for ABC Manufacturing is $1,000 ($2,500 - $500 - $1,000)."

Under a VAT subtraction method, a firm would calculate its value added by subtracting the taxes already paid on its inputs - all of the materials, goods and services used to produce the firm's goods or services - from its sales revenue, and then applying the VAT tax. That avoids one company in effect paying a tax on taxes already paid by others. The addition method to figure out the VAT tab would have the business calculate its value added by adding the untaxed portion of its costs, such as wages, benefits and profits, and then applying the tax rate.

Steinberg and Nagel correctly warn that the VAT would add new burdens and costs on businesses; require a bigger federal bureaucracy to collect and enforce a VAT; entice states to pile on with their own VATs; and boost incentives for tax evasion. They also note: "Small businesses would be hit disproportionately harder by the VAT's cost and complexity."

Indeed, there is no upside to imposing a VAT on the U.S. economy. Well, that is, unless your exclusive interest is to expand the size of government at the expense of growth-generating, job-creating businesses in the private sector.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. He can be reached at

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Published: Thu, Apr 29, 2010