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
Devaluation is a standard response to excessive public debt, but would not make sense for the
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.