Comparison of VAT and Tariffs as Revenue Raisers

With the large and growing U.S. national debt and continued annual budget deficits, we will ultimately need to make policy changes. While some of the reduction in the deficits might be done by reducing programs and efficiencies, it is likely that there would need to be some tax increases. So, that raises the question of what kind of taxes could be raised.

Trump is attempting to raise taxes on U.S. citizens by increasing taxes through tariffs (although he may mistakenly believe that the other countries are paying the tariffs). In another post, I raise the possibility that the U.S. could adopt the Value Added Tax (VAT) as most European countries do.

So, that raises the question of how two different types of taxes that could be paid by Americans (the VAT and tariffs) compare and contrast. The following Chatgpt.com prompts on August 1 may be of interest. Food for thought on the national scene.

Prompt: Compare and contrast the value added tax and tariffs for who indirectly and ultimately pay the tax.

A Value Added Tax (VAT) and tariffs (import taxes) are both consumption-based taxes, but they operate differently and affect different groups of people and businesses. Here's a comparison focusing on who ultimately and indirectly pays each tax:

🔹 Value Added Tax (VAT)

What it is:
A VAT is a tax applied at each stage of production or distribution, but it's ultimately paid by the final consumer. Each business in the supply chain pays VAT on its purchases and charges VAT on its sales, remitting only the difference to the government.

Who indirectly pays:

Producers and suppliers initially pay VAT on inputs, but they pass the cost down the supply chain.
Retailers collect the full VAT from consumers but recover the VAT they paid on their own purchases.
Consumers ultimately pay the full VAT embedded in the price of the final good or service.

Who ultimately pays:
✅ Consumers, especially lower- and middle-income households, since VAT applies uniformly regardless of income and tends to be regressive (a greater share of income for the poor).

🔹 Tariffs (Import Taxes)

What it is:
A tariff is a tax imposed on imported goods, usually as a percentage of their value. It increases the cost of foreign products relative to domestic ones.

Who indirectly pays:

Importers pay the tariff when the goods enter the country.
Retailers and manufacturers that use imported goods often face higher input costs and may pass those costs to consumers.
Foreign exporters may reduce their prices to stay competitive, absorbing part of the tariff (but this varies).

Who ultimately pays:
✅ Consumers, who often face higher prices for imported goods (and sometimes domestic alternatives).
✅ Businesses, especially those that rely on imported inputs, may see reduced margins if they can’t pass the cost on.
➡️ The final burden may be split between consumers, importing firms, and foreign producers, depending on market dynamics.

🔸 Comparison Summary

Feature	VAT	Tariffs
Taxed Activity	All domestic consumption	Only imports
Who Pays Initially	Each business in the supply chain	Importers
Who Bears the Cost Indirectly	All producers/retailers, via higher prices	Importers, retailers, possibly foreign firms
Who Ultimately Pays	💰 Final consumers (domestic)	💰 Final consumers (mainly), businesses, possibly foreign exporters
Effect on Domestic Prices	Uniform across domestic goods/services	Distorts prices between imported vs. domestic goods
Regressivity	Often regressive	Regressive, but more targeted by product

⚖️ Bottom Line:

VAT is more broadly applied and transparently embedded in the price of all goods/services.
Tariffs are more selective but can create price distortions, trade friction, and inefficiencies.
Consumers usually pay both, but tariffs can hurt businesses and supply chains more than VAT.

You said:

Prompt: Isn't there a difference in that the VAT is applied to both goods and service but tariffs only goods?

Yes, you're absolutely right — and that’s an important distinction.

🔹 Key Difference: Scope of What’s Taxed

Type of Tax	Applies to	Explanation
VAT	✅ Goods and services (domestic and imported)	VAT is a broad-based consumption tax. It applies to nearly all transactions, including things like restaurant meals, haircuts, legal services, software subscriptions, etc., as well as physical goods.
Tariffs	❌ Only physical imported goods	Tariffs are applied exclusively to imported tangible products. They do not apply to services, digital goods, or domestic products, which gives domestic producers a relative price advantage.

🔸 Why This Matters for Who Pays

Because VAT is applied broadly to all consumption, including services, it:

Affects everyone in the economy — not just people who buy imported goods.
Is less distortionary between sectors, but more regressive in general.

Tariffs, by contrast:

Are targeted, affecting prices of specific imported goods only.
Can lead to narrower but sharper price increases for those specific products (e.g., cars, electronics, steel).
Leave services and domestic goods unaffected in a direct sense.

🔹 Bottom Line on Scope:

VAT = broad and uniform, across both goods and services → wider economic impact, but more predictable.
Tariffs = narrow and selective, on imported goods only → concentrated impact on specific sectors and consumers.

You said:

Prompt: What is the tax incidence difference between the VAT and tariffs by household income by quintile?

Great question. The tax incidence of VAT and tariffs—meaning who ultimately bears the cost by income level—differs in both scope and distributional impact. Here's a breakdown of the differences by household income quintile:

🔍 Tax Incidence: VAT vs. Tariffs by Income Quintile

Income Quintile	VAT Incidence	Tariff Incidence
Lowest (1st)	🔴 High burden relative to income — VAT is regressive. Low-income households spend a larger share of income on taxed goods/services.	🔴 High burden, particularly for imported goods common in budgets (e.g., clothing, household goods). Tariffs on basic imports disproportionately impact this group.
2nd Quintile	🔴 Still regressive — most income goes to consumption.	🔴-🟠 Burden remains significant. May substitute to domestic goods if possible, but limited flexibility.
Middle (3rd)	🟠 Moderate burden — more ability to save/invest, so less affected proportionally.	🟠 Tariff exposure depends on consumption habits (e.g., imported appliances, electronics).
4th Quintile	🟢 Lower proportional burden — more income is saved or spent on exempt/untaxed services.	🟢 Better ability to substitute or absorb cost increases.
Highest (5th)	🟢 Lowest relative burden — spending is a smaller share of income; more on untaxed or luxury services.	🟢 Tariffs are small relative to income. May spend on untaxed luxury services or foreign travel instead.

🔸 Summary of Distributional Impacts:

Metric	VAT	Tariffs
Regressivity	❗ Highly regressive	❗ Regressive, but depends on which goods are taxed
Scope	Broad (all goods + services)	Narrow (imported goods only)
Effect on Low-Income Households	VAT hits harder due to higher share of income spent on consumption	Tariffs hit hard if basic imported goods are taxed (e.g., clothes, food)
Effect on High-Income Households	VAT is smaller relative to income	Tariffs generally negligible as % of income

📊 Example from U.S. Studies:

A 2019 study by the NY Fed and Columbia University showed that tariffs enacted under Trump had a regressive impact similar to a 2% income tax on the lowest quintile, but only a 0.3% tax on the top quintile.
OECD and IMF analyses of VAT consistently show that VAT burdens are highest as a share of income for the bottom 40% of households, even in countries with rebates or exemptions.

🎯 Policy Implication:

Both VAT and tariffs tend to burden lower-income households more, but VAT is broader and hits across all sectors.
Tariffs can be more targeted, but their impact can be severe if they fall on basic necessities.
To reduce regressivity, many countries exempt essentials (like food or medicine) from VAT, or provide rebates or earned income tax credits.

You said:

Prompt: What items are often exempt from the VAT to make them less regressive?

To reduce the regressive impact of a Value Added Tax (VAT)—which tends to burden lower-income households disproportionately—many countries exempt or apply reduced rates to essential goods and services. These exemptions help ensure that basic needs are not taxed as heavily.

Here’s a breakdown of commonly VAT-exempt or reduced-rate items used to reduce regressivity:

🧺 Common VAT Exemptions or Reduced-Rate Items

🔹 Essential Goods

Category	Examples
Food (especially unprocessed)	Bread, milk, vegetables, rice, meat, eggs, water
Medicine & Health	Prescription drugs, vaccines, medical devices, hospital services
Children’s Products	Baby formula, diapers, children's clothing and footwear
Utilities (in some countries)	Residential electricity, water, heating fuel
Public Transportation	Buses, trains, subways (especially for local commutes)

🔹 Essential Services

Category	Examples
Healthcare	Doctor visits, public hospitals, mental health services
Education	Tuition for public schools and universities, textbooks
Social Housing & Rent	Government-subsidized housing, residential rents
Financial Services	Basic banking services, insurance premiums (in some systems)
Funerals	Burial and cremation services (sometimes exempt or reduced rate)

🔹 Other Reduced-Rate Goods (varies by country)

Category	Examples
Books & Periodicals	Physical books, newspapers, educational publications
Cultural Activities	Museum entry, theater, library services
Renewable Energy Equipment	Solar panels, energy-saving appliances (incentivized through lower VAT)

🌍 Country Examples

Country	VAT Standard Rate	Reduced/Exempt Items
UK	20%	0% on most food, children’s clothes, books; 5% on home energy
Germany	19%	7% on food, books, public transport
France	20%	5.5% on food and some utilities; 2.1% on medicine and newspapers
Canada (GST/HST)	5–15%	0% on groceries, rent, medical services; 5% on utilities
South Africa	15%	0% on staple foods (maize meal, rice), basic healthcare, education

⚖️ Policy Goal:

These exemptions and reduced rates are intended to:

Shield low-income households from high consumption taxes on necessities.
Preserve progressivity in the tax system without eliminating VAT’s broad revenue base.

However, economists often caution that blanket exemptions can be inefficient, and some advocate for targeted cash transfers or tax credits instead of complex VAT exclusions.

Prepared and paid for by Olson Senate Committee, P.O. Box 15, Prior Lake, MN 55372

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