What is the difference between sales tax and VAT?
Today, the Conservative Party leadership contest will be narrowed down to the final two candidates. One of the remaining four candidates, UK Environment Secretary Michael Gove recently announced that if he were elected leader he would scrap VAT after Brexit. Writing in the Sunday Telegraph, he argued: “It would mean reducing the regulations which hold businesses back…using the opportunity of life outside the EU to look to replace VAT with a lower, simpler sales tax.”
The suggestion has been met with derision in some quarters, but why? The most powerful economy in the world, the United States, favours sales tax over VAT. So what’s the difference and what does it mean for businesses?
Differences between VAT and Sales Tax
Companies throughout the supply chain all pay VAT on the individual goods they purchase. The government then receives the total tax revenue from the entire supply chain. Businesses track the VAT they pay on purchases that will be resold and are able to reclaim the VAT from the government.
Only the end consumer of the goods that are purchased pays sales tax. Businesses send resale certificates to their suppliers when paying for purchases that will be resold, so they do not have to pay the sales tax. The government only receives the tax revenue when the final product is sold to the end consumer.
Sales tax in the US
Since Gove describes his proposed tax as “simple”, one might assume he would intend it to be a flat rate, unlike the US model where taxes include federal, state and local taxes levied on specific commodities. This can actually create complexity and sometimes has the effect of “cascading” tax, as the vendor might have to apply multiple tax rates to a product when selling to an end consumer. If you sell many different products in many different states, this can make it difficult to apply tax accurately. Also, the continuous exchange of resales certificate may create considerable additional administration.
The current tax code in the US is comprised of more than 74,000 pages of rules and regulations. It is not always so easy for the average person to wrap their heads around such a complex document.
What does it mean for businesses?
Replacing VAT with sales tax could assist businesses by removing a lot of fiscal complexity. Since it would only be necessary for final consumer of a product to pay tax, it would make it easier for companies to trade domestically by removing the need to reclaim VAT on goods that are resold.
However, since most goods today go through many different stages of manufacturing, handled by different entities, it does create a problem: how do you prove that you are not liable to pay sales tax? Usually, this also requires a lot of documentation, so it is debateable how much time and money a sales tax would actually save your average small business.
This can also create a cascading effect when goods are not simply being resold. This is where a lower tax is applied at each stage of production and manufacture, so that the end consumer actually ends up paying more for the same goods.
Imports vs Exports
For complex product that require many levels of production and manufacture, it could favour importers from outside the UK. For companies who export to VAT-regulated countries, this could mean significant competitive disadvantage, since a potentially larger amount of tax would be ‘cascaded’ into the final product. It would be cheaper to just buy domestically, which could affect UK companies’ ability to compete.
Similarly, it might be cheaper for businesses to import products from foreign companies than to buy domestically when they intend to use them in manufacturing. Since there would be no VAT charge for the foreign company and there would be a cascaded sales tax on domestic products, domestic companies could easily be undercut on price.
What does sales tax mean for invoices?
Sales tax makes B2B invoicing simple as there is no tax settlement implied on the invoices between businesses – there are no complex rules for special rates for supply of specific commodities, no VAT exempt rules, reverse charges or 0-rating rules. However, end-point tax calculation and filing is incredibly intricate as it is dependent on the concept of ‘the nexus of business’.
The seller is held responsible for the calculation, collection and settlement of tax to the local state.
State and local authorities charge sales tax, managed by the seller, who must charge a combined % tax (combined between State and Local). A merchant must charge sales tax if it has a so-called 'nexus' in a particular state, which can be a physical presence of employees or property – misfiling (i.e. from the wrong entity to avoid Nexus) is a criminal offence and subject to huge penalties. You need to ensure that you know in which state the tax should be recognised, which could be a complex apportioning exercise, and you cannot just simply choose the most beneficial (no Nexus).
Why is it complex?
If you do business in one State only, it is simple. It becomes very complex for Interstate business: Each state operates its own compliance regime. In addition, cities have the right to levy taxes; there are literally 1000’s of tax regimes in US. Working with suppliers with wrong/undisclosed registration numbers will get you into trouble with the SEC. If Michael Gove wants tax to be simple, he would be wise not to stick too closely to the American model.