Imposing VAT Would Be Terrible Mistake

On October 26, the Washington Post reported that the Treasury Department is studying plans to impose a value-added tax (VAT) to replace the corporate income tax and finance other tax reforms. This is a dangerous road for the Bush Administration to travel, both politically and economically.

The idea of replacing the corporate income tax with a VAT is not a new one. On a technical economic level, it has much to recommend it. The corporate tax is a bad tax because it is a double tax on corporate profits since dividends are also taxed. The result is a higher cost of capital that lowers investment, productivity and wages. Most economists think it should be abolished.

The problem is that the corporate tax raises a significant amount of revenue. This year it will bring in about $150 billion to the Treasury, about 1.5% of GDP. It is simply unrealistic, in a time of budget deficits, for the government to give up this much revenue without replacing it somehow.

A VAT, sometimes called a business transfer tax, could easily make up the revenue from abolishing the corporate income tax. On a broad base, it might raise perhaps $50 billion per year for each percentage point. Thus a 3% VAT could replace the corporate tax.

The VAT works like a sales tax. The difference is that it is not imposed directly on consumers at the checkout, as state and local sales taxes are, but rather on producers. The tax is built in to the prices of goods and services.

One big advantage of the VAT is that it is rebatable at the border on exports, according to world trade law. U.S. exporters have complained for years that they are at a competitive disadvantage relative to countries with VATs for this reason.

Another advantage of the VAT is that it does not fall on saving or investment. Therefore, a switch from a corporate income tax to a VAT would lead to a sharp drop in the cost of capital, which would raise investment and productivity.

Against these advantages, however, are some very powerful disadvantages with a VAT. To begin, it really wouldn’t make much sense to impose a VAT at just a 3% rate. The startup and compliance costs would eat up a high percentage of the revenue. Therefore, the rate would probably have to be at least 5% just to justify the cost of imposing it.

A second problem is that a comprehensive VAT would be very regressive. That is, it would take proportionally more out of the pockets of the poor than the rich. Although over one’s lifetime the tax would be proportional to income, there is no question that the poor would pay more taxes than they do now under a VAT.

In most countries, efforts to relieve the poor have involved exemptions in the VAT. Usually, food and medical services are exempted, but in different places there can be a large number of other goods and services exempted as well. The problem is that this erodes the tax base, requiring higher rates to achieve the needed revenue, and it greatly increases the complexity of the tax, thereby increasing the compliance cost.

Now we are up to probably a 10% rate on the VAT to compensate for the compliance cost and exemptions for the poor. So we already see the biggest problem with a VAT-its tendency to ratchet up. When European countries first imposed VATs in the 1960s, they mostly had rates around 10%. Today the average rate is about 18%, according to the Organization for Economic Development and Cooperation.

It has proven too easy for governments to piggyback on inflation and raise VAT rates as prices were rising anyway. People did not notice the tax increases because they were hidden in the prices of goods and services. Consequently, the VAT proved to be a massive money machine that fueled a vast increase in taxation in every country that has adopted it.

The latest OECD report shows that the overall tax burden in Europe has reached 42% of the gross domestic product, compared to 30% in the U.S. By contrast, before the VAT came along, U.S. and European tax burdens were comparable: 28% of GDP in Europe and 25% in the U.S. in 1965.

Much of the tax growth came from the VAT, which averaged 4% of GDP in Europe in 1965 and is twice that today.

In 1984, the Treasury Department published a comprehensive study of the VAT that recommended against its adoption. The reasons laid out in that report are still valid today. Adopting a VAT, however it is termed, would put the U.S. on a slippery slope toward European levels of taxation and government. The Bush Administration will be making a terrible mistake if it starts down that road.