The Functionality of VAT

To illustrate how VAT works, consider a chair produced in a region with a 10% VAT. A lumber company sells wood to a manufacturer for $100; with the VAT, the price increases to $110. The additional $10 is submitted to the government.

Next, the manufacturer converts the wood into a chair, selling it to a retailer for $300, which becomes $330 with VAT. However, instead of paying the entire $30 tax to the government, the manufacturer deducts the $10 already paid, only remitting $20. The retailer then sells the chair to the final consumer for $500, or $550 including VAT, and pays $20 to the government, having previously accounted for the $30 tax paid when purchasing from the manufacturer.

This mechanism effectively prevents tax pyramiding, a scenario in which multiple taxes on a product lead to an inflated overall tax rate. The self-policing nature of VAT makes it not only easier to collect but also harder to evade, generating significant revenue. In OECD nations, VAT contributes approximately one-third of total government revenue.

Stability and Reliability of VAT

Compared to income taxes, VAT offers a more stable revenue source. Income can fluctuate significantly, while consumption patterns tend to be more consistent, making VAT a dependable source of funds.

Criticism and Misconceptions

Critics from the political left often label VAT as regressive since lower-income individuals spend a larger share of their income on consumption. In the short term, this perspective seems valid; wealthier individuals tend to save more, thus avoiding VAT on non-consumed income. However, over a lifetime, those savings are eventually spent, making VAT burdens proportional across income levels.

On the political right, some argue against VAT due to its potential to expand government size, as it generates substantial revenue "invisibly." This argument overlooks the current lack of transparency in American sales taxes, where consumers only discover the total price after the purchase. A properly structured VAT offers clarity about tax costs upfront.

Addressing Regressivity Concerns

To mitigate perceived regressivity, governments often lower VAT rates or exempt certain essentials like food and healthcare. However, these exemptions complicate administration and distort consumer behavior, a concern noted by VAT's creator, Maurice Laure, who referred to exemptions as a "cancer."

A well-designed VAT should avoid exemptions and instead expand its base to include sectors previously deemed difficult to tax, such as financial transactions and housing. This broadening can minimize deadweight loss, which is more pronounced at higher tax rates.

Potential for Progressivity

If regressive perceptions persist, we can reframe VAT as a progressive tax by channeling the revenue into progressive policies, a strategy referred to as "progressive revenue recycling." Implementing a 10-15% VAT on most goods could generate significant revenue, which could fund initiatives like universal healthcare or education.

In conclusion, while not all taxes have equal economic impact, VAT stands out as a viable option alongside Land Value Tax and DBCFT. When effectively utilized, VAT can serve as a robust tool for fostering a pro-growth, inclusive economy while providing adequate funding for essential social programs.

In this video, titled "Scrap It All For A Consumption Tax | Intellections," the discussion focuses on the advantages of transitioning to a consumption tax system, emphasizing the potential benefits and drawbacks.

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