The value added tax [VAT] and vertical integration.

Currently there are calls [Mankiw Cowen] for a national VAT to help pay for projected government shortfalls in the future. The US is one of the few developed nations not to use a VAT. In its operation the VAT is like a sales tax, only each seller gets a credit for past VAT taxes paid.

Say for example we have a VAT tax of 10%. In the widget business, raw materials cost $999 to produce and they are sold to a widget maker for $1000 plus a VAT tax of 10% for a total price of $1100. A widget costs $900 to produce, plus the cost of raw materials for a total cost of $2000. Widgets sell for $2000 plus a VAT tax of $200 for a total sales price of $2200. The seller gets a credit of $100 for past VAT taxes paid reducing the widget maker’s VAT payment from $200 to $100, giving the seller a net profit of $100.

At first glance it may appear that a VAT does nothing to encourage vertical integration, the selling price and net profit will likely be the same if the widget maker owns the raw material suppler. The problem is that the VAT is essentially a no interest loan to the government.

Assume the same facts as above only this time imagine that the widgets take a full fiscal year to produce, and assume a 5% annual interest rate. The widget maker buys the raw materials in year 1 for a total price of $1100. In year 2 the widget maker sells the widget for a net profit of $100. The problem is the opportunity cost of paying $100 in VAT taxes in year 1.

Now assume the widget maker has purchased the raw material producer. In year 1 the raw materials cost $999 to produce. The widget maker takes the $101 that would have been spent on raw materials, and invests that money earning 5% annually. In year 2 the seller has interest income $5.05 on the $101 investment. In year 2, the seller also sells a widget which costs $1899 to produce [taking into account the cost of raw materials]. The widget is sold for total sales price of $2000, plus the VAT of $200. The seller nets a profit of $101, for total net profits in year 2 of $106.05. The $6.05 difference in net profit is the opportunity cost associated with not vertically integrating the raw material producer with the widget maker.

The VAT is likely to cause otherwise inefficient parings of companies in an attempt to recoup the opportunity cost associated with paying for the VAT earlier in the distribution chain. This is not to say that on balance the VAT is inferior to the income tax, but it should be noted that the VAT increases transaction costs in ways not directly related to any potential deadweight loss due to price increases.