When lawmakers on the congressional supercommittee charged with solving the U.S.’s fiscal problems get to work, they will quickly realize that, without fundamental tax reform, their job will be arduous.
They would do well to consider an innovation that every developed nation except the U.S. has already employed: the value-added tax.
The government’s structural budget deficit — the gap that must be closed to achieve long-term sustainability — is now between 5 percent and 6 percent of annual economic output, or more than $800 billion. That’s more than the defense budget, and over 10 years would be about four times larger than the $2.1 trillion debt-ceiling deal Congress just passed. U.S. tax revenue, meanwhile, is running well below the long-term trend — by about 3 percent of gross domestic product. Just getting taxes back to the average would cover about half the gap.
The question, then, is what kind of tax increase would be the least-bad option. Simply raising rates would be politically difficult, to say the least, and would waste an opportunity to change the country’s unduly complicated tax system. The deficit commission led by Republican Alan Simpson and Democrat Erskine Bowles has rightly advocated an income-tax reform that would eliminate most deductions, lower rates and get more people to pay what they owe. Along with such reforms, a VAT could generate a lot of added revenue with minimal cost, and might even provide a short-term stimulus to the economy.
First developed in the middle of the 20th century, the VAT is similar to a sales tax. The crucial distinction is that it is collected in stages along the supply chain, an approach that spreads the burden among all businesses and ensures that goods don’t get taxed multiple times before reaching the consumer.
Under a 10 percent VAT, for example, a farmer selling $20 in wheat to a miller would charge $2 in tax, which he would pass on to the government. If the miller made flour from the wheat and sold it to a baker for $40, he would collect $4 in VAT. But he would remit only $2 — the difference between the $4 he collected and the $2 he already paid when he bought the wheat. If the baker used the flour to make cakes and sold them for $100, he would collect $10 in VAT and remit $6, because he already paid $4 when he bought the flour. Ultimately, the final consumer pays the whole tax. Businesses collect it on behalf of the government.
The system may sound complicated, but it’s actually much more efficient than other types of tax. All the buyers and sellers along the chain already keep track of the transactions for their own books, and the VAT is very difficult to game or cheat: If you consume something, you pay the tax. Estimates of administrative costs range from 0.5 percent to 1 percent of the amount collected, compared with more than 3 percent for state and local sales taxes in the U.S. In onepaper, a group of economists found that replacing the entire U.S. tax system with aconsumption tax like a VAT would increase the economy’s long- term output by 9.4 percent.
Democratic opponents of the VAT point out one big flaw: The tax falls more heavily on the poor, who mostly spend rather than save their income. Many countries try to compensate for this regressive trait by exempting basic food items and other necessities — an imperfect fix that complicates the system, distorts the economy and doesn’t adequately help the poor.
An income-tax credit, in which all taxpayers receive a cash payment to offset VAT paid on a fixed, minimal amount of purchases, would work better. A study by the Urban Institute and theBrookings Institution found that such a credit could turn a VAT into a progressive levy, with the bottom fifth of earners gaining 1.7 percent in after-tax income (see chart). It would also provide an added incentive for people to come out of the shadows and into the income-tax system.
Another major concern with the VAT involves state and local governments, which might consider a federal VAT to be in competition with their sales taxes. In reality, they are more likely to gain by converting their sales taxes into VATs. In doing so, cities and states could share administrative costs with the federal government and should be able to capture the sales of more service enterprises and Internet retailers, such as Amazon.com.
The VAT is also more conducive to investment than a sales tax, which tends to fall disproportionately on certain types of businesses, such as manufacturers. In Canada, for example, some provinces converted their sales taxes into VATs after the national government introduced its VAT in 1991. The converts saw a significant boost in machinery and equipment investment.
A third objection to the VAT, typically leveled by Republicans, is that the government would become addicted to the revenue it generates, hindering efforts to control taxes and spending. The experience of Canada, which ultimately lowered its federal VAT to 5 percent from 7 percent, suggests this concern is overblown. In any case, it can easily be addressed by making the VAT part of a focused deficit-reduction program.
A 10 percent VAT with an income-tax credit would generate revenue equal to about 2 percent of GDP, covering about a third of the U.S. government’s fiscal gap. If states converted their sales taxes, the combined rate would be about 15 percent to 17 percent, lower than in most European countries. The time needed to implement a VAT — as much as two years — could even provide a much-needed economic stimulus. If people knew the tax was coming, they would probably make big purchases now.
Make no mistake: The VAT would be a new tax. It would raise the total burden on U.S. taxpayers and, once it takes effect, would almost certainly take a bite out of consumer spending. But done in concert with broader tax reform, it would go a long way toward solving the country’s fiscal crisis.
If there’s a better way, we’d love to hear about it.