April 25, 2010
Should the United States Institute a Federal Value-Added Tax?
Should the United States Institute a Federal Value-Added Tax? Posner
In the type of VAT that is simplest to understand, the retailer pays the tax, which is a percentage of the difference between the price at which he sells his goods or services and the cost of his labor, materials, and other business expenses (such as rent and insurance). In other words, he is paying tax on the value that he added to the inputs he bought. His suppliers likewise pay the VAT on their sales revenues minus their costs—that is, on the value they added in the production-distribution process.
Because (assuming no exemptions) the tax base for a VAT is so broad—all goods and services—a VAT can generate enormous tax revenues at a low tax rate, which reduces the distortionary effect of the tax. Moreover, a tax proportioned to value added is a reasonable if crude proxy for the government services that a business firm (and hence its customersd) receives. The VAT also avoids the double taxation of savings under a corporate plus individual income tax system, further encourages savings by making consumption more costly, and reduces the disincentive effects of heavy income taxation. The VAT is criticized as regressive, but if the tax rate is low the regressive effect is slight, and in any event could be offset by subsidies for the poor. The VAT is also criticized as inflationary, because it causes retail prices and thus the consumer price index to increase, but the empirical evidence (most nations have a VAT, so there are abundant data for studying its effects) is that at worst the imposition of a VAT causes a one-time blip in the index.
Of course the benefits of the VAT are greatest if it is substituted for income taxes and other inefficient taxes rather than being added to the existing tax system to generate additional tax revenues. (The inflationary effect would disappear if the VAT merely substituted for other taxes that are passed on to consumers.) Not only is such a substitution politically infeasible, but the cost of transitioning from a tax system based on income to one based on value added at the successive stages of production and distribution would be immense.
Becker's main objection to the adoption of the VAT by the federal government, which is similar to the objection to taxes on Internet sales and indeed any new taxes that do not merely replace existing taxes, is that by increasing government revenues it will increase the size of government relative to the private economy, and if (as is doubtless true) government is less efficient, the result will be a reduction in economic welfare. An efficient tax is less costly and so is likely to be set at a level that generates more tax revenue than an inefficient one; and, as Becker notes, because it is less costly, it is likely to grow more over time than an inefficient tax.
I agree but on the other side of the issue is our awful fiscal situation. Our public debt is soaring at a rate of more than $1 trillion a year, and for political reasons it is extremely unlikely that the debt will be brought under control by higher tax rates, spending cuts (or forbearance to adopt new spending programs), or a rate of economic growth faster than the rate of growth of the public debt. The fact that the dollar remains the strongest major currency, which is why it remains the dominant international reserve currency, is enabling the Treasury to borrow at low rates. But this will not last if we continue on the road of fiscal imprudence; and as interest rates on the public debt rise, compounding the deficit, we could find ourselves in the position that Greece is in.
Devaluation is a standard response to excessive public debt, but would not make sense for the United States: first because foreign trade in not a very large part of our economy, and second and more important because devaluation would greatly impair the international standing of the dollar. Inflation is another standard response to excessive debt, but it would hurt our foreign trade, and the rate of inflation would have to be high because most of our public debt is short term, so that moderate inflation would be largely ineffectual because interest rates on the debt would adjust quickly. But high rates of inflation have negative effects on the economy.
In light of the nation's fiscal bind, the imposition of a federal VAT becomes a more attractive prospect. One immediate beneficial effect, provided that the VAT was not entirely additive to existing taxes but was coupled with some reduction in corporate and payroll taxes, would be a reduction in export prices and therefore an increase in exports and hence a reduction in our trade deficit, which is a contributor to our public debt. The General Agreement on Tariffs and Trade permits VAT to be rebated on exports, thus lowering the cost to the foreign buyers.
More important, the VAT would increase federal tax revenues with minimal distortion because it is an efficient tax. To the extent (even if modest) that it replaced less efficient taxes, it would increase economic efficiency and thus increase the rate of economic growth.
Most important, by discouraging consumption in favor of savings, a VAT would reduce the interest rate on our public debt and the Treasury's dependence on foreign lenders.
Should the US Introduce a Value Added Tax? Becker
Given the current and projected large scale budget deficits of the United States, many people are advocating that the US follow the example of Europe and many other countries, and introduce a value added tax (VAT). President Obama suggested only a few days ago that a VAT for Americans is still on the table. The case for a VAT is that it is a relatively efficient tax that induces less distortion in behavior than say a progressive income tax that raises the same amount in revenue. On the other hand, once introduced the VAT almost always tends to rise over time, which increases the burden of government spending and taxation. If a country were starting a new tax system I would on the whole (I discuss my concerns later) recommend relying mainly on a VAT. However, countries like the US that already have complicated tax systems would make a mistake to simply add a VAT to the tax system without radical surgery in income and other taxes.
Since a VAT is a tax on the value added by companies at each stage of production of consumer and investment goods, it is similar to a sales tax levied directly on these consumer and investment goods. Usually, a VAT is a fixed percent, such as 10 or 20 percent, of the value added by each company, although often medicines and certain other necessities are exempt. A VAT does not distort consumption decisions relative to savings and investment decisions since it taxes consumer and investment goods at the same rate. An income tax, by contrast, discourages savings and investment because it taxes savings twice: once on the income from which any savings are taken, and again on the income earned later on from any savings.
Like an income tax, a VAT does distort the decision whether to work more, or take more leisure and earn less. Since leisure time is not taxed, a VAT encourages an increase in leisure time and a decline in working time. A VAT is usually a flat tax, with the same tax rate for richer people who spend a lot on consumption and poorer persons who spend much less, whereas income taxes are usually progressive, with higher marginal tax rates on higher incomes. The higher the marginal tax rate, the greater the labor-leisure and other distortions-economists call the inefficiencies introduced by these distortions dead weight losses. A flat VAT tax would be more efficient for two reasons than a progressive income tax that raises the same revenue: it does not discourage savings relative to consumption, and it induces fewer distortions on other behavior because it has flat rather than rising tax rates. A flat income tax eliminates the effects of rising tax rates, but still distorts savings behavior.
The downside of a value added tax to anyone concerned about growing government spending and taxing is very much related to its upside; namely, that a VAT is a more efficient and relatively painless tax. As with all taxes, proposals to increase the rate of taxation on value added runs into opposition from individuals and companies hurt by a higher VAT. However, since a VAT is easy to collect and causes fewer distortions in behavior than income and most other taxes, governments have an incentive to raise the VAT over time. In fact, value added tax rates do usually start low, but tend to grow rapidly over time. For example, the VAT rate in Europe started low but now ranges from 15 to 25%, and averages about 20%. In Denmark, for example, the VAT rate was 9% in 1962, but quickly rose to 25% by 1992, and has remained at that level.
So the greater efficiency of a VAT and its easy of collection is a two-edged sword. On the one hand, it would raise a given amount of tax revenue efficiently and cheaply. Since economists usually evaluate different types of taxes by their efficiency and easy of collecting a given amount of tax revenue, economists typically like value added taxes. The error in this method of evaluating taxes is that it does not consider the political economy determinants of the level of taxes. From this political economy perspective, the value added tax does not look so attractive, at least to those of us who worry that governments would spend and tax at higher levels than is economically and socially desirable (see the discussion by Mulligan and me "Deadweight Costs and the Size of Government", The Journal of Law and Economics, October 2003).
In deciding how to close the sizable fiscal deficits facing the US and other countries, introducing or expanding a VAT appeals to many economists and politicians because of the features already discussed. However, the problems is that a VAT would be introduced not as a partial or full substitute for personal and corporate income taxes, but rather as an additional tax. This would make it much easier to close the fiscal gap by maintaining or increasing government spending and overall tax levels.
Since high taxes and high levels of government spending would discourage economic growth and raise rather than lower the overall distortions in an economy, I am highly dubious about introducing a VAT into the federal tax system unless accompanied by a major overall of this system. One big improvement that does not involve a VAT would be to flatten the present income tax rates and greatly reduce the various exemptions, so that the tax basis is widened. Even then it is necessary to be vigilant about combating the incentives government officials have to increase flat taxes over time, whether they are flat income taxes or flat value added taxes.