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.

 

Comments

[Jack]

Would a VAT be "efficient" or simpler to collect and enforce? Seems as though for companies it would be like tax season all year long. Would the tax be tied to individual products? Or, would costs and gross sales be averaged at year end? If the latter it sounds like an income tax, if the former a nightmare. BTW wouldn't such a tax had another hefty chunk to the cost of a college education?

"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."

Perhaps this theory is due for testing in the real world. While I've heard those getting overtime premiums on W/E's, wrongly, turn it down for "putting me in a higher tax bracket" how many are able to make such decisions? Usually there is a full time job with defined hourly expectations. At the most lucrative end such as our WS bonus seekers is there evidence that many opted for leisure time over carving off another bundle due to "creating a tax problem?" At the bottom those working two jobs to make ends meet are still well down on the income tax rates, but with the VAT they'd be even more likely to have to work a second job when the goods they bought were 10% higher.

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.

Oh? You flat tax advocates! What I see is there being little choice for lower income folk but to spend 40% of income on housing, 10% or more on transportation, with the rest not quite covering basic expenses of a family. Higher up the income scale it's a choice whether to buy a bigger home or more costly cars.

There seems no way to put the brakes on expansion of government spending but to have the will power to adopt a Pay-go ethic that is maintained in the typical year. When some small political group decides to throw a war, we should return to having Congress declare such a war, project it's likely costs, and pass the hat.

You touch on an interesting problem, of "easy" and hidden taxes being tempting to raise, so it would seem best for containment to make extra taxes visible and irksome. Even today's withholding system has people talking of what they "got back" while likely not knowing what they paid.

It's interesting to consider what the "right" level of deficit spending "should be". I'm sure the number is not zero as modern governments spend well ahead for say an aircraft carrier, the benefits of which will accrue over time. Like a young family or growing company, total debt is likely to expand with their ability to cover the debt service.

Politically, I suspect "Zero" is also untenable. When the Clinton era ended with near zero, it may well have had a chilling effect on the economy, and in any case opened the door for a campaign on cutting taxes. The same happened after the balanced budgets of the Carter era, and we all know that HW's loss of reelection was heavily influenced by his, responsible, considering the deficits, renege on his "Read my lips" pander that helped get him elected.

[jimbino]

The rich will have a lot of choices that will allow them to escape the VAT. Though far from rich, I choose to spend my dollars in nice places that are not inside the USSA, like medical care in Mexico, a home in Brazil, etc.

If we get a VAT, there will not be much reason for a rich person to stay in the USSA, especially since nowadays he can work from a home in a foreign country. If income taxes were replaced by a VAT, the USSA will end up populated only by folks too poor to take a bus to Mexico or Costa Rica.

[Jim]

There are plenty of people who are perfectly capable of moving to locations even within the US with lower overall tax rates and a lower cost of living and/or getting their income down to a no or little income tax levels. The other trick of course with a VAT is to buy as little as possible; That would really help the economy. Of course I would mind paying more taxes a lot less if the governments which tax me would waste less of my tax money, say like the SEC attorney who makes 200 K plus per year and has been surfing porn sites 8 hours a day on his government computer. The SEC announced the other day that he was Disciplined. Wow, thank God he wasn't fired. My own personal goal is to find a spot within the 40-50% of American tax filers who pay NO federal income tax. The VAT I can handle simply by living simply and , I might add, more freely from the desires of those who wish to be supported by my labors, the weak and needy excepted. Do you think that it has ever occured to governments to solve their defict and debt problems by cutting spending or is that just a foolish and ignorant question.

[eleanor swent]

Corrections needed --
In paragraph 6, line 2 -- "the problems is" should be "problems are"
and in paragraph 7, line 3 -- instead of "a major overall of this system" you mean "overhaul"

[NEH]

A large percentage of World Governments today, already operate with some form of Value Added Tax. Why should the U.S. be any different? Given our current Budgetary problems, any method to raise revenue should be studied. So what do we have to raise revenue with?

1. sales tax
2. personal income tax
3. corporate tax
4. value added tax
5. tariffs & duties

As for the tax structure in this country, Tax no. 1, 2, 3 have pretty much been maxed out in terms of revenue generation. No. 5 has major ideological problems in this country (ahh the joys of the free market & free trade ideology), no too mention, particuliar problems with international commerce law. So what's left? No. 4, a Value Added Tax. This Nation has got a major financial problem staring it in the face and playing the Ostrich and running away and sticking our head in the sand, all the while screaming about the evils of a VAT will not solve our problem.

Taxation may be evil, but a necessary evil. At least for a Nation and an Economy to exist and survive.

[jimbino]

Taxing breeding would be a great alternative. Not only would it raise revenue, it would put an end to overcrowding in schools, air pollution, extermination of plant and animal life, and over-exploitation of fossil energy resources.

It would also end the illegal immigration problem in Arizona, as then we would seriously welcome all the cheap potty-trained immigrant workers to sustain our Amerikan lifestyle.

[Vivian Darkbloom]

Professor Posner wrote:

"A VAT does not distort consumption decisions relative to savings and investment decisions since it taxes consumer and investment goods at the same rate".

This does not make much sense to me and suggests that Posner does not completely understand how VAT works. Business enterprises are allowed a refund for the VAT that they incur and must pay the VAT they collect. Only the difference is remitted to the government (or refunded). Thus, the VAT on "investment goods" is effectively exempt when incurred by a business enterprise. The VAT is ultimately recovered by the government when VAT is collected from a person who is not in business (i.e., the ultimate retail consumer). There are minor exceptions. As VAT works in Europe, for example, banks and insurance companies are not considered businesses for VAT purposes and must not collect VAT on their products (but also cannot obtain a refund for their VAT expenses).

Thus, I would argue that VAT does not tax investment and savings at the same rate as consumption because the former is effectively not hit by the VAT at all.

[Jack]

NEH, Let me offer taxation 2.0. That of ramping up a tax on NON-RENEWABLE fossil fuels adding about a buck a gallon. With consumption of oil in the US at nearly a billion gallons a day there's quite a bit to work with.

Sound harsh? As the US still consumes a quarter of the world's energy, putting ourselves on something of a diet should put a strong downward pressure on OPEC oil prices as took place when we responded to high oil prices in the 70's with CAFE stds, lower speed limits etc. Once prices begin to soften, or Ha! the instant the enabling legislation passed, the current oil futures speculators should run for the hills thus lowering prices further.

We might get the win-win-win of filling our federal coffers instead of OPEC's, lowering our pollution and carbon footprint, and paying little more than we're paying now.

President Carter proposed one thin dime of demand lowering taxes back in the 70's, the Clinton Admin, under pressure to reduce deficits in 1992, put a finer point on it by taxing all fossil fuel BTU at the same rate.

Neither of them passed, of course, but had we started down that road in Carter's time or even early Clinton, we'd all have made millions of small decisions based upon the predictable increases in fuel taxes and might have skipped building the world's largest fleet of gas hogs entirely and improved the energy efficiency of the 30 million homes built over the last couple of decades.

Before the current mess, unlike our flat taxers, I'd have favored making the BTU tax mostly revenue neutral so as not to unduly impact lower income earners. Today we could tailor such a tax to gin up significant additional revenues. A side benefit? An automatic spurring of more economic activity as individuals and business implemented energy saving projects and our car companies sold more high efficiency cars and trucks.

BTW isn't it odd that VW has about the only mass produced, quiet, spunky diesel that meets all US air quality standards?

[Jim]

Jack,

We are in our occasional state of agreement. Another advantage of getting some cars off the road is being able to ride my 120 MPG scooter with less risk of being killed on the road. Maybe others would get the same idea. If you don't think that would work, visit Paris sometime.

[MJ]

We should not try to emulate Europe. If we do we will raise no more tax revenue but have disposable income (after taxes) 30-50% lower. The truth is big government is a major drag on the economy since its ROI is almost always lower than the private sector. And without a good ROI we won't get any richer.

BTW I'm supporting this No VAT candidate Ryan Brumberg: www.brumberg2010.com

[Jack]

Jim: More agreement than you know. I was an early proponent and activist for bike trails that, at the time, seemed a radical idea for this far north city. (Anchorage) Today there are over 200 miles of dedicated (off street) trails that are used in the winter by skiers and walkers, as well as growing numbers of bicyclists with special winter tires. The city is now trying to link more of the trails together in a grid that makes it easier to get to more destinations. Riding on the trails is a pleasant experience and as you know riding with traffic is often a white-knuckle affair.

BTW here's another win-win natural incentive to use less fuel that was written about extensively by financial writer Andrew Tobias a decade ago or so. That would be a simple change to a no-fault auto insurance paid at the pump as a part of the gas price. In addition to solving the problem of uninsureds, it would make insurance costs a variable cost related to the amount of fuel consumed.

Such a change would be more than justified in insurance savings alone plus offering a number of possibilities and incentives for using less fuel. One of the obvious ones is that for those having to own a pick/up or other guzzler for their job or recreation, they could own a fuel sipper w/o the high fixed cost of another insurance policy. (Ha! I've always "wondered" how insurance companies think we can drive two vehicles at once, and surely the income from two policies is among their "reasoning".)

MJ: I'd like to see more ROI analysis of government spending. At the one end, and our largest expense of the military, it's likely impossible to determine the cost/benefit of the new nukie sub being built to fight someone somewhere or anything else, which opens the whole arena up to conjecture, flag waving and, often, pork for virtually every congressional district.

At the other end, I've seen figures of $7 of return for a buck spent on Headstart, and as we bear the considerable costs of locking up our fellow citizens at rates 10 fold higher than other advanced nations, surely we should delve more deeply into the relationship of educational and other childhood developmental costs that could be shown to lessen the negative costs of vice in the first place and costs of courts and lengthy incarcerations in the second.

As we lock up SO many more than do other nations and for FAR longer sentences we'd surely benefit from an ROI analysis of "investing" in locking up small time drug addicts and sellers for a decade at a cost of half a million each when a combo of treatment and electronic monitoring may be more likely to return many to productive lives.

For the "Bridges to Nowhere" proposed by Alaska's Don Young when over three decades of seniority put him in the Chair of transportation, the most rudimentary ROI analysis would have shown a black hole of negative returns for the entire life cycle of both bridges with next to NO benefits whatsoever.

[SMU Cox MBA]

I think that we need to largely do away with charitable organizations as they currently exist. My personal feeling is that once you have paid employees, you are no longer a charity.

We do need to create an intermediate category of "Charitable Enterprise" which is very lightly taxed - mostly on property.

[traffic school online california]

VAT Value Added Tax).... it is also a right and responsibility in the society to pay the taxes with in the period of suggested time.Hopefully more people can learn from this post what I have. Thanks for stopping by and sharing some great information and looking forward for your upcoming updates.

[Pies]

a VAT tax is presumably a pre-consumption consumption tax. at each stage of proudction before the final product digested by consumers there is a tax. However, the rise of price at each stage of production will be aggregated into the price of the final commodity thus essentially being an income tax. Either i don't really understand VAT or VAT is ridiculous.

the only real application i can think of VAT for is that of advertising. Unlike most stages of production the advertising stage does not have diminishing marginal returns in terms of added value accrued by increased consumption due to advertising. Moreover, advertising though it increases consumer information leading to more predictable spending patterns ( less fluxating demand) it principally does so by diverting disposable income expenditure from one firm to another. In other words, advertising is at least partly a form of transfer payment. it is this sort of private transfer payment that should be the true target of VAT because such to the degree that advertising is a transfer payment to the same degree it does not affect aggregate demand.

also, dear Becker, tell your buddy Posner that it is not academically fashionable to include multiple variables in the same social science analysis. In reading Posner's latest article in the JOIE i felt like i was reading a Sam Huntington book there were so many variables operationalized. though to be honest i really enjoy Huntington's book and am to this day still thinking about Political Order in Changing Societies.

[Pies]

*books

[Luca]

I just realized something. Since the burden of a tax falls on whoever exhibits the least behavioral elasticity (e.g. the elasticity of supply and demand), it should not matter whom a tax is levied on. The same rule should apply to a value added tax...why shouldn't it? If oxygen, for example, was manufactured in a multistage process, consumers, who need air to live and thus face a perfectly inelastic demand curve, would bear the full burden of any VAT on the process. I bet that Ronald Coase's insights into cost-shifting may also be helpful in understanding this phenomenon.

But then I am just an undergraduate. What do I know?

[Jack]

Pies -- You bring up a good point on the timing of a VAT. At least in one sense an income tax is an "easy" tax as companies pay it at the end of a profitable quarter and catch at least a bit of a break in an unprofitable quarter or year by owing little or nothing. Losses carried forward can help a company rebound when they do become profitable.

As you point out the VAT is paid ahead perhaps months before it's collected from the ultimate consumer. As another cost of production there'd be a justifiable tendency to mark up the amount of the tax to maintain ROI ratios or to cover the costs of having paid interest on loans to cover the VAT paid to the raw material or lower level producers.

Too, I wonder if those currently engaged in abusive tax transfer games would have a field day! Abusive transfers work like this: A hammer costing a dollar in China might be transferred to an offshore tax haven subsidiary where it's marked up to $6, then in the US it's marked up only another buck so as to escape US taxes.

In any attempt to lower our deficits we've got to look at (and do something!) about corporate tax evasion. Oh? so they'll leave this largest of all consumer markets and go "offshore?" Fine, while appreciating the benefits of free trade, when access to our lucrative market is abused by either clever evasion of taxes or by egregious human rights violations in working stds and gross environmental degradation, appropriate penalties or tariffs seem the only rational response.

Luca: I'm not sure you got your point across. Also, the "perfect" inelasticity of the price of a glass of water to a man dying of thirst usually don't serve well to illustrate a broad general concept like a VAT on all of our goods and services. Give it another try?

[Ursula Zagar]

As you mentioned, VAT is more efficient and relatively harmless tax. We shouldn't forget what damage it could make if were not carefully managed. If the VAT is introduced, the income tax could be immediately reduced or abolished. To prevent policymakers' temptations to increase VAT later on, as many countries have experienced, VAT should be written as an amendement to the Constitution, next to law that would prevent policymakers to increase VAT together with income tax. Otherwise, the US economy would resemble the European model of high-tax welfare state.

[Rok Spruk]

The introduction of a VAT would increase the burden of tax and government spending. In a few years, the US government spending would reach the levels of European nations.

The VAT would make economic sense only if the income tax system were fundamentally surged. Economic theory has the answer at glance. A VAT would further increase trade-off between leisure and labor time by diverting availible working hours into more leisure. In addition, current progressive income tax rates decrease the potential labor supply through lower coefficient of income elasticity of labor supply. If income tax were replaced by a VAT, deadweight loss would be smaller (in relative terms) and the ending of double taxation would cause fewer distortions of labor supply and, hence, less trade-off between labor and leisure.

The growing burden of government is an inevitable consequence of the VAT adoption. Since the European Commission released the VAT Directive in 1960s, value-added tax burden rose considerably alongside the rise in minimum value-added tax rates for European Union member states.

If the US followed the advice and adopted the VAT, US economic growth prospects would be significantly diminished in a long-term perspective. And despite the efficiency in raising revenue, the VAT would not likely have any effect on deficit reduction because revenue increases in the early stage would correspondingly result in higher government spending. Higher burden of government spending is, in fact, a significant and persistent threat which would result in lower productivity growth and higher tax burden to US taxpayers.

[Jack]

It seems a "given" among many here that Federal spending would grow to consume any additional tax revenue. But! recent history doesn't seem to support the idea. While spending did rise sharply during the Reagan era, since that peak it has been relatively flat at about 20% of GDP since. Half of the deficits of the Bush era have been due to tax cuts not accompanied by spending cuts, while the rest was due to a weak economy with low wage jobs "replacing" middle class jobs. Today's steep recession combines with those tax cuts to make the deficits untenable.

http://perotcharts.com/2008/05/us-government-spending-as-a-percentage-of-gross-domestic-product-1980-2007/

Given that the additional costs and less revenue of boomer retirements have been known for years it was utterly irresponsible to have cut taxes in 2,000 and once the M/E wars were ginned up the unaffordable tax cuts should have been rolled back immediately. Failing to respond to the ongoing deficits and added costs of war added nearly $2 trillion to our debt.

The VAT is unlikely to pass for all the reasons mentioned, including the cumbersome and risky biz of reworking the entire tax code. My own favorite of ramping up taxes on non-renewable energy is unlikely to pass while oil is $80 for being "too onerous" and unlikely to pass if oil dropped to $20, as "the crisis would be over" and we'd be reveling in cheap oil again and my second favorite of raising tariffs on those not playing by the rules doesn't raise much revenue.

So, we're back to letting the irresponsible Bush tax cuts expire and Ha! hoping that the Bowles/Simpson led commission comes up with some significant cuts, some means of raising more revenue and a few other miracles?

[Brooks]

Although a large retail sales tax obviously would present practical problems regarding compliance and therefore seems undesirable, would it be correct to say that, compared to a retail sales tax, a VAT increases inventory carrying cost and thus reduces ROI, ROA, and NPV (and thus value of the enterprise) for parties throughout the supply chain (manufacturers, wholesalers, retailers)? With a retail sales tax the retailer, for example, never needs to expend capital for the purpose of taxation until after that retailer already has it in hand from the consumer (actually, even later) and then passes it on to the government. But with a VAT, the retailer must first expend a portion of the overall sales-related taxation upon purchasing goods for inventory, only recovering it after it sells those goods to the consumer. That means more capital tied up in inventory than there would be under a retail sales tax system, and for the same dollar amount of profit, thus lower return on invested capital.

Correct?

[Brooks]

Actually, I think the same thing I described as applying to retailer with VAT vs. retail sales tax applies as well to VAT vs. sales tax at every step in the supply chain. Basically, it's the difference between each buyer in the process having to expend funds for the tax upon purchasing the inventory and only later getting reimbursed upon sale of that inventory (except for the ultimate consumer) under a VAT vs. simply taking the tax upon selling the inventory and later forwarding to the government.

[Jack]

Books, FWIW that's my take. See Pies and Jack above. VAT seems a "hard tax" for the reasons you mention and that there would be a tax on value added even though those margins might be unprofitable or below break even.

I suspect a straight up end user sales tax would be too shockingly transparent and at 10% or more many would try to duck it. Leasing new cars? or homes? Unless phased in very gradually we'd have a distortionary disparity between existing homes and cars or other costly machinery Vs new ones with the VAT built in.

These guys! They seem to love any "flat tax" or any other tax of a regressive nature despite ALL of the productivity gains and the benefits of the Bush tax cuts going to the topmost earners for the last 25 years. "Incentives" they say, how about some incentives for struggling middle and lower income folk?

[Brooks]

Jack,

Thanks for responding, but I'm not sure I see an answer in your comment. Am I correct that the value of retail firms would be lower with a VAT than with a retail sales tax due to the differences in the timing of cash flows, which are more favorable to the retailer under a retail sales tax than under a VAT per my comment?

By the same token, an "initial supplier" (at least one close to a theoretical initial supplier that doesn't purchase inputs from other firms) would become more valuable, because it would get an incremental influx of funds (the VAT) upon selling its products and would only subsequently have to pass it on to the government, enabling it to benefit from the float or other benefits of that cash flow.

I think parties between that "initial supplier" and the retailer could fare either better or worse, because they have to expend incremental funds upon purchasing for inventory, but later upon selling it they would get a larger influx of funds, so it's magnitude vs. time value of money.

[Jack]

Brooks; well you're getting down to the "devil's in the details" level. Many years ago I considered a business in CA and found that the Franchise Tax Board expected an estimate of first quarter gross with a deposit covering the projected sales tax upfront.

But yes your reasoning seems right in that a retailer would have something like 10% more tied up in inventory costs with market pressures not allowing him to get his normal markup on the added 10% invested.

Ha! a stock or company valuation play on who might benefit (or be hurt less by another tax) based on the float seems thin. This bird isn't going to fly anyway.