Magazine | December 21, 2009, Issue

VAT Attack

Will the Democrats enact a new kind of tax to pay for their bender?

The U.S. has a smaller government than most rich countries do, but we don’t have much lower corporate tax rates or top income-tax rates. That’s one conclusion to be drawn from a paper on the history of world taxation by American Enterprise Institute scholars Kevin Hassett and Aparna Mathur. Most developed countries have cut their corporate tax rates over the last two decades, and our rates are now among the highest in the developed world (adding state and federal corporate tax rates, we’re second only to Japan). Our top income-tax rates are only slightly lower than the rich-country average. Most other developed countries have, in short, managed to build larger governments than we do without leaving their citizens with smaller incentives to save and invest.

They have done it by relying on value-added taxes, called VATs. And that, in a nutshell, is why VATs are suddenly attracting a lot of interest in Washington, D.C.: They’re seen as a way to raise a lot of revenue while doing little damage to the economy. But introducing a VAT is also considered politically risky. Whether the Obama administration tries to do it will depend on just how badly it wants the extra cash.

A VAT is a tax on consumption. But it is not administered as a sales tax, for two main reasons. When sales-tax rates climb into the double digits they generate serious compliance problems. And in practice sales taxes often apply to business-to-business sales, which can have such perverse consequences as inducing companies to integrate solely to reduce tax payments. 

A VAT is levied at each stage of production, with credits given for the taxes paid at previous stages. So a lumber company pays a tax when it sells wood to a pencil manufacturer; then the pencilmaker pays a tax when it sells the pencils to a chain of stores, but gets a credit for the taxes that the lumber company already paid; then the store pays the tax when it sells the pencil to a customer, but gets a credit for the taxes paid in the first two rounds.

Economists generally agree that the VAT is an efficient tax: Other taxes do more damage to the economy per dollar of revenue they raise. Because the income tax applies in many cases to returns on investment, it biases consumption decisions toward today rather than tomorrow; and because returns compound, it is even harder on consumption the day after tomorrow. It creates an incentive to spend now rather than add to the capital stock. A consumption tax doesn’t: It is neutral with respect to time. An additional source of its efficiency comes from the way it reaches previously accumulated capital as it gets consumed. Enact a VAT now, and the buying power of your nest egg will fall. But you can’t go back in time and work and save less in response to the tax. By some estimates, replacing the current tax code with a consumption tax would, over time, add 10 percent to the nation’s economy. 

Proponents of a VAT frequently argue that it would shrink the trade deficit because importers would pay it while exporters would get rebates. Alan Viard, who has studied the issue for the American Enterprise Institute, says that this type of “border adjustment” would make it easier to administer a VAT for internationally traded goods, but thinks it doubly mistaken to hope for an effect on the trade balance: There is no good reason to favor exports over imports, and in any case a VAT would cause the dollar to appreciate and thus cancel out the pro-export effect.

It is mainly the VAT’s potential as a revenue-raiser that has piqued Democratic interest. Every few weeks a small trial balloon floats up. In May, a spokesman for the administration’s budget director mentioned it. In June, the chairman of the House committee on taxes, Rep. Charlie Rangel, said, “It’s been put on the table.” In September, John Podesta, who ran Obama’s transition, talked up a VAT on television, citing its effect on revenue and its alleged effect on competitiveness. In October, two influential liberal think-tankers, Henry Aaron and Isabel Sawhill, wrote an op-ed urging Congress to enact a VAT that would take effect as soon as the economy recovers. Doing so, they argued, would itself promote recovery, since people would want to make purchases before the tax kicked in. Speaker of the House Nancy Pelosi said that “it’s fair to look at a value-added tax.”

Two former Fed chairmen have also made supportive comments. Paul Volcker said that he would prefer to see spending cuts but that a VAT or a carbon tax might be necessary in their absence. Alan Greenspan also said he would prefer spending cuts, but that a VAT would be “the least worst way” to raise revenue. A similar thought process has led right-leaning economic journalist Bruce Bartlett to drop his opposition to a VAT and become a crusader for it.

Anti-tax activist Grover Norquist is preparing to campaign against a VAT. “When you listen to the patter on Japanese radio traffic and they keep mentioning Pearl Harbor, you begin to see a pattern. . . . They keep blurting out, ‘The VAT.’” He assumes that a push for a VAT is coming because it’s the only way that liberals can finance their plans for bigger government.

But there are a lot of political hurdles in the way of a VAT. Liberals often oppose consumption taxes as insufficiently progressive: They tax the consumption of the rich at the same rate as that of the poor, and the poor consume a larger percentage of their income. The government could send everyone a large check to defray taxes on the basic necessities of life, but that would still leave the rich and the middle class paying roughly the same share.

Conservatives worry that a VAT would be too easy for the government to raise once it was in place. Economists Gary Becker (a Nobelist) and Casey Mulligan have done research suggesting that the more efficient a tax, the easier it is to increase. This may be especially true when the tax is hidden from most people. In Europe, quoted prices typically include the tax. Even if they did not, people wouldn’t keep track of the taxes: American consumers don’t add up how much they pay over the course of a year in sales taxes. Fear that a VAT would fuel the growth of government would make most conservatives wary of it even as a replacement for today’s income and payroll taxes. They will be even less likely to support it as an additional tax.

Senior citizens might fight against VAT proposals. Having been taxed during their working lives on the income they made, they may not be eager to pay additional taxes as they spend their savings. Since seniors receive gargantuan subsidies from younger people, for the government to take some money back might not be the worst injustice in the world. But seniors do vote at high rates.

There are other complications, too. A VAT should lead to wage cuts, because it is, in part, a disguised tax on wages collected by firms. (To look at it another way, firms can’t deduct their wage costs when calculating the tax and pass some of the burden to their employees.)  If wages do not drop — if they prove “sticky downwards,” to use the jargon — then unemployment will rise. One way around this problem is for the Federal Reserve to inflate the money supply so that wages can stay flat on paper while declining in value, but this solution has obvious drawbacks.

While he hopes that political circumstances have changed, Bartlett has noted in Forbes that politicians who have proposed VATs have often seen their careers end soon afterward. Al Ullman, one of Rangel’s predecessors, lost his reelection bid after advocating a VAT. Leaders in Canada and Japan have lost their jobs after introducing VATs.

A crisis might suspend the normal political rules. Hassett outlines one scenario. The Democrats raise top income-tax rates but the extra revenue take is disappointing. The government’s creditors start worrying that it might default and start a run on the dollar. A plummeting dollar then leads Congress to pass a VAT as an emergency measure to reassure creditors. Nobody doubts that VATs can raise money.

It is possible to smooth the jagged edges of the VAT. The late David Bradford, an economist at Princeton University, proposed a variant called the X tax. The difference is that under the X tax businesses would be able to deduct wages and workers would pay taxes on their wage income. The wage tax could be made as progressive as Congress wants, making the X tax more attractive to liberals. It would also be more visible to voters, making it more attractive to conservatives. And wages wouldn’t have to fall.

Economic analysis alone can’t answer the most important questions about a VAT. Some of those questions are moral: How progressive should the tax code be? Many of them are political: How much progressivity must a proposed tax code have to be politically viable? How much would a VAT expand government, and how should we weigh that effect against the tax’s efficiency? Could Washington be trusted to levy a uniform tax rate, as economists wish, or would special favors encrust the VAT as they do today’s tax code? 

Greenspan’s argument for a VAT depends on the most important political judgments of all: Is spending reduction so improbable, and is deficit reduction so important, that even conservatives should support big tax increases? Like most conservatives, I’m inclined to say no. It’s worth noting that at no point during the Republican ascendancy did liberals ever give up on the idea of tax increases, given Republican and public resistance, and start pushing instead for spending cuts.

Republicans should not react to Democratic rule with a tit-for-tat strategy; but they should drive a smart bargain. If the Democrats want Republicans to support any sort of tax increase, it’s up to them to propose a deal that includes serious spending cuts: an increased retirement age, or a change in Social Security’s benefits formula. With nothing of the sort on the table, for conservatives to talk up a VAT as the least-worst tax increase would be to negotiate with themselves. That’s never a good idea.

Ramesh Ponnuru is a senior editor for National Review, a columnist for Bloomberg Opinion, a visiting fellow at the American Enterprise Institute, and a senior fellow at the National Review Institute.

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