“I have three responses to the regressivity complaint. The first is that a VAT is regressive, but not as regressive as commonly thought. Part of the reason that a VAT appears regressive is that it is paid at the time of consumption, so it appears that savers are avoiding the VAT. In fact, saving only delays your VAT burden; savers accrue tax liabilities that are payable at the time of consumption…
…(T)he Tax Policy Center shows how a VAT burden is distributed when taking account of the fact that a VAT burden attaches itself to investments, even if it is not paid in the current period. They find that a 5 percent VAT with a comprehensive base costs 5.7 percent of income for those in the bottom quintile and 4.3 percent for those in the top quintile.
Secondly, VAT is just one component of the overall tax code. The regressivity of the VAT can, and should, be offset in part by greater progressivity in other areas of the code. Some of the proceeds of a substantial VAT should go toward progressive cuts in the payroll tax or policies that exclude a significantly larger share of households from the personal income tax. Expanding the Earned Income Tax Credit would be another possibility.
Third, the tax code should get more regressive as government spending rises as a share of GDP. Regressive taxes tend to be more efficient taxes, and efficiency in tax collection becomes more important as the government needs to collect more revenue. The rising tax share of GDP also partly reflects increased spending on means-tested entitlements, which is progressive. Even financing such programs with regressive taxes is progressive on net.
The transition complaint is that introducing a new VAT amounts to a one-time tax on existing assets. Think of it this way. Imagine that a country used to have only one tax, an income tax, and then abolished it in favor of a VAT. The taxes might have the same rate, but a person who had saved lots of money would end up paying twice: income tax at the time he earned and saved, and then VAT when he finally spent.
In a vacuum, this would indeed be an important equity concern with the VAT. But we are not in a vacuum. Instead, we are in a situation where people in retirement are claiming entitlement benefits whose cost now far outstrips their dedicated revenue sources. Today’s retirees got a great deal, working when payroll taxes were low and collecting benefits whose costs are high. And the political consensus is that they are untouchable: Social Security and Medicare will have to be fixed by the young paying higher taxes and taking benefit cuts.”