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Modern Times: An Inquiry on “VAT” Internationally and in Caribbean Islands

In Economy on May 20, 2014 at 12:46 AM

Internationally, largely the preferred tax revenue arrangement today in developed and developing nations has been the value-added tax (or “VAT”) arrangement. Large nations and small nations, large firms and small firms, producers and consumers of all wealth varieties, therefore, have already adopted or, at least, considered adopting such an approach to funding “the price of civilization.” More than 160 countries worldwide have enacted a VAT, according to Michael Graetz, law professor at Columbia University. Despite its prevalence, however, VAT is very rarely referred to, much less rigorously discussed, in places like the United States or The Bahamas, until recently at least. In order to minimize discontent and better grasp the economic consequences of VAT implementation, several Caribbean Islands nations are analyzed here in greater detail in an attempt to shine light on the little known economic subject.

American Viewpoints:
For understanding VAT, a recommended approach is to watch Charles McLure, Jr. walk through an example of how a value-added tax is applied or read The Atlantic’s primer here. Benefits of a VAT system include less tax evasion, less corruption and less lobbying dollars given the structure and efficiency of how the payments are organized through a series of credits passed along through the chain of manufacturers involved in leading up to the final sale of marked-up products and services. A great source for a clear overall explanation of VAT implementation in the U.S. context, along with a formal policy proposal, is Michael Graetz’s analysis presented on November 21, 2013 to the National Tax Association. Mr. Graetz five pieces to what he brands the “Competitive Tax Plan” are as follows,

“First, enact a VAT, a broad-based tax on sales of goods and services, now used by more than 160 countries worldwide. Many English-speaking countries call this a goods and services tax (GST). Second, use the revenue produced by this consumption tax to finance an income tax exemption of $100,000 of family income—freeing more than 120 million American families from income taxation—and lower the income tax rates on income above that amount. Third, lower the corporate income tax rate to 15 percent. Fourth, protect low-and-moderate-income workers from a tax increase through payroll tax cuts. Fifth, protect low-and-moderate income families from a tax increase by substantially expanded refundable tax credits for children, delivered through debit cards to be used at the cash register.”

Aside from Mr. Graetz and Mr. McLure, Jr., a wide array of American economists and tax analysts from Jeffrey Sachs to Martin Sullivan have endorsed implementation of a VAT tax in the U.S., which is not to be confused with a “Fair Tax” nor “Flat Tax” regime – see Michael Graetz’s debate with former talk-radio Libertarian Neal Boortz for an entertaining exchange. In the entrepreneurial corner, Warren Buffett has also expressed interest in moving to a “progressive consumption tax” which would be closer to a sales tax-based arrangement in the VAT tradition, granted one that indirectly looks a lot more like Mr. Graetz’s overall version with embedded inequity off-sets, as opposed to Mr. Boortz’s plan. Paying a speeding ticket in Finland, might more closely resemble Mr. Buffett’s intent here. Beyond a Jubilee plan, Republican economist Bruce Bartlett and CNN host Fareed Zakaria have also endorsed VAT publicly.

Here is what Jeffrey Sachs has to say about the subject, “The United States is the last of the high-income countries to introduce such a tax, and the absence of the VAT is the main reason why U.S. tax collections as a share of GDP are much lower than in Europe. The VAT is relatively easy to collect, creates low distortions, and raises considerable revenues. The main problem is that it is mildly regressive, meaning that it tends to collect a higher proportion of incomes of low and middle-income households than of rich households. Even that might be acceptable and fair, however, if the tax proceeds are used overwhelmingly for the poor. Then the overall combined effect of increased taxes and spending would still be progressive on balance, that is, helping the poorest disproportionately to their income.”

As a basis of comparison against the United States, presented below is a table breaking down total taxes as a percentage of GDP for various OECD countries and one subgrouping. The results illustrate that the United States is a low tax nation compared to the Scandinavian nations and the OECD average. For example, in 2011 the U.S. took in 24 percent of GDP in taxes, whereas Norway, Denmark and Sweden averaged a higher 44.8 percent. In 2011, the OECD average also was higher at 35.2 percent. The United States’ higher standard deviation of 1.7 percentage points over the time-period analyzed, i.e., from 1990-2011, displays greater realized volatility of tax receipts versus the typical OECD country, likely attributable to the U.S. being a non-VAT country. From 2009 onward the U.S. has been at its lowest level of tax receipts on record.

oecd_table

International Viewpoints:
Unfortunately, the standard American economics textbook by Greg Mankiw, Macroeconomics, read by many first-year business majors in college, has no single reference to VAT. Fortunately, however, organizations like the OECD and the IMF have at least made significant international statistics available with which one can clearly analyze public revenue as a percentage of GDP, for instance, and compare findings across different countries.

A critical video on VAT implementation in St. Kitts and Nevis grants insight on what individuals have experienced in that country after having enacted it in 2010. However, for the IMF’s 2014 estimate St. Kitts and Nevis, a VAT country, recorded higher real GDP growth than The Bahamas, a non-VAT country, i.e., 2.35 percent versus 2.3 percent, respectively. Unemployment data is not available for St. Kitts and Nevis. Mr. Graetz would underscore that this edge is realized even after having recognized that real GDP is likely larger in the year leading up in advance of VAT implementation (in The Bahamas, VAT implementation is expected later in the year). Ultimately, as the comments in the video indicate, if VAT is to be implemented effectively, then it needs to be better applied in many respects. Evidently, policymakers need to craft and implement better communication efforts, consider a phasing-in contingency plan, ensure broader recognition by the public upfront of what typical payment increases are expected by the average household and business, and enact “automatic stabilizer” public expenditure plans which would auto-correct for predictable regressive income results, i.e., disproportional cost burdens shifted to lower-income individuals. Short of following this advice, refraining from enacting VAT during a global recession is recommended.

Auto-correcting measures could have the feature of ensuring X percentage of GDP allocated to education infrastructure projects and scholarships, e.g., like that done with the United States “G.I. Bill,” which is often credited with building the middle-class post-WWII. In the past, U.S. Defense Secretary Chuck Hagel has recommended a public service term for youth. Another similar end may be to establish United States-style land grant institutions in order to better diversify the economy towards inclusion of larger scale agricultural operations or other untapped, natural comparative advantages that have been deemed latent, which would have auto-stabilizing features as well.

Muhammad Yunus, a Bangladeshi economist, has referenced this idea of honing in on comparative advantages in the context of analyzing Haiti’s international trade position. Finland, which publicly pays for its education and is notorious for offering the best education in the world at a low price according to education experts, represents another model to mirror. Moreover, in Finland as an added risk control in order to ensure high-quality results a teacher has to obtain an advanced university-level teaching degree. Funding of public transit and recreational programs represents a final productive effort, which could mirror what Chicago does by offering a free Lincoln Park Zoo, Atlanta does by offering free Shakespeare performances and Venezuela does by funding youth symphony orchestras.

Caribbean Islands Analysis:
In reviewing IMF data on various Caribbean Islands since 1980 through 2014 (2014 represents estimates), the following analysis pulls together VAT country-year references from sources on-line indicating VAT implementation years as follows: Antigua and Barbuda (2007); Barbados (1997); Dominica (2006); Dominican Republic (1983); Grenada (None); Haiti (1982); Jamaica (1991); St. Kitts and Nevis (2010); St. Lucia (None); St. Vincent and the Grenadines (2007); The Bahamas (None); and Trinidad and Tobago (1990).

A binary variable is generated for each VAT country-year, with “1” indicating a VAT-implemented year and “0” indicating a non-VAT year. The format of linear regressions administered are standard panel data, fixed effects versions, with various model specifications applied in order to allow for comparison of robustness in parameters reported. In summary, 420 country-year observations are presented and analyzed, which amounts to 12 countries analyzed over 35 years. Key macro-variables analyzed are provided in the summary statistics table in the Appendix, including data on real GDP percentages, unemployment rates and public revenues.

Here is a summary graph of real GDP percentages by country for a visual,

vat_graph

And here is a summary graph of public debt as a percentage of GDP (note that St. Kitts and Nevis, referenced earlier, has the largest spike and subsequent decline in debt/GDP percent over the analyzed sample),

vatpub_graph

As far as regression findings, of all the major macro-statistics scrutinized 6 of 10 variables are deemed statistically significant at the two-tailed 95 percent confidence-level, i.e., current account balance as a percentage of GDP, public expenditures as a percentage of GDP, public revenues as a percentage of GDP, real GDP percent changes, savings as a percentage of GDP and unemployment as a percentage of the labor force. Of particular interest as part of the results presented in greater detail below, is the variable on public revenues as a percentage of GDP. After all, implementation of VAT is purported to raise tax revenues and make them more predictable as a source of public funding over time. In fact the volatility metrics offered earlier in comparing U.S. data to OECD data lend credence to this claim, as evidenced in the deviation numbers. So, what is the effect of VAT on public revenues as a percentage of GDP? In VAT countries, at first glance public revenues as a percentage of GDP are predicted to be 4.6 percentage points higher. What this means is that after having controlled for heterogeneity differences across countries, i.e., via including fixed effects dummy variables for each country in the regressions, the public revenues claim holds true to prediction.

preg_1

Other predictions are estimated, as mentioned, and two stand out in particular. First, the unemployment rate is estimated to be significantly affected. In VAT countries, at first glance unemployment rates are predicted to be 6.9 percentage points lower. And at first glance real GDP percentages are predicted to be 1.3 percentage points lower. The key takeaway here seems to indicate broadened income distribution. But, are declines in national income expected as a result? Looking at the data averages helps to solve this query. In fact, upon closer inspection VAT countries report an average real GDP percentage of just over +2 percent, versus non-VAT countries reporting just below +3.3 percent. Averages for VAT and non-VAT country jobless rates are 10.6 percent and 15.5 percent, respectively. A key policy question given these findings appears to be, Is the improvement in jobs warranted given the predicted loss in national income? Interestingly, income inequality is the ill-recognized signature economic topic of our times in the United States, Switzerland and everywhere, and decisions regarding VAT squarely weigh-in on this subject.

In order to further probe the resilience of these last two key findings regarding major macro-variables, I have further adjusted the baseline model specification referenced above. In the table presented below, you will see auto-regressive models on real GDP percentages and unemployment rates. In particular, both tables include lagged variables on the predicted variables within the overall linear regressions in an effort to compare the coefficients on VAT for clarity. In VAT countries, for instance, under closer scrutiny unemployment rates may more realistically be expected in the range of 1.3 to 1.1 percentage points lower than those observed in non-VAT countries. Note that the VAT parameter holds statistical significance across the three model specifications and R^2 of 92 percent, as reported, measures significantly higher under the lagged variable models.

preg_4

Observing real GDP percentages regression results bodes a much different revelation. Judging from the models presented below, VAT countries, under closer scrutiny, surprisingly, may more realistically expect no discernible difference in real GDP percentages as measured against non-VAT country growth rates. This nuance is brought to light by controlling for observed variation in lagged real GDP percentages, which are included in the model, and rightly so (note the statistical significance levels). Here, R^2 of approximately 20 percent in indicated in the fuller models. In net summary, one could argue that a slight loss in real GDP percentages is associated with VAT-applied countries compared to non-VAT countries, however, the claim is made tenuous by realistic testing.

preg_3

Conclusion:
In conclusion given the VAT analysis and outlined results, Caribbean Islands nations and other nations have confidently benefitted, or may confidently benefit, from value-added tax implementation, but definitely risks are abound. Mr. Graetz and Mr. Sachs underscore a few of these risks and offer various preventative control measures to be applied against them in the form of anti-regressive public spending measures and phase-ins, etc. From an economic efficiency standpoint, a less consumptive and more mindful citizenry offers a nice by-product resulting from such an arrangement. As debt rises in an economic downturn one would expect it to off-set income declines, ideally temporarily, as a smoothing measure in order to uphold total spending levels; therefore, the VAT arrangement has beneficial anti-cyclical features by taxing a relatively inelastic metric in spending. Perhaps most beneficially, however, will be the reduction in income allocated toward for-profit corporate lawyers carving out tax exemptions and subsidies for various special interests at the public’s expense.

Philosophically, therefore, Cato and Socrates would have to agree on the benefits of living with less and with greater moderation, as opposed to disincentivizing income acquisition by taxing it. They would probably also likely avoid neglecting placement of a stiffer tax on perennial goods and services ills like for-profit lobbying, unpriced carbon emissions, gerrymandering, high-frequency financial asset transactions, hedge fund preferential treatment, financial products not treated like insurance, direct-to-consumer pharmaceutical drug advertising and the like.

An “idiot” is one “given over to private interests,” according to the Greeks.

Appendix:
preg_2

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