Value-added taxes (VATs) have been attracting growing attention in the United States. GOP presidential hopeful Ted Cruz has proposed a VAT as part of a sweeping tax reform plan. The idea has also been backed by House Speaker Paul Ryan (R-WI), Senator Ben Cardin (D-MD), and others.
There are many benefits to such a tax. It could replace the revenue lost from reducing and simplifying the income tax, it could shore up the nation’s long-term fiscal situation, and a well-designed VAT could be more efficient than today’s messy income tax. But VATs also generate criticism, including from those who argue that it would be a burden to small business.
However, new Tax Policy Center research finds that most firms ought to be able to handle the tax, especially if very small businesses are exempted from collecting the levy. (This complements other recent TPC work that explores the effects of a VAT on state and local budgets.) A VAT is applied to the difference between a business’s sale of goods and services to other businesses or consumers and its purchases from other businesses. Under the credit-invoice method used by most developed countries, businesses levy a tax on their sales and claim a credit on the taxes they paid on their input purchases. In the usual case, the sum of these remittances is the total value of the tax levied on consumers. Thus, a VAT replicates the effect of a retail sales tax.
A critical policy design question is whether to exempt small businesses and, if so, at what size. For very small firms, the government’s administrative costs and the business’s collections and compliance costs may be high relative to the amount of tax revenue they generate. As a result, most countries exempt some small businesses from their VATs, though nearly all allow small businesses to register for the VAT if they would like. Evidence from countries with a VAT, as well as theoretical models of the trade-off between compliance saving and revenue loss, suggests that firms adjust their size to receive favorable tax treatment. A recent study by Treasury economists suggests that the optimal exemption is about $200,000 in sales for a 10 percent VAT.
While we can’t directly estimate the effects of a VAT in the U.S. since one has never existed, we can learn how a VAT would affect small businesses by studying the variation of existing state taxes.
In new research, Hilary Gelfond, Aaron Krupkin, and I estimated the effects of state-level income and sales taxes on the number of small firms and on their employment. We adapted a model from research by W. Robert Reed in 2008 and a paper Aaron Krupkin, TPC’s Kim Rueben, and I published last year. Both papers examine the role of taxes on growth, controlling for other factors. Overall, we found that increases in state sales tax rates have little or no effect on the number of firms or the employment within those firms. This implies that a VAT should not be a major hurdle for small businesses, especially if it is paired with a reasonably-sized exemption.
Whatever else you think of a VAT, it does not have to be a burden on small businesses.
This article first appeared at TaxVox.