Puerto Rico first to adopt value added tax

value added tax

value added tax

value added taxMany states and localities have recently raised sales taxes in response to mounting budget deficits. But no U.S. jurisdiction has taken such drastic measures as Puerto Rico, which not only increased its sales tax rate by nearly 65% this year – it plans to replace the sales tax altogether with a value added tax (VAT). This would make Puerto Rico the first U.S. state or territory to adopt a VAT, which is commonly used by other nations around the world.

Debt crisis prompts major tax increase

On August 3, the government of Puerto Rico defaulted on a $58 million bond payment. Puerto Rico’s governor, Alejandro Garcia Padilla, noted the island’s economy is in a “death spiral” due to years of government overspending and declining employment. Indeed, the $58 million default was only the first sign of trouble. The government currently owes more than $70 billion to its creditors, with major payments coming due in December and January.

In an effort to raise government revenues, Gov. Padilla signed a tax reform law known as Act 72 this past May. Among other things, Act 72 raised the island’s sales and use tax from 7% to 11.5% as of July 1. (The island-wide rate is actually only 10.5%, but municipalities collect an additional 1%.) The law further extended the sales tax to a variety of services, including car rentals, bank charges levied against business checking accounts, waste disposal, and telecommunications. Act 72 will also create a new 4% sales tax, effective October 1, for providers of “designated professional services,” such as accountants, architects and engineers.

Sales tax vs. Value Added Tax

Puerto Rico adopts a VATThese sales tax increases are only a transitional measure, however, until April 1, 2016, when Puerto Rico will switch from a traditional sales tax regime to a value added tax (VAT). A VAT is a consumption tax traditionally assessed at each stage of production. In other words, while traditional sales tax is only calculated at the point of a retail sale to an end user, a VAT applies every time there is a transaction involving a product or service.

The idea is to embed the tax in the supply chain so that each participant – i.e., the producer of raw materials, the manufacturer of finished goods, and the retailer who sells he goods – must account for the VAT. In theory, this allows the government to collect more revenue than a traditional sales tax, as every participant in the supply chain must account for the VAT, cutting down on opportunities for tax evasion. This is no doubt why the value added tax is attractive to Puerto Rico’s revenue-starved government.

Yet Puerto Rico’s VAT will differ from similar tax regimes in one major respect. The island will exempt the sales of “raw materials” used in manufacturing from the VAT. (Technically, these sales will be subject to a 0% VAT.) Normally raw materials are a principal source of VAT revenue. But given Puerto Rico’s unemployment rate is well over 12%, the government is understandably reluctant to further burden the island’s beleaguered manufacturing sector.

S.M. Oliva is a writer living in Charlottesville, Virginia. He edits the international legal blog PrivyCouncil.info

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