Can a VAT Tax Solve the Nation’s Fiscal Problems?
A White House advisor suggests a federal sales tax as a remedy for the nation's soaring debt problem.
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The Fiscal Times
April 14, 2010

Desperate times call for desperate measures. So goes the argument for what could be, after health care reform, the next most politically divisive proposal to come out of the White House: The introduction of a federal value-added tax.

With a $1.3 trillion federal deficit and steadily rising costs of Medicare and other entitlements, “We’re at a crossroads,” says Clint Stretch, director of legislative affairs for Deloitte & Touche in Washington, D.C. “We have been cutting taxes for decades while not cutting entitlements. There is no possibility we can just grow our way out of the long-term deficit. We’re going to have to make some painful decisions.”

The so-called VAT, which is essentially a federal sales tax, was suggested as a remedy for the nation’s soaring debt problem in recent speech by White House advisor Paul Volcker. It would be the most significant change in tax policy since the Social Security payroll tax was introduced in the 1930s, and already is drawing sharp criticism, mostly from Republicans.

While there have been no formal VAT proposals yet and it is by no means a certainty, “it is probable,” says Rudolf G. Penner, a fellow and economist at the Urban Institute. “It will be fought over vigorously, but a VAT is easy. It’s an efficient tax. And it could be implemented fairly quickly.”

At a 5 percent flat rate, the VAT could raise $293 billion in 2012 and $3.3 trillion by 2019, according to a study by the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution, non-partisan think tanks in Washington.

The VAT would be new to the U.S., but it is one of the most common systems of taxation around the globe. Some 150 nations have a VAT, such as Canada, Australia, New Zealand, Mexico and those in the European Union. In European nations, the VAT generates an average 40 percent of gross domestic product, far more than an income-tax system typically raises, according to the Tax Policy Center. The U.S. income-tax system brings in about 28% of GDP.

Unlike a retail sales tax, which is paid by consumers at the register in a single transaction, a VAT tax is collected bit by bit along the path of production. Consider a bagel. A VAT tax would be applied to each transaction starting with the farmer’s purchase of seed and fertilizer to grow wheat. Assuming a 10 percent VAT, if a farmer bought $500 of seed he would have to pay $50 in tax. When he then sells his wheat to a miller for $3,000, he would collect $300 in tax from the miller, take a $50 tax credit for the tax he already paid, and send $250 to Uncle Sam. If the miller then sells $7,000 in flour to a bagel maker, he will collect $7,700 ($700 in VAT), deduct the $300 he already paid in taxes, and submit $400 to the government.

Finally, the bagel maker charges consumers 10% more. Consumers bear the burden of the VAT, just like they would with a retail sales tax. But governments generally like the VAT better, because “the credit invoice system is a self-enforcing feature,” says Joel Slemrod, professor of economics at the Stephen M. Ross School of business at the University of Michigan. “A business pays tax, then gets a credit, but you only get this credit if there’s evidence that the business you buy from has remitted the tax they owe.”

In its simplest form, the VAT has a single rate applied uniformly to all products. In practice it often gets more complicated, with some consumer products exempt from the tax or subject to a lower rate. In Canada, for example, food is exempt from the VAT, but snacks are not.

Some Republicans in Congress quickly responded to Volcker’s suggestion of a VAT by saying it will lead the nation further down the path of a tax-and-spend economy that impedes long-term growth. An April 9 letter to President Barack Obama signed by 16 members of Congress urged the Administration to reject the VAT, saying that “raising taxes will only result in additional hardship for America’s workers and families.”

Some tax policy experts say the VAT works well in theory, but the reality could be quite different. Forty years ago, many European nations adopted the VAT tax at a 5 percent rate.  “Because the VAT is intrinsic – it’s part of the price of a good and people forget they pay it, it’s easy to raise,” says Ryan Ellis, tax policy director at Americans for Tax Reform in Washington.m “The average VAT rate in Europe is now 20 percent.” He notes the effects of high consumption taxes are a decline in consumer spending, corporate profits and the return to shareholders, and slow overall growth.

When you consider the retail sales taxes that U.S. consumers are already paying – 8.875 percent in New York City; up to 10.25 percent in Chicago – even a modest 5 percent VAT "would hurt the economy almost immediately," Ellis says. He also notes that there will be administrative costs. "The IRS would need to start a whole new division and around 10,000 employees just to get it started," he says. "Then you would have an army of lobbyists arguing for exemptions or preferential rates. All this creates a wildly complex VAT system and has to be thrown in as part of the cost."

Karen Hube

Karen Hube is a freelance writer covering taxes, investing and personal finance. In addition to her work for The Fiscal Times, she writes a tax column for The Washington Post and contributes to Barron’s. She began her career as a beat reporter at The