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Entrepreneurship and small business under a value-added tax

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The possibility of introducing a value-added tax (VAT) in the United States has been discussed on a sporadic basis for several decades. In recent years, efforts to implement a VAT have been spurred by a desire to replace the revenue lost from reducing and simplifying the income tax (for example, Graetz 2010; Toder, Nunns, and Rosenberg 2012) and/or a desire to shore up the nation’s long-term fiscal situation (Debt Reduction Task Force 2010; Gale and Harris 2011).

As explained below, the VAT is, in effect, a consumption tax. Although it would be new to the United States, the VAT is a workhorse of tax systems around the world. Approximately 160 countries around the world— including every OECD member except the United States—administer a VAT. VATs provide the third largest revenue source in OECD countries, behind income and payroll taxes. Across all levels of government, VAT revenue averaged 5.5 percent of GDP and almost 17 percent of overall revenues in OECD countries (OECD 2015) in 2012.

One of the critical questions in designing a VAT is whether to exempt small businesses and, if so, at what threshold. Including all businesses may seem, a priori, like a natural policy choice, but the government’s administrative and private compliance costs associated with collecting tax from small businesses often prove to be high relative to the revenue generated. As a result, most countries with VATs exempt some small businesses.

This paper examines issues related to small business and entrepreneurship under a VAT. Section II discusses the basic mechanics of a VAT, including the important distinction between goods or businesses that are zero-rated compared to those that are exempt.

Section III discusses the treatment of small business under a VAT. Most OECD countries provide VAT exemptions to businesses with total sales below a given threshold. Applying the tax to very small businesses often creates significant compliance costs for these firms with little or no revenue gain to the government. The optimal threshold balances the revenue collected and the administrative and compliance costs. Brashares et al. (2014) finds that the optimal threshold for a VAT in the United States would vary dramatically with the actual VAT rate. At a rate of 5, 10, or 20 percent, the optimal threshold—based on a firm’s total annual sales —would be $600,000, $200,000 or $90,000, respectively. Political factors may reduce the thresholds further. Despite this seemingly clear relationship in theory and simulations, in practice there appears to be no correlation between an OECD country’s standard VAT rate and its business exemption threshold.

The creation of a VAT in the United States would raise taxes on business sales to other businesses and consumers. While it is impossible to directly estimate the effects of a VAT in the U.S. since one has never existed, it is nevertheless possible to shed light on a variety of related subjects that bear on the question of how a VAT would affect small businesses. Toward this end, Section IV shows that the previous literature examining the effects on sales and income taxes on firm behavior and overall economic activity reaches fragile and uncertain conclusions.

Section V presents estimates of the effects of income and sales taxes on the number of small firms and on employment by those firms. Notably, although the VATs around the world define small businesses in terms of total sales, our classification of small firms is based on employment. We find that increases in state sales tax rates, given their impact on revenues, do not have statistically or economically significant effects on the number of firms or the employment within firms. Section VI provides concluding remarks.

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Authors

Aaron Krupkin

Senior Research Analyst - Urban-Brookings Tax Policy Center

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