Hidden costs of VAT

First Published: 2016-02-21

Back in April 2013 during the Nassau Institute’s, Economics of Liberty Lecture Series,  Professor Richard Ebeling was asked the following question.

Question: It is said that a Value Added Tax (VAT) encourages big government. How do you feel about that and also what type of tax system would you recommend or would agree that government should impose on people?

While, as a rule, we do not have the various layers of production as described in Dr. Ebeling’s answer below, the Government does add VAT on at the port and it is added on from the wholesale to the retail level etc, so VAT costs are hidden like import taxes.

Here’s Dr. Ebeling’s answer:

“The danger that I see in a Value Added Tax (VAT) is that it makes it increasingly difficult for the voters and the taxpayers to know exactly what the products they are buying are really costing, and what the burden of government is as a result of that.

“The value added tax works (like this). To make a product it goes through various stages of production. We can look at this way. The tree is cut down in the forest. It’s transported to the lumber mill. The lumber mill cuts up the trunks of the trees into various forms. Some of them might be the beams for a construction project. It’s sold to the construction company. They will build the frame of whatever building it is. And then it’s finally sold to whoever buys the building. So it has gone through various stages of production where something is done and sold to the next guy who does something and the next step, until finally it’s bought by some consumer of some type.

“The difficulty of the VAT is that each stage of these production processes is taxed. The good changes hands in the transaction leading to its further development to it’s finished form. And at each stage of this production process the manufacturers and the sellers are paying a tax. Therefore the tax is embedded through the entire production leading up to the finished product. And therefore, since it’s embedded in this cost structure, it is more difficult for the consumers and the taxpayers to be able to distinguish what is the real value and cost of the product, and how much has been added on as a tax burden. It hides he cost of government in this way.

“For example, in the United States we have sales taxes. These are at State level, there is no Federal sales tax. Michigan has a 6% sales tax. So I go in and I pay $1 for something. It’s going to be $1.06 at the cash register. So obviously if you are buying something like a refrigerator that costs a couple thousand dollars, that 6% on top of that, you notice that. But you see, you know what the government is costing you. Because when the product is scanned, $10 plus the 6% sales tax. So it’s clear to you the consumer, the citizen and the taxpayer how much the government is costing you at these retail levels.

“But when it’s embedded through all the stages of production, the government could be changing the tax, raising the tax and it makes government less transparent. And certainly one of the elements of an open society is that we the citizens should know, not only what the government is doing in terms of duties, functions and responsibilities, which may be argued and disagreed about, but what it’s costing us. And when it’s embedded through the stages of production you don’t know when it’s the normal cost of hiring workers and buying resources for that stage, or whether there is, and how much of a tax on it.

“I consider it, if you will, anti-democratic in that sense because it hides something from the voter citizen.

“So what would be a preferable tax?

“Let me go through several of these, because you know, on one hand I’m not a fan of income tax, because I believe that it has the tendency to undermine peoples incentive to work, save and invest. Because when the government can tax a certain amount of each additional dollar you earn, the more it taxes a percentage of that dollar the less incentive you have to earn that dollar. But let me say this. If there is going to be an income tax I would rather see a flat tax, rather than a progressive one, where the more you earn, the higher the tax. Because I believe that undermines again peoples incentive to earn more because you get into the higher tax bracket and government takes a larger take. I think if you are going to have an income tax it’s better to have a flat tax. Like 10%. Now that means rich people still pay more than a person. Because if I’m making a million dollars, 10% of a million dollars is more than 10% of $20,000 a year. The rich person is still paying more. It’s less negative in its effects on people’s incentives to want to earn more though production and investment and so on.

“More preferable to that, people have advocated and there’s a movement in the United States called the Fair Tax Movement and this is for neither form of an income tax, neither progressive or flat, but a national sales tax. This means it doesn’t have a negative effect on people’s willingness or ability to earn by taxing your income directly. It’s not embedded in the production process like with a VAT and everybody would know what the government is costing them because that’s the price and that’s tagged on as a national sales tax. But I would only be for these types of reforms if the other taxes were abolished. I think it would be a disaster to have an income tax plus a national sales tax. It should be a reform that you pick one, and it should be the one that is the least intrusive into people’s freedom of choice and their incentive to work and be productive.”

The extra burden of proper accounting/record keeping, software systems and time spent on returns etc are not addressed here, but should be included with any analysis. They are all very real, adding to the cost of living and a larger government.

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