My Brain In A VAT

by Pejman Yousefzadeh on May 3, 2010

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No, this isn’t a Hilary Putnam reference. Rather, it is yet another discussion of the utility of a value-added tax. As readers know, I am in favor of a VAT that is coupled with a dramatic reduction in the top income tax rate–to about 25% or so–along with a slash-to-the-bone approach to corporate and capital gains taxes. I believe that such an approach will lower individual taxes and bring about much needed tax reform, while broadening the base enough to bring us back to fiscal sanity.

I recognize and respect Greg Mankiw’s concerns, on behalf of conservatives, that a VAT might simply be used to fund an ever larger, ever more intrusive federal government. This is not an insignificant issue. But if we lower taxes as part of the deal in implementing a VAT, we could combat the expansion of government. In addition, we could prevent the institutionalization of a disincentive to work that may come with higher tax burdens, a disincentive that may well exist in Europe.

As Mankiw notes, the responsible implementation of a VAT could bring about policy developments that conservatives like:

. . . conservatives have long argued that the American tax system is grossly inefficient and impedes the economy’s ability to reach its full potential. They contend that taxing consumption is better than taxing income, and a value-added tax does exactly that.

Moreover, a VAT is the twin of the flat tax that conservatives sometimes advocate. To see why, imagine that we started with a VAT. Then we add a wrinkle: We allow businesses to deduct wages, in addition to the cost of goods and services. We also require households to pay a tax on their wage income.

Other than shifting the responsibility for the tax on wages from the business to the household, it might seem that we haven’t done anything significant. Indeed, we haven’t. But the new tax system would no longer be a VAT. It would be the flat tax that Robert E. Hall and Alvin Rabushka first proposed back in 1981.

So why, if these two tax systems are really the same, are conservatives attracted to the flat tax and repelled by the VAT? It is because the flat tax is usually proposed as a substitute for our current tax system, whereas the VAT is often suggested as an addition to it.

As I have repeatedly stated, if conservatives are presented with a deal that helps bring about a Hall-Rabushka tax system–or something akin to it–that deal ought to be taken instantly. It will dramatically simplify the tax structure, and dramatically augment the government’s ability to take in revenue. Yes, there is a danger that increased governmental revenue will only feed the federal leviathan. But there is no way to avoid the horrific fiscal calamity that awaits us with spending cuts alone, so the responsible implementation of a VAT is the best way to combat fiscal disaster. Along with that implementation, there will have to be consistent and loud pressure on the federal government to use the increased revenue from a VAT to bring down the budget deficit and the national debt, so as to ensure that extra revenue is not simply used for increased spending, without regard to the fiscal situation.

All of this having been written, Gary Becker makes a good point with the following:

In deciding how to close the sizable fiscal deficits facing the US and other countries, introducing or expanding a VAT appeals to many economists and politicians because of the features already discussed. However, the problems [sic] is that a VAT would be introduced not as a partial or full substitute for personal and corporate income taxes, but rather as an additional tax. This would make it much easier to close the fiscal gap by maintaining or increasing government spending and overall tax levels.

Since high taxes and high levels of government spending would discourage economic growth and raise rather than lower the overall distortions in an economy, I am highly dubious about introducing a VAT into the federal tax system unless accompanied by a major overall [sic] of this system. One big improvement that does not involve a VAT would be to flatten the present income tax rates and greatly reduce the various exemptions, so that the tax basis is widened. Even then it is necessary to be vigilant about combating the incentives government officials have to increase flat taxes over time, whether they are flat income taxes or flat value added taxes.

Becker is brilliant, of course, and his comments are exceedingly well-taken. Indeed, his concerns are my own. But at the end of the day, to address those concerns, we ought to push for both a VAT and a major re-working of the tax system, because of the reasons stated by Becker’s blogging partner, Judge Richard Posner:

Becker’s main objection to the adoption of the VAT by the federal government, which is similar to the objection to taxes on Internet sales and indeed any new taxes that do not merely replace existing taxes, is that by increasing government revenues it will increase the size of government relative to the private economy, and if (as is doubtless true) government is less efficient, the result will be a reduction in economic welfare. An efficient tax is less costly and so is likely to be set at a level that generates more tax revenue than an inefficient one; and, as Becker notes, because it is less costly, it is likely to grow more over time than an inefficient tax.

I agree but on the other side of the issue is our awful fiscal situation. Our public debt is soaring at a rate of more than $1 trillion a year, and for political reasons it is extremely unlikely that the debt will be brought under control by higher tax rates, spending cuts (or forbearance to adopt new spending programs), or a rate of economic growth faster than the rate of growth of the public debt. The fact that the dollar remains the strongest major currency, which is why it remains the dominant international reserve currency, is enabling the Treasury to borrow at low rates. But this will not last if we continue on the road of fiscal imprudence; and as interest rates on the public debt rise, compounding the deficit, we could find ourselves in the position that Greece is in.

Devaluation is a standard response to excessive public debt, but would not make sense for the United States: first because foreign trade in not a very large part of our economy, and second and more important because devaluation would greatly impair the international standing of the dollar. Inflation is another standard response to excessive debt, but it would hurt our foreign trade, and the rate of inflation would have to be high because most of our public debt is short term, so that moderate inflation would be largely ineffectual because interest rates on the debt would adjust quickly. But high rates of inflation have negative effects on the economy.

In light of the nation’s fiscal bind, the imposition of a federal VAT becomes a more attractive prospect. One immediate beneficial effect, provided that the VAT was not entirely additive to existing taxes but was coupled with some reduction in corporate and payroll taxes, would be a reduction in export prices and therefore an increase in exports and hence a reduction in our trade deficit, which is a contributor to our public debt. The General Agreement on Tariffs and Trade permits VAT to be rebated on exports, thus lowering the cost to the foreign buyers.

More important, the VAT would increase federal tax revenues with minimal distortion because it is an efficient tax. To the extent (even if modest) that it replaced less efficient taxes, it would increase economic efficiency and thus increase the rate of economic growth.

Most important, by discouraging consumption in favor of savings, a VAT would reduce the interest rate on our public debt and the Treasury’s dependence on foreign lenders.

  • http://newledger.com Ben Domenech

    “But if we lower taxes as part of the deal in implementing a VAT, we could combat the expansion of government.”

    And this would bind future Congresses from raising those again how?

    I think this deal only works on paper, and not in real life, since it would require an outright elimination of the individual income tax. Congress is happy to play games with rates with any form of taxation, but if you eliminated federal income taxes, I think it's safe to assume they'd be reluctant to bring it back as anything but an act of political suicide.

    Barring that extremely unlikely scenario — laughable, really — no reduction in rates would survive more than a few years.

  • http://profiles.yahoo.com/u/4SZNTV3MEY2RHUML7TOB7J52SQ John

    In 1975, Milton Friedman (rightly) said in his interview on The Open Mind (and elsewhere): “I think the remarkable thing, the thing that needs to be explained, is not why we've had a movement towards collectivism and towards more government control, because that's been the natural state of mankind for thousands of years. The remarkable thing in my opinion, from an intellectual point of view, is how you ever managed to get a century or a century and a half in which the dominant philosophy was the opposite. That's the exception.”

    The rule is ever more collectivism and government control; the opposite is the exception. Given that (truism), what do you think the chances are that a VAT would be “in lieu of” rather than “in addition to”? What are the odds that “consistent and loud pressure on the federal government to use the increased revenue from a VAT to bring down the budget deficit and the national debt” will actually result in the desired outcome? To the former and the latter, I figure they're somewhere between very slim and none. Oh, and what Ben said.

  • http://profiles.yahoo.com/u/4SZNTV3MEY2RHUML7TOB7J52SQ John

    In 1975, Milton Friedman (rightly) said in his interview on The Open Mind (and elsewhere): “I think the remarkable thing, the thing that needs to be explained, is not why we've had a movement towards collectivism and towards more government control, because that's been the natural state of mankind for thousands of years. The remarkable thing in my opinion, from an intellectual point of view, is how you ever managed to get a century or a century and a half in which the dominant philosophy was the opposite. That's the exception.”

    The rule is ever more collectivism and government control; the opposite is the exception. Given that (truism), what do you think the chances are that a VAT would be “in lieu of” rather than “in addition to”? What are the odds that “consistent and loud pressure on the federal government to use the increased revenue from a VAT to bring down the budget deficit and the national debt” will actually result in the desired outcome? To the former and the latter, I figure they're somewhere between very slim and none. Oh, and what Ben said.

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