The Mighty Temptation of a Value-Added Tax

At a recent conference held by the Hamilton Project, participants looked at various methods by which Washington could achieve fiscal balance.  One of the proposals by William Gale of the Brookings Institute and Benjamin Harris of the Urban Institute and Urban-Brookings Tax Policy Center suggested the introduction of a Value-Added Tax (VAT).  Here are the details.

Let's open by looking at a selection of VAT rates in Europe and a brief explanation of the concept:

The minimum standard VAT rate in Europe is 15 percent and states are free to set rates above that level.  As well, they have the option to set a lower rate on a restricted list of goods and services including food, medicines, books and newspapers among others.

The VAT or GST (in Canada and New Zealand among others) is an indirect tax on consumption that applies to most transactions that involve goods and services.  Value-Added Taxes were first introduced in France in 1948 at the manufacturing level and in 1954 at the consumption level.  These consumption tax systems exist in more than 120 countries around the world including every OECD nation other than the United States and rates range from 3 percent to 25 percent.  Value-Added Taxes are charged on the majority of transactions at every level in the supply chain from production through to the final sale of the product to the consumer.  For the most part, the levying of the tax is completely hidden to the final consumer.  These taxes are not meant to be a cost to businesses and are generally recoverable either by direct refund of the amount paid or by offsetting the VAT incurred in production against the VAT due.  Ultimately, it is the end consumer (you and I) that bear the entire cost of the VAT or GST unless local governments offer an offsetting tax credit.  Governments, in particular, like taxes like the VAT because they have more revenue potential (particularly as the rate generally seems to increase with time) and it means that there is a paper trail for governments to follow, ensuring that there is compliance.  It also allows governments the leeway to tax different goods at different rates; for example, China taxes most items at 17 percent while household necessities like food are taxed at 13 percent.

Value-Added Taxes can be extremely lucrative for governments.  As shown on this chart, on average, the biggest source of revenue for European Union nations is VAT, exceeding the revenue from personal income taxes and nearly tripling the revenue from corporate taxes:

In 2009, total VAT receipts in Europe were around EUR 783 billion, representing an average 7.4 percent of the GDP of all Member States.  In total, VAT raises about 20 percent of the world's entire tax revenue on an annual basis.

As I noted above, VAT rates tend to rise with time.  Here is a chart showing how VAT rates have varied since they were first introduced for several nations:

Only one nation out of the ten, Canada, has reduced its VAT since it was first introduced.  It is the fact that VAT rates can be so easily raised as time passes that is particularly appealing to governments.  Basically, don't trust the introductory rate as it won't last long!

Mr. Gale and Mr. Harris suggest that a broad-based 5 percent VAT accompanied by subsidies to offset the regressive impacts of imposing the tax could raise about $160 billion per year or 1 percent of GDP. Since the annual deficit currently sits at around 6.5 percent of GDP, this is not an insignificant amount but all of that money has to come from somewhere - Main Street America.  

Of course, there is always a downside.  Randall Holcombe at the Mercatus Center published a paper in 2010 that outlined issues which suggested that a VAT was not a good fit for the United States:

1.) The VAT would tax a base that has traditionally belonged to state governments who rely on that same base to provide 32 percent of their tax revenues through the implementation of sales taxes.

2.) The economic impact of a VAT would depend on how the tax was implemented and what rate was used.  The cost of both compliance and administration of the tax would negatively impact economic growth.  The imposition of a VAT that generated additional revenue to the government would divert resources from the private sector, implying lower growth levels.  Here is a chart showing how various levels of VAT would impact economic growth:

Upping the VAT rate to 10 percent would reduce baseline GDP growth from 3.0 percent to 2.46 percent, a fairly significant drop considering the low rate of growth since the end of the Great Recession.  In real numbers, by 2030, the GDP losses would be more than double the revenues raised by a 7 percent VAT as shown here:

While governments around the world love the thought of raising revenue, the ultimate benefit of implementing a VAT could be a risky proposition for Washington.  While some economists suggest that Value-Added Taxes have a stimulative effect on the economy by encouraging companies to create jobs, it is quite clear that the jury is out and that we should be just as hesitant to believe that a new VAT will benefit us any more than a drop in the corporate tax level.