Neither the retail sales tax (RST) nor the value added tax (VAT) apply directly to the individual. They are both forms of an indirect tax. So how does each type work, what are the differences and which system is best? That’s what we are going to find out in this article.
Retail sales tax (RST)
The retail sales tax is the system that has been implemented in the United States (on the state level). The retail sales tax is based on consumption. Consumption being a person taking something from society and using it for his own use. We shall look at a simple example to elaborate on the retail sales tax system. Store A has a table for sale, the price is $1000 and the state has imposed a 10% retail sales tax. This would mean that you and I as consumers would need to pay the store $1000 for the table and an extra 10% tax ($100) so overall the table costs us $1,100. The store keeps $1000 for itself and sends the 10% of tax, in this case $100 to the government.
So what are facing with the retail sales tax? First off, it’s efficient, since it is easy to collect. Furthermore, it taxes consumption and not savings. This is therefore usually seen as more fair system. The retail sales tax also allows governments to push social goals forward as different rates can be set for different products. This all sounds wonderful. Unfortunately, as is the way with these things, there are one or two problems:
- The retail sales tax is basically a regressive tax. Thus, a billionaire buying a new xbox is going to pay the same amount of tax as a poor old minimum wage worker. Therefore the tax burden decreases as your income increases. There is an issue with fairness here.
- From the revenue point of view, if a tax is too high, we may encounter a lose lose situation in which people simply avoid purchasing the product altogether. The consumer isn’t pleased and the tax authorities haven’t collected any revenue.
- We may also have a distortion in buying habits. This meana that I may refrain from buying the product that I want and buy a cheaper alternative due to the tax.
- The system is simple and a simple system is easy to beat. Consider a scenario with two stores. Store A is a lawful outfit of impeccable integrity. Store B is quite the opposite. Both stores are selling a macbook laptop that costs $1000. The retail sales tax is 10%. Store A would sell me the computer for $1000 + $100 tax. Store B thinks that the tax is pointless and decides it would be best to sell the computer for $1050. This means the store earns more than he normally would and the consumer is still getting a better deal. The only loser is the government that has lost all of its potential revenue from this deal. All it takes is for the store to cheat and the government loses everything. As if that wasn’t enough, both the store and the consumer have an incentive to cheat, because as we saw with the computer example, cheating is a win win situation for both the store and the consumer.
That’s the retail sales tax in a nutshell.
Value Added Tax (VAT)
What is the value added tax (VAT) all about? Both systems are actually very similar. The key difference is that the VAT is collected at every stage of the production process compared to the retail sales tax that is collected only at the final sale to the consumer. With the VAT, tax is paid on every stage of the production process. If we consider the computer example, the chip company pays a small tax, the hard drive manufacturer pays a small tax, the company making the computer case pays a small tax etc. So instead of collecting tax on the final product when it’s being sold to the consumer, the government collects tax on all the pieces used to manufacture the final product. Basically, every time value is added to the product, there is a tax, and thus the name – value added tax. Is this system better? Or worse?
- Effectiveness – it is very hard to avoid the VAT tax as each stage of the manufacturing process is taxed. The scenario of the computer sale and store B is not applicable in a world of value added tax. Even if someone cheats under the VAT system, the government still collects part of the tax revenue and all is not lost (as it would be with the retail sales tax).
- Revenue – The collected revenue is likely to be larger with a VAT system because as said, even if people cheat, revenue is still being collected.
Are there any downsides?
- Like the retail sales tax, the VAT is a regressive tax. See discussion above.
- Government tax collection revenue may not ultimately be higher than a retail sales tax system due to the massive amount of resources needed to administrate a VAT system.
- The VAT system is more complicated thus allowing clever citizens to find loopholes.
Which do you think is more effective and why? We would love to hear your thoughts.
Feature image: GotCredit