A New Money Machine for the U.S.

The United States needs to adopt a value-added tax. Passage of the prescription drug legislation last year demonstrated that there is no longer any hope of holding the line on government growth -- especially when Republicans voted for the multitrillion-dollar entitlement program.

That being the case, the only relevant question is how to finance the growth of government. A value-added tax, or VAT, isn’t the complete answer. Other taxes are also going to rise. But a value-added tax is the least bad way of raising the needed revenue because there is little likelihood that spending will be cut enough to avoid that necessity. If some of a VAT is used to finance improvements to the tax code, more total revenue could conceivably be raised at less economic cost.

Under the Congressional Budget Office’s most likely long-term scenario, Medicare and Medicaid spending alone will consume 21.3% of gross domestic product by 2050 -- more than all federal spending today. Social Security will add 6.3% more, meaning that federal revenue will have to rise by nearly 12% of gross domestic product from where it is now even if interest on the debt is ignored and every other government program, along with the Defense Department, is abolished.

Congress isn’t going to go that far, which means that federal spending would rise to about one-third of GDP over the next several decades, absent substantial and highly unlikely changes in major entitlement programs. Given that Republicans just created one of the biggest such programs in history with the prescription drug legislation and that Democrats want to expand healthcare to the uninsured, we can assume this is a bare-minimum estimate.

In effect, the United States would slowly move toward European levels of spending as a share of GDP. And if we spend like Europeans, we will have to tax like them too, and embrace a value-added tax.

The tax was originally adopted as part of European integration in order to avoid double taxation by national sales taxes. Its key feature is refundability at the border. This requires tax authorities to know exactly how much tax is embedded in the prices of all exports. The VAT provided that paper trail. In its classic form, the tax is paid at each stage of production and distribution, with a credit for taxes paid at earlier stages. Because producers and retailers need to show that they paid the tax to be credited for the taxes included in the prices of the goods they purchased, the system is largely self-enforcing. And the invoice trail allows governments to refund the entire tax on exports at the border.

From the point of view of consumers, a value-added tax is embedded in prices, which tends to make it less transparent than the state and local sales taxes Americans pay. And because a VAT falls only on consumption, it doesn’t burden saving or investment. This makes it a highly efficient tax in the sense it discourages less economic output -- what economists call the “deadweight” cost of taxation -- than income taxes of similar magnitude.

The lack of transparency and the low economic cost of a value-added tax make it possible for this tax to raise substantial revenues relatively easily, both politically and economically. The average VAT in Europe is 20%, and European governments raise about one-third of their total revenue from consumption taxes, including excise taxes on gasoline, tobacco and other items. The U.S. raises about half that, including sales taxes at the state and local levels.

This suggests there is substantial room for raising broad-based consumption taxes in the U.S. without overburdening the economy. A very broad value-added tax levied on virtually all personal consumption could raise about half a percent of GDP in revenue for each 1% tax rate. But this sort of value-added tax is highly unlikely, though it would be best to treat all consumption equally. In practice, it is unlikely that more than 30% of GDP would be taxed, meaning that a 10% VAT would raise revenues equal to 3% of GDP -- about $350 billion this year. We could raise twice that at a rate no higher than now exists in most European countries.

The great bugaboo of a value-added tax is its regressive feature -- taking more from the poor than the rich. In the short run that’s true, because the lower one’s income, the higher one’s consumption is as a share of income. Over a lifetime, however, consumption is roughly proportional to income, so a VAT would also be proportional -- taking about the same from rich and poor alike in percentage terms.

In any case, no value-added tax will be introduced without substantial changes in other taxes and spending that could offset its regressive element. For instance, VAT revenues could be used to abolish the alternative minimum tax and sharply raise the standard deduction.

Conservatives often complain the value-added tax is a money machine to finance government growth. There is truth in this. But government is growing rapidly. The only real alternative is to raise existing taxes significantly. If we did that, it would mean higher tax rates and abolition of many pro-growth elements of the 2001-2003 tax cuts, such as bonus depreciation and lower rates on capital gains and dividends. A VAT might also finance other pro-growth initiatives, such as abolishment of the corporate income tax.

There won’t be much resistance from the corporate community to a value-added tax. Big corporations like its refundability feature. They will also view any alternative as higher taxes on them. Although they will have to collect the VAT, its burden is passed through to consumers and does not fall on the corporation. Small businesses, especially retailers, are more likely to complain about a value-added tax, but most could be exempted from collecting it at little revenue cost. Because they will pay the tax when they buy goods to sell, the only revenue lost would be on the final retail markup.

Some years ago, economist (now Harvard President) Lawrence Summers quipped that the reason the U.S. doesn’t have a value-added tax is because liberals think it’s regressive and conservatives believe it’s a money machine. We will adopt such a tax, he said, when liberals realize that it is a money machine and conservatives see that it is regressive. Perhaps that day has come.