Could the US go to a VAT system?

In an earlier post today, I took aim at the Trump proposal to cut corporate taxes from a top rate of 35 percent that hardly any corporation actually pays, to a rate of only 15 percent, which is lower than even Paul Ryan’s budget blueprint would have us go. My argument is that this kind of tax cut would explode the deficit, and would, despite any GOP talking points to the contrary, not be offset by “explosive growth” which would result in increased tax revenue that would pay for the tax cuts.  Simply stated, this approach has never resulted in that kind of increased growth, although you can expect the GOP to double down on this talking point soon, now that they have required the GAO to use “dynamic scoring” in estimating the true cost of a tax cut.  With this deceptive system, the GAO is required to assume that the promised growth would occur, even though that growth didn’t occur under similar tax cuts under Reagan or George W. Bush.

One real possibility for meaningful tax reform is a “value added tax” or VAT.   Although imperfect, such a tax would likely have the dual effects of lowering the overall marginal tax rate on corporations, and capturing a huge amount of tax revenue which is left on the table and uncollected under our current system.  Although a VAT is not a panacea, it is certainly something that should merit serious consideration in Washington.

Unlike a traditional sales tax, a VAT is a levy on consumption. It taxes the value added to a product or service by businesses at each point in the chain of production. Businesses along the chain collect the tax and send it to the government.  Supporters point out that this would greatly improve the efficiency of revenue-collection efforts.  The downside to this approach is that it is ultimately the consumer who pays the tax, because the final price of the goods and services they buy reflects all of the taxes that have been charged up to that point. When you buy a loaf of bread, the taxes are already “baked in”, if you’ll forgive the pun.

Actually, a loaf of bread is a useful example to show how a VAT system works.  In this example, the VAT rate is 10 percent.  A farmer grows the wheat and sells it to the baker for 20 cents. The VAT is 2 cents (10 percent of the “value added” in creating wheat out of seed). The baker pays the farmer 22 cents, reflecting the 20 cents for the wheat plus the 10 percent VAT.  The farmer, who has essentially collected the tax, sends 2 cents in VAT to the government.

Next, the baker bakes a loaf of bread, and sells it to the supermarket for 60 cents. The VAT is 6 cents. Now the supermarket pays the baker 66 cents, of which 6 cents is the VAT. The baker sends the government 4 cents — he pays 6 cents in VAT but receives a two cent credit from the government (for the VAT he paid for the wheat).

The store sells the loaf to me for a dollar. I pay $1.10. The store sends the government 4 cents total – the 10 cents it collected in VAT on its sales, minus the 6 cents it paid to the baker in VAT, which it gets back in a credit. In total, the government gets 2 cents from the farmer, 4 cents from baker, 4 cents from the store. That’s 10 cents on a final sale of a dollar — for a 10 percent VAT.

Some consider a VAT to be unfair, because the burden of taxation falls disproportionately on those with lower incomes. And, to be sure, any tax that burdens the lower earners in our society cannot be truly said to be “progressive” in theory.  As discussed below, there are work-arounds to fix that.  But we should also note here that  the prices of many consumer goods are artificially low because of flaws in our current system which harm domestic employment and reduce revenue.  Foreign companies who aren’t headquartered here avoid taxes on the items they sell here and the profits they make here.  So our current system encourages companies to offshore their operations.  Also, wages in many of these foreign countries are substantially lower than wages would be for similar jobs in this country.  In this way, our current corporate tax system harms domestic employment, and also misses out on taxing a lot of the profit generated by doing business here. All so we can buy cheap crap from China.  A VAT system would apply to all revenue generated by sales of any kind within the country, removing a large part of the incentive to offshore operations, and capturing substantial revenue that the current system just doesn’t tax.

Most of the industrialized world is already on a VAT system. And in poll after poll, many US citizens say they wouldn’t mind paying a little more in taxes if that money could be used to pay for other priorities which have fallen by the wayside, such as education, healthcare and infrastructure.   These things greatly improve the quality of life for everyone, and arguably, if some of the income people direct towards things like education and healthcare could be funded through tax revenues coming from other sources, there would be more discretionary income in people’s pockets, and slightly increased consumer prices that might be caused by a VAT would not burden individuals as much.

Supporters of a VAT maintain it is better for economic growth than an income tax because it doesn’t tax savings or investment.  Rich people with capital gains income should love that.   And governments like it because it tends to bring in more revenue, thanks in part to the role that businesses play in its collection. Incentivizing their efforts, businesses receive credits for the VAT they pay, as we saw in the “loaf of bread” example.

According to rankings from the Organization for Economic Cooperation and Development, the US is a low-tax country already.   However, other developed countries get nearly a third of their tax revenues by taxing consumption through VAT systems, while we get less than 18% of our revenues that way – and virtually all of that comes from state and local sales taxes.  So there is a strong argument that serious tax reform could replace income taxes on businesses and individuals with a value-added tax on sales of goods and services collected at all stages of production. Today, more than 160 countries have a VAT. The U.S. is the only OECD country that doesn’t.

Here’s a selling point: If we went to a VAT system, more than 150 million Americans would never again have to file tax returns or deal with the Internal Revenue Service. And it would enable us to cut our corporate income-tax rate to compete with the lowest in the world without shifting the tax burden away from those who can most afford to pay.

In theory, a VAT would also spur economic growth, increasing U.S. GDP by as much as 5% in the long run, compared with proposed income-tax changes that would increase GDP by far less. This estimate is based upon results of other countries making the shift, and there is no strong argument against the idea that we would see similar growth here as well.  Indeed, it may “repatriate” some of the companies who have offshored, by largely eliminating the benefits which have come from this mode of doing business.  Taking the additional step of taxing imports and exempting exports would yield hundreds of billions of dollars for the U.S. Treasury within a decade.

Former Treasury Secretary Lawrence Summers once said that Republicans don’t like VAT systems because they are a “money machine” (i.e., they bring in a lot of tax revenue), and Democrats don’t like them because they are regressive. We will get a VAT, he said, when “Democrats realize that it is a money machine and Republicans realize that it is regressive.” Although that’s a pretty funny/true take on the matter, it’s possible to do a VAT that’s designed to ensure that it is neither regressive nor a money machine. The potential for regressivity should be addressed for low- and moderate-income households by eliminating payroll taxes. Households which fall below a certain income threshold could also be made eligible for debit cards which cancel taxes at the cash register.  Now that’s everyday low prices, folks.

A properly done VAT would let us restructure our tax system to produce greater economic growth and more jobs, fairly, and at far lower costs.  All we need is the political will.