Ramesh published an excellent article on the VAT in NR last month, and I’ve been meaning to share some thoughts for a while. The case for a VAT is simple:

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.

There are, of course, serious downsides.

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.

Ramesh also suggests that conservatives shouldn’t preemptively embrace a VAT.

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.

I support the broad view outlined by Michael Graetz in 100 Million Unnecessary Returns, namely that a VAT should be used to finance a large exemption, indexed for inflation, from the income tax, $50,000 for single earners and $100,000 for married couples. An X tax, a modified VAT Ramesh describes in his piece, could also do the trick. Let’s definitely not accept a VAT without getting something big and substantial in return, like sparing most Americans the burden of filing an income tax return.

I don’t embrace the Becker-Mulligan critique in large part because I think that there are better ways to change the dynamic in favor of spending restraint than simply relying on an inefficient tax system, like moving towards a more competitive federalism. By eliminating the state and local tax deduction and federalizing Medicaid, the choices made by state governments would suddenly matter far more to households. And that would spur efficiencies.

P.S. Robert Stein’s “Taxes and the Family” proposal, which doesn’t involve a VAT, offers some interesting thoughts on indexing.

Why adjust the filer credit by inflation but the child credit by wage growth? The purpose of the filer credit is to ensure that all taxpayers can earn the basic costs of living — food, clothing, and shelter — without having to pay any income taxes. Over time, the basic cost of living should rise with inflation. The purpose of the child credit, however, is not only to let parents deduct the costs of creating the next generation of taxpayers, but also to reward parents for raising the future workers who will support the public retirement system. The amount of that future support will, naturally, be tied to overall wage growth. And if the child credit grew only with inflation, each year would gradually erode the incentive parents have to raise children relative to those children’s future payroll contributions — thereby undermining a key rationale for offering the credit in the first place.

Stein also makes the case for axing the state and local tax deduction, and I find it persuasive.