Pulling a VAT Out of a Hat
December 15th, 2009 - 16 Comments
The combination of a skyrocketing federal deficit, a slow economy, and Washington’s penchant for unrestrained spending is causing economists and legislators to look for new and creative ways to get their hands on more taxpayer dollars. One option that is gaining momentum is the value-added tax, a national sales tax of sorts that is assessed on goods and services at every step in the supply chain.
Below, Smeal’s resident tax expert, Charles Enis, lays out the political and economic challenges facing the value-added tax as well as some of its benefits over other forms of taxation:
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Equity and efficiency are conflicting policy goals in taxation. In short, how fair is the tax and how well does it work. An income tax is imposed on production, while a value-added tax (VAT) is imposed on consumption. The former tends to embrace equity while the latter is noted for efficiency. Because all production is ultimately consumed, theoretically the major difference is timing.
A VAT is efficient because it has a broad base, is relatively simple, and is a good revenue raiser that minimally distorts economic decisions. A VAT is a multilevel sales tax on all parties in the supply chain with upstream taxpayers collecting taxes from their customers while receiving credits for taxes paid by downstream businesses. A VAT must be kept on the table when considering ways to alleviate the federal fiscal crisis.
A VAT is politically challenged on the equity dimension in that it is regressive. The rich spend less of their incomes relative to the poor. Wealthy people have surplus income that can be diverted from consumption to investment thereby escaping consumption taxes. To overcome equity deficiencies, a pure VAT must be tweaked. Such modifications include integrating the VAT into a more progressive version of our income tax system, exempting food and other necessities from the VAT, and allowing for higher tax rates on luxury goods.
Designing a politically acceptable VAT is the charge of Congress, the same institution that gave us the Internal Revenue Code, one of the most massively complex documents in human history. Instead of having just an uncompressible income tax, we will also likely have an incomprehensible VAT.
The most difficult problems in implementing a VAT will be transitional issues. For example, baby boomers headed for retirement have paid income taxes all their lives, now they will be taxed again as they consume their savings. Sales taxes are important revenue sources for state and local governments, how will they react to the federal government getting into the sales tax business. How will consumers react in anticipation of a VAT? Will they rush to stores to load up on merchandise to beat the tax increase and incur more debt? Will there be a sharp decline in consumer demand following the VAT?
Because a VAT is imposed on consumption and not investments, income attributed to the financial sector—i.e., interest, dividends, and capital gains—will be relatively unscathed by a VAT. It would be ironic that the financial sector, a major culprit in the economic crisis winds up paying little of the tax that is needed to fix the fiscal damage.
A VAT may be prescribed to restore federal revenues once the great recession is over. A VAT will be a tough sale to the public. One suggestion would be to promote it as a permanent replacement for the dreaded Alternative Minimum Tax. Nevertheless, a well designed VAT may require Congressional acts of legislation and magic.