A Tax Most Americans Have Never Paid
A recent article in The Economist made what it called “The Case for VAT.” The value-added tax may be unfamiliar to most Americans, but it has become a primary funding source across developed Europe and has since spread to Africa and Latin America.
In its September 28, 2024, article, The Economist described the VAT as “second best for efficiency.” A levy on consumption, it is a tax that governments can raise without the public outcry that typically greets increases to income or property taxes.
When Britain raised its VAT from 17.5% to 20% in 2011, it faced little public backlash, the magazine noted. High VAT rates have also helped Nordic countries pair large governments with thriving market economies, levying among the highest rates in the rich world at 24% or 25%. As the magazine put it, if a state is fat, it needs a VAT.
How the VAT Works
Put simply, a VAT is a tax on consumption. Businesses along the entire supply chain are assessed a tax on their goods. Because the cost is folded into production rather than added visibly at the register, consumers largely do not notice it. That invisibility makes it a more politically palatable funding source than a direct charge.
The International Monetary Fund argues the VAT makes economic sense on the production side. Because it does not affect the prices firms ultimately pay for inputs, it does not distort production decisions, and it avoids “cascading,” the tax-on-tax problem that arises when a levy is charged on both an input and the output made from it.
Every firm above a specified annual turnover must participate, not just those selling to consumers. In the end, only the net value of final sales forms the tax base, so a properly functioning VAT amounts to a tax on final consumption. Other approaches, like a retail sales tax, exist, but collecting throughout the production chain gives the VAT a considerable practical advantage.
A Rapid Global Rise
The VAT is not new, but its spread has been remarkable. The IMF has called its rise the most dramatic and probably most important development in taxation in the late twentieth century. Forty years ago, the tax was barely known outside theoretical treatises. Today it is a key component of tax systems in more than 120 countries and raises about one-fourth of the world’s tax revenue.
Though the first proposals emerged in France in the 1920s, the first recognizable VAT did not appear until 1948, also in France. Brazil became the first Latin American country to adopt it in 1967, and Denmark’s adoption that same year began the tax’s spread across Europe. It moved quickly through the industrial world and South America into the late 1970s, reaching developing and transition economies a decade later. The number of African countries with a VAT jumped from 2 to 30 during the 1990s.
The European Union now requires a standard VAT rate of at least 15% on most goods and services. Member states may also apply up to two reduced rates as low as 5%, one super-reduced rate below 5%, and one zero rate, each limited to an agreed list of goods and services.
Is It Regressive? The Central Debate
In America, the chief objection comes from left-leaning politicians who view the VAT as regressive. Their argument: because everyone pays the same rate on goods, lower-income people shoulder a heavier relative burden than they would under a progressive income tax that scales with earnings rather than consumption.
The IMF sees it differently. It argues that no single tax determines fairness. Rather, the tax system as a whole, combined with public spending, shapes poverty and equity. In theory, a regressive tax could be the best way to finance pro-poor spending that more than offsets any anti-poor effect of the tax itself. The practical question is how this plays out in developing countries that use a VAT.
Studies remain limited, but the IMF reports growing evidence that the VAT is not an especially regressive tax in practice.
Untapped Potential
The IMF believes the VAT’s full potential has yet to be realized. Future challenges include implementing it in decentralized states and within regional trading blocs that lack formal border controls, properly treating the financial sector, and reducing the damage caused by multiple rates and exemptions that work against the tax’s basic logic.
A deeper and still little-recognized set of questions concerns how the VAT relates to income taxes, both domestically and internationally. For all its achievements, the IMF suggests, the VAT’s potential has not been fully exploited, or perhaps even fully understood.
Why It Matters
The VAT funds a quarter of the world’s public services while remaining nearly invisible to the people who pay it. That combination of reach and quiet makes it one of the most consequential fiscal tools of the modern era, and one worth understanding even in a country that has so far chosen not to adopt it.
Whether the United States ever embraces a VAT, the global economy already runs on it.
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References:
“The Case for VAT,” The Economist, Sept. 28, 2024.
Liam Ebrill, Michael Keen, Jean-Paul Bodin & Victoria Summers, “The Allure of the Value-Added Tax,” International Monetary Fund.
European Commission, “Value Added Tax.”