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Puerto Rico Brings First-Ever Value-Added Tax To The U.S.

September 21, 2015

Value-added taxes (VAT) have made their first landfall on U.S. shores as a potential fix to Puerto Rico’s financial crisis. Is this a harbinger of things to come in the continental U.S.? That may depend on how things go in Puerto Rico.

First some background: VAT is consumption-based tax that is applied at each point in the production and sale of goods whenever value is added. For example, if a farmer sells corn to a processing company for $1, the processing company then sells high-fructose corn syrup to a soda company for $2, and the soda company sells the consumer a two liter bottle of root beer for $3, each of the three producers has a value-added of $1. In a VAT environment, each $1 profit in the supply chain would be taxed. Likewise, expenses at each leg of the chain are used to offset the tax.

Tax authorities around the world (with the exception of the U.S. and Saudi Arabia) have been implementing this type of tax as a means of increasing revenues without directly increasing retail sales taxes. They love VAT because it is embedded directly into the supply chain, allowing for full transparency into each step in a transaction, and is thus very difficult to avoid through clever accounting practices. Although it serves the same basic function as a standard retail sales tax, the VAT typically ends up generating more revenue for governments, depending on the details of how it is implemented.

As I wrote earlier this year, several different tax authorities around the world, including Japan, New Zealand, the UK, and Malaysia have all recently expanded their VAT systems in an effort to stimulate revenue. Many have been successful. New Zealand, for example, raised its VAT from 12.5% to 15% while reducing corporate tax from 38% to 33% in 2010. Over the next four years, total tax revenue increased 22% while GDP increased over 53%. By striking the right balance between corporate and consumption taxes, New Zealand was able to generate more tax revenue without disrupting its economic growth engine.

While no two economies or specific tax plans are identical, the trend toward global adoption of VAT is hard to ignore.

In the case of Puerto Rico, a 10.5% VAT will be applied to a wide range of goods and services effective April 1, 2016. The move is part of a sweeping plan to inject $1.5 billion into the island as part of a turn-around from its recent financial crisis.

Anil Kuruvilla, senior manager for tax research and content at Thomson Reuters TRI +%, has been tracking recent trends in VAT. He says Puerto Rico’s approach is unique because it does not apply to the raw materials imported by the island’s largest industry: manufacturing. He explained: “Within Puerto Rico’s VAT law, there is a provision which applies a zero percent tax rate to many of the goods that are imported for manufacturing (raw materials, certain machinery, equipment, etc.). Normally in a VAT system, when you import items for use in a manufacturing facility, the importer is required to pay VAT on the import. The electricity, gas and water and other variables required to run a manufacturing facility will be subject to the tax, but the raw materials will not be subject to the tax. This creates a sort of hybrid customs and VAT system that was designed to preserve the preferential treatment Puerto Rico has afforded historically to its manufacturing sector under its old sales and use tax formula.”