Value Added Tax Will Not Solve Budgetary Woes

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There has been a fair amount of useless discussion among pundits and Obama administration officials about a Value Added Tax, a National Sales Tax, the mainstay of the crumbling welfare states in Europe.  I say this discussion is useless, because Congress would never pass it, as the 85-13 vote in the Senate on an anti-Value Added Tax non-binding resolution indicates.

Today in the Washington Post Robert Samuelson explains why a VAT wouldn’t solve our budgetary woes:

The basic budget problem is simple. For decades, the expansion of Social Security, Medicare and Medicaid — programs mostly for the elderly — was financed mainly by shrinking defense spending. In 1970, defense accounted for 42 percent of the federal budget; Social Security, Medicare and Medicaid were 20 percent. By 2008, the shares were reversed: defense, 21 percent; the big retirement programs, 43 percent. But defense stopped falling after Sept. 11, 2001, while aging baby boomers and uncontrolled health costs keep retirement spending rising.

Left alone, government would grow larger. From 1970 to 2009, federal spending averaged 20.7 percent of the economy (gross domestic product). By 2020, it could reach 25.2 percent of GDP and would still be expanding, reckons the Congressional Budget Office’s estimate of President Obama’s budgets. In 2020, the deficit (assuming a healthy economy with 5 percent unemployment) would be 5.6 percent of GDP. To cover that, taxes would have to rise almost 30 percent.

A VAT could not painlessly fill this void. Applied to all consumption spending — about 70 percent of GDP — the required VAT rate would equal about 8 percent. But the actual increase might be closer to 16 percent because there would be huge pressures to exempt groceries, rent and housing, health care, education and charitable groups. Together, they account for nearly half of $10 trillion of consumer spending. There would also be other upward (and more technical) pressures on the VAT rate.

Does anyone believe that Americans wouldn’t notice 16 percent price increases for cars, televisions, airfares, gasoline — and much more — even if phased in? As for a VAT’s claimed benefits (simplicity, promotion of investment), these depend mainly on a VAT replacing the present complex income tax that discriminates against investment. That’s unlikely because it would require implausibly steep VAT rates. Chances are we’d pay both the income tax and the VAT, making the overall tax system more complicated.

Europe’s widespread VATs aren’t models of simplicity. Among the European Union’s 27 members, the basic rate varies from 15 percent (Cyprus, Luxembourg) to 25 percent (Denmark, Hungary and Sweden). But there are many preferential rates and exemptions. In Ireland, food is taxed at three rates (zero, 4.8 percent and 13.5 percent). In the Netherlands, hotels are taxed at 6 percent. An American VAT would stimulate ferocious lobbying for favorable treatment.

Higher consumer prices from the VAT could also slow the economy. The Federal Reserve would face policy dilemmas. If it tried to prevent businesses from passing along the tax to consumers, it would have to raise interest rates and risk a recession. If it tried to blunt the effect of higher prices on spending, its easy credit policy might trigger a new wage-price spiral.

A VAT is no panacea; deficit reduction can’t be painless. We’ll need both spending cuts and tax increases. A VAT might be the least bad tax, though my preference is for energy taxes. But what’s wrong with the simplistic VAT advocacy is that it deemphasizes spending cuts. The consequences would be unnecessarily high taxes that would weaken the economy and discriminate against the young. It would become harder for families to raise children. VAT enthusiasts need to answer two questions: What government spending would you cut? And how high would your VAT rates go?

Go here to read the rest.  The VAT proposal is a bad idea whose time has not come.

6 Responses to Value Added Tax Will Not Solve Budgetary Woes

  • Donna V. says:

    As for a VAT’s claimed benefits (simplicity, promotion of investment), these depend mainly on a VAT replacing the present complex income tax that discriminates against investment

    And there’s the rub. I would have no objection to the VAT if it replaced income tax. But it never has – both the income tax and VAT have grown ever larger in European countries. The VAT simply allows a government addicted to spending to expand even further, like a junkie obtaining a new supplier.

  • Blackadder says:

    A VAT wouldn’t replace the income tax, but it would replace income tax increases, which is the only other plausible source of the extra revenue we need.

  • Donald R. McClarey says:

    If a political climate existed to pass a VAT BA, and if the Democrats can’t do it with the majorities they command now I find it difficult to imagine such a political climate, I guarantee you that the VAT taxes would ever increase, that the politicians would spend every cent raised in new spending and that reckless borrowing would continue. At least that has been the experience in Europe:

    “One trait of European VATs is that while their rates often start low, they rarely stay that way. Of the 10 major OECD nations with VATs or national sales taxes, only Canada has lowered its rate. Denmark has gone to 25% from 9%, Germany to 19% from 10%, and Italy to 20% from 12%. The nonpartisan Tax Foundation recently calculated that to balance the U.S. federal budget with a VAT would require a rate of at least 18%.

    Proponents also argue that a VAT would result in less federal government borrowing. But that, too, has rarely been true in Europe. From the 1980s through 2005, deficits were by and large higher in Europe than in the U.S. By 2005, debt averaged 50% of GDP in Europe, according to OECD data, compared to under 40% in the U.S.

    Thanks to the recession and the stimulus, U.S. federal debt held by the public has now reached about 63% of GDP and is headed higher, but the OECD forecasts that the 30 wealthiest nations will see debt burdens “exceed 100% of gross domestic product in 2011.” Debt levels in France, Germany, Spain and Italy are expected to have increased by 30 percentage points of GDP from 2008 to 2011. Greece has a VAT rate of 21%, but its debt as a share of GDP is 113%.

    The very efficiency of the VAT means that it throws off huge amounts of revenue that politicians eagerly spend. The VAT thus becomes an engine of even greater public spending. In Europe, average government spending was about 30.2% of GDP when VATs began to spread in the late 1960s. Today, those governments are more than 50% larger, with spending of 47.1% of GDP on average. By contrast, U.S. government spending (federal and state) rose to 35.3% from 28.3% as a share of GDP in the same period.”

    http://online.wsj.com/article/SB10001424052702304198004575172190620528592.html

  • I don’t think it’s likely but a VAT along with an income tax cut might be political feasible. You can probably massage the numbers and sell it as a net tax cut.

    I’d love to replace all or part of the income tax with a VAT but I have no faith in the government getting it right. I’ve become convinced that ever-increasing bureaucracy is what will bring America down.

  • Blackadder says:

    If a political climate existed to pass a VAT BA . . . I guarantee you that the VAT taxes would ever increase, that the politicians would spend every cent raised in new spending and that reckless borrowing would continue. At least that has been the experience in Europe.

    Actually this *hasn’t* been the experience in Europe. It’s true that VAT rates has tended to go up after its introduced; however, this increase in revenue has been at least partially offset by reductions in taxes elsewhere. Thatcher, for example, raised the VAT to offset decreases in the income tax while simultaneously cutting spending. The same thing happened in New Zealand in the 1980s, Canada in the 1990s, and (to a lesser extent) Australia in the 2000s.

  • Blackadder says:

    The very efficiency of the VAT means that it throws off huge amounts of revenue that politicians eagerly spend.

    This argument would apply equally to any kind of tax simplification, including the Flat Tax, the Fair Tax, the Reagan tax cuts, etc. It would also apply to income tax cuts to the extent that they are justified on supply side grounds.

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