Example 3. If the relief granted in Example 2 were in the form of an exemption rather than a zero rating, the results would be as follows: In Example 3, the exempt manufacturer may be in a worse position than if no exemption were granted. Although the manufacturer pays no VAT on the sale, neither the manufacturer nor the retailer receive credit for the $100 of VAT paid by the supplier. Thus, the total amount of VAT paid through the production process is greater when the intermediate seller is exempt from the VAT than when the intermediate seller is taxable (even if it is zero rated). In addition, if an intermediate seller is exempt from the VAT, the total amount of VAT paid will be greater than (and bear no necessary relationship to) the theoretically correct amount of the VAT on an item. Administrative issues The form of the relief from the VAT (zero rating versus exemption) raises certain administrative issues. For instance, if the intent of the relief is to ease the administrative burden of a certain class of sellers, the exemption method may be preferable since it totally eliminates VAT bookkeeping requirements. Under a zero-rating system, the seller is still considered a VAT taxpayer and must maintain records in order to determine the amount of VAT credit for which it is eligible. On the other hand, an exemption may increase the total VAT paid and cause administrative complications in some instances. The VAT credit generally is allowable only with respect to the VAT paid on the purchase of goods or services that are used for the production of taxable goods and services. If a taxpayer engages in both taxable and tax-exempt transactions, the amount of VAT paid on inputs must be allocated or apportioned between the taxable and tax-exempt activities in order to determine the amount of VAT credit allowable. Such an issue does not arise under a zero rating system. If a taxpayer engages in both fully taxable and zero-rated transactions, all his activities are considered to be taxable for purposes of the VAT credit and no allocations need be made. Finally, with respect to either exempted or zero-rated activities, a clear definition of the transactions that qualify for the relief becomes critical for purposes of reducing the number of potential disputes between the taxpayer and the taxing authorities and between the taxpayer and its customers. For these and other reasons, it generally is agreed among VAT experts that a VAT system that is applicable to a broad base of consumption is theoretically preferable to a system that provides a wide range of exclusions. It is also generally agreed that zerorating is theoretically preferable to exemptions. b. Exclusions provided by the bill The bill would provide various exclusions from the VAT. Most of the explicit exclusions are in the form of zero ratings (discussed in detail below) as opposed to exemptions. Explicit exemptions would be provided for employee services to his employer,25 and for de minimis activities.26 However, the bill also would provide for implicit exemptions by narrowly defining taxable transactions. For instance, it appears that the sale of intangible property would not be subject to the VAT. Food The bill would provide that the retail sale of food and nonalcoholic beverages for human consumption (other than consumption on the premises) would be zero rated. Most VAT systems in other countries provide some sort of relief for purchases of food, generally on the grounds of the regressivity of the VAT. Those who favor a tax on all consumption argue that an exclusion for food (as well as other items normally considered to 25 As discussed in section III. C. 1. of this pamphlet, p. 11. be necessities of life) favors those with higher incomes who are better able to afford more expensive foodstuffs. They would propose other ways to combat any regressivity imposed by a broad-based VAT, including income tax relief or increased means-tested government assistance. In addition, those who favor a broad-based VAT argue that providing exclusions from the VAT may create artificial consumer demands for the excluded products or services. Other VAT systems have addressed the regressivity issue with respect to food by providing different VAT rates for different types of food, with "luxury" items bearing a greater tax rate.27 Such systems, however, impose the administrative burdens of identifying goods that are similar but are differently rated. This type of administrative burden may also exist in the VAT imposed by the bill. For instance, the bill would tax food prepared and consumed on the premises, while it would zero rate food prepared on the premises but consumed at home. This would require different tax treatment of identical items purchased at a facility that offers the purchaser the option of either eating on the premises or carrying food out (e.g., a fast food restaurant). Housing The bill would provide a zero rating for the sale and renting of residential real property used by the purchaser or tenant as a principal residence. A mobile or floating home would be treated as real property. Zero ratings for housing would favor those who choose to spend a relatively large proportion of their income on housing and may provide an incentive to increase housing consumption relative to other goods. However, the taxation of housing is a troublesome area even for those who favor a tax on all consumption.28 First, if housing were to be subject to the VAT, purchasers and tenants should be treated equally. The taxation of tenants is relatively easy-a VAT would be imposed on periodic rents. The VAT treatment of purchasers may be more difficult. The tax point for purchases of goods generally would be the date of acquisition. In the case of home sales, imposing a large VAT liability at the point of purchase, however, may be viewed as burdensome and may discriminate between existing home owners and new purchasers. One solution to the differing treatment of owners and renters would be to base the VAT on the imputed fair rental value of owner-occupied housing. Such imputations historically have been difficult to implement and administer. The bill does not define principal residence, but presumably the term would be given the same meaning as that used for Federal income tax purposes. Also not addressed in the bill is the situation of the purchase or rental of furnished housing. In such instances, an allocation must be made between amounts charged for the zerorated item (housing) and the taxable item (furnishings). 27 For example, Italy imposes a 18-percent VAT on the purchase of pate and fancy chocolates, but only a 2-percent VAT on bread and pasta. 28 See, the discussion in Treasury Report for Fairness, Simplicity, and Economic Growth, Treasury Department Report to the President (hereinafter "Treasury Report"), Vol. 3, 1984, p. 72. Medical care The bill would provide a zero rating for medical care. Medical care would be defined as the performance of any service and the retail sale of any property, the payment of which would eligible for an income tax deduction (ignoring the limits imposed by section 213(a)). Such costs would include health insurance premiums. The analysis of whether or not to exclude medical care from the VAT is no different than the analysis required for any other good or service. A zero rating of medical care would encompass amounts spent for private as well as publicly supported care. It can be argued that the regressivity of imposing a VAT on medical care can be alleviated by increasing other means-tested health programs rather than by providing a zero rating. Farmers and fishermen Sales by farmers and fishermen (other than at retail) of their produce would be zero rated under the bill. Presumably, the retail sale of such items would qualify for the zero rating allowed for sales of food (to the extent they constitute food). The 1984 Treasury Report 29 states that it is not feasible to treat farmers and their products the same as other segments of the economy. The report suggests that it may be appropriate to exempt farmers from the VAT since including the large number of small farmers in the VAT system would tend to increase administrative costs and burdens for both the Government and taxpayers. In addition, some sort of exclusion may be appropriate since a relatively large percentage of U.S. agricultural produce is shipped overseas and a VAT system designed consistently with the destination principle would zero rate exports. Exempting rather than zero rating farmers would not allow farmers to claim a credit for the VAT incurred on farm inputs. Several solutions have been offered with respect to this issue. Farmers could be zero rated (as would be done under the bill) despite the increased administrative and compliance costs. Alternatively, farmers could be allowed to elect to be either zero rated or exempt. Such an election may discriminate in favor of large farmers who could bear the related compliance costs. Farmers could be exempted from the VAT but allowed an income tax credit for the VAT on their purchases. Such a solution would only be feasible if all farmers filed income tax returns and may merely shift the underlying complexities to the income tax system. One solution that is widely used in Europe would be to exempt farmers and allow the purchasers of farm products to presume that a certain percentage, specified by the government, of the purchase price of farm products is related to the VAT. The purchasers would be allowed a VAT credit with respect to the presumed VAT, thus attempting to compensate for the lack of VAT credit at the farm level. A final solution would be to exempt farmers and zero rate sales to farmers. Under such a proposal, farmers would not bear any compliance or purchase costs but would, however, be required to prove their status at the time of purchase. 29 Treasury Report, at p. 61. Mass transit The performance of mass transportation services in urbanized areas would be zero rated under the bill. The bill does not provide a definition of either mass transportation or urbanized area. Thus, for example, while bus or subway service within one city would likely qualify for the zero rating, it is unclear whether rail or air service between two cities in a densely populated area (e.g., within the Northeast corridor) would also qualify. As in the case of medical care, the bill would not distinguish between mass transportation subsidized by the government and that provided by private enterprises. However, since most urban mass transportation is subsidized by a government in order to relieve problems caused by traffic congestion and pollution, it may be appropriate to exclude such services from the VAT. If such services were taxed, fares would rise by the amount of the tax and ridership may fall, thus requiring increased subsidizes. In addition, because of the relatively small dollar value of each purchase, there may be administrative benefits to excluding these services. Exports The bill would provide a zero rating for exports. This provision is consistent with the destination principle that holds that goods and services should be taxed in the jurisdiction of consumption rather than the jurisdiction of origin. Other VAT systems also zero rate exports so that they may enter international trade free of all domestic VAT burden.30 Interest The bill would provide a zero rating for interest. The term "interest" is not defined by the bill but presumably would include the items and amounts considered to be interest for Federal income tax purposes. The taxation of financial products and transactions, including interest, generally presents difficult issues for a VAT system. 31 Government activities Under the bill, sales to government entities would be zero rated. The providing of property or services by a governmental entity in connection with the education of students would also be zero rated. In addition, sales of property or the performance of services by government entities would also be zero rated unless the sale involves a specific charge or fee. The treatment of governmental entities involves issues of administration, competitiveness, and intergovernmental relations. Specifically, questions arise as to whether the tax base can be accurately measured and how the tax would be collected, whether the government entity is in competition with a private enterprise, and whether it is appropriate for the Federal Government to include a State or local government in its tax system. 30 For a more detailed discussion of the treatment of exports, see section III. C. 5. of this pamphlet, pp. 23-25. 31 See section III. C. 6. of this pamphlet, pp. 25-28, for a discussion of the treatment of financial services. |