Taxing state governments under a federal value added tax: Part 2

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Employees work inside a steel factory July 1, 2010.

Article Highlights

  • Economists and other tax policy experts uniformly agree that production inputs should not be taxed.

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  • The appropriate federal tax treatment of state governments deserves far more consideration than it has so far received.

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  • .@AEI’s Alan Viard on taxing state governments under a federal value added tax

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Taxing state governments under a federal value added tax: Part 2

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In the first article of this series, I considered the proper treatment of state governments under a hypothetical federal value added tax.1 In this article, I extend that analysis. As in the first article, I assume that a federal VAT should maintain neutrality between goods provided by the private sector and those provided by state governments. Although the federal government may well wish to subsidize state governments' provision of particular goods, such subsidies are better provided through specific grant programs than through the VAT system. Also, the VAT should surely not favor in-house production of goods by state governments' own employees and capital stock over state governments' production of goods using inputs purchased from private firms.

In the first article, I considered the case in which the state government produces consumer goods. For that case, economic analysis yields a simple, if politically problematic, prescription. Private firms' sales to state governments should be subject to VAT and state governments should be subject to an employer payroll tax with a tax rate equal to the VAT rate. As I explained, a VAT is equivalent to an employer payroll tax combined with a tax on business cash flow. The imposition of business cash flow tax on state governments' in-house production is impractical because the ‘‘cash flow'' does not take the form of cash. The imposition of cash flow tax is also unnecessary because the tax does not affect the marginal allocation of resources. But economic neutrality requires that state governments' in-house production be subject to employer payroll tax.

I said in the first article, though, that the analysis changes when the state government provides goods that function as inputs into production rather than as consumer goods. As I explain below, federal VAT should not apply to state governments' provision of production inputs. I also briefly consider the treatment of state taxes under a federal VAT. I first examine the economics of production inputs and the VAT treatment of the provision of those inputs by private firms. I then consider the distinctive challenges posed by state governments' provision of the inputs.

Economics of Production Inputs

A production input is a good that increases the production of other goods. The steel that is used to make cars is a production input; the steel does not itself have value to consumers, but it is valuable because the cars that it helps produce have value. As I have discussed elsewhere, a good's status as a production input depends on whether it increases the production of other goods on the margin.2 For example, food is not a production input for me or for most American workers, because a slight increase in food consumption would not make us more productive and a slight reduction in food consumption would not make us less productive. If anything, it's the reverse. Although a complete lack of food would obviously prevent us from producing anything, that fact has no bearing on the relevant marginal analysis.3

"Economists and other tax policy experts uniformly agree that production inputs should not be taxed." -Alan D. ViardEconomists and other tax policy experts uniformly agree that production inputs should not be taxed.4 At first glance, that may look like disparate tax treatment, because, for example, electricity that is used to heat a home is taxed while electricity that is used to operate a widget-producing machine is exempted. But the reason that there should be no separate tax on the latter electricity is because tax is imposed on the full value of the widgets, including the cost of the electricity. Because the electricity is already taxed through the taxation of the widgets, a separate tax on it would constitute inefficient overtaxation.

The distinction between production inputs and consumer goods is not unique to consumption taxation. Income taxation must also make the same distinction, providing deductions for the costs of production inputs but not for the costs of consumer goods. The resulting treatment of production inputs is the same as under consumption taxation, except that the costs of capital goods (production inputs with extended useful lives) are deducted over time through depreciation allowances rather than immediately.

Actual VAT systems around the world routinely provide appropriate treatment of production inputs that are sold by private firms. Under the common credit-invoice method of VAT administration, the firm that sells the input is taxed on the sale proceeds, but the purchasing firm is allowed to claim a credit for the selling firm's tax payment. Under the subtraction method, the firm that sells the input is taxed on the sale proceeds, but the purchasing firm claims a deduction for the purchase cost. The deduction and the credit have identical effects if tax rates are uniform.

In its textbook form, the retail sales tax also provides appropriate treatment of production inputs that are produced by private firms. Because a textbook retail sales tax applies only to sales of consumer goods, it simply ignores the sale of a production input by one firm to another. That approach is arguably simpler than the VAT approach of imposing tax on the selling firm and then offsetting it with a deduction or credit for the purchasing firm, although the sales tax approach may create greater enforcement difficulties. Unfortunately, as I have previously noted, many state sales taxes in the
United States deviate from the textbook approach by taxing a wide range of production inputs.5 In short, economic theory prescribes that production inputs should not be subjected to a separate tax because they are already taxed through the taxation of the final output that they help produce. VATs routinely provide the appropriate treatment when the production inputs are sold by private firms. Unfortunately, attaining the proper tax treatment becomes more difficult when the production inputs are provided by state governments.

State Governments' Provision of Production Inputs

Consider a federal VAT that taxes private firms' sales to state governments and imposes an employer payroll tax on state governments. As discussed in the first article of this series, that policy results in neutral tax treatment when state governments produce consumer goods. Unfortunately, that neutrality breaks down if the goods provided by the state governments are production inputs rather than consumer goods.

As with consumer goods provided by state governments, state governments generally do not sell production inputs at market value. Instead, they finance the provision of those goods from tax revenue and then provide them free of charge. The free provision of production inputs complicates the application of the VAT. Recall that the standard VAT treatment is to provide firms that purchase production inputs with a credit or deduction for the purchase costs. But when firms receive production inputs free of charge from state governments, they have no purchase costs for which a credit or deduction can be provided. The tax imposed on state governments' provision of production inputs therefore cannot be offset at the firm level. 

A tax on state governments' provision of production inputs then results in inefficient overtaxation.
Like production inputs sold by private firms, inputs provided by state governments should not be separately taxed because they are already taxed through the taxation of the output that they help produce. Production inputs provided by state governments increase the output produced by private firms. Because VAT is imposed on the firms' increased output, overtaxation results if a separate tax is also imposed on state governments' provision of the inputs.

Suppose, for example, that spending an additional dollar on production inputs would enable private firms to produce an additional dollar of output from the same workforce and capital stock. In a world with no federal taxes, the state government should be indifferent between, on the one hand, spending the dollar on the production input and thereby gaining a dollar of additional output, or on the other hand, letting the state's residents spend the dollar to directly produce more consumer goods. A neutral federal VAT must continue to leave the state government indifferent. But that does not happen if the federal VAT taxes the state government on the dollar of production inputs and also taxes private firms on the resulting additional dollar of output. The state's population then faces two layers of tax if the input is produced, but faces only one layer of tax if the same resources are used to directly produce consumer goods. That inefficient overtaxation distorts the state's choice away from the provision of production inputs.

Policy Options

On paper, the above analysis yields a straightforward prescription. A federal VAT should be imposed (through taxation of purchases combined with an employer payroll tax) on state governments' provision of consumer goods, but not on their provision of production inputs. Real-world tax policy must, however, confront the difficult challenge of distinguishing consumer goods from production inputs in that context.

When goods are sold in private markets, a VAT, retail sales tax, or income tax can start from a working assumption that goods purchased by households are consumer goods while goods purchased by business firms are production inputs. Although the tax system must be on guard for exceptions to that pattern, particularly consumer goods that taxpayers purchase through firms in order to disguise them as production inputs, the two types of goods can be reliably distinguished in a wide range of cases. When goods are provided free of charge by state governments, however, there is no purchaser for the tax system to identify, preventing the use of that shortcut.

Instead, it is necessary to examine the nature of the benefits offered by each good that state governments provide. Does the good generate additional production, on which VAT will be imposed, so that there should be no separate (second) tax on its provision? Or does it instead generate consumer benefits on which no VAT is imposed, so that a separate tax is necessary? In many cases, the good may offer both types of benefits. Police and fire protection presumably enable firms and workers to produce more and education presumably makes workers more productive. However, these services also provide some benefits unrelated to production.Hybrid goods that serve as both consumer goods and production inputs should be partly taxed, but it is difficult to determine the appropriate degree of taxation.

Even if the goods are properly classified, cost allocation questions arise. Employer payroll tax should apply to state governments' wage payments to workers producing consumer goods, but not to their wage payments to workers producing inputs. VAT should apply to the state government's purchases from private firms if the purchases are used to produce consumer goods, but not if the purchases are used to produce inputs. The implementation of this system therefore requires that costs be allocated between the two types of goods.6

Proposed VATs and sales taxes have addressed those issues in different ways. It is unclear that any of them have reached satisfactory conclusions. As noted below, the current income tax system has also not arrived at a satisfactory policy.

As I observed in the first article, the FairTax bill, introduced in the 112th Congress as H.R. 25, generally imposes tax on state governments' purchases, accompanied by an employer payroll tax. But the bill provides an exception for education and training provided by state governments, on the ground that it is a production input. To begin, proposed Internal Revenue Code section 2(a)(4) defines education and training to include ‘‘primary, secondary, or postsecondary level education, and job-related training courses.'' Proposed Code section 2(a)(8)(D) then states that ‘‘education and training shall be treated as services used to produce, provide, render, or sell taxable property or services,'' which causes those services to be treated as services ‘‘purchased for business purposes'' under proposed Code section 102(b)(2) and therefore exempt from sales tax under proposed Code section 102(a)(1). Having granted that tax exemption to privately provided education and training, the bill proceeds to also offer tax relief for publicly provided education and training. Proposed Code section 2(a)(14)(B)(ii)(IV) states that the employer payroll tax does not apply to wages paid by state governments (or by other ‘‘taxable employers'' subject to the payroll tax) to ‘‘employees directly providing education and training.'' On a potentially broader, but extremely vague, note, proposed section 102(a)(3) states that no tax shall be imposed ‘‘on State government functions that do not constitute the final consumption of property or services.''

Many VAT proposals simply do not impose an employer payroll tax on state governments. The failure to impose an employer payroll tax, if accompanied by an exemption for sales by private firms to state governments, achieves the correct treatment of production inputs, but inappropriately subsidizes state governments' production of consumer goods. Of course, if sales by private firms to state governments are not exempted, the lack of an employer payroll tax arbitrarily induces state governments to move production (of both consumer goods and inputs) in-house.

At the risk of adding still another complication, the effect of a VAT on state governments also depends on how state taxes are treated. Throughout this discussion, I have assumed that taxes paid to state governments are not deductible under a federal VAT. Allowing a deduction for state taxes would provide tax relief for the costs of state governments' provision of production inputs, but it would also provide tax relief for the costs of state governments' provision of consumer goods and transfer payments made by state governments. That deduction would therefore offer little help in resolving the questions discussed here.

Moreover, any state tax deduction provided under a federal VAT would inevitably be highly selective. Although a deduction might be provided for some or all state taxes remitted by firms, there would surely be no deduction for state taxes imposed on the firm's workers and providers of capital, even though there is no economic reason for that distinction. For example, it would be distortionary to allow firms to deduct state corporate income taxes in computing their value added, given that there would surely be no deduction for state individual income taxes.

Conclusion

That state governments provide production inputs as well as consumer goods complicates the proper treatment of state government production under a federal VAT. In an ideal world, tax would apply only to the latter, but there is no ready way to distinguish the two types of goods. The best approach may be to draw rough and ready distinctions, offering tax relief for education and other programs that are likely to be production inputs.

One might be tempted to think that those problems can be avoided by not adopting a federal VAT. In reality, however, the same difficulties arise under income taxation, perhaps in even greater force, because income taxation must also distinguish between consumer goods and production inputs. The current income tax system unavoidably confronts those questions but does not address them in a systematic manner. With little fanfare, the current system taxes state and local government employees' wages, the same policy that becomes so controversial when it is proposed as part of a VAT or sales tax. The current system also taxes the workers, capital owners, and firms that produce goods that are sold to state governments. No distinction is drawn based on whether the state government is providing consumer goods or production inputs. The current system also allows many, though not all, state taxes to be deducted. The resulting patchwork bears little resemblance to neutral tax policy.

The appropriate federal tax treatment of state governments, either under the current tax system or under alternative tax systems, deserves far more consideration than it has so far received.

Endnotes

1Alan D. Viard, ‘‘Taxing State Governments Under a Federal Value Added Tax: Part 1,'' State Tax Notes, May 14, 2012, p. 487, Doc 2012-8642, or 2012 STT 93-7. As in the previous article, I use the term ‘‘state governments'' to refer to state, local, and tribal governments.

2Alan D. Viard, ‘‘The Child Care Tax Credit: Not Just Another Middle-Income Tax Break,'' Tax Notes, Sept. 27, 2010, p. 1397, at pp. 1400-1401.

3See Alan D. Viard, ‘‘Should Groceries Be Exempt From Sales Tax?'' State Tax Notes, July 25, 2011, p. 241, Doc 2011-14643, or 2011 STT 142-5.

4Alan D. Viard, ‘‘Sales Taxation of Business Purchases: A Tax Policy Distortion,'' State Tax Notes, June 21, 2010, p. 969, Doc 2010-12212, or 2010 STT 118-4.

5Id., pp. 967-969. 

6I noted in the first article (p. 490) that those complications also arise if the VAT zero-rates particular consumer goods provided by state governments.

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