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GAO Studies Compliance and Transition Issues of Value-Added Taxes (VATs)

3 min readBy: Joseph Bishop-Henchman

The Government Accountability Office (GAO) has released a report examining Value-Added Taxes (VATs) in Australia, Canada, France, New Zealand, and the United Kingdom to look at compliance costs, how VATs work with subnational taxes, and what issues arose during transition to a VAT. About 130 countries have a VAT, including all of the OECD countries except the United States.

A VAT is similar to a sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. , except that it is paid at all levels of production, on only the value added at each level, to prevent pyramiding and eliminating the need to separate business inputs from retail sales. For instance, take a wooden table sold at retail and a 10 percent VAT rate. The lumber company sells the wood to the furniture maker for $50, paying $5 (10% of $50) to the government. The furniture maker sells the table to the retailer for $120, sending $7 ($120 – $50 = $70 X 10% = $7) to the government. The retailer sells the finished table to a customer for $150, sending $3 to the government ($150 – $120 = $30 X 10% = $3). The total taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. paid is $15, or 10% of the final retail price.

Advocates of VATs say this structure reduces evasion because it’s harder for three entities to avoid paying a $15 tax than it is for one. This in turn allows VAT rates to be much higher than ordinary sales taxes (which suffer evasion as they move into double digits), and they can generate huge sums of money. The GAO reports that on average, countries with VATs generate 18 percent of government revenue from them.

The report’s results:

  • Compliance Problems Similar to Other Taxes. VATs are vulnerable to refund fraud (illegitimate businesses or fraudsters submitting fraudulent refund claims) and missing trader fraud (businesses set up for the sole purpose of collecting VAT on sales, disappearing with the proceeds). Because of such compliance risks, even simple VATs require enforcement activities, such as audits, and record-keeping by businesses that create administrative costs for the government and compliance burden for businesses. (The GAO notes that these costs are comparable to other taxes.)
  • Shrinking the VAT Tax BaseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. Decreases Revenue and Increases Compliance Costs. A VAT may be less expensive to administer than an income tax, but adding complexity through exemptions, exclusions, and reduced rates, which can exist in other tax systems, generally decreases revenues and increases compliance risks, administrative costs, and compliance burden. (France and the UK, for instance, exempt more than half of the taxable base, driving the tax rate up on everything that’s left taxed.)
  • Having Both Federal and Local VATs Increases Complexity. Tax system complexity and compliance burden in Canada vary among provinces depending on the level of coordination between the provinces and the federal VAT.
  • Transition Issues Arise Even With Significant Efforts. Countries take 15 to 24 months to implement a VAT with a great deal of time and effort devoted to education activities. Despite significant efforts to encourage businesses to submit materials early for VAT registration, both Australia and Canada still had difficulty getting businesses to register prior to the VAT implementation date.

Read the complete study here.

Back in 1979, the Tax Foundation examined whether a Value-Added Tax (VAT) could work in the United States. Read that study here.