Saturday, March 06, 2010

Why a VAT Tax Is Where It's At Adoption of a value-added tax in the U.S. would be a fair, efficient way to help restore the country's financial health

Why a VAT Tax Is Where It's At - Adoption of a value-added tax in the U.S. would be a fair, efficient way to help restore the country's financial health, argues Bloomberg BusinessWeek columnist Chris Farrell
By Chris Farrell
Copyright by Business Week
March 5, 2010, 10:30PM EST


The U.S. government's debt is triple-A rated, and with good reason. Could the adoption of a value-added tax help keep it that way for generations to come? Simply put: yes.

The U.S., as both the world's wealthiest economy and a vibrant democracy, remains the investing safe haven of choice in times of financial and political turmoil. Witness the flight of capital into U.S. Treasury securities from investors around the world during the Great Recession, a remarkable measure of trust considering the epicenter of the financial crisis was the U.S. housing market. Treasury securities are the gold standard of the global capital markets. The embrace of the full faith and credit of the American taxpayer and the federal government are worth honoring.

Now, there's no shortage of folks worried about the federal government's budget deficit and soaring debt levels. The concern is misplaced in the short-run. Much of the current fiscal situation largely reflects the cost of combating the Great Recession, the worst downturn since the 1930s. But long-term, the budget deficit and steep government debts are an ominous combination. The underlying budgetary issue is the Holy Trinity of entitlement programs: Social Security, Medicare, and Medicaid, with the primary emphasis on health care. Spending on those three programs alone accounts for about half of the government's noninterest spending. It is only going to go up with an aging population.


The Woodstock Generation, aka the roughly 76 million baby boomers born between 1946 and 1964, is getting ready to retire. The oldest boomers were eligible to start collecting Social Security at age 62 in 2008. They'll be eligible for Medicare next year. Eventually, over the next half-century or so, if the nation's total tax burden stays around its current 18% of gross domestic product, Uncle Sam will end up borrowing to pay interest on the interest, according to Rudolph G. Penner, economist at the nonpartisan Urban Institute. "At that point, total spending, the deficit, and the national debt begin to go straight up," he writes.

Clearly, the long-term fiscal numbers are unsustainable. Something has to give long before the fiscal disaster strikes, Yet any solution will take years to come into law, so now is a good time to get started. It's long past time to lay to rest such deficit solutions as "starve the beast." Mantras such as "tax cuts pay for themselves" aren't true no matter how often repeated. Social Security, Medicare, and Medicaid are popular programs that aren't going to fade away. The government may take on even greater obligations with health-care reform. Indeed, between the aftermath of 9/11 and the Great Recession, the government has taken on enormous responsibilities, from waging war on two fronts and boosting domestic security to expanding Medicare and bailing out the banks. Any viable solution will have to involve both the spending and the tax side of the fiscal ledger.

That means it's time to consider a value-added tax, or VAT. Unlike a sales tax, which is levied by 45 states and many municipalities only on the retail consumption of a good or service, a VAT is collected at each stage of production and distribution rather than just from retailers. A VAT is a highly efficient tax from an economic point of view. It's essentially a flat consumption tax, and the way it's collected minimizes compliance problems. More than 100 countries use a VAT to help fill their coffers. New Zealand, for instance, has a 12.5% VAT, and Denmark's is 25%.


To be sure, a VAT has never gained much traction in the U.S. Many liberals oppose it because they believe it falls heaviest on the poor and elderly. Many conservatives dislike it because it's a new tax—and an efficient one. "The greater (but often unspoken) fear of many conservatives is that a VAT would be too efficient a revenue-raiser," writes Joel Slemrod, tax economist at the Stephen M. Ross School of Business at the University of Michigan. A number of conservatives worry that an efficient VAT might allow government to get even bigger. Perhaps Grover Norquist, the longtime tax opponent at the conservative lobbying group Americans for Tax Reform, put the opposition best. "VAT," he said, "is French for big government."

Yet it's the very efficiency of the VAT that makes it attractive for taking a large step toward meeting America's future obligations. The VAT works best as a supplement to the income tax. Indeed, President Bush's bipartisan White House commission on tax reform in the middle of the decade did consider the option. Businesses would pay tax on the difference between their sales receipts and the cost of their inputs purchased from other businesses. The VAT would be joined with a greatly simplified income tax system.

It's an idea worth reviving. No one really defends the current income tax system anymore. It's far too complicated, with all kinds of loopholes and special interest favors, from various tax-sheltered retirement savings plans to multiple tax deductions and credits for home ownership to separate tax treatment for asset sales. Worse yet, arbitrary phase-outs of various levies, such as the estate tax, needlessly complicate the tax code and add to a widespread sense that it's fundamentally unfair. Congress and the Administration could reward taxpayers with serious tax simplification. They could lower income tax rates greatly by broadening the tax base through eliminating as many credits and deductions and shelters as are politically practical. The highly efficient VAT would then supplement the income tax to restore long-term fiscal discipline.


The University of Michigan's Slemrod wonderfully opened an essay on tax reform by quoting Ralph Waldo Emerson: "We ascribe beauty to that which is simple; which has no superfluous parts; which exactly answers its end." He ended the discussion with Albert Einstein's legendary admonition that "everything should be made as simple as possible, but not simpler." Taxation involves contentious issues of ethics, values, efficiency, and social goals, Slemrod says. Pure simplicity is possible only on paper, not in the real world.

But much can be done with the tax code, keeping Einstein's caution in mind but moving closer to Emerson's standard of beauty. Simplify the tax code and embrace the VAT. Together, the actions would show that the American democracy can run a sound fiscal policy. Investors around the world could continue to sleep soundly, knowing their money is safe in U.S. Treasuries.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on


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