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The NST v. the VAT
Posted by: Dale Franks on Wednesday, December 08, 2004

Reader Fredrik Nyman asks, "Why is a sales tax more easily evaded than the VAT? I addressed this a bit back in August, pointing out that the NST isn't all fuzzy kitties, the way the Fair Tax advocates and their ilk like to pretend. But, I addressed it in a more general way, and a more detailed explanation might be helpful.

The thing is, a VAT and a NST are two very different animals. A NST is a one-time tax that's levied only on final retail sales. A VAT, on the other hand, is a tax levied at every stage of production, on both producers and consumers alike. To get a better understanding about why a VAT is less prone to evasion, it's probably best to get a clear idea about how the VAT and NST actually work.

Wikipedia has a very nice and simple explanation of how the VAT and NST works:
Without a VAT

* A widget manufacturer spends $1 on raw materials to make a widget.
* The widget is sold wholesale to a widget retailer for $1.20, making a profit of $0.20.
* The widget retailer then sells the widget to a widget consumer for $1.50, making a profit of $0.30.

With a VAT

Adding on a 10% VAT:

* The manufacturer pays $1.10 for the raw materials, and the seller of the raw materials pays the government $0.10.
* The manufacturer charges the retailer $1.32 and pays the government $0.02 ($0.12 minus $0.10), leaving the same profit of $0.20.
* The retailer charges the consumer $1.65 and pays the government $0.03 ($0.15 minus $0.12), leaving the same profit of $0.30.

So the consumer has paid 10% ($0.15) extra. The businesses have not lost anything directly to the tax, but they do have the extra paperwork to do so that they correctly pass on to the government the difference between what they collect in VAT (output VAT, an 11th of their income) and what they spend in VAT (input VAT, an 11th of their expenditure).

With a U.S.-style sales tax

With a 10% sales tax:

* The manufacturer pays $1.00 for the raw materials.
* The manufacturer charges the retailer $1.20, leaving the same profit of $0.20.
* The retailer charges the consumer $1.65 and pays the government $0.15, leaving the same profit of $0.30.

So the consumer has paid 10% ($0.15) extra. The retailers have not lost anything directly to the tax, but they do have the extra paperwork to do so that they correctly pass on to the government. Supplier and manufacturers are unaffected by the tax.
As you can see, the VAT allows the IRS to track the VAT very closely, because, at every stage of production, they are getting both a payment from the seller and the buyer, giving them two sources to find the same VAT payment. Also, at every intermediate stage, it's in everyone's interest to pay their VAT, because their customers are certainly going to deduct the VAT they've paid from their own VAT payments. So, if the IRS starts getting a lot of VAT deductions and no matching payments, they'll not only know that something smells fishy, they'll also have a pretty good idea where the smell is coming from. The enforcement strength of the VAT, and the incentive to avoid evasion, is that your tax payments are always reported by the third party.

Conversely, a NST is only levied once, at the point of final purchase. That means that nobody has to keep any tax records at all except the final seller. This provides a bit of perverse incentive. A retailer can simply fail to report all sales, and keep the sales tax for himself. Buyers can present a fraudulent sales tax exemption, or use their valid tax exemption for intermediate goods to buy capital goods or even personal items for which they should pay the tax. Both buyers and sellers, in other words, have an incentive to avoid paying sales taxes, and both have an incentive to report less-than-actual transaction costs. A tax system that provides a built-in incentive to tax evasion, along with increased difficulty in enforcement probably isn't workable in the real world. The only reason it works in the states--and, by the way, often not even there, since states are constantly prosecuting sales tax evaders--is that state sales taxes are almost universally below 10%.

As William Gale points out in this Brookings Institute paper on the NST:
The rate of evasion is currently around 17 percent in the income tax, but varies greatly by withholding and reporting arrangements. For income where taxes are withheld and reported to government by a third-party, the evasion rate is about 1 percent. This is predominantly withholding of taxes on wages. At the other extreme, for income where taxes are not withheld and there is no reporting, the evasion rate is 30 percent or more. In contrast, the pure retail sales tax would be collected only from businesses that make retail sales, and there would be no withholding or reporting by anyone other than the business itself. That is, the entity reporting the tax payment would also be the entity legally responsible for the tax liability. Because the pure retail sales tax would feature no third-party withholding or reporting, the possibility of high rates of evasion needs to be taken quite seriously.
The historical evidence is that, once a retail sales sax rate rises above 12%, tax avoidance and tax evasion becomes increasingly rampant. And, since the documentation that a NST requires is quite minimal, it's very hard to crack down on those problems.

Now, of course, the VAT has a much heftier paperwork requirement than the NST does, which is, of course, what makes it so much harder to evade. But this isn't the drawback that some claim. After all, we are talking about replacing the income tax with it, and the income tax itself has extremely hefty paperwork requirements. Indeed, after looking at the Tax Code, one could argue that the administrative burden of a VAT would be substantially less than the current burden of corporate income taxation.

The path of experience is also instructive here. In 1965, 19 of the OECD countries had some form of national retail sales tax. By 1995, every one of them had switched over to a VAT in order to end the compliance problems--and revenue shortfalls--caused by rampant tax evasion and avoidance.

So, if you're going to talk about some form of national consumption taxation, then you need to wake up a smell the coffee, and realize that a NST is just a non-starter. Practically all of the real-world experience with it at rates approaching anything like the 25% or so rate that would be required has just been a disaster. The VAT works at those rates, the NST simply doesn't.

There are other problems that have to be addressed with a VAT though. First, there is always political pressure to exempt goods or services from taxation. There's always a powerful lobby ready to convince politicians that their particular good or service is too vital to be taxed. And, for each class of good or service that is exempted, the overall VAT rate has to rise to stay revenue-neutral. Another problem is that the VAT is in many ways a hidden tax. When you purchase a product, the VAT is included as part of the price. So, you see a price tag of, say $100, and really have no idea how much of that $100 is the price of the good, and how much goes to pay the VAT. This makes it easier for the government to slide incremental tax rate increases into the VAT.

On the whole though, The VAT works, and that's a claim that you really can't make about the NST.
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Previous Comments to this Post 

Do you really consider us FT supporters as Ilk? I'm not an economist Dale, and as much as I'd love to ensure I'm 100% right on any given subject, I can't be. But I support the Fair Tax because it appears that it is the most fair system out there, it doesn't allow much room for lobyists, and enforcing the tax would still be easier than what we have today.

No system is perfect. Each has it's drawbacks and the folks at fair tax seem to agree that there are problems and show how they can be managed. I can't remember all the VAT issues pointed out over the past months (stuff like that doesn't stick in my memory well) but they brought up issues with it the same as you are with NST.

Honestly, I'm just tired of paying more than my fair share in taxes. I, like many others, just want a more simple system that allows me to take home what I earn. I'm not against an VAT but at this point, I prefer the NST.

I do value your opinion though, and I like knowing all the pitfalls (as well as the benefits) so please keep on. I just kinda feel odd being called ilk ;)

Also, as a side note, in Firefox, the comment box is only 3 lines deep which makes commenting a little cramped.
Written By: Sharp as a Marble
Well, again, every country that has had an NST has been forced to switch to a VAT. You can prefer what you like, but the real world is what it is, not what we wish it to be. If we try to implement the Fair Tax, it will fail.

Sorry, that's just the way it is.
Written By: Dale Franks
The biggest problem I see with establishing a tax on financial transactions is it provides an amazingly good incentive for bartering.

Money worked well in the past because it provided an automatic benchmark for value. Bartering "cost" more due to the difficulty of communication. But email and online purchase points like eBay allow literally millions to view an item and bid an item in trade. Even large conglomerations could conceivably find it profitable to trade finished goods for raw materials to make more finished goods and thus avoid a VAT.

Simply put, humans have an amazing cleverness when it comes to avoiding punishment/penalty/tax.

So what's wrong with a flat income tax rate with no loopholes that allows you to fill out your taxes on a postcard? Is that no longer even on the table? Is it so much worse than VAT or NST?
I'm not an economist, so I may be missing something important and basic.
Written By: Nathan
I think the big negative about the vat is it being hidden. Just look at the amount of taxes hidden at the gas pump. One other point, If the vat is collected by the seller, isn't it a sales tax on all sales(wholesale and retail) or am I missing something? If it is ,then the incentive to cheat is still there is it not?
Written By: thomas
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