Adds to what?
For a manufacturer, to raw materials. A simple example, a furniture maker adds value when she forms and fits the raw wood into a chair. The lumber company, one step up the supply chain, has added value to the wood product it sells by roughing raw logs into lengths and perhaps delivering them to the buyer. The actual growing of the tree is value added more by ownership of the resource than activity.
In each case, in a market economy, the value added is computed by subtracting from the price at sale the cost of the purchased inputs. In our example, from the price of the chair or desk, the costs of wood, tools, the shop in which she works are subtracted.
So value added includes all the profits, wages and salaries paid to workers and owners, plus any amounts not paid out, but not spent (so-called "retained earnings").
Receipts from SalesThis calculation includes all the components of a business's operation except taxes. it could be fairly argued that taxes fund some of the inputs -- the roads, the institutional framework of courts and police and consumer protection, education and training of workers, etc. But the task of government is to make its tax code fair. This is exactly the issue in reforming Washington's B&O tax.
minus Cost of Inputs
equals Value Added
which is composed of
Profits
Wages and Salaries
Retained Earnings
Imagine that for one reason or another, the producer of the furniture is forced to sell her product at a price that is lower than the cost of her inputs. Say, for example, an economic downturn has cut into demand for hr type of product, or foreign producers introduce a competing product at a much cheaper price.
Under Washington's current B&O, which is based on gross sales, she would be liable to pay a tax. Under the reformed B&O, based on value added, no tax would be required.
This seems eminently fair. Certainly it reflects more the ability to pay and brings government more in line with the interests of the business. But the reform is all the more fair when you realize that a B&O tax has already been paid on the inputs by the lumber company.
Under the gross sales base, the original business activity is lumped in with the next and taxed again, and so on, all the way down the supply chain. The value of the wood is taxed repeatedly, again at each transaction. This so-called "pyramiding" does not occur for cheap foreign producers, because they are operating outside the taxing authority of the state. Similarly, it can be avoided by large, vertically integrated companies. Because the tax is levied at the point of purchase and sale, if the furniture maker is big enough to mill and transport its wood products, it can avoid the tax by avoiding a transaction.
Thus, the current B&O has an effective rate much higher for in-state businesses, and smaller businesses. Out-of-state businesses and large corporations pay a lower effective B&O.
Q&A
Q: This doesn't sound like the VAT of Canada or Britain.
A: Value added is value added. Somehow in the course of public finance history, a value added tax has come to be a tax on consumption. (See the Wikipedia discussion). Similarly, the label "gross sales tax," which the current B&O operates under, has caused researchers to categorize it as a sales tax, meaning a consumption tax similar to a retail sales tax.
Here we have described the simplest and most straightforward method of calculating the tax owed, the "subtraction method." This illustrates the tax is on income: profits, wages and salaries, and retained earnings. Because there are no deductions, the rate can be very, very low and still generate substantial revenue. The fact that the reformed B&O can be extended to nonprofits and government as a levy on employee compensation demonstrates further that it is fundamentally different from a consumption tax.
Other countries, perhaps to enforce a notion that the tax is ultimately paid by the consumer, calculate the tax owed on each product, note it on each invoice as it passes down the supply chain, and at the end the consumer sees two essentially parallel totals, one for product, one for tax.
While this is almost universally accepted, it is confused, because it implies that the entire burden of the tax falls on the consumer, when in a market economy, some is borne by owners and workers.
To illustrate this point, assume the tax was very large and was suddenly removed. Would the price paid by the consumer drop precipitously? Perhaps and perhaps not. It would depend on supply and demand. It would be unlikely the price would drop the full amount of the foregone tax. The net gain would be shared by workers and owners. If you reverse this thought experiment, you can see that the entire burden of the tax is not passed on to the consumer.
Fortunately for Washington State and this reform of the B&O, this question of adding another line on the retail receipt is moot. The B&O is now prohibited from appearing on invoices. This practice would be retained under the reform.
Unfortunately for the Value Added Tax, the confusion is nearly complete with respect to its being categorized as a consumption tax. For this reason, it is quite useful to have a more descriptive phrase "Business & Occupation Tax" at hand.
