Value-Added Tax for America?

Dan Mitchell wrote an interesting op-ed in NY Post (link) concerning the prospects of adopting a European-style value-added tax (VAT) in the United States.

Imposing a VAT would be detrimental to economic growth and productivity performance. If the U.S imposed the VAT, its spending levels would quickly approach the European spending levels. Indeed, the VAT is already used by OECD nations. In European Union, European Commission’s Directive requires each country to harmonize value-added tax rate at the level of at least 15 percent. Federal spending in the U.S has already escalated. The consequence of $787 billion of stimulus measures is high public debt. Congressional Budget Office has forecasted the public debt to approach 70 percent of the GDP by 2012 and remain constant until 2020 (link). Rising costs of health care, entitlement spending and aging population have triggered government spending (link) and tax burden on the U.S firms and households. By 2020, health care spending is expected to reach 20 percent of the U.S GDP (link). Historical figures suggest a rather glimmering fiscal scenario for the United States in the next decade. In 1965, before the VAT spread across the European community, average tax burden of EU15 reached 27.7 percent of the GDP versus 24.7 percent in America. In 2006, the average tax burden for 15 developed European countries reached 39.8 percent. In United States, where VAT has not been introduced, average tax burden in 2006 remained close to the level of 1960s – at 28 percent of the GDP. The immediate consequence of VAT introduction in Europe was a surge in government spending. From 1965 to 2006, average government spending (as a share of the GDP) in the European Union increased by 17 percentage points while in America it increased by 7 percentage points. The total increase of spending growth in Europe and America is attributed to the widespread growth of the welfare state which includes entitlement spending and a growing cost of health care.

The economics of tax system is pretty straightforward. Alan Viard of the American Enterprise Institute (link) has outlined basic features of the VAT system. Contrary to the income tax system, VAT is a consumption tax. From the economic perspective, consumption tax is less distorting to economic behavior than the income tax. A pure VAT is tax at each stage of the supply chain. The taxation of individual income is a major distortion mostly because the source of direct taxation is labor supply. Introducing a tax on labor supply creates the so-called substitution effect where lower wage (w’=w(1-t)) is offset by a decrease in working hours and an increase in leisure hours either in pure leisure time or working more in household production or in the informal sector of the economy. Higher tax wedge in net wages has been the major factor behind fewer working hours in slow-growth European countries (Italy, France, Germany, Belgium etc.). The VAT is not as damaging as the income tax since the tax rate on individual consumption is applied when the income is already earned, so that income earning is not distorted. From a pure economic perspective, consumption taxation is more appropriate than income taxation mostly because the price elasticity of consumption goods is lower than price elasticity of labor supply. The consumption tax is based on the so-called Ramsey rule which states that the optimal tax rate is the inverse of the price elasticity of demand for a particular good ((t*=1/-dQ/dP*(P/Q)). It follows that on consumption goods with lower elasticity of demand, higher tax rate should be applied since the deadweight loss is smaller than in consumption goods with high price elasticity of demand. For example, price elasticity of demand is very low in goods such as gasoline since there’s no close substitutes to gasoline. On the other hand, the elasticity of demand is pretty high in goods such as Big Mac or Coca Cola since there’s a lot of substitutes for these goods (Subway snacks, Pepsi etc.) and a tax rate on Big Mac or Coca Cola can easily divert consumers to consume more Subway snacks, Pepsi or other goods.

While the introduction of a VAT is less income-distorting than a direct income tax, the imposition of both tax structures is a negative effect on economic growth, productivity and employment. Aside from the harmful taxation of income, the introduction of the VAT would further hamper individual consumption, raise consumer and producer prices and harm the manufacturing activity. One advantage of the VAT is a low cost and easy way of raising revenue. In economic theory, a uniform consumption tax is preferable to the income tax mostly due to fewer distortion in generating income which is the key feature of economic growth. A VAT also avoids imposing additional penalizing disincetives to labor supply and productivity.

Congressional Budget Office (link) has recently released Budget Outlook 2010, in which it laid out future perspectives of America’s fiscal policy. Assuming an exerting pressure of tax burden in the coming years, the CBO has predicted the individual income taxes to grow from 6.4 in 2009 to 10.9 percent of the GDP by 2020. Imposing a VAT on top of the existing income tax would further reduce real disposable income and individual consumption. If a VAT were implemented on the federal or state level, there would be a significant and immediate increase in effective tax rates. The evolution of federal effective tax rates from 1970 to 2001 (link) shows a trend of decreasing effective tax rates and a growing after-tax income in all income quintiles.

The introduction of a VAT would dramatically change the US fiscal map. An article from OECD Observer (link) shows a comparative tax revenue distribution for the U.S, Europe and Japan. Back in 1999, the U.S was the only global economic giant with tax revenue from goods and service taxation of less than 30 percent of all tax revenues. The share remained steady until now. The non-existence of the VAT in America has contained the growth of overall tax burden. In 2004, total government revenues were 32 percent of the US GDP, far below the shares of high-tax countries. In Sweden, government revenue presented 59 percent of the GDP. While the U.S tax burden, measured as a share of government revenue in GDP, stayed below the level of France (50 percent), Germany (43 percent), Italy (45 percent), the introduction of a VAT may quickly turn America into a European-style country with high tax burden and benign economic growth. The international data (link) on total tax revenue in 2007 show that total tax revenue in the U.S presented 28.3 percent of the GDP. In 2007, taxes on goods and services presented about 4.7 percent of the US GDP; about three times less the level in Sweden (12.9 percent of the GDP) and four times less the level in Denmark (16.3 percent of the GDP). If a revenue from a VAT captured approximately 9.5 percent of the US GDP, America’s tax revenue from a VAT would present about 14.2 percent of the GDP (9.5+4.7=14.2) comparable with high-tax countries such as Finland, Austria or Belgium and even more than in France.

Although the VAT is an easily applied method of taxing general consumption, imposing a VAT on the federal and state level would seriously harm America’s future growth, investment, personal consumption, manufacturing activity and productivity. It would make America look like a typical slow-growth European welfare state for the first time.

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