A Way to Boost Demand and Reduce Long-term Budget Problems
Policy makers are rightly focused on boosting demand as a way to pull us out of the current recession. The proposals offered so far will help, but none directly target the price of goods and services that people buy and all will add to our alarming budget deficits. So here’s a simple suggestion. Why don’t we promise future price increases so consumers will have an incentive to spend more now.
Enact a value-added tax (VAT) that phases in starting in 2010. (A VAT, common throughout the rest of the world, is basically a sales tax that is collected in stages from producers and retailers.) If the VAT started at a 5-percent rate, that would push retail prices up by 5 percent (assuming the Fed lets the money supply grow), providing an incentive for consumers to make purchases in 2009 rather than postpone them.
This would reduce the risk of deflation—actual declines in prices—which would tend to exacerbate the economic decline. If consumers expect prices to fall, they have an incentive to postpone purchases, which weakens demand further and depresses prices more.
The VAT revenues could eventually constitute a significant part of overall federal tax revenues, which would help pay off the debt that we are piling up in our efforts to avert economic collapse. When fully phased in, revenues could be used to pay for all or a portion of federal health care costs, allowing for cuts in income and payroll taxes while moving federal finances to a more secure footing. The VAT would hit lower-income people especially hard, but the tax's regressivity could be offset through income tax credits or by pairing the tax with health insurance subsidies targeted at low- and middle-income households. And, since a VAT taxes consumer spending, but not saving, it could help reverse the alarming decline in personal savings in the United States, making the next recession a little less painful.
Moreover, once on the books, the VAT would be a powerful tool to help manage fiscal policy. The rate could be increased to help keep the economy from overheating during booms and cut to spur demand during future recessions.
I’m not underestimating the political and practical problems inherent in enacting a VAT in the United States, but the fact is that there are no painless or perfect solutions to our current economic problems. And this option has the unique advantage of actually diminishing the likelihood of the future budget catastrophe that many of us fear much more than the current economic downturn.
Postscript: After I posted this, I learned that Princeton economist, Alan Krueger, had been thinking along very similar lines. See his excellent post, “A Future Consumption Tax to Fix Today’s Economy,” on the NY Times Economix blog. Most interesting, one of his commentators noted that the UK has temporarily cut their VAT to boost demand. And, while we're acknowledging antecedents, I first broached this idea on the National Journal expert's blog back on January 5 as part of a series of “neglected stimulus ideas.”
Thanks for those comments. I like Michael's book a lot, although he and I disagree about the political wisdom of making the income tax a levy only on the top 10%. I proposed to dedicate a VAT to pay for universal health care in Senate testimony last year. My proposal would, like Graetz's, vastly simplify the income tax and cut rates, while maintaining a high level of progressivity. (An updated and expanded version of my testimony will be published in the Fall 2008 Virginia Tax Review, whenever Fall 2008 reaches Charlottesville, VA.)
I'm not too keen on the idea of expanding the corporate tax to include unincorporated businesses. Like most public finance economists, I'd prefer to tax corporations more like partnerships and S-corps–that is, tax the corporation's income to shareholders as it accrues.
I am in favor of a tax reform which would include a Value Added Tax, an expansion of the business income tax to include all types of firms (including partnerships and sole proprietorships) and make wage and salary costs taxable. The EITC, CTC and most other popular credits would be taken against the business income tax (which would also include non-retirement payroll taxes – with survivors insurance for retired workers considered a part of the retirement protion – as well as any increased levies and offsetting credits enacted as part of health care reform).
Personal income taxes would be simplified with a $100,000 floor for individuals and no family aggregation (so a couple making $50,000 and $75,000 would not get caught – nor would the spouse of someone making $120,000). Personal income tax rates would also be cut by the percentage of income attributable to the VAT and BIT. Assuming a 10% VAT and a 15% BIT, the 28% tax rate would become 3% on all income from $100,000 to the 31% rate (now 6%). The highest rate would be a 15% levy on income over $250,000 (including all cash payments and withdrawls from inheritence with the exception of the sale of assets to broad based employee ownership plans).
The impact of the change in taxation would be an increase in the perception of tax payment, along with perceptably higher incomes at the lower end of the scale (depending upon how much CTC and EITC credits were increased – I would go as high as 6 times the current level on the CTC and include provisions for doubling the minimum wage so no one is paid solely through their CTC credit). Firms might trim higher level salaries, as well as everyone's base and nominal salary levels – especially to the extent that payroll taxes are no longer withheld from individuals.
This may or may not decrease the pool of money available for savings. It is interesting to note this week that savings are up, while deposits are down. People are hiding the money under the mattress or keeping more cash on hand. There is one sure way to reverse this trend – allow interest rates to increase. Lower interest rates may make it cheaper for banks to borrow – however they won't lend without deposits and deposits won't be made unless they carry some return with them.
Making refinancing cheaper won't work without the banks having some cash to actually lend. The Fed needs to increase rates so cash becomes available.
Have you read Michael Graetz's book, 100 Million Unnecessary Returns? His VAT solution is by far the best I have seen (aside from my own).
You're making the big assumption that people are simply withholding spending until prices decline enough. Many people, unfortunately, are instead not spending because they simply don't have enough money to spend. If you promise price increases in the future you are simply giving them more reason to be worried and not spend (though perhaps some of them will run out to Price Club and buy rice and potatos in bulk). Further, with a VAT you are increasing prices without increasing wages, so people will have less money to pay for goods that cost more. Demand will further slump and we'll still be in the same mess only worse.