TAXATION (GENERAL);

TAXATION;

Program Description;

You asked what value-added taxes and transaction taxes are and how they work.

SUMMARY

A value-added tax (VAT) is a tax levied at each step in the production and distribution process on a taxable item or service. Instead of imposing a tax on the final sale price of a taxable item, a VAT taxes the increase in the value of the product or service as it moves from initial manufacture to final sale. There are several possible variations of both a VAT and a transaction tax. The most widely used version of the VAT requires each business entity in a production chain to charge the tax on items it sells and to pay it on materials it buys to produce them. The taxes paid offset the taxes charged so the net tax paid on each transaction represents a tax only on the “value-added” by each business.

“Transaction tax” is a generic name for any tax whose imposition is tied to a taxable business or commercial deal, such as a sale or conveyance.

In the United States, only Michigan and New Hampshire impose modified forms of the VAT on businesses operating in those states. Transaction taxes are commonly imposed by states and localities, though not all are referred to by that name. Such taxes typically equal a percentage of the transaction price. Connecticut’s sales and real estate conveyance taxes are examples of transaction taxes.

VALUE-ADDED TAX

General Definition and Background

The value-added tax (VAT) is a consumption or “turnover” tax. Instead of taxing a percentage of the entire sales price at the time a taxable item or service is sold to the consumer, as a sales tax does, a VAT imposes a tax on the “value added” to the taxable item or service at each stage of its production and distribution. Under a VAT, each taxpayer in the production chain pays taxes on the increase in value his activity contributes to the taxable goods and services. That increase or “value added” is generally the difference between the value of an enterprise’s sales (outputs) and purchases (inputs).

According to the International Monetary Fund, the VAT is a major component of national tax systems in more than 120 countries and raises about 25% of the world’s tax revenue. First introduced in France in 1948, the tax is currently used by Great Britain, the European Union, Canada, and many South American and African countries (Ebrill, Keen, Bodin & Summers, “The Allure of the Value-Added Tax” Finance & Development, IMF, June 2002). Its use by subnational political entities, such as states or provinces, is less common, but several Canadian provinces and Brazilian states have local VATs, which are coordinated with their national VATs. In the United States, Michigan and New Hampshire use modified VATs to tax businesses operating in those states (Final Report of the Washington State Tax Structure Study Committee, December 2002).

How the VAT Works

There are several possible variations on a VAT, but the one used by Great Britain and the European Union is the “subtraction method” VAT. In this type of VAT, each trader in the supply chain charges VAT on its sales and is entitled to subtract from that amount the VAT it pays on its purchases. The full VAT is included in the retail price paid by the final consumer. The offsetting credits and payments effectively mean that the tax is imposed only on the increased value of the item or service at each step in the chain, as represented by the difference in the purchase price of the materials and the sale price of the taxable item. The VAT thereby avoids imposing multiple layers of taxation on prices that include taxes already paid at earlier stages (an effect known as “pyramiding” or “cascading”), which, according to the IMF, can distort production decisions.

Table 1 illustrates how the subtraction version of the tax works, using the Irish VAT rate of 21%.

Table 1: Subtraction Method VAT

Source: Irish Revenue Commissioners, Guide to Value-added Tax, 9^th Edition, July 1999

Though the subtraction method VAT described above is a common version, there are several possible VAT designs, including different ways to measure the value each business adds, differences in whether the tax is levied where goods or services are made (origin-based) or where they are consumed (destination-based), and different ways to calculate VAT liability. The subtraction method has already been described. There is also an “addition method,” which requires a business to calculate its tax base by starting with its profit and adding such costs as employee compensation, rent, interest, and depreciation.

These VAT variations and the pros and cons of each are more fully summarized in an outline included in the Washington State Tax Study Commission’s final report. Although the outline focuses on how the VAT variants compare with Washington’s current business and occupation (B&O) tax, it provides a succinct overview of VAT options (copy attached).

State VAT Taxes

The Washington State Tax Study Commission classifies two state business taxes as modified addition-method VATs. They are Michigan’s Single Business Tax and New Hampshire’s Business Enterprise Tax.

Michigan Single Business Tax. Michigan’s Single Business Tax (SBT) is a modified addition-method value-added tax on businesses and is the only general business tax the state imposes. It was enacted in 1976 to replace seven separate business taxes, including the corporate income tax. It levies a tax on business activity rather than income.

The SBT tax base is each company’s labor, capital, and profit. Labor includes the compensation and benefits the business pays its employees; capital includes depreciation, interest, dividends, and royalties it pays; and profit is the company’s federal taxable income with state adjustments. Many exemptions, deductions, and credits are allowed, which modify the value-added nature of the SBT. Businesses with annual gross receipts of less than $ 250,000 are exempt. The SBT rate was 1. 9% as of December 2002.

Michigan’s SBT is described in more detail in the attached brochure published by the Michigan Department of Treasury. The state is currently phasing out the SBT. A 2002 public act repeals the tax for tax years starting January 1, 2010.

New Hampshire Business Enterprise Tax. New Hampshire imposes a 0. 75% tax on each company’s “enterprise value tax base,” which is the sum of all its compensation paid or accrued, interest paid or accrued, and dividends paid, after special adjustments and apportionment. It applies to businesses with more than $ 150,000 in annual gross receipts or an enterprise value tax base greater than $ 75,000.

The tax, which is in addition to the state’s 8. 5% business profits tax, was first enacted in 1993. Business enterprise tax payments are credited towards any business profits tax a company owes.

TRANSACTION TAX

“Transaction tax” is a generic name for any type of tax imposed when a defined type of business deal or transaction occurs, such as a purchase of a particular item or service, the conveyance of a deed, or the transfer of stock or currency. In Connecticut, the sales tax and the real estate conveyance tax are “transaction” taxes.

Transaction taxes typically involve paying a tax equal to a percentage of the transaction price. For example, Kansas levies a “transaction tax” on leasing an office or home; lodging; meals; and renting a motor vehicle, videotape, or film. The tax is 5% of the transaction price received. It is paid by the consumer who buys, leases, or rents the property when the transaction occurs (Kan. Code, § 9. 301).

Another example of a transaction tax is the proposed currency transactions tax, also known as the “Tobin Tax” after one of its primary advocates, Nobel Prize-winning economist James Tobin. The tax, which would be implemented at a national level, proposes to tax foreign exchange transactions with a goal of reducing currency price volatility and volume of flows, thereby slowing or preventing damaging “runs” and speculation on national currencies. More information about the currency transactions tax is available on a website on the topic created by the Halifax Initiative, a Canadian organization that promotes economic democracy.

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