In Defense of the VAT

Earlier today, President Obama convened the first meeting of an eighteen-member bipartisan commission tasked with devising a plan to bring down the federal government’s record budget deficits. Expectations are understandably low. Few believe that the necessary but politically unpalatable decisions will be made in an election year, and even fewer believe that Congress will actually adopt the recommendations of the commission in the event that a consensus does emerge.

Cumulative federal deficits are projected to exceed $8 trillion in the coming decade, a level that economists believe poses a serious threat to future growth. As the president explained in his remarks at the start of the meeting, the magnitude of the problem is such that all options must be on the table. This means that liberals ought to be willing to consider reductions in the amount spent on popular programs such as Social Security and Medicaid, and conservatives ought to accept the fact that federal revenues must somehow be enhanced. These two sides of the equation – spending cuts and tax increases – are equally vital, but it’s the second that I’d like to briefly examine in greater detail.

Raising taxes on the wealthiest Americans is the least damaging option politically, but there are limits to the amount that the government can actually collect by doing so. In addition, there is truth to the argument that excessive taxation of corporations and high-earning individuals inhibits the sort of investment spending essential to the competitiveness of our economy. This is not to say that social priorities like economic equity cannot factor into the design of a tax code, but that these priorities must not be pursued at the expense of our standard of living.

An alternative to an across-the-board increase in income and payroll taxes is a value-added tax or VAT, a type of consumption tax widely used in the industrialized world. The VAT has a number of appealing attributes: it is relatively easy to collect, it promotes saving over spending, and it is border adjustable.

A VAT is a tax that is collected at every step in the chain of production and that is levied only on the “value added” at a particular step. Ultimately, the cost of the tax is borne almost entirely by the consumer, though it is not collected only at the point of purchase like an ordinary sales tax. By levying the tax on all producers and not just on those that sell to consumers, the government is able to minimize revenue losses. The effect of a single firm attempting to evade the tax is diminished by the fact that there are more firms paying it.

Critics of the current federal tax system, which relies primarily on personal and corporate income taxes and payroll taxes, point out that the status quo encourages immediate consumption over saving and investment. Income that is spent is taxed once; income that is saved is taxed twice, since depositors and investors pay taxes on interest and capital gains. Moving toward a consumption-based tax system would encourage individuals to opt for behavior that is better for the long-term structural soundness of the economy (saving) over behavior that has mostly short-term benefits (spending).

The VAT would also help to correct America’s enormous trade deficit by virtue of the fact that it is border-adjustable. Under current World Trade Organization agreements, nations with taxes such as the VAT allow exports an exemption while still exacting a levy on imports. The fact that the United States does not have taxes that are inherently border-adjustable is a significant damper on the competitiveness of our exports. A policy of this sort amounts to a de facto tariff on products bought from the United States, or a de facto trade subsidy to products that the U.S. buys from elsewhere.

There are two main arguments against the value-added tax. The criticism advanced primarily by liberals is that such a tax is regressive. Low and middle-income individuals spend a greater portion of their income on consumption than do the wealthy, who are more likely to save and invest. Some nations with VATs have attempted to reduce their burden on the poor by exempting certain essential goods and services like food and medical care, but there is a solid case to be made that this only causes inefficiency by incentivizing firms to pretend that their products are something they are not (e.g. prepared food rather than non-prepared food) in an effort to gain a price advantage over their competitors. Even worse, it can set the stage for intense political lobbying of the authorities who decide what gets taxed and what doesn’t. A more elegant solution to the problem of regressivity is to provide rebates to low-income taxpayers or to modify the rest of the tax code so that progressivity is preserved (i.e. by cutting marginal income tax rates or by increasing the personal exemption).

The other notable criticism of the VAT comes from the other end of the political spectrum. Conservatives claim that the very efficiency and relative invisibility with which the tax can be collected is a reason to believe that it will only serve to license a dramatic growth in government spending. This is a valid fear, and one that is substantiated by the past experiences of other nations with VATs and states with high sales taxes such as California and New Jersey. But the alternative is much worse; heavy borrowing cannot continue forever, and the sooner steps are taken to rein in the problem, the less painful they need be. Given our nation’s history of vigorous opposition to any form of new taxation, I find it difficult to accept the notion that politicians could wantonly increase VAT rates without coming up against the same sort of antitax forces fueling the current opposition to the policies of Obama and the Democrats in Congress.

Former Federal Reserve Chairman and Obama Administration economic adviser Paul Volcker recently declared that the VAT is “not as toxic” an idea as it has been made out to be. Politically, it remains to be seen whether this is the case, and it’s doubtful at best that it is. Economically, this is certainly true. Such a tax can be an important part of a recipe for ensuring robust economic growth and sustainable fiscal policies in the years and decades ahead. Let’s hope that Obama’s bipartisan commission and our leaders in Congress have the courage and will to consider it.