Don’t Let the VAT Out of the Bag

Economists may often be wrong. But they are also doggedly persistent.

One recent example of this persistence involves a continuing lobbying effort by economists of many stripes on behalf of a national value-added tax to help raise revenues to reduce the federal deficit. This effort may score high for persistence, but it scores even higher for wrongheadedness.

First the background and then the arguments.

Numerous economists have favored some kind of value-added tax in the United States for years, pointing to its apparently effective use in many European economies. The lobbying effort has intensified since the mid-1980s as Congress has proved relatively incapable of otherwise reducing the federal deficit.

I received earlier this year, as one example of this lobbying effort, a mailing that sought endorsements of a circular “In Support of a Value-Added Tax.” The co-signers of the cover letter included economists ranging across the political spectrum, from business lobbyist Charls E. Walker and conservative Paul W. McCracken to moderates such as Lawrence H. Summers, a key economic adviser in the Michael Dukakis presidential campaign, and liberal economist Lester C. Thurow. The punch line of the circular urged “Congress to consider seriously the imposition of a federal value-added tax or other form of national sales tax to raise needed revenues.”

The VAT would serve essentially as a national sales tax, with a flat-rate percentage tax assessed against each dollar’s worth of output. The principal difference between a VAT and a more conventional retail sales tax is that each is collected at different points in the circulation of goods and services. The sales tax is assessed at the point of final retail sale, paid by the consumer. The value-added tax is paid by the producer, not the consumer, levied on the extra value that producer has added at that stage of production. The two kinds of taxes are otherwise equivalent.

Economists appear to be infatuated with the VAT for two main reasons:

- Many economists believe that we should try to boost savings to stimulate investment. Since the VAT taxes only the value of products produced, it serves as a tax on consumption, leaving untaxed the income that households set aside as savings. (An income tax, by contrast, enfolds all income--regardless of whether it is saved or spent on consumption.) As my mailing argued, “since a major purpose of deficit reduction is to raise the low rate of net domestic saving, a consumption-based VAT is preferable to an increase in income taxes.”

- In a general climate of taxpayer hostility to increased taxes, the VAT would be less visible to consumers than a national retail sales tax, buried in the price of goods and services rather than separately assessed on top of their retail price. Many therefore believe that there would be less opposition to a VAT than to a supplementary national retail sales tax.

These grounds for support may sound alluring. But there are a couple of much more compelling reasons to oppose a national value-added tax.

The first and probably most important objection is that a VAT would be highly regressive, imposing the greatest tax burden on those who can least afford it. (This is also a problem with the retail sales tax and the payroll tax.) A report by Arne Anderson, recently issued by the Economic Policy Institute in Washington, estimates the impact of a VAT on different segments of the income distribution.

Assuming that a 5% VAT had existed in 1986, households in the poorest 20% of the income distribution would have paid 14.9% of their after-tax income. The tax burden for the other quintiles of the income distribution would have ranged from 6.3% of after-tax income for the second 20% down to a low of only 3.5% for the most affluent 20%.

VAT proponents are sensitive to these charges of tax regressivity and sometimes propose that the VAT include an exemption for food expenditures. But this scarcely moderates the steep slope of the VAT’s regressivity. In this case, a 5% VAT with food exemption would have claimed 12.1% of the after-tax income of the poorest 20% of households and only 3% for the top 20% in the income distribution.

These numbers may seem abstract. But the least affluent households in the United States have been taking it on the chin throughout the 1980s--through both declining real wage and salary incomes and higher relative tax burdens. This is hardly the time to squeeze those households even more harshly.

A second central objection comes from observing the history of tax efforts to boost savings in the 1980s. Since 1981, an increasingly conservative federal government has been lavishing the wealthy with tax relief on the ostensible grounds that this would free up some of their extra income for savings. But despite these frenzied tax efforts, personal savings rates have dropped continuously during the 1980s to their lowest levels in the postwar period.

For example, personal savings as a percentage of disposable personal income averaged only 4% from 1985 through 1988 while it averaged 7.1% from 1955 through 1984. Even though the personal savings rate has crept back up somewhat over the past couple of quarters, it is still lower than in any year since the Korean War.

Why have these tax efforts failed so dismally? The story is complicated, not easily illuminated, but it seems quite likely that these tax efforts have failed in part because real incomes have stagnated or declined for the huge majority of U.S. households during the 1980s, pushing them further and further away from savings toward borrowing and ever-increasing debt. What these households need is more income, not higher taxes.

In short, the VAT would do more harm than good. There are plenty of other ways to free up revenues at the federal level: trimming military spending, restoring some of the recent cuts in tax rates for the wealthiest households, lowering real interest rates to stimulate growth and the tax revenues that it generates. These persistent economists pressing for a VAT have been wrong before and are wrong again. If you’ll pardon a New Yorker’s expression, their persistence and a subway token could buy them a ride on the subway.