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Why a VAT Tax is a BAD Idea for U.S.

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Applied in about 130 countries worldwide, a “value-added tax” (VAT) is known as a consumption tax levied on any value that is added to a product.  At the moment, such a tax is not implemented in the U.S.  Rather, we have a state and local sales tax structure that is linked to the fiber of our nation, spending.  As a means to pay for the towering U.S. deficit brought about by war, financial bailouts, and healthcare reform a VAT is being chatted up in the depths of Congressional offices.  Politicians would no doubt find it next to impossible to garner support of a VAT by their constituents, but given the rise in government debt and structural changes to our economy (people saving more) it may be a difficult pill that may have to be swallowed by, none other than the U.S. taxpayer.

How a VAT Works

A VAT ultimately penalizes consumption and encourages savings.  Many supporters (including Nancy Pelosi and increasingly, inflation fighter Paul Volker) believe adoption would immediately provide a boost to the U.S. economy as consumers rush to the malls to purchase goods prior to a rise in final prices.  This activity is sort of like what’s happening in the U.K. currently, where consumers have flocked to High Street post Christmas to buy merchandise before the VAT returns to 17.5% from its present residence of 15%.  Note those tax percentages!  They are miles and miles away from existing U.S. state and local sales tax rates.  I digress.  Here is a good common man example of how a VAT works.
Say you agree to pay cash to a plumber to install a new toilet in the bathroom.  By agreeing to pay cash, under the current U.S. tax system, the government receives no tax on the value offered by the plumber.  It’s a win win for the plumber and homeowner, though deceptive in its own right.  Assuming a value-added tax, the plumber and homeowner would receive no benefit by agreeing to a cash transaction for service rendered as:

* The tools bought to install toilet would have been taxed through the production chain
* The raw materials used to complete the job would have been taxed through the production chain

The end user of the plumber’s services, the homeowner in this case, would be charged a higher price as the plumber is being taxed on each stage of production for the items he uses to finish the job.  Looked at another way, a pair of jeans would be taxed at each state of production.  The materials source would pay a tax.  The manufacturer would pay a tax.  The distribution company would pay a tax.  The retailer would pay a tax.  When all is said and done, a pair of jeans once being sold for $15.00 may now cost $18.00.  For a low-income consumer, that $3.00 differential could be a tipping point, and lead to a lost sales for a retailer and a deeper profit killing markdown down the line.

Potential Impact of VAT

* Economic cost to businesses: more tax services needed, updates computer accounting technology needed, lost sales as consumers save their income.
* Opportunity cost: small businesses would be devoting more effort to tax collection and planning, time that could be better served working on expansion strategies that create jobs.
* Distortions in the marketplace: once consumers conclude the buying process prior to VAT implementation, demand for goods and services could fall off precipitously.
* Higher prices for the consumer: costs of the program and increased risk of carrying inventory that potential goes unsold due to reduced demand will be reflected in much higher retail prices.  Discount retailers, already feeling the impact of rising healthcare costs, would have their low price business model come under heavy attack.
* Cost to stock market participants: lower equity valuations as the market adjusts to account for reduced consumption (as seen in revenue growth rates and net profit margins)


According to a paper written by Leonard Burman in the Virginia Tax Review, a 25% VAT would pay for healthcare reform, balance the federal budget, and exempt millions of families from the income tax while slashing the top rate to 25%.  The penalties you ask?  A gallon of gasoline would jump close to $5.00 and a $5,000 kitchen remodel would now run nearly $6,500.

While I can appreciate the need for the government to find new revenue sources to foster greater fiscal health for the country, there must be a less penalizing means to the end.  Maybe the government could slash taxes to spur investment by businesses and consumption by households.  It’s just a thought.

Disclosure: We do not own stocks mentioned.