The VAT Buzz Grows, But What Would It Mean?

By :: April 13th, 2010

Lots of chatter in Washington about a Value Added Tax.  Paul Volcker, the former Fed chairman and gray eminence of the Obama economic team, was talking up the idea the other day. The Congressional Budget Office is looking at the implications of a consumption tax. And Representative Paul Ryan (R-WI) has included one as part of his fiscal Roadmap.

Deficit hawks see a VAT as a valuable source of new revenue. Economists appreciate that it taxes consumption rather than saving, and thus may help cool the American penchant for spending far too much and saving much too little (recessions aside). And some businesses like that a VAT could be a way to lower our uncompetitive corporate tax rate.

That’s not to say a VAT is hugely popular. Many conservatives, Ryan excepted, loathe it. And it has few friends on the left. Back in his academic days, Obama economic adviser Larry Summers joked that a VAT was opposed by conservatives who saw it as a money machine and opposed by liberals who feared it was regressive. It will win broad support, Larry predicted, once liberals realize it is a money machine and conservatives recognize it is regressive.

A new paper by my Tax Policy Center colleagues Eric Toder and Joe Rosenberg does a nice job of clarifying many of the issues surrounding the VAT. They make several key points:

*A VAT could generate a bundle of revenue. A broad-based 5 percent VAT that covered about 80 percent of goods and services would raise about $260 billion in new taxes in 2012.

*The U.S. is the only developed country in the world without some form of national broad-based consumption tax, such as a VAT. 

*A VAT would raise taxes roughly equally across-the-board—with one exception. The tax is a boon to high-income taxpayers, who make much of their money from VAT-free savings and investments. On average, the 5 percent VAT would reduce after-tax income by about 2.7 percent. The lowest earners would face an income loss of 2.8 percent while middle- and upper-middle class taxpayers would lose about 2.9 percent. But the highest earning 1 percent would see their after-tax incomes fall by only 2.1 percent.   

How to offset this extra burden on those with low incomes? What may be the most politically popular solution—exempting housing, food, and medical care from the VAT—would make the tax somewhat more progressive, but add a lot of complexity and inefficiency to the system in the process. A better solution would combine a broad-based VAT with a refundable tax credit. Combining the VAT with the credit would cut taxes for those at the bottom, and increase them for the middle-class, who would face a drop in after-tax income of between 1.5 percent and 2 percent. The rich would see their after-tax income fall by about 2.3 percent, while the very rich would face a decline of about 2 percent. 

What if a VAT were used instead to reduce the corporate income tax? Ryan, for instance, would use his to eliminate this levy entirely. Eric and Joe figure revenues from a 5 percent VAT could reduce the corporate rate from 35 percent to 7.4 percent. That would be a big benefit to U.S. companies, and a huge windfall for the wealthy—raising their after-tax income by almost 7 percent-- while boosting taxes for nearly everyone else.

That’s political death. But what if revenues from a broad-based VAT were used to buy down both corporate and payroll taxes? In that case, the corporate rate could be cut to a very competitive 20 percent and the employer contribution to the Social Security payroll tax slashed from 6.2 percent to 3.5 percent.

Of course, we have a huge fiscal problem, so we probably should use a substantial share of revenues from a VAT  to reduce the deficit, rather than just to cut other taxes. Still, Eric and Joe’s paper provides a good sense of the relative gains and losses of a VAT for different taxpayers as policymakers think about what to do with its substantial revenues.       
 

      

24Comments

  1. Anonymous  ::  1:17 am on April 14th, 2010:

    Obama killed any slim chance of bipartisan support for major new taxes when he rammed through the trillion dollar health care expansion. That makes him like the teenager who blows through his allowance then complains he has no money for lunch. Time for tough love.
    Obama might be able to get a VAT in trade for repeal of the health care law, but he wouldn't ever consider that option. Since Democrats don't have the votes to enact a VAT on their own, it simply won't happen.
    Once the government bond market crashes, formerly impossible options will become possible. Massive cuts in entitlement programs will be coupled with a modest VAT as we imitate Greece and try to pull out of the mess.

  2. Anonymous  ::  5:55 pm on April 14th, 2010:

    Actually, a VAT makes health care more affordable and if combined with corporate income tax cuts, it would also make it more politically acceptable.
    Obama could very well enact one, although it will more likely be enacted by the Independence Party instead, which will contain the non-nativist remnants of the GOP and the fiscally conservative wing of the Democrats (as well as all those people who wish a pox on both houses).
    At the very least, a VAT could be used to consolidate a lot of little employer levies into two or three (if you distinguish between a visible 10% VAT and a 20% subtraction VAT replacing payroll taxes, corporate income taxes collected from personal income taxes above the first 10% up to the revenue collected at the 25% rate (and the middle 15% of the higher rates). FICA retirement payroll taxes could still be collected on payroll, rather than total value, but with a higher cap.

  3. Anonymous  ::  8:22 pm on April 14th, 2010:

    After looking at the paper, I realize I have not been conveying what I am in favor of accurately. What I have been proposing for the past few years is a 10% invoice GST to fund domestic discretionary and CONUS based military spending (except for military retirement), an expansion of the base of the Business Income Tax to include all forms of ownership (including business tax filings by individuals) and to include wages and salaries (like a VAT) to fund entitlement and health care spending and revenue offsets – as well as current income tax credits to families, with a progressive surtax on high income taxpayers to fund interest, debt repayment and military and sea deployments.

  4. Anonymous  ::  9:36 pm on April 14th, 2010:

    Maybe this just shows how off your perspective is, but you write, “The tax is a boon to high-income taxpayers…[because the] highest earning 1 percent would see their after-tax incomes fall by only 2.1 percent.” That's not a BOON! That just means they're getting smacked less hard! Don't you get it?! Think of it this way. Let's say my house catches fire, and only half of it burns down. Now let's pretend my neighbor's house catches fire, and burns to the ground. Was it a “boon” to only lose half of my house relative to my neighbor? NO! I didn't gain half of a house — that would be a boon. Just because someone loses less doesn't mean they gain.

  5. Anonymous  ::  8:59 pm on April 15th, 2010:

    I think you are missing the context, since in this example middle income taxpayers lose more than 2.1% of after tax income. By your example, the middle income person loses their whole house while the rich person loses the detached garage.
    The analysis in the paper goes on to consider the use of the VAT to replace payroll taxes and corporate income taxes. In the last case, the rich actually gain when this happens.
    The analysis uses an either/or scenario – using the VAT to reduce the deficit OR decrease employer payroll or corporate income taxes. A higher VAT rate could do all three. Such a reform, to be really effective, could do what I suggested above – transfer low rate personal income and employee payroll taxes to a broader business income tax which include all employers (not just corporate ones) with a base expanded to include labor. This would, of course, have no distributional effect – barring a replacement of mortgage and property tax benefits with an expanded child tax credit (by eliminating such credits and moving the exemption for children to a credit, you could give the child credit a monthly value of $500). Only the paperwork burden would shift – which would both improve compliance and reduce burden.
    In the long run, tax increases for debt repayment (rather than simply deficit reduction) must come from upper income tax payers in order to avoid negative growth effects. This is because increases up to balanced budget levels have no multiplier effect (especially if we are borrowing overseas). Reducing the debt, however, would slow the economy if such reduction is broad based, because it would hurt consumption. Taxing the rich takes more from the savings sector, so it does not damage consumption. If debt reduction is important to the nation's health – and if the Japanese and Chinese stop buying the debt, it certainly is – than it needs to be done eventually and the sooner the better.
    Intergenerationally, taxing the rich is a boon to the rich because eventually the children of the rich must absorb both the interest costs or commit assets to debt finance. The poor and the middle class will never, ever, have to pay back the national debt for the same reason that Willie Sutton did not rob the corner lemonade stand (no money).
    Of course, part of Hamiltonian economics is to use state finance to give the wealthy a disproportionate piece of the pie and an interest sinecure – financed by broader based taxation. In its extreme, it creates an aristocracy of debt holders – or did until the income tax was enacted and the debt increased because there was confidence in that tax's ability to bring in cash. Now, for the sake of the progeny of the rich, it is better to use broad based taxes to reduce the deficit in operating programs and high income surtaxes to pay interest, the debt and those military adventures which would have to be debt financed without an income tax.

  6. Anonymous  ::  6:31 pm on April 19th, 2010:

    Absolutely not. Just like when income taxes were originally proposed the public was told that the rate would not go up from it's modest single digit beginnings. If you want to do away with income tax altogether and go with a flat tax, great. But don't screw us with federal income taxes, state income and sales taxes, AND VAT taxes. One tax and EVERYONE pays the same rate AND IT DOESN'T GO UP. Anyone proposing that we need more taxation needs to be dumped 200 miles off the coast wearing a concrete life jacket. How about the government learning to live within it's means instead of writing checks with money they expect to squeeze out of us later? How the hell did our country survive when they weren't taxing everything in sight? I'm just an average guy and don't give a crap about political parties since they lie to us on a regular basis. But I'm absolutely fed up to the point where I have become a seething ball of rage. Woe to the next entity or individual that tries to chisel another penny out of my pocket.

  7. Anonymous  ::  8:54 pm on April 19th, 2010:

    Our country barely survived it cycle of booms and bust and its dependence on slave labor. One of the things that helped stop that scandal was a progressive income tax.
    If you are paying income tax, you make an above average income. If everyone paid their employees an average wage, there would be no need for redistribution through the tax system – an honest wage being that the employee's kids have as good a standard of living as the employer's kids. The market for wages does not do that, so governmental action is justified in this area.

  8. Anonymous  ::  10:48 pm on April 19th, 2010:

    The income tax can never be dispensed with until the national debt is paid in full (including all trust funds and the share owned by the Federal Reserve).
    As it is now, we actually have a mostly flat tax for income over $50K a year. As payroll taxes wane as a percentage of taxation they are replaced by higher progressive income tax rates. Every time someone named Bush becomes President, we have had a flat tax of about 31%, all things considered. If you wish a slightly higher flat tax, we can do subsidies for the poor outside the tax code – which would be essential if you take away 31% of their already meager incomes. You could also split the tax into 15% employee, 15% employer, no exclusions – including on wages for employers and with the self employed paying both so that they aren't using self-employment to dodge what they would otherwise pay.
    Of course, after the debt is paid off, I would be perfectly fine with a 30% employee-levee or VAT with no visible taxation. You could also do it as a Fair Tax, but then you would get nasty distortions and would require a higher rate unless the debt were paid off first in order to make up for Neil Boortz's ignorance on how and why government should be taxed under a consumption tax (since if you followed his plan, you would have to increase all government spending by 30% to buy the same amount of services).

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