The Drumbeat for a Value Added Tax Has Begun

On September 29, presidential advisor Paul Volcker told Charlie Rose that the U.S. should consider a VAT or a carbon tax to get its deficit under control. On October 5, House Speaker Nancy Pelosi talked with Charlie Rose about the competitive advantage enjoyed by foreign automakers because of our health care costs, “They have a competitive advantage. Somewhere along the way, a value-added tax plays into this. Of course, we want to take down the health care cost, that’s one part of it. But in the scheme of things, I think it’s fair look at a value- added tax as well.”

There’s no doubt we need to put our fiscal house back in order once we get firmly into a recovery, but do we need a VAT to do it? Later this month, the federal government will announce its first trillion dollar deficit in history. That will be about 10% of GDP. Most budget experts expect trillion dollar deficits next year and the year after as well. Concern about leaving our children a public debt of about 70% of GDP, up from just 41% a year ago, has prompted talk of finding a new revenue source. This is very reminiscent of the talk in the late 1970s and early 1980s when we faced deficits that peaked at 6% of GDP in FY1983 and a public debt that peaked at 49% in FY1994. We balanced the federal budget without a VAT for four years from FY1998 through FY2001. Admittedly, we’re in worse shape now.

I need to state up front that I’m biased against adopting a VAT because of my experience formulating the VAT that House Ways and Means Chair Al Ullman (D-OR) proposed in 1979. If I were starting a new country’s tax system in today’s world, I would choose a VAT, as would most economists. Europe switched to a VAT in 1968 to reduce the harmful effects of cascade taxes (sales taxes on all stages of production, so consumers paid taxes on taxes.) and to harmonize taxes across nearby borders. We don’t have cascade taxes, and our borders are further away, and our exports are a smaller share of our economy. However, we’re starting from an income tax that has many consumption tax attributes (savings deductions and lower taxes on capital income).

The transition to a VAT here would be quite painful. Particularly hard hit would be the poor (They consume more than they earn.), the elderly (They would be doubly taxed on their wealth.), housing (Try coming up with 15% VAT on top of the full sales price of a home.), old capital (It would be doubly taxed.), state revenues (States depend upon their own sales taxes and would see revenues decline if the federal government muscles in.), and imported goods. Exempting food, housing, and medical expense would do little to reduce the VAT’s regressivity, and exempted items would still bear some tax because they get no credit for VAT paid on inputs. The only way I could find that would alleviate the impact on the poor would be to give them an offsetting refundable tax payment, blunting the revenue raised and creating inequities overcompensating some and undercompensating others.

A VAT would be quite expensive to administer. As I recall, the British Inland Revenue Service had to double its employment to cope. A massive effort is required to collect tax from hundreds of thousands of businesses that only file now under the individual income tax.

The biggest advantage of a VAT is its ability to produce large amounts of revenue, but, ask yourself, do we want to boost the size of our government as measured by the OECD from 28.3% of GDP today to Britain’s 36.6% or France’s 43.6%? See Column 2 of this Wikipedia article. A VAT would also boost exports and help stabilize the dollar. New investment would be credited immediately (expensed), another big advantage over our current haphazard depreciation system.

Businesses would be divided into winners and losers. Exporters would like a VAT to level the playing field with foreign competitors, but importers and their customers would pay. New businesses with high levels of investment would benefit, but established, capital intensive businesses would, in effect, pay a double tax having paid previously under the income tax. Labor intensive industries would be hard hit. Private hospitals would suffer compared to public hospitals. If we adopted a credit-invoice method VAT, like Europe, business recordkeeping and compliance costs would soar. Most countries exempt financial services from their VATs, but that would leave them paying VAT on inputs without any credit, which they would pass on to customers. VAT proponents cite its simplicity, but Britain’s complicated and loophole ridden VAT shows what could happen here. A well administered VAT can reduce tax evasion, but it would also be seen as an invasion upon businesses that have traditionally dealt in cash.

Finally, there’s a lot of misinformation about the inflationary effects of a VAT. A VAT will raise prices on a once and for all basis by approximately the VAT rate multiplied by the ratio of the tax base divided by GDP. Unless we’re operating at full capacity, the VAT wouldn’t have much inflationary effect as Europe found when it adopted the VAT.

The best short description of a VAT and its advantages and disadvantages is in this Encyclopedia of Taxation and Tax Policy by Joe Cordes, Bob Ebel, and Jane Gravelle.

This excellent 28-page 1984 Treasury analysis goes into more detail.

Len Burman, now the Moynihan Chair of Public Affairs at Syracuse University’s Maxwell School, recommended a 15% VAT to pay for health vouchers for all Americans in testimony before the Senate Finance Committee on May 13, 2008. That kicked off the recent debate over a VAT for the U.S.

By the way, it’s an old saw that Al Ullman’s support for a VAT cost him his seat in the 1980 election. It certainly didn’t help, but he really lost because he rarely went home to his district, because he got caught in the Reagan landslide, and because Jimmy Carter conceded the election 70 minutes before the West Coast polls closed. Ullman lost by 780 votes or so as I recall.

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