What a Value-Added Tax Would Mean for the Tax Code—and the Economy

By :: January 31st, 2012

A well-designed Value-Added Tax could simplify the tax code for most households and finance significant reductions in corporate and individual income tax rates without adding to the budget deficit. And it could be a key piece of a revenue system that is both progressive and less intrusive in economic decisions than today’s law.

That’s the conclusion of a new study by my Tax Policy Center colleagues Eric Toder, Jim Nunns, and Joe Rosenberg.

The VAT, a national consumption levy that would tax household purchases of all goods and services, is hardly perfect—no tax is. But properly structured, it could be a vast improvement over what we have.

In a project funded by the Pew Charitable Trusts, TPC modeled a sweeping reform of the federal tax system that includes a VAT. The plan was authored by Columbia Law School professor Michael Graetz . While there are many forms of consumption taxes (Herman Cain’s 9-9-9 tax included several), Graetz’s is similar in structure to the one used by most other countries. In effect, every business pays tax on its sales and gets a credit for any tax that is included in the price of what it buys from other firms.

Graetz does not eliminate the existing income or payroll tax. This no doubt disappoints some reformers, but helps fix a problem that is common to many consumption taxes—they hit poor people (who spend nearly all of their income) more than rich people (who don’t).

Mike’s solution is two-fold: First, he creates a family allowance of $100,000 ($50,000 for single filers), which wipes out all income tax liability for 8 out of 10 households. To ease the burden of the VAT on low-income families, he also creates a rebate tied to wage and self-employment income. But he does not exempt items such as food or housing from the tax.

Graetz sets two income tax rates--16 percent and 25.5 percent—that apply to all income, including capital gains and dividends. He’d repeal the Alternative Minimum Tax. He’d also eliminate the standard deduction and all family-based provisions, such as personal exemptions and the child credit and earned income credit, which he’d replace with the rebates.

He’d allow deductions for charitable gifts and mortgage interest only if they exceed 2 percent of adjusted gross income. Of course, these wouldn’t matter for those making $100,000 or less, since they’d owe no income tax anyway.

Finally, Graetz would cut the corporate rate to 15 percent, eliminate all business credits except the foreign tax credit, and end many deductions and exemptions.

Eric, Jim, and Joe figure Graetz could do all this with a relatively low VAT rate of 12.3 percent. That would raise the same amount of money as the 2011 tax law and be just about as progressive. People in various income groups might pay a bit more or less on average than they do today, but the changes would be surprisingly small.

Besides fairness, economists always look at how much any tax law distorts economic decisions. The current code is a swamp of subsidies aimed at encouraging or discouraging specific economic behavior. By contrast, a well-designed VAT mostly keeps government out of these decisions. It would reduce effective marginal taxes on labor, thus encouraging people to work. And it would reduce overall effective tax rates on capital.

The VAT does have issues. While it would reduce compliance costs for individuals, it would also create new administrative burdens for businesses that have to collect it.

But the biggest question is whether Congress would ever pass such a levy in anything like its ideal form. Any consumption tax must have a very broad base to succeed and this one does. It would apply to new home construction, health and education spending, and purchases and payrolls of non-profits and state and local governments. If Congress buckles under the inevitable pressure to exempt some or all of this consumption from tax, it would have to raise the rate.                                                                                                   

Still, at a time when the campaign trail is awash in tax “reform” plans that are more surreal than serious, it’s nice to see a proposal that has the potential to vastly improve the revenue code without adding trillions to the deficit or providing a windfall to those who need it least.





  1. Toby  ::  2:40 pm on January 31st, 2012:

    The idea of a VAT tax should scare most Americans. It not only is regressive but also is an invitation to the politicans on both sides of the aisle to reject any meaningful limitations on spending. Those who say the VAT tax will be low are either naive or corrupt. Look at the VAT taxes in Europe — 18% is not unheard of. What this demonstrates is that tax law professors should be seen and not heard.

    The structure Professor Graetz envisions is a bald-faced income-redistribution scheme. Hopefully, no one in authority will listen.

  2. denim  ::  2:51 pm on January 31st, 2012:

    In my view, any tax on food and housing is immoral to the nth degree. What business is it of government, that’s us” to raise the price of food and shelter to any American by taxes? It is bad enough to tax the producers as we do now. A $100,000 overall deduction does not address the underlying immorality of taking tribute for letting one eat.

  3. SteveinCH  ::  4:54 pm on January 31st, 2012:

    You keep saying “a well designed VAT”. What’s the probability of one emerging from or being sustained by Congress?

    I have visions of VAT rates based on political characteristics. SUV bad 20% VAT, Prius Good (10% VAT), Volt awesome (5% VAT).

    Nope. The chances of a VAT being anything other than a bigger mess than the current tax code are basically nil.

  4. Michael Bindner  ::  6:41 pm on January 31st, 2012:

    The scoring of this plan is a welcome development. I encourage you to score other privately offerred tax plans, especially my plan and the plan mentioned by Lawrence B. Lindsey (which is still light on detail). A few comments on the analysis.

    First, the treatment of government expenditures looks a bit more like the analysis of how they are treated under the FairTax by its sponsors than I would expect. I would have specified that federal salaries would be reduced rather than taxed.

    Second, an iteration that is deficit neutral under current law, meaning with the expiration of the Bush/Obama tax cuts, would have been useful – both in terms of adjusting the VAT rate, the prebate and the tax rates on high income individuals. One of the reasons Bruce Bartlett gives in his recent book for doing a VAT at all is to increase revenue.

    My particular plan does increase revenue by broadening the base for the corporate profits tax to all businesses and by including labor in the base, but would also end the Hospital Insurance, and perhaps other payroll taxes as well. For this reason, I would make the VAT border refundable but not the business income tax.

  5. Brian Dell  ::  10:37 pm on January 31st, 2012:

    Canada, which is culturally much more similar to the United States than Europe, introduced a VAT at 7% and years later reduced it by 2% to its current 5%.

  6. The “Nevadans throw the word freedom around a lot” Daily Quinn « The Daily Quinn  ::  1:40 pm on February 1st, 2012:

    […] from the report. The most important charts. On the stimulus and austerity. Taxes A new study on value-added tax. Health The House is going to vote to repeal CLASS. Kaiser has put […]

  7. Michael Bindner  ::  5:24 pm on February 1st, 2012:

    Essentially, we pay a hidden VAT when we buy products because included in the price are the income taxes of everyone who brought you the product. In this example, wages would go down to offset any price increases because of adding a tax. In my own proposal, I would give everyone a 13% raise to net pay, while dropping gross pay to the current net pay plus 13 percent plus the payroll tax, plus a prebate targeted at families with children. Lower income employees would likely get a raise or exactly the same amount they get now (their tax rates are low or non-existent). Higher income employees would take a big hit to gross pay. Because I would uncap payroll taxes, net pay would go down for them too.

  8. Michael Bindner  ::  5:26 pm on February 1st, 2012:

    Rescuing people from filing while essentially holding their tax liability constant, as this proposal does, would be a good thing. Whether it is regressive or not depends on the prebate size. It could actually redistribute income down if tax rates were higher to pay for a higher prebate.

  9. Ralph H  ::  12:23 pm on February 5th, 2012:

    I would welcome a VAT but if we impose one we need to eliminate the corporate income tax entirely, or else there is no benefit.

  10. Gigi  ::  9:21 pm on April 22nd, 2012:

    The thing that confuses me about the “fairness” of filers of $100,000. or less for a couple: a couple making $100,000. in NYC, LA, Seattle is barely making it. Their standard of living is modest, even though that sounds like a terrific sum. I live in North Carolina where housing costs are more reasonable. There is such a vast difference in housing costs and property taxes in those high cost areas I don’t see how this could be equal. Then your proposal is that we would also pay tax when one bought a house and a car, large ticket items. Would this also include State Sales Tax? Would this be VAT taxed as well? I think I paid about 23% in Federal Income Taxes this year on my retirement income. I think I pay more in taxes (in percentage) that President Obama. My feeling is that if this is implemented we’d just have another 13% tax, income tax wouldn’t really be reduced and when I bought a car I’d end up paying a VAT and Sales tax as well. You didn’t mention if States would get part of the VAT or if they’d still collect their own taxes.