With the exception of the U.S., every country in the Organization for Economic Cooperation and Development has a value-added tax -- one on business sales that functions much like a retail sales tax. It’s time for the U.S. to join that club.
The is that they have a broad base, and they don’t discourage investment. They can raise a lot of money without causing nearly as much economic damage as income taxes. They are also much harder to evade than sales taxes.
Here’s how they work: Businesses pay tax on their sales, less the cost of goods and services they bought. Working up the supply chain, the value-added tax is ultimately charged exactly once on the final price of goods and services sold to consumers. If you buy a sweater for $50 and the VAT is 10 percent, the price includes $5 of tax. Unlike a retail sales tax, payments are made by all the companies that added value along the way.
Unfortunately, the VAT hasn’t been a central feature of most tax-reform discussions. Bipartisan plans such as the one proposed by the commission led by Alan Simpson and Erskine Bowles focused on expanding the personal income tax base while cutting rates, so that more revenue could be collected without hurting the economy. The calculation seemed to be that Americans were unlikely to accept an entirely new tax, so we should focus on making the income tax better.
The problem with this theory is that Americans are also unlikely to accept the changes needed to make the income tax much more efficient, such as abolishing the deductions for mortgage interest and health-care expenses.
No Good Alternative
The tax plans of Paul Ryan and Mitt Romney have lots of specifics on cutting rates -- and no detail on how the base would be expanded. The difficult parts are to be filled in later. President Barack Obama won’t endorse a broad plan to expand the tax base, focusing on increases on the top 2 percent of earners, many of them small and symbolic. A version of the Simpson-Bowles budget went down in flames in the House of Representatives, attracting fewer than 40 votes.
With little appetite for any plan that really expands the income-tax base, it is time to reconsider a VAT. It would be both substantively better and more politically palatable.
A value-added tax raises a ton of money. The base (the total amount of goods that would be subject to tax) would range from one-third to one-half of gross domestic product. U.S. tax revenue, meanwhile, is running well below the long-term trend -- by about 3 percent of GDP. A 10 percent VAT with a relatively broad base could raise $750 billion a year, enough to pay for about a fifth of the federal budget. This would make room for cuts in other taxes.
A VAT is much less visible than an income tax --individuals don’t have to file an annual return for it -- so a tax that is paired with income-tax cuts might be surprisingly palatable, especially if it is phased in.
The VAT offers an opportunity to expand the tax base. Politically, it may not be feasible to abolish the most expensive and popular income-tax deductions, such as those for mortgage interest and health care. But the VAT starts fresh with a new base. Taxing home construction (as many countries, such as Canada, do) would help offset the distortion of the mortgage deduction. Ideally, this should even apply to health-care services.
A tax only on consumption does not tax returns on capital. While most of the base-broadening proposals in plans such as Simpson-Bowles are sound, one recommendation is pernicious: to tax capital gains and dividends at the same rate as ordinary income. Rather than making the tax code more neutral, the change would actually make the double taxation of equity investments more distorting. The VAT offers a way to expand tax collections without going after capital.
Increases Aren’t Inevitable
The rates need not spiral upward. In European Union countries, rates are in the teens or 20s, because EU rules force all members to levy a VAT of at least 15 percent. The U.S. does not have to follow suit. Non-European VATs have tended to stay at reasonable levels. The Australian value-added tax is 10 percent, and Japan’s is 5 percent. Canada introduced a 7 percent VAT in 1991; the rate has since been cut twice and stands at 5 percent.
With these advantages, it’s discouraging that the value-added tax seems to be off the table in Washington. At least one powerful fiscal leader was, until recently, an advocate. Earlier versions of Paul Ryan’s “Roadmap for America’s Future” included an 8.5 percent VAT, rebadged as a “business consumption tax.”
Representative Ryan recognized that these taxes are an efficient way to finance government and can make room for pro-growth improvements elsewhere in the tax code. If he and other fiscal hawks start singing that tune again, Americans might get the more efficient tax code they deserve.
(Josh Barro is a contributor to Forbes.com and a fiscal-policy analyst based in New York. The opinions expressed are his own.)
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