Lessons for Policy Makers from the History of Consumption Taxes

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Abstract: A consumption-based tax system has attracted a variety of supporters, including proponents of tax simplification and policy makers in search of more or alternative revenue sources. Such a system could involve the use of a value-added tax (VAT) or a sales tax. Policy makers and legislators should consider the history of the background of the VAT. A cursory review of the development of sales taxes is presented as a background for the problems that might be encountered in adopting the VAT. This review of the historical development shows that there are numerous and complex issues requiring careful study.

INTRODUCTION

When thousands of hard pressed taxpayers and others have reached the stage of desperation, when they are willing to try anything - any patent medicine or panacea - then they are in a mood which makes them easy victims not only of their own self deceptions but also of the alluring promises of others always anxious to find opportunities to shove their tax burdens off their own shoulders regardless of where they fall. In such times the majority of the people are not inclined to weigh alternatives carefully and may accept very questionable measures [Blakey, 1935, p. 70].

Legislators and policy makers are considering a number of alternative tax system proposals, including a flat-rate income tax, a national sales tax, a value-added tax (VAT), and other consumption-based systems. A consumption-based tax system has attracted a variety of supporters, including proponents of tax simplification and policy makers in search of more or alternative revenue sources [Anderson, 1994, p. 77]. Such a system could involve the use of a VAT or a sales tax. Blakey issued the above warning in 1935, alarmed over the rapid spread of sales taxes in the U.S. He would surely have cautioned us to study past experiences when considering alternatives.

Policy makers and legislators should consider the history of consumption taxes. The primary focus of this paper is on the background of the VAT. A cursory review of the development of sales taxes in the U.S. is presented as background for the problems that might be encountered in adopting a VAT. No other study could be found that examined the history and past experiences with VAT and sales taxes in the U.S. and other countries. This analysis is particularly important in light of the sweeping tax reforms that are being discussed in Congress. The question addressed in this paper is, what can be learned from the European and American experiences with consumption taxes? Specifically, what events trigger the passage of a consumption tax?

VAT DEFINED

Trebby [1990, p. 8] defined a VAT as "a tax on the value added by a firm during the production and distribution process to the goods and services that it purchases from other firms." Aaron [1981, p. 2] defined "value added" as "the difference between the value of a firm's sales and the value of the purchased material inputs used in producing goods sold." He continued by stating that value added is the sum of a firm's wages and salaries, interest payments, and before-tax profits.

A comparison of a VAT and a retail sales tax reveals that "the VAT is a multistage tax; the retail sales tax is a single-stage tax" [Price and Porcano, 1992, p. 45]. Table 1 provides a comparison of a VAT and a retail sales tax using hypothetical data relating to the production and sale of an oak basket. Assume a tree farmer cuts down an oak tree (at no cost to the farmer). He sells enough of the wood to make one oak basket to a sawmill owner for $8.00. The sawmill owner cuts the wood into oak strips and sells them to a basket weaver for $12.00. The basket weaver weaves the strips into a basket and sells it to a craft-shop owner for $20.00. The craft-shop owner sells the oak basket to a customer for $30.00.

The total VAT paid is $1.50 or 5% of the sum of the values added at each stage. Note that the VAT generates the same amount of tax revenue as a retail sales tax of equal percentage. …