The Vat: Politically Determined Consumption?

December 28, 2009

For release noon Tuesday Dec. 29 (691words)

How would you like a new tax hidden in the price you pay for goods? Or one determined more by politics than actual market cost? Or that exempts tourists? These are features of a Value
Added Tax (VAT), an option that some in government argue is commanded by our economic troubles.

Before taking up the issue, the full brace of Indiana taxes should be considered. The Tax Foundation reports that Indiana levies seven percent general sales tax on consumers, exceeding the national median of six percent. In Indiana, state and local governments combined collected $849 per capita in general sales taxes in 2006, ranking 24th highest nationally. Indiana’s gasoline tax, in addition to its general sales tax, stands at 29.7 cents per gallon, which ranks 16th highest nationally. Indiana’s cigarette tax stands at 99.5 cents per pack of 20, which ranks 28th highest nationally.

The gasoline tax was adopted in 1923, the state gross income tax in 1933. the cigarette tax in 1947 and the retail sales tax (2 percent) in 1963. Unprepared foods are generally exempted from Indiana sales taxes, but certain products such as soda pop, chips and pretzels are not.

Now, as combined federal and state income taxes begin to exceed 50 percent of marginal income, policy makers realize that any further increases will diminish work effort as individuals retire earlier and work fewer hours. In a recent interview, the Speaker of the House, Nancy Pelosi, said the time has come to consider a Value Added Tax (VAT), a type of federal sales tax on consumption.

Some economists and tax accountants prefer consumption taxes to income taxes because they believe that a VAT tax would encourage U.S. households to save a higher percentage of their incomes rather than consume. In practice, however, VAT taxes will be in addition to rather than as a substitute for income taxes. And with the federal budget deficit continuing to rise, Congress must either reduce spending or seek additional sources of tax revenue. 

John Dixon in a letter to the Wall Street Journal suggests that there is not much value in the value-added tax. Having grown up in Britain, Dixon wished to warn American consumers and business owners about VAT. The tax was introduced in Britain in 1973 at 10 percent and was subsequently raised to 17.5 percent. In other European countries, the rate reaches 25 percent.

With federal value-added taxes, each business owner would be required to remit, in quarterly payments to the government, the VAT rate times the difference between sales and costs, even if the revenue from sales has not yet been collected. For example, the farmer will pay VAT on the value added above the cost of inputs and wheat sales, the miller on flour sales, the baker on bread sales, the retailer on packaged loaves of bread. As of now, there is no public discussion of how the present 35-percent corporate profits tax, one of the highest rates in the developed world, would be affected by VAT, which is included in the sticker price, not added at the register. Unlike sales taxes, the consumer does not realize how much tax he or she is actually paying.

Obviously, a value-added tax by increasing the price of each good limits total personal domestic consumption. To encourage exports, however, governments generally exempt sales to those living outside the country from VAT taxes. Within Canada and Britain, tourists are given a VAT rebate and pay significantly less than natives for the same products purchased in local shops. How will this play in Peoria or Muncie?

The most undesirable aspect of VAT taxes is that consumer prices do not reflect relative market costs of production. A public-choice process inevitably will exempt certain products from paying VAT. This distorts relative prices that at present reflect the cost difference between producing a bottle of soda pop or a gallon of milk. With VAT, observed prices in the store to final customers (such as what one pays for cloth vs. disposable diapers or for ballet vs. football tickets) could be determined more by politics than the actual market-determined cost of production.

For now, let’s be grateful for having to pay only state sales taxes. At the local McDonald’s, the sales receipt lists the price for a senior coffee, hamburger and fries as $2.58. We know precisely the total cost including profit earned by McDonald’s in providing our lunch ($2.41) as well as the sales tax send to Indianapolis ($.17). At present, in spite of the Governor Mitch Daniel’s concern for fitness, relative prices do not induce us to forfeit fries for salad.

Maryann O. Keating, Ph.D., is an adjunct scholar of the Indiana Policy Review Foundation. Contact her at 


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