The introduction of value-added taxes in Europe installed a more efficient tax on economic activity and facilitated the development of the European Economic Community.
The value-added tax, a sales tax that taxes the value added to a commodity in each stage of the production and distribution process, was first put into practice on a national scale when France adopted the taxe sur la valeur ajoutée on April 10, 1954. The French tax, though it is considered a relatively unsophisticated version of the value-added tax, was the first true test of a taxation theory that eventually was embraced throughout Europe and in many other countries.
The merits and faults of a value-added tax, or VAT, were first considered in 1918, when German industrialist Carl Friedrich von Siemens spoke in the Reichstag on behalf of the theory that businesses should be taxed only for their contribution to the value of a product. At the time, Germany and several other European nations had “turnover” taxes in place that simply taxed a percentage of all business turnover, or sales. Siemens asserted that such a tax was inefficient and burdensome to business since a “cascade” effect could occur when a product was taxed repeatedly as it passed from manufacturer to wholesaler to retailer.
Moreover, Siemens believed that the turnover taxes put disproportionate burdens on different commodities and promoted the vertical integration of companies, since businesses would attempt to avoid as much turnover as possible. (For example, a shirt produced by a company that grew its own cotton and manufactured its own dyes internally would be taxed significantly less than would the same shirt if the manufacturer purchased cotton and dyes from other companies.) In contrast, he suggested that nations could more efficiently raise revenue from economic activity by taxing the net value added by each firm in the production-distribution chain, regardless of the amount of turnover involved. Thus, in the example of the shirts, it would be the process of sewing and coloring that caused the tax, rather than the process of one firm selling materials to another, and both shirts would be taxed at the same rate.
Siemens’s ideas were picked up by the American tax scholar Thomas S. Adams, who had become prominent after pioneering U.S. federal income tax legislation in 1913. Three years after Siemens’s speech in the Reichstag, Adams published an article in the Quarterly Journal of Economics titled “Fundamental Problems of Federal Income Taxation.”
Although both Siemens and Adams recognized the tremendous revenue-raising ability of multistage taxes such as the turnover tax and the value-added tax, they both also believed that the efficiency of the VAT was a more important quality, since it treated all economic activity alike. In contrast, for example, a turnover tax falls harder on a retailer than on a wholesaler. Finally, the tax is an indirect one in that it is a tax on economic activity, not on individuals. Proponents of the VAT thought that by increasing the revenue collected from the indirect tax base, governments could adjust taxes to have less of an impact on citizens and consequently lessen the negative impact of fiscal policies on savings and investment behavior.
Following these theories, tax scholars in the early twentieth century began to formulate methods to collect a value-added tax. Since the value added to any product or service is equal to the difference between sales and the amount paid for inputs such as labor and raw materials, collection of a VAT would require businesses for the first time to keep track of their inputs for accounting purposes. Under the two most popular theories, a VAT could be collected by either the “invoice” or the “subtraction” method. Under the invoice method, the tax rate is applied to the total sales of a business, but the tax paid to the government is reduced by the amount of VAT shown on the invoices from all the inputs. Under the subtraction method, the tax is collected by subtracting purchases from sales and applying the tax rate to the net figure.
Since a value-added tax is neutral and treats all economic activity alike, it is well suited to an environment of competitive private enterprise. It was no surprise, then, that nations such as the United States, Germany, and France initially showed the most interest in the tax. Following the ideas pioneered by Siemens and Adams, France experimented with several different tax systems during the early twentieth century. In 1936, it adopted a single-stage production tax in a first attempt to eliminate the cascade effect of turnover taxes. In 1953, the state of Michigan took the first step toward installing the value-added tax when it adopted a temporary, modified VAT called the Business Activities Tax
In Europe, however, because of the existence of multistage turnover taxes, the conversion to a value-added tax was much easier. Thus, under Étienne Hirsch’s version of the Modernization and Equipment Plan, France adopted legislation on April 10, 1954, that applied a full VAT to the production process. In essence, the taxe sur la valeur ajoutée, or TVA, simply allowed a credit for the tax paid in the purchase of raw materials, but it nevertheless stands as the first national attempt to install a more efficient multistage tax.
The TVA was installed as part of France’s protracted attempt to return to a normal economy following the devastation of World War II, and it was intended to provide both relief to French businesses and significant revenues to the government. One thing the tax lacked, however, was a clear vision as to its administration. The makeshift coalition of various political factions that was in power at the time led to confusion and dissatisfaction on the part of French citizens. These feelings gave rise to movements of tax agitation, most notably led by a former shopkeeper, Pierre Poujade. Reports of the agitation led by Poujade in 1954-1955 tell of mobs of up to five thousand people physically obstructing the process of tax investigation and enforcement and even threatening tax officials and their families. Such opposition eventually subsided as the French government stabilized under the return of Charles de Gaulle. In later years, France improved and extended its VAT to cover the service sector (1968), then virtually all economic activities (1970).
France’s adoption of a value-added tax, despite internal problems in the country, was soon imitated by most other European nations, which were also dissatisfied with their tax structures and saw the economic advantages of converting to a VAT system. On April 11, 1967, the Council of the European Economic Community
After the installation of a VAT system, European businesses immediately realized that the tax system demanded much more work on their part than they were accustomed to doing. Most countries adopted the invoice method of collecting value-added taxes, in which businesses use the invoices from purchases to claim a credit against the tax on their sales. This process required much more paperwork and stricter record-keeping on the part of business, but the burden was borne without much complaint, since it was only by keeping such records that a business could claim a credit against the tax on its sales.
Businesses previously subject to turnover taxes (as was the case in most of Europe) were already accustomed to dealing with a multistage tax, making the switch to value-added taxes easier for the government and less costly for businesses than would have been the case in switching from a single-stage tax such as the retail sales or corporate income tax. Finally, the European adoption of value-added taxes also demonstrated one of the most attractive elements of these taxes to the nations adopting them: the fact that they have a fairly effective self-enforcement mechanism. Under a VAT, a business has an economic incentive to keep track of all sales and purchases, while a retail sales tax, in contrast, is easily and often avoided, especially when the rate rises, by businesses that simply refuse to record some sales.
Value-added taxes caused some problems for business because of concerns over the inflationary potential of the tax. Since the VAT on a product is ultimately passed on to the consumer in the form of a proportionately higher price, many feared that the tax system could cause prices to increase throughout the economy, consequently driving up the rate of inflation. The inflationary potential of a VAT worried France and other European countries, because if, for example, inflation were triggered in a particular country, both exporters and domestic firms competing with imports could be harmed, as their prices would be high relative to those in other countries. In such circumstances, a VAT would favor capital-intensive industries over labor-intensive industries, since industries with strong collective bargaining could be hurt by the wage-increase demands that would be sought by workers in response to inflation.
Fears of a VAT’s effect on prices also raised concerns about the regressivity of the tax, or its disproportionate impact on low-income people. Throughout the debate over value-added taxes, critics asserted that the tax, which is essentially a consumption tax, would place a disproportionate burden on young, old, and poor consumers, since these groups tend to consume high proportions of their income. In order to compensate for this effect, many nations tried to make the tax more progressive by setting the tax rate at different levels for different products and even exempting some products and services altogether. France, for example, applied a reduced rate to products of social interest (such as coal and livestock feed) and completely exempted twenty-three products. On the other hand, surtaxes ranging from 4 percent to 26 percent were applied to a small number of “luxury” products.
The number of special provisions, differential rates, and exceptions made it even more costly and complicated for businesses to comply with the tax and led economists to state that although the measures imparted some measure of progressivity to the tax structure, they also had a detrimental effect on efficiency. It was also seen that the higher costs to businesses were largely passed on to consumers in the form of higher prices, leading to speculation concerning how progressive such measures really were. In the end, the European experience with exemptions and multiple tax rates on the VAT showed that such provisions not only were undesirable on administrative and revenue grounds but also failed to ensure any significant progressivity.
Despite the complications and additional expenses associated with a value-added tax, the fact that the tax can be made neutral with respect to international trade was widely seen as a great advantage over other taxes and even over entire countries that had different tax systems. In most cases, VATs were designed so that exporters received a credit for the VAT paid in manufacturing a product while imports had the VAT levied against them. In this way, exports from a particular country are not put at a disadvantage in international trade because of home-country taxes. Similarly, domestic firms can be sure that imports are taxed on an equal basis. Further, a VAT, since it was rebated on exports, was thought to provide a competitive advantage in markets in which some businesses were subject to taxes that were not rebated, such as U.S. exporters subject to the corporate income tax.
The EEC chose the VAT, because it was seen as the best way to promote neutrality and uniformity of the tax burden while still providing incentives to increase productivity and industrialization. Consequently, the tax played a key role in fostering the development of the EEC and in making the economic integration of the member nations significantly easier to manage. It continues to be the foundation of reformed and enlarged European Union. The VAT’s impact on businesses operating internationally took on an even broader scope when regulations were enacted under the auspices of the General Agreement on Tariffs and Trade (GATT) to permit border adjustments (refunds) for indirect taxes such as the value-added tax, and the successor to GATT, the World Trade Organization (WTO) made efforts to promote more effective VAT collections at the border.
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Baum, Warren C. The French Economy and the State. Princeton, N.J.: Princeton University Press, 1958. Provides an excellent history of the French economy, with a particularly interesting chapter on the nation’s tax system. Because the book was published before the EEC’s adoption of the VAT, it lacks a discussion of the VAT’s use in international trade. -
Bickley, James M. Value Added Tax: Concepts, Policy Issues, and OECD Experiences. New York: Novinka Books, 2003. Examination of the theoretical and practical considerations informing the imposition of the value-added tax in Europe. Bibliographic references and index. -
Lindholm, Richard W. Value-Added Tax and Other Tax Reforms. Chicago: Nelson-Hall, 1976. Informative look at the characteristics and effects of value-added taxes. Discussion of other taxes provides useful comparisons. -
McLure, Charles E., Jr., and Norman B. Ture. Value-Added Tax: Two Views. Washington, D.C.: American Enterprise Institute for Public Policy Research, 1972. Interesting debate over the VAT and its possible use in the United States. -
Organisation for Economic Co-operation and Development. Consumption Tax Trends: VAT/GST and Excise Rates, Trends and Administration Issues. Paris: Author, 2006. Official governmental study of taxes on consumption, including the value-added tax, the goods and services tax, and others. Bibliographic references. -
Pechman, Joseph A. Federal Tax Policy. 5th ed. Washington, D.C.: Brookings Institution, 1987. Comprehensive explanation of U.S. tax policies. Updated periodically. -
Shoup, Carl Sumner. The Value-Added Tax. Athens, Greece: Center of Planning and Economic Research, 1973. As part of a lecture series, this book is easy to read and explains the basics of the value-added tax. -
Tait, Alan A. Value-Added Tax. New York: McGraw-Hill, 1972. Particularly useful in describing how the value-added tax works in European Community countries. Somewhat technical in places as a result of its orientation toward management. -
Ture, Norman B. The Value-Added Tax, Facts and Fancies. Washington, D.C.: Heritage Foundation and Institute for Research on the Economics of Taxation, 1979. Well-written discussion of the characteristics of value-added taxes and the implications of a VAT in the United States. Includes an interesting foreword by Senator Russell B. Long.
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