VAT Flap

If you find yourself stuck at another boring dinner party and desperately seek some new topic which will get the attention of all in attendance just mention the federal VAT tax. Whether in lowly New Jersey, or in the stratosphere of Washington DC, federal lawmakers are being teased by the prospect of scrapping the entire Internal Revenue Code in favor of a federal consumption tax. Just imagine the income, estate gift and FICA taxes would all evaporate with a stroke of the pen. April 15 would be remembered only for the sinking of the Titanic and not the day that Americans suffered through the annual task of filing federal income tax returns. The Internal Revenue Service itself could perhaps be cut to a 10th of its size saving oodles on the federal payroll, perhaps to be used for more worth while pursuits. So what is this thing called VAT? From to time  I have referred to it simply as a sales tax. This short changes the idea. From the buyer's perspective, VAT in fact looks a lot like a sales tax, which is paid upon the purchase of listed items. However, from the seller's point of view and the tax collection authorities, it is not all that simple. Take a peak at what Wikipedia has to say about VAT tax:

A value added tax (VAT) is a form of consumption tax. From the perspective of the buyer, it is a tax on the purchase price. From that of the seller, it is a tax only on the value added to a product, material, or service, from an accounting point of view, by this stage of its manufacture or distribution. The manufacturer remits to the government the difference between these two amounts, and retains the rest for themselves to offset the taxes they had previously paid on the inputs.
The value added to a product by or with a business is the sale price charged to its customer, minus the cost of materials and other taxable inputs. A VAT is like a sales tax in that ultimately only the end consumer is taxed. It differs from the sales tax in that, with the latter, the tax is collected and remitted to the government only once, at the point of purchase by the end consumer. With the VAT, collections, remittances to the government, and credits for taxes already paid occur each time a business in the supply chain purchases products.

A true sales tax lets a buyer potentially worm out of paying the tax by claiming that he is not in fact the ultimate consumer. Sellers are required to obtain certificates affirming that fact, but what is it to him? With a VAT tax the seller has his own head and money in the game:

Value added taxes were introduced in part because they create stronger incentives to collect than a sales tax does. Both types of consumption tax create an incentive by end consumers to avoid or evade the tax, but the sales tax offers the buyer a mechanism to avoid or evade the tax—persuade the seller that the buyer is not really an end consumer, and therefore the seller is not legally required to collect it. Therefore, the burden of determining whether the buyer's motivation is to consume or re-sell is on the seller, and the seller has no direct economic incentive to collect it. The VAT approach gives sellers a direct financial stake in collecting the tax and eliminates a decision needing to be made by the seller about whether the buyer is or is not an end consumer.

So there you have it a short tutorial on VAT tax. Since Congress doesn't seem to be able to do much of anything these days some congressmen with time on their hands have actually put together a proposal called the Fair Tax. It is in essence a federal VAT. The tax rate would be 29.9%. Tax rebates would be provided to some taxpayers and some asset purchases would be exempt. Of course there are critics who say such a VAT tax would simply not raise sufficient revenue as the current system. But the reason may also be in our political system that it would be difficult for congressmen and senators to slip in as many exemptions for pet taxpayer contributors if such a simplified method of taxation were to be adopted. The current Internal Revenue Code is simply riddled with special interests. In fairness, the current tax code does raise substantial revenue, but it is also used for economic and social tinkering, and it is there where a VAT tax may not fill the bill.

The IRS Audit Lottery

Face it, the odds of winning the lottery, power ball or whatever it may be called are probably only slightly less then being hit by lightning on an absolutely clear winter evening. Twice. The odds of winning the IRS lottery are better. But not as good as you may think. Tax returns are not selected by random. Au contraire. The IRS does its best to use its limited resources laser like to select those returns which most likely present compliance issues. As computers become ever more sophisticated the process becomes more fine tuned. For the most part, audit selection is based upon the entries on the return. In a well kept IRS secret, a formula exists which when pumped into the IRS computers spits out tax returns which should at least be reviewed by a human and possibly further examined by the IRS examination division. Now as to the odds themselves: there are about 140 million individual income tax returns filed annually about 1.5 million are audited. That is approximately 1.1%. Most of these audits are conducted by correspondence. That is, lucky winners get mail from the IRS requesting explanation and verification of tax return entries. For business returns showing total gross receipts of $100,000-$200,000 approximately 4% are audited and for those returns with receipts of $200,000 or more 3.8% get to chat with IRS. For lucky winners with total positive income of 1 million or more, the rate may be as high as 12.5%. In all categories for recent years IRS claims that audit rates have increased slightly. How does one avoid winning this lottery? Recognize that the deductions, credits and allowances claimed on a tax return are actually compared to income and that the IRS formula also considers the likelihood of being able to survive on the amount of net reported income. IRS does also conduct special audit projects to identify non filers and problem cases and the agency may respond to hate mail from disgruntled spouses, employees and such. IRS has also gotten rather good at matching those pesky forms 1099 that are sent to taxpayers every year by all manner of income sources. Brokerage houses for example will be letting IRS know not only the gross sale proceeds of stock sold but also the tax basis or cost that is used to figure the taxable gain on the transaction.

Italian tax authorities have shifted their attention away from tax return numbers on their forms and toward finding out what Italians spend and then comparing that to their filed tax return. How did Mario have the lira to get that Maserati on the paltry income reported on his not so buono Italian tax return? As computers, iPhones, iPads and such track a taxpayer’s every purchase and preference, hiding from IRS or the Italian tax people for that matter, may become very difficult indeed.