VAIT - The Value Added Income Tax

By Jalexson

Copyright 1992

 The United States needs to replace its corporate profits tax with a Value Added Income Tax(VAIT). The corporate profits tax has outlived its usefulness. It discriminates against American businesses and hampers efforts to modernize American factories. A VAIT could increase federal tax revenues without increasing the burden on most American companies. It would keep companies from avoiding taxes by setting up offshore shell companies..

The VAIT would treat corporate income in terms of the value added by the corporation and ignore the whole question of profit and loss. In its simplest form the VAIT would apply to income(revenue) minus taxed costs, primarily purchases from VAIT paying businesses and labor costs subject to employer matching F.I.C.A. tax. The VAIT would be somewhat similar to the European Value Added Tax(VAT). Tax deductable costs would have to be related to revenue sources. The cost of purchasing another company's stock wouldn't be deductable from revenue generated by sale of manufactured goods. Purchase of imported goods wouldn't qualify as a deductable cost. A more complex VAIT could disallow deductions for nonessential costs such as expensive corporate furnishings.

The broader range of income subject to the VAIT would allow a much lower rate without reducing tax revenue. Ignoring the profitability of corporations would spread the tax burden among more companies including those that show a profit for stockholders but not for tax purposes.

The current corporate tax structure has become so complex that the cost of figuring taxes increases the prices of American goods while reducing federal tax revenues. Replacing it with a simpler tax system would eliminate some unnecessary business costs.

Taxing corporate profits made sense decades ago when a business subtracted its expenses from its revenues at the end of the year and considered whatever was left profit. Today a corporation's profit is whatever the accounting department says it is. Changing the way a corporation handles inventory or depreciation can mean the difference between profit and loss. Some corporations create public relations problems for all businesses by using accounting methods that show a profit for stockholders but a loss for tax purposes.

Basing the corporate tax on profits places the highest tax burden on American manufactured goods. Foreign companies do not pay American profits taxes and thus purchases of foreign manufactured goods do not generate the same federal tax revenues as purchases of American made goods. Shifts in American buying habits have played a greater role in reducing the role played by corporate taxes than "tax loopholes".

Corporate profits do not provide an adequate measure of corporate income. A corporation can survive and grow without ever showing a profit so long as stockholders do not object. A corporation owned by management does not need to show a profit because managers can reward themselves with higher salaries or bonuses instead of stock dividends. High management salaries and benefits have also reduced corporate tax revenues. The corporation can use depreciation of purchases or show paper losses on financial dealings to avoid showing a profit. Stockholders may prefer to benefit from increased stock prices rather than dividends.

             From a technical standpoint no American corporation pays income taxes. "Revenue" is the term for a corporation's income. The term "profit" applies to stockholders' income. Profits may be distributed to stockholders or used to enhance the value of the corporation and thus increase the value of the corporation's stock.

The current corporate profits tax creates economic problems. Exorbitant federal tax rates discourage corporations from operating at a profit. Government must create special tax breaks for favored industries to stimulate profitable operations. Operating a corporation with one eye on the tax situation causes corporations to make what otherwise would be dysfunctional business decisions. Businesses and individual investors may become so preoccupied with tax situation that they ignore income producing opportunities.

The VAIT would ignore the question of profit and loss. The tax would apply to revenue minus costs upon which federal taxes have already been collected. The primary reason for deductions should be to prevent double taxation. A purchase from a business that pays the VAIT could be a deductible cost. A purchase from a foreign supplier, a non-profit corporation, or some other non-VAIT paying entity could not be deducted. Manufacturing costs at plants outside the United States would not be deductible. Partnerships and other types of businesses would have the option of operating as a corporation for tax purposes. Employee expenses subject to employer matching F.I.C.A. tax would be deductible because the corporation would already pay a federal tax on the expense.

The tax should be revenue and cash flow oriented. Generally revenue would be taxable during the tax period the corporation received cash or its equivalent. Relevant costs would be deductible during the period the corporation expended cash or received revenue. The latter approach would be especially useful for companies that manufacture products with long lead times or for research and development expenses. A company wishing to expand could expend current revenue on additional supplies or equipment. A company could deduct the cost of some planned purchases of buildings and equipment by committing cash to such a purchase. Failure to complete the transaction would subject the company to paying the appropriate tax plus interest.

Deductions would have to relate to revenue sources. For example, purchase of raw materials would be deductible from revenue received from the sale of the finished product. The purchase of stock as an investment would be deductible only from the sale of investment stock, not from the sale of the company's manufactured products.

 A corporation would deduct the cost of buildings and equipment when the company used cash from revenues to pay for the purchase. If the corporation used revenue to pay directly for the purchase, the company could deduct the total expense at one time. If the corporation used a loan. the deduction would occur as the company used revenue to retire the principle of the loan. Interest would be deductible if the loan came from a VAIT paying entity. A corporation could deduct the appropriate VAIT tax from the interest it would otherwise pay to non-VAIT paying investors.

Payments using cash raised through sale of the corporation's own stock would be deductible as the corporation used profits to pay dividends. The deduction would continue until the amount of dividends paid equaled the amount of the payment. This procedure could encourage use of stock sales rather than borrowing to raise funds for expansion.

Purchases using this procedure would have to involve the company's principle business and involve buildings and equipment. Purchase of another company's physical assets would be deductible but not purchase of the other company's stock. The purchase price of stock could only be deducted from the sale price of stock.

This approach would replace arbitrary assignment of a depreciation period for building and equipment deductions. Corporations can adapt to technological changes better if they can purchase the newest equipment and discard the old as fast as they can generate the necessary revenue. Preoccupation with depreciation schedules can financially lock a company into outdated equipment.

The need to use depreciation to expense an item may force a company to borrow money rather than use revenue. Otherwise the company would have to use the revenue for tax expenses rather than to purchase new equipment. With borrowing, the company can pay out a amount of cash equivalent to the amount of depreciation expense. Using revenue could require the company to pay more because of the difference between revenue and the amount of depreciation allowed for tax expense.

Assume a company wants to finance a $1 million purchase of buildings or equipment. Under a VAIT the company could accomplish this goal by spending $1 million in revenue. Under the current profits tax a corporation using revenue to expand would be using profits. Assuming a 50% tax rate, the company would have to have additional profits of $1 million minus allowable depreciation expense to finance expansion. The additional amount would be a tax on expansion. Borrowing would allow the company to finance the expansion without having additional profits for income tax. Assuming the company can arrange the repayment schedule to avoid the profits tax, the company would eventually pay an additional amount(possibly exceeding $1 million) for interest.

Attempts to encourage investment in new technology through the current tax system have been inefficient. Companies may decide to act to take advantage of the law rather than to purchase what the company needs to remain competitive. Arbitrary legal depreciation schedules may provide excessive benefits to some industries and inadequate assistance to others. Some corporations waste money(in an economic sense) by purchasing other companies rather than building new plants or otherwise expanding the nation's productive capacity.

Allowing deductions for labor expenses subject to employer F.I.C.A. taxes would protect labor intensive industries. Otherwise the tax could increase unemployment by increasing labor costs in marginal industries. This approach could have the effect of taxing various employee fringe benefits such as medical insurance. Taxing these benefits at the company level(even if paid to a VAIT paying corporation) would eliminate the problems associated with attempting to determine the income equivalent benefit for individual employee/taxpayers. If the VAIT rate is lower than the F.I.C.A. tax, a corporation might be allowed to deduct additional labor expenses to make the rates effectively equal. This provision would insure continued employer support for Social Security.

This deduction would eliminate any need to exempt some industries from the VAIT. The food industry in particular relies heavily at all levels upon workers whose salaries are well under the maximum salary for the F.I.C.A. tax. The VAIT on food would have a lower effective rate than the VAIT on some other products. The same situation would exist with American made clothing.

Industries with many highly paid employees would deduct only a portion of labor costs and thus pay a higher effective VAIT rate. Sports and entertainment oriented businesses would pay some of the highest taxes. Among manufacturers, those facing the least competition, especially foreign competition, would pay the highest taxes. These companies can afford higher salaries and more executives than companies facing stiff competition.

A company purchasing goods from a foreign non-taxpaying company could not deduct the cost of goods. A corporation could not even deduct production costs at its own plants outside the United States. This provision would discourage companies from operating foreign subsidiaries at a profit to avoid American taxes. Increasing the value added to a good outside the U.S. would increase tax liability by reducing the deductible portion of the good's final value.

Import taxes would be deductible. The payment of import taxes would not qualify an item as a deductible expense because tariffs depend upon various political factors including treaties. Tax rates may vary according to type of good or nation of origin. Foreign policy considerations might cause the government to set the rate for a given country's goods lower than the VAIT rate. The lack of uniformity could give some businesses an advantage over others.

Purchases from partnerships and other non-corporate entities would not be deductible. Such organizations might pay taxes at substantially different rates from the VAIT. Disallowing deductions for payments to outside partnerships, individuals, etc. would discourage use of highly paid "consultants" to handle jobs normally performed by highly paid employees. Allowing deductions to consultants would allow some companies to deduct salaries for attorneys or some managers by treating them as if they were outside consultants.

Partnerships or individuals wishing to sell goods or services to corporations would have the option of paying the VAIT under the same conditions as a corporation. This option would allow partnerships to enjoy the non-tax advantages of a partnership without having to lose business to corporate competitors.

Making the VAIT a corporate tax rather than a business tax would exempt many small retail businesses, especially "mom and pop" operations, from the VAIT. These businesses could continue to pay taxes under individual or other rates. Individual businesses could make their own decisions about whether to pay taxes as a corporation or not. This provision would help make the VAIT a corporate income tax rather than a sales tax.

Corporations could deduct some but not all payments to government. The nature of the payment would determine its deductibility. Federal taxes would be deductible to avoid double federal taxation. Purchases of goods or services, particularly rental of government owned buildings, would not be deductible because government landlords would not be paying federal taxes.

Corporations paying reduced rates for rent or government services would have to treat the difference between their rates and normal rates as taxable revenue. Profit-making corporations are not charitable institutions. Corporations receive revenue(cash or some good or service) for providing goods or services. When a corporation agrees to remain in or relocate to a community and provide jobs to community residents the corporation is providing a service. If the local government provides the corporation reduced-rent buildings, tax breaks, or reduced costs for government provided services the corporation has received payment(revenue) for its service, providing jobs. This revenue should be as taxable as a direct payment of cash by government to the corporation. The above approach would not apply to a corporation forced to relocate within a community because of government needs for the corporation's current business site.

Corporations seldom need any special financial considerations from local governments. Some companies like to use the desperation of local communities for jobs to extort money. These companies claim they need special assistance in order to obtain minor cost reductions. Successful companies must locate plants based on broader geographic and economic factors in order to survive. Marginal companies that must receive government welfare to survive will probably eventually fail anyway.

State and local taxes would not be automatically deductible. Property taxes could be deductible to reduce the impact of arbitrary tax exemptions local governments sometimes grant to favored businesses. An alternative approach would treat less than normal taxes as taxable revenue rather than allowing a deduction. Purchases from government owned utilities, including water, would be nondeductible because a corporation might purchase from a corporate supplier, produce its own electricity, etc.

Highway taxes would be deductible because of the central role state expenditures play in maintaining the national highway system. Local airport taxes and fees would be nondeductible because the benefits apply to the local community and because a private VAIT paying corporation could own part or all of the airport. Government owned airports can charge less because they do not pay the VAIT and do not need to make a profit.

State income taxes would not be deductible because allowing such a deduction violates the Constitution. The constitutional convention was called in part to eliminate state control over federal revenue. Allowing deductions for state income taxes gives state governments the power to control federal revenues like the states had under the Articles of Confederation. The "people of the United States" rather than the states themselves created the Constitution. Allowing the states any control over the national government's handling of national functions violates the very nature of the Constitution. Nothing in the Constitution grants the federal government the right to tax the income of persons(including corporations) in one state at a higher effective rate than the income of persons in another state.

The same argument would not apply to property or sales taxes because these taxes become part of regular business expenses. The property tax is a property maintenance expense. The sales tax increases the cost of purchases of taxable items.

Some purchases might be partially deductible. For example, payments for business lunches can be either an employee benefit or a form of advertising. Allowing a full deduction would mean a company could provide expensive meals as a fringe benefit to favored employees. Precluding a deduction could discourage a company from entertaining clients and adversely affect the restaurant industry. Forcing businesses to keep intricate records so that some lunches would be deductible would create unnecessary expenses for companies and the government.

Corporations might also be able to deduct some portion of money donated to colleges and universities or spent to purchase research and development services from universities. Allowing such deductions would reduce the amount government would have to spend to support higher education. Deductions for research would encourage universities to apply knowledge to improving society rather than simply passing information along to future professors.

Shifting from the traditional profits tax to a VAIT would require a transition period whose length would depend upon the business activity involved and past tax liabilities. Some corporations should begin paying a VAIT as soon as possible. Others might switch gradually. Treatment of deductions would shift away from that used for the profits tax to the form of the VAIT. The tax rate would decline as previously available deductions disappeared.

Importers who purchase foreign products for resale should begin paying the VAIT no later than January 1 of the year after adoption of the VAIT. This same timetable should apply to corporations that have shown no, or only an insignificant, taxable profit while showing a significant profit for stockholders. Imposing the VAIT would make more sense than attempting to levy an arbitrary minimum tax. A minimum tax could place an unfair burden on marginal companies or industries.

he first step in shifting to a VAIT for many companies would involve splitting various corporate activities up for tax accounting purposes. Loses in one area such as stock transactions could not be applied to the tax liability for manufacturing. Conglomerates would have to handle various subsidiaries as separate tax paying entities. Losses from a meatpacking plant could not be deducted from the profits of a sporting goods manufacturer.

Depreciation would pose the most significant problem in shifting from a profits tax to a VAIT. The VAIT would handle building and equipment purchases on a cash flow basis rather than using a standard depreciation formula. One way to handle the transition would involve continuing the depreciation schedule method for purchases prior to initial implementation of the VAIT and the VAIT approach for new purchases. Corporations using straight-line depreciation would have the option of switching to a cash flow based deduction. Corporations using accelerated depreciation would have to show that their cash expenditures had equaled or exceeded their previously claimed depreciation in order to switch to a cash flow deduction.

Purchase of a controlling interest in another corporation would no longer qualify the purchases to any deductions such as depreciation. A company would have to integrate the purchased company's assets into its own operations to take advantage of the purchased company's existing deductible costs, including any remaining depreciation deductions.

Even if Congress does not adopt the VAIT, it should eliminate the practice of allowing depreciation deductions on the purchase of corporate stock when purchase allows one corporation to gain control over another corporation. The purchase of another corporation's stock involves purchase of a financial instrument which provides a claim on the physical assets of the corporation rather than the actual purchase of these assets. Banks and other lenders often have a stronger claim to buildings and equipment than stockholders have.

Revenue from the sale of assets to pay for a corporate takeover or buy out would be taxable. The cost of the takeover would not provide any deductible expenses. Deductions would have to involve acquisition and maintenance expenses not previously deducted. The lower VAIT rate would not prevent sales necessary for business reasons. This approach would reduce profits and thus provide a neutral way to discourage the practice of buying corporations and destroying them by selling their assets.

Inventory accounting procedures would also change under the VAIT. Corporations would no longer have the opportunity to choose between First In First Out(FIFO) and Last In, First Out(LIFO). The cash flow procedure under the VAIT would resemble FIFO, except that a corporation might be able to deduct the cost of unsold inventory already paid for with revenue. Corporations currently using FIFO would simply switch at some point with unsold but paid for inventory becoming deductible before its sale. Corporations using LIFO would have to switch to FIFO under the old profits tax system with new inventory becoming deductible under VAIT rules.

A VAIT would insure a relatively constant source of revenue regardless of the country of origin of consumer goods sold in the United States. The rate could be low enough and uniform enough among competing businesses to discourage manipulating business decisions to reflect the tax system rather than economic needs. American companies would not lose sales to foreign companies because of federal taxes. The tax on American goods would be the same as comparably priced foreign goods. The VAIT approach would allow the federal government to increase revenues without increasing the tax burden on taxpaying American companies or upon individuals.

The corporate profits tax has outlived its usefulness. It imposes double taxation upon stockholders who as a group pay taxes on their profits(reducing dividends) and as individuals pay taxes on their dividends. The European VAT applies the tax to labor costs and thus must be passed along like a sales tax. The VAIT would apply to corporate income that exceeds most essential expenses such as purchases and basic labor costs. Importers would have to pass along the cost of the VAIT because of the lack of deductions. American manufacturers would avoid part of the VAIT expense by reducing management salaries and other expenses such as investments in tax shelters. As with the current profits tax, corporations would pass along as much of the tax as competition allowed.

The profits tax rewards mismanaged companies that lose money while providing unjustifiably high management salaries and benefits. The VAIT would tax these companies, but would not tax a corporation in a depressed industry if the corporation avoids luxury purchases and its executives work for much lower than normal salaries while attempting to change the company's financial position. The European VAT would continue to tax a corporation's labor costs regardless of the corporation's financial position or attempts to improve its ability to survive.



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