A VAT Tax Is Not the Answer

With Congress and the White House mindful—and troubled— that health-care reform could cost over $1 trillion in the next decade, the House Ways and Means Committee this week compiled a list of ways to raise money based on options from the nonpartisan Congressional Budget Office.

One is that hoary old chestnut the national value-added tax (VAT), similar to a national sales tax. It is more popular with some conservatives, who see it as an alternative to taxing income, than with liberals, but a few liberals like it because they see it as a tax on consumption that will encourage saving, or as a way to pay for subsidies to low-income families.

Perhaps he was only practicing legislative diplomacy, but chairman Charles Rangel (D-NY) of the Ways & Means Committee, where tax bills originate, refused to rule out a VAT in recent conversations, saying “it’s been put on the table.”

To be sure, Rangel went on to acknowledge obliquely that many Democrats might not support such a tax. Nor has there been any hint from the Obama White House that the 44th president would go for a VAT.

But a 1% VAT could raise $100 billion a year, and a 5% VAT could bring in $500 billion. That may have a seductive ring in the ears of some in the White House and on Capitol Hill—a small tax yields a lot of money. Nevertheless, it is a bad idea.

The tax, on goods and services, is levied only on the value added at each stage of production. Take a hand-made guitar: When the maker buys the strings and the wood, he receives invoices that show how much value-added tax their producers have paid. By assembling the guitar into an instrument a musician can use, the maker adds value, and can sell the guitar for more than the cost of the materials. He will pay tax on his sales price, but may first subtract the taxes that suppliers have paid, avoiding double taxation. Net, he pays tax only on the value he adds.

The problem with the VAT is that it is biased upward over time, because it is so tempting for legislatures to produce more revenue by making small rate increases. When imposed in 1967, Denmark’s VAT was 10%; it is now 25%, in addition to a top income tax rate of around 59%. A year later, in 1968, Germany levied a 10% VAT. Germans are more fortunate; their VAT has risen “only” to 19%, and their highest income tax rate is “only” 45%.

Twenty-nine OECD countries have VATs, and only three— Canada , Japan , and Switzerland —apply rates under 10%. The others impose rates of 10% of more, and 12 have rates of 20% or higher. In sum, the notion that a VAT will be a small, single-digit tax is not born out by other countries’ experience. In fact, in many countries the VAT is the largest source of government revenue.

It’s politically unrealistic to expect that a VAT would be a substitute for the income tax, so it would end up being an additional levy, one that enlarges the government’s claim on the rest of the economy. Putting a VAT in the hands of Congress is like giving an alcoholic the keys to the wine cellar and saying he’s welcome to drink just one bottle. Of course, the following morning several bottles will have been consumed.

Len Burman, a liberal economist with the Tax Policy Center, suggests imposing a VAT and then rebating the revenue back to families through lower income taxes and vouchers to buy health insurance. If this complicated plan seems too good to be true, that’s because it is. The notion that Congress will reduce other taxes when it imposes a VAT strains credulity at a time when it is considering expensive “investments” in energy, health, and education.

OECD countries do not use their VATs solely for one program, such as health care. They use them to pay for a wide variety of expenditures. There’s no reason to expect it to be different in America.

Should Congress wish to move towards a consumption tax in order to encourage savings, there are better and simpler ways to do so. The best is to take the myriad of tax-free savings accounts we have now—529 college savings plans, 401(k) retirement plans, traditional Individual Retirement Accounts, Roth Individual Retirement Accounts, Health Savings Accounts, Simplified Employee Pensions, etc.—and meld them into one large tax-free savings account and place no limit on annual contributions. Income going into this omnibus savings account would not be taxed, so de facto we would have a consumption tax, since the only money subject to income tax would be money spent.

A VAT has the potential to fund all of Congress’s pet projects, such as cap-and-trade, renewable energy, electric cars, high speed rail, and, of course, health care. It’s the taxpayers who would be the losers.

This piece originally appeared in RealClearMarkets

This piece originally appeared in RealClearMarkets