Lessons from the VAT

London’s Oxford Street has over 300 shops stretching along one and half miles; itreceives 200 million visitors each year, making it Europe’s top shoppingdestination. Just over a year ago,the United Kingdom decided to capitalize on this attraction by raising its VAT,value-added tax, from 17.5% to 20%. Actually, the increase had little to do with Oxford Street and everything to dowith the UK’s budgetary concerns coming out of the recession.

OnJanuary 4,2011 Chancellor Osborne increased the UK’s VAT 2.5 percentage points in effort to relieve debt byraising a projected £300billion in one year. Highlycriticized by the Labour Party, the Federation of Small Businesses, retailersand residents, the VAT hike quickly fell shadow to other financial issues, such as thedramatic increase in University tuition. The UK willsignificantly benefit from the additional VAT revenue brought in during the2012 Olympics – despite the fact most items over £75 are VATexempt for non-European Union tourists under the Retail Export Scheme and London taxpayers will have to cover costs of the mismanaged Olympic Park budget.

The value-addedtax, a consumption tax, is used in most developed nations but hasn't been seriously considered as an option in the United States - except in Michigan. The value-added tax is regressive innature, although the UK exempts products such as food, books, and children’sclothing; other items such as domestic utilities are taxed at 5%. As a result, many argue the VAT can be a fairly progressive form of taxation. The recent VAT rise in the United Kingdom willdisproportionately harm the poorest residents, but it avoids raisingincome taxes.

Thevalue-added tax resembles a traditional US sales tax to consumers because theend product is taxed at a flat rate; the difference lies in the multi-stageproduction process. VAT is only used on gross margins, the value-added along the supply-chain spectrum – this avoids tax cascading. The process benefitsbusiness and manufactures, however a dollar taxed to the consumer does notalways equal a dollar gained by the government - VAT createsadditional deadweight loss. Value-added taxes are structured to avoid taxevasion, but are oftentimes subject to carousel fraud.

Although the value-added tax is moreapplicable to international economies, it is an important alternative model tounderstand. Plus, Michigan used it!