Monday, January 25, 2010

Heritage Founation: VAT - no easy fix for the deficit

The conservative Heritage Foundation highlights the ways that a value-added tax can be gamed:

1. False Claims of Taxes Paid. Businesses create false invoices for the purchase of inputs they never bought and get bigger deductions for taxes paid than they are entitled to.

2. Credit Claimed for Non-Creditable Purchases. Typically, VATs have a variety of rates and exemptions. For example, basic needs such as food, medicine, and clothing often receive preferential VAT rates or outright exemptions from the tax, as do certain industries considered economically vital or politically sensitive.

Businesses that sell both VAT-exempt and non-exempt items have an incentive to allocate the purchase of supplies they use to produce exempt items toward the production of non-exempt items. This improper shifting increases the business's tax refund because it allows them to claim deductions on their tax returns for the taxes paid on inputs where there should be none. This fraud is common because it is difficult for authorities to prove which supplies the business used to produce the different products.

3. Bogus Traders. Businesses are set up exclusively to produce VAT invoices so other businesses can claim refunds on taxes they never paid.

4. Hidden Sales. Professional service providers, such as doctors and lawyers, often engage in this kind of fraud. They offer relatively high-value services, but their purchases from other businesses are relatively low cost. They charge their unknowing customers full price and collect the proper amount of VAT on the sale. But to the authorities, they show that they charged a lower price. The service provider forwards to the government less tax than it collected from its customers and pockets the difference.

It is always hard for tax authorities to determine the actual sales of an intangible good like a service. Many state and local governments in the United States often forego levying sales tax on most services because of this difficulty. Moreover, service providers and individuals can circumvent the tax by agreeing to use cash or barter transactions. This avoids a paper trail altogether and makes it nearly impossible for authorities to prove abuse.

The shortfalls in the EU's VAT collections average 12%, or just a bit over the IRS estimate of the U.S.' tax shortfall under current law. The Heritage Foundation of course argues that this means the U.S. should not raise a VAT, but they would say that about any tax. I still think a VAT should be on the table, but advocates will need to ensure the integrity of the tax.

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