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Vat Caveats
If we take on this tax reform, let's do it right.


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Talk of the U.S. adopting a value-added tax — a cousin of the sales tax — has made a splash recently. House Speaker Dennis Hastert mentions the VAT as a tax reform option in his new book, Speaker. A couple of weeks ago, a secret Treasury study that looked at the VAT as a tax reform option was posted on Internet. Even conservative columnist Bruce Bartlett says the U.S. needs to impose a VAT on top of current taxes.

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Should the United States enact a VAT? The tax has the same advantages that retail sales taxes have over the income tax: lower compliance costs, favorable treatment of savings and investment, and improved U.S. business competitiveness. The difference is administrative: VATs are collected at each state of production, while sales taxes are collected only at the final purchase.

There are dangers to the tax. For one thing, most VAT supporters see it as an add-on to existing taxes. The Treasury study, completed for former secretary Paul O’Neill, included one proposal that would retain the corporate tax, retain the individual income tax for families earning over $100,000, and impose a 15 percent VAT. That is a dreadful option because the economy would be burdened with a new VAT infrastructure on top of the most inefficient parts of the existing income tax.

A VAT has been pushed as a way to raise money for reducing the federal deficit. But the steady rise in European VAT rates since 1970 has created larger governments, not smaller deficits. In 1970, tax revenue as a share of gross domestic product was 28 percent in the U.S. and 30 percent in Europe. In 2000, the U.S. share was 30 percent but the European share had grown to 42 percent.

However, if Congress were to substitute a VAT for a fully repealed individual or corporate income tax, then it’s worth considering. The key would be to guarantee that the VAT was listed explicitly on all retail sales receipts. VATs in Europe, which have rates of about 20 percent, are hidden in the prices of goods. A hidden VAT would clearly be a money machine for the government.

On the other hand, the Canadian VAT, called a “goods and services tax” (GST), is legally required to be listed on all sales receipts. Canadian fiscal experts tell me that this requirement has been crucial in averting any increase in the GST’s 7 percent rate since it was introduced in 1991. Taxpayers hate the GST because they see it every time they buy a donut or a hockey stick. The occasional government trial balloon to raise the tax has been quickly shot down by negative poll numbers. In this respect, the GST is a good tax.

If Bush is re-elected, his tax-reform commission should examine replacing the corporate income tax with such an explicit VAT. After all, the corporate tax is a $200 billion hidden burden on Americans that kills jobs, causes Enron-style scandals, and has huge compliance costs. Replacing the revenues of the current corporate tax would require about a 3 percent VAT on a very broad base, or a higher rate on a narrower base.

That underscores a key tax-reform trade-off. Low-rate, broad-based VATs are efficient, but they make it too easy to raise a lot of money with a small rate change. By contrast, the 35 percent corporate income tax has a narrow base that has been shot full of loopholes. While an inefficient mess, the corporate tax’s high rate is unlikely to be raised and its base seems to be shrinking over time. Corporate tax revenues have fallen from an average of 3.8 percent of GDP in the 1960s to 1.5 percent today. Thus, the corporate tax has not been a fuel for expanded government.

Narrow tax bases are disliked by economists, but any tax reform should avoid creating a more powerful federal revenue engine, particularly now as some politicians are looking for ways to fund rising entitlement costs. Thus with a VAT, reformers should consider a narrower base that exempts hard-to-tax items such as financial services. More importantly, Canadian experience shows that making a VAT explicit on sales receipts is a crucial feature for restraining demand for bigger government.

Chris Edwards is director of fiscal policy at the Cato Institute.



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