Republicans Rip into One of Their Own Over VAT
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The Fiscal Times
October 22, 2010

An extremely interesting incident occurred on Oct. 14. Republican Indiana Gov. Mitch Daniels addressed the right-wing Hudson Institute and appeared to endorse a value-added tax, something that has been forbidden in Republican circles for the last 25 years. There was an extremely harsh and negative reaction, providing a good illustration of how Republicans enforce party discipline, create ideological rigidity, disdain rational debate, wallow in self-delusion, and consciously make government unworkable just to achieve partisan objectives.

To begin, the VAT is a form of sales tax that was invented in Germany about a century ago. Its purpose was to prevent a very serious problem with existing sales taxes, which was that they could cascade as goods were resold, with new layers of sales tax added at each stage. Thus the ultimate tax burden was more a function of turnover than the price of a good or its nature. The result was to impede trade and create economic inefficiency.

The VAT solved this problem by creating an invoice trail for goods that are resold or used as inputs so that resellers could get a credit for taxes that were previously paid. This prevented double taxation and made sure that when goods reached the final consumer they bore only a single layer of taxation, even though the tax was collected in stages. It also improved tax compliance because taxes had to be paid at each stage to qualify for credits on taxes previously paid and embedded in the sale price of goods at each stage.

Another virtue of the VAT is that it can be rebated at the border on exports so that goods bear only taxes imposed by the country of final sale. Virtually all economists believe that this territorial system of taxation is the optimum way of taxing internationally traded goods and multinational corporations. Other forms of taxation, such as the corporate income tax, may not be rebated under international trade law due to uncertainty about its incidence.

This system became very attractive to Europeans as they began the process of moving toward full economic and political integration in the 1960s. With the goal of abolishing all tariffs and trade restrictions in Europe, it was important to ensure that domestic taxes be reformed to prevent cascading as goods might pass through multiple countries on their way to the final consumer. The European Union thus required all its members to replace their general sales taxes with value-added taxes.

Unfortunately, the imposition of VATs throughout Europe took place right on the eve of the great inflation of the 1970s. Because budget deficits and excessive consumption were considered to be prime causes of inflation, many countries raised their VAT rates to increase revenue, reduce deficits and reduce consumption. This proved to be relatively easy because people tended not to notice the difference between an increase in prices resulting from a higher VAT and one resulting from higher oil prices or general inflation.

Bruce Bartlett’s columns focus on the intersection of politics and economics. The author of seven books, he worked in government for many years and was senior policy analyst in the Reagan White House.