Pick Your Poison: VAT or Higher Income Tax Rates

By :: December 5th, 2011

With congressional deficit reduction efforts largely collapsed, the question remains: What are we going to do about the nation’s long-term budget mess? Since any realistic deficit reduction plan will require significant new revenues, is a Value-Added Tax a sensible way for government to raise those extra dollars?

In an effort to find out, the Pew Charitable Trusts asked my Tax Policy Center colleagues Eric Toder, Jim Nunns, and Joe Rosenberg to set up something of a cage match: In the blue trunks, a broad-based VAT (think 9-9-9 only much less complicated). In the white trunks, the income tax.  And they asked a basic question: What are the pros and cons of using a VAT to cut the deficit compared to an across-the-board hike in income tax rates.

Of course, real deficit reduction would surely involve substantial spending reductions and, in the real world, Congress might raise some new revenues by cutting tax subsidies not just raising rates. But to keep things relatively simple, Eric, Jim, and Joe looked at just two options: raising rates in the existing income tax system or adding a prototype VAT to what we’ve got.

They found that, even with one form of rebate, this version of a VAT would impose a larger tax burden on low- and moderate-income households than an across-the-board income tax rate increase. And it would significantly increase compliance and administrative costs, especially at the beginning.

However, a VAT would result in a smaller increase in marginal tax rates on labor than an income tax rate hike. And it would intrude on fewer economic decisions, especially related to savings and investment.

The goal of the exercise was to reduce the ratio of debt to Gross Domestic Product (a standard way of measuring red ink) to 60 percent. They looked at doing this by 2020, 2025,  and 2035. The debt/GDP ratio is about 69 percent today and the Congressional Budget Office predicts it will rise to 187 percent by 2035 if the government keeps doing what it has been doing (maintaining the 2001/2003/2010 tax rates, continuing to protect middle-income families from the Alternative Minimum Tax, etc.).

To hit the 60 percent target by 2020, average after-tax incomes would have to be cut by 8.7 percent under the VAT or 9.3 percent with tax rate hikes, relative to incomes under today’s tax rules. Income for the lowest-earning 20 percent of households would be cut by 1.8 percent under the VAT but only 0.5 percent if Congress raised income tax rates. Middle-income households would see  their after-tax income fall by 7.9 percent under the VAT but just 5.5 percent from higher rates. By contrast, the rich would be better off with the VAT. After-tax incomes of the top 1 percent would shrink by 9.6 percent compared to 17.2 percent with a rate hike.

Regular people can probably stop here, but if you are a serious tax wonk, here are some details on this prototype VAT and the income tax alternative:

This VAT has a very broad base (no exemptions for food and clothing, for example). However, it does not tax Medicare and Medicaid payments, spending by non-profits, or state and local sales taxes (yes, Virginia, some VATs do) . Combined, it would tax about 60 percent of all consumption and about 40 percent of GDP.

The VAT would partially protect low-income households with two rebates—one for workers and a second for Social Security recipients and others who get government cash transfers. Assuming current tax policy does not change, they estimate it would take a VAT rate of 22.9 percent in 2015 to meet the debt target in 2020. Because the glide path would be longer, the 2015 rate would only have to be 16.7 percent if the goal is to hit 60 percent by 2035.

To hit the 2020 target though an across-the-board income tax rate increase, rates in 2015 would rise from today’s 10-15-25-28-33-35 to 17.1-25.6-42.6-47.7-56.3-59.7 (yup, that’s a top income tax rate of almost 60 percent). As with the VAT, income tax rates would also be lower if the aim was to reach the 60 percent goal in 2025 or 2035. Rates on capital gains and dividends would also have to rise—to a top rate of 29.4 percent in 2015 if Congress wanted to meet its deficit target by 2020.

Not surprisingly, Eric, Jim, and Joe found flaws in both options. Without entitlement cuts hitting this ambitious debt target forces painful tax hikes either way. And, of course, a differently designed VAT would have yielded a different outcome. But in its cage match with a big income tax rate increase, the VAT at least gets a draw.


  1. AMTbuff  ::  1:25 am on December 6th, 2011:

    Without entitlement cuts hitting this ambitious debt target forces painful tax hikes either way.

    Without very large entitlement cuts, tax increases will not pass. Until benefit promises are reduced to fiscally realistic levels, tax increases make no sense. It would be throwing good money after bad.

    Let the parties compromise on a maximum percentage of GDP for spending, cut the promised benefits to fit that percentage of GDP, then find a package of tax increases to bring in the necessary revenue.

    The fundamental problem is that progressives will resist to the bitter end any ceiling on spending. Bowles-Simpson came close to agreement on spending level, but even they were afraid to specify any cuts in the one essential area of promised benefits: health care.

    Revenue increases which precede rationalization of the promised benefits will be revenues squandered. Both parties know this. One party welcomes that fact. The other party opposes it, preferring to squander money in different ways to please different voters.

  2. Michael Bindner  ::  8:17 am on December 6th, 2011:

    Why not do both? My plan transfers most tax payment to a visible VAT of 13% and a hidden 33% VAT-like net business receipts tax with offsets for things like an enhanced refundable child tax credit paid with wages and contiuation of the health insurance exemption (for an effective rate of just under 27%). My rates may be high, since I used the TPC estimates for doing rates based on the Toder paper from 2009, even though I have an explicit subsidy. These taxes would replace income tax collection for most households, as well as the collection of non-OASI payroll taxes. Indeed, Survivors Insurance for non-retirees would also be shifted to the NBRT. Remaining OASI would be 6.5% (to account for lower base – again probably leading to over estimate of VAT rate by making adjustment) on employees and employers – though employer OASI would be credited equally to all workers, not as a match to employee premium. A residual graduated income tax levy would be retained on households making over $100,000 per year (current $150,000 income levels – as gross income would decline) – or $50,000 for indviduals). The tax rate would range from 7% (4% if keeping Obama’s middle class tax pledge) to 27% (matching effective tax rate of NBRT) and would have few deductions (charity and sales to ESOPs). You should score this plan. It would win (or hire me and I will score it under your guidance).

  3. Michael Bindner  ::  8:24 am on December 6th, 2011:

    might have been the 2008 paper

  4. Michael Bindner  ::  8:29 am on December 6th, 2011:

    The reason to retain higher personal income tax rates is for period progressivity, since in the short term, the rich don’t consume as much of their incomes. Also, to not overtax the middle class, it is better to have an explicit tax rather than put in a higher rate in the NBRT for dividend and high salary income – either reporting becomes onerous or the non-rich are taxed too much (or the rich are undertaxed – which in the long term is the same thing).

  5. Garry  ::  9:17 am on December 6th, 2011:

    Why not a VAT that would increase jobs in the USA and which then create higher tax revenues due to those jobs. Our global competitors use their VATs to rape our manufacturing jobs by giving their country’s manufacturers a rebate on their VAT on all EXPORTS. If we lowered Corporate tax rates to 0%, instituted a 6-8% VAT, rebated that VAT on export of a product, we would level t he playing field for our manufacturers and create many new jobs which could be competitive with living wage rates. This would create jobs and DEMAND in our economy.

  6. Secondary Sources: Europe’s Mistake, Higher Taxes, Global Imbalances – Real Time Economics – WSJ  ::  9:44 am on December 6th, 2011:

    […] […]

  7. Scop  ::  6:57 am on December 7th, 2011:

    The poor will not be taxed unfairly if there is a generous tax allowance or the tax allowance is tapered as income increases. It will also be helpful for the tax bands to be generous at the lower end and to encourage wealth creation do the same at the very top end.

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