Brookings: Topics - Value-Added Tax

Inoculate the Budget Deficit From Healthcare Reform

William G. Gale — Tue, 08 May 2012 16:48:00 -0400

The United States faces large federal budget deficits over the short-, medium-, and long-term. Although perhaps subject to the greatest public attention, the short-term deficits are generally thought to be helping the economy recover. In contrast, medium- and long-term deficits projected for years after the economy returns to full-employment are a source of concern: these deficits will create growing and serious burdens on the economy even if they do not lead to an immediate crisis. Economists of all political stripes agree on this point.

While extending the Bush tax cuts, if that occurs, will play a big role in making the medium and long-term deficit problems worse, economists agree that a key driver of the long-term deficit problem is growth in government spending on health care. Medicare and Medicaid, our two largest health spending programs, currently account for 23 percent of federal spending, or 5.6 percent of GDP. Under current law and optimistic assumptions for health spending, the Congressional Budget Office (CBO) estimates these programs will represent 30 percent of total federal spending (6.8 percent of GDP) by 2022 and will continue to grow thereafter.

The prospect of health-driven deficits has produced a burst of proposals for reform. Sadly, the simple truth is that we do not yet know how to reform government health programs to both rein in costs and maintain or improve quality and access.

One approach has been to maintain the current structure of the system but use better incentives (that is, restructure payments) to encourage patients and doctors to eliminate unhelpful or unnecessary medical procedures, and instead focus on ones that are necessary and effective. The Obama administration's health care reform effort relies on this approach. However, the entity created to oversee this process, the Independent Payment Advisory Board, or IPAB, was effectively neutered by Republicans during negotiations leading up to the enactment of the Affordable Care Act.

Another approach, sometimes called premium support, would convert Medicare into what is, in essence, a voucher system. Medicare would offer subsidies to individuals to buy their own insurance from government-managed regional insurance exchanges. This approach, if adopted consistently, could limit government costs. It may not, however, limit overall health costs. Indeed, CBO recently estimated that under the "premium support" plan proposed by Rep. Paul Ryan (R-WI), total health spending for a typical beneficiary would grow faster under the proposal than under traditional Medicare.

So what do we do? The medium- and long-term deficits that will result from debt-financed health care spending will inexorably dampen economic performance. They will soak up capital, reduce our ability to grow, burden future generations with debt, and perhaps even influence the military and diplomatic stance of the country. We cannot, and indeed should not, wait for effective health care reform to rein in the budget deficit. Health reform is a process; it will take time to get it right as we learn about what works and what doesn't. We won't get it right on the first shot.

As we work to restrain health care cost growth, we must, at the same time, inoculate the future deficit from the inevitable failures of health reform.

We can do this by choosing a federal health care spending level and stipulating that any spending above that amount must be financed on a current basis with a tax. For example, if federal health care spending were allowed to grow at the rate of GDP plus 0.5 percent (a rate proposed by both President Obama and Rep. Ryan), any health spending in excess of that growth rate would be financed with tax revenues in the next year.

Suppose we used a value-added tax (VAT) to finance excessive health spending; using a VAT in this way would accomplish several goals and simultaneously mitigate general concerns about the VAT. Most importantly, the deficit could be controlled; the grinding economic effects of persistent long-term deficits could be avoided even before society resolves the economically difficult and politically treacherous questions raised by trends in health costs.

In addition, the proposal would link health care spending and the means to pay for such spending. When considering whether health spending should rise, voters would have an explicit choice between higher spending and higher taxes on the one hand or lower spending and lower taxes on the other.

Some will inevitably oppose this fiscally responsible proposal simply because it uses a VAT. At a recent Brooking conference, Larry Summers restated his classic summary of political opposition to a VAT: conservatives worry that it is a money machine and would fuel expansionary government, and progressives worry that it is regressive. He concluded that a VAT will only be possible when conservatives realize it is regressive and progressives realize it is a money machine.

Although Summers' characterization captures an important aspect of the VAT debate, linking the VAT to health care spending would help address both issues. A VAT linked to health care spending would necessarily be less of a money machine than a VAT that provides general revenues - it would limit voter willingness to raise health care spending, not provide a reason to increase it. It may also change their health care consumption and reduce demand for techniques and procedures that may not be effective or necessary. A VAT linked to health care spending would also be less regressive than a general-revenue VAT because it would finance a widely-distributed good. Any regressivity could be further lessened by demogrants or income tax credits.

Linking a VAT to health spending is not a new idea. It has been proposed by my colleagues Henry Aaron (20 years ago) and Isabel Sawhill, Syracuse economist Len Burman, and others. But it is certainly an idea whose time now has come, given the negative effects of persistent deficits on economic growth and the difficult technical and political aspects of health care reform. Health care reform is a desperately important task and should proceed apace. But it will take time and it should not hold hostage the effort to reduce medium- and long-term budget deficits.

Authors

William G. Gale

Publication: Real Clear Markets

Image Source: Darren Hauck / Reuters

Fixing the Budget Means Higher Taxes

William G. Gale — Tue, 24 Jan 2012 00:00:00 -0500

If we are going to reduce the medium- and long-deficit, new tax revenues must be part of the solution. And those taxes must be progressive and as conducive to economic growth as possible.

Historical revenue levels will not be sufficient to fund the federal government in the future. We will need to control the ballooning costs of Medicare, Medicaid, and Social Security. However, because their enrollment will be growing with the aging population, additional revenue still will be needed.

Past major budget agreements included both revenue increases and spending cuts because using both sides of the budget provides a sense of fairness and shared sacrifice. Americans prefer a balanced approach to spending cuts alone

Interestingly, raising taxes has proved more effective at restraining spending than allowing the government to finance its outlays with deficits. Under presidents Reagan and George W. Bush, taxes fell but spending rose. Spending fell only in the 1990s, when President Clinton and Congress raised taxes. This makes sense, since raising taxes to pay for current spending makes it clear to taxpayers that there is a cost to current spending, whereas the cost of deficit financing, while real enough, are obscured by the fact that it is does not create current tax liabilities.

Done right, higher taxes will not destroy the economy. In 1993, top income tax rates rose to 39.6 percent, and the economy flourished for the rest of the decade. Even the massive tax increases during and after World War II-amounting to a permanent rise of ten to fifteen percent of GDP-did not hamper U.S. economic growth.

The best way to raises taxes is to broaden the tax base by reducing the number of specialized credits, deductions, and loopholes. For example, limiting the tax benefit of itemized deductions to 15 percent would affect mostly high-income households and raise more than $1 trillion over the next decade without raising marginal tax rates.

New revenues should come from a progressive tax, which means the tax burden on high-income, high-wealth households needs to rise. Last year’s debt deal contained only spending cuts that place almost the entire burden of closing the fiscal gap on low- and middle-income households but have little or no impact on high-income households.

Over the past 30 years, the share of total household income for the top one percent of the income distribution more than doubled. Yet, those high-income households have seen their average tax burden fall, not rise, during that period.

The claim that these tax increases will harm small business is often overstated. Most income for high-income households is not business income. Yet, a recent Treasury report shows that just 1 percent of small business owners would be affected by a “millionaire’s surtax.” And even those firms face effective tax rates likely to be zero or negative since they can immediately and fully deduct the cost of new investment, even as they finance it WITH tax-deductible debt.

In addition to income tax reform, our leaders should move the United States toward a system that taxes consumption (using a value-added tax for example) and nonrenewable and polluting energy use (by increasing gasoline taxes or implementing a carbon tax).

The VAT exists in about 150 countries worldwide. It can raise substantial revenue, is easily administrable, and is minimally harmful to economic growth. In addition, a pre-announced, phased-in VAT could accelerate economic recovery. Concerns about regressivity and transparency can be addressed, and concerns that it would fuel an increase in government spending are overstated.

Long-term challenges related to energy production and consumption and long-term fiscal challenges can be addressed together. A far-reaching, upstream carbon tax can reduce the deficit and our dependence on foreign oil, protect the environment, lower the costs of healthcare, and encourage the development of clean, sustainable energy sources without the need for costly, inefficient energy subsidies. In the absence of a full-blown carbon tax, raising the gas tax offers many of the same advantages.

None of this means the United States needs to move to European levels of taxation. But between the very low tax revenues we raise now-the lowest share of the economy in six decades-and the high levels of taxation in other developed countries, there is room to raise revenue in a way that achieves serious medium- and long-term deficit reduction and supports a reasonable level of government.

Authors

William G. Gale

Publication: Christian Science Monitor

Image Source: © Larry Downing / Reuters

A Value-Added Tax as a Solution to the U.S. Budget Deficit

William G. Gale — Fri, 21 Oct 2011 10:10:00 -0400

At a recent event, William Gale discussed the possibility of using a value-added tax (VAT) to solve the budget deficit in the United States. He argued that instituting a VAT could be a good, although not perfect, way to raise new revenues that could be used for both deficit reduction and tax reform. He detailed the use of a VAT around the world, noting that approximately 150 countries have instituted one, and in most, it either raises the most revenue or the second most, after the income tax.

Gale also outlined the two different ways to set up a VAT: the credit invoice and the subtraction method. The credit invoice is set up so that each transaction includes the tax. The subtraction method more closely resembles an income tax with the tax added up at the end of the year. This set-up is similar to parts of Herman Cain's 9-9-9 plan.

According to Gale, a VAT does not have to be either a money machine or regressive. In most countries with a VAT, there has been no growth in the size of the government due to the tax or major increases in the tax rate itself in the past twenty-five years. Yet it remains one of the best ways to raise substantial amount of revenue; raising a comparable amount with income tax reform would require massive increases in the tax rates.

Authors

William G. Gale

Image Source: Â© Shannon Stapleton / Reuters

A Value-Added Tax for the United States: Part of the Solution

William G. Gale and Benjamin H. Harris — Thu, 22 Jul 2010 09:49:00 -0400

The U.S. faces a large medium-term federal budget deficit and an unsustainable long-term fiscal gap. Left unattended, these shortfalls will hobble and eventually cripple the economy. The only plausible way to close the gap is through a combination of spending cuts and/or tax increases. This paper discusses why a federal Value-Added Tax (VAT) should be part of a constructive solution to the fiscal problem.

Under a VAT, businesses pay taxes on the difference between their total sales to other businesses and households and their purchases of inputs from other businesses. That difference represents the value-added by the firm to the product or service in question.2 The sum of value-added at each stage of production is the retail sales price, so in theory the VAT simply replicates the tax patterns created by a retail sales tax and is therefore a tax on aggregate consumption. In practice, the key distinction is that VATs are collected at each stage of production, whereas retail sales taxes are collected only at point of final sale. As a result, the VAT is easier to enforce and is widely regarded as having a superior administrative structure to a retail sales tax.

Although it would be new to the United States, the VAT is in place in about 150 countries worldwide and in every OECD country other than the United States. Experience suggests that the VAT can raise substantial revenue, is administrable, and minimally harmful to economic growth. Additionally, the VAT has potential advantages worth highlighting: a properly-designed VAT might help the states deal with their own fiscal issues, and a pre-announced, phased-in VAT might be able to accelerate the pace of economic recovery.

Several concerns that have been raised about the VAT can be easily addressed. While the VAT is regressive relative to current income, the regressivity can be offset in several ways. While the VAT is not readily transparent in many countries, it would be easy to make the VAT completely transparent to businesses and households by reporting VAT payments on receipts just like sales taxes are reported today. While the VAT has led to an increase in revenues and spending in some countries, higher revenues are precisely why the VAT is needed in the U.S., and efforts to limit spending should be part of an effort to enact a VAT. Making the VAT transparent should also reduce the extent to which a VAT would fuel an increase in government spending, a concern that is sometimes overstated by critics in the first place. While the VAT may lead to a one-time increase in prices, it is not the case empirically that VATs inevitably, or even usually, lead to continuing inflation.

None of this implies that the VAT would unilaterally solve the country's fiscal problems; nor would it be painless. Nevertheless, the VAT is a relatively attractive choice, given the need to close the fiscal gap and the other options for doing so.

The sections below address each of these issues. We also summarize the Canadian VAT experience, which shows how many of the concerns can be addressed in practice. The final section summarizes our specific recommendations regarding the VAT.

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Authors

William G. Gale
Benjamin H. Harris

Image Source: © Fred Prouser / Reuters

Should There Be a VAT in America’s Future?

Gary Burtless — Mon, 26 Apr 2010 10:58:00 -0400

For many years sober budget analysts and economists have been warning of the rising future cost of government health and retirement programs. The increase in expected federal outlays is the result of two predictable developments: The rise in the proportion of the population that is past age 65 and the apparently irrepressible surge in the price and quantity of medical services consumed by people who are covered by public insurance (medicaid and Medicare).

The aging of the population will increase spending requirements for social security, Medicare, medicaid, and all other public programs from which the elderly receive an out-size share of program benefits. The tendency of medical care costs to climb faster than the cost of most other consumption and investment items means that government outlays on health insurance will need to grow faster than the overall economy, even if the population eligible for public insurance increased no faster than the population as a whole.

Without increasing the deficit, there are three basic ways of dealing with these developments. We can curb future spending on public health insurance and programs for the elderly, either by cutting benefits or changing the rules to reduce the size of the population eligible to collect benefits. We can increase federal revenues to cover the additional costs of our existing programs. Or we can reduce federal spending on non-health programs and on programs not targeted on the elderly.

To an important degree, past increases in spending on health and on the elderly were financed with reductions in defense spending. Defense spending averaged a little more than 9% of GDP between 1950 and the end of the Vietnam War. It fell to 5.5% of GDP between 1974 and the end of the Cold War in 1990. Since 1991 it has averaged 3.8% of GDP, a decline of 5.3 percentage points since the early post-war years. By spending less on defense we were able to spend more on health and the elderly without raising taxes. Fueled by the cost of fighting two wars, spending on defense has risen since 2001, but defense spending as a percentage of GDP remains well below the level of the 1950s and 1960s.

Even if spending on defense falls substantially in the future, the savings will not be big enough to pay for expected increases in the cost of public health insurance and federal programs for the elderly. For this reason, the CBO predicts a sizeable increase in total federal spending and in government debt held by the public. If the President’s 2010 budget proposals are adopted, the CBO forecasts that the deficit will shrink substantially in the next four years, falling from 10.3% of GDP this year to 4.1% of GDP in 2014. However, mainly because of rising commitments for health insurance and programs for the elderly and the increasing burden of paying interest on the growing national debt, the predicted deficit will then begin to rise, reaching 5.6% of GDP by 2020. This budget path is not sustainable in the long run. Public spending will eventually have to be cut or government revenues increased if the United States wants to continue selling its debt to prudent investors.

Introducing a value-added tax (or VAT) is one way to reduce the long-term imbalance between spending commitments and revenues. A VAT is similar to a sales tax, except that it is imposed on the value added at each stage of production of a good purchased by consumers. Many economists, including me, consider it an attractive way to increase revenues. Compared with other kinds of taxes, including sales taxes, property taxes, and an income tax with a very high top marginal rate, the VAT probably causes less economic distortion. Compared with the income and sales tax, it is almost certainly harder for taxpayers to evade (or at least to evade completely). Because of these attractive features, the VAT is an important part of the tax system in 29 of the 30 member countries of the OECD, an international organization that includes all of the world’s richest countries. In the most of these countries, the VAT accounts for over one-fifth of tax collections. The United States is the only OECD country that does not have a VAT.

For the U.S. the VAT would have some disadvantages. Introducing the tax would require the nation to establish a new tax collection administration. It would force businesses to set up new procedures to collect the tax and send proceeds to the government. This is a more costly undertaking than boosting tax rates in an existing tax, such as the payroll or income tax. Also, establishing a VAT would involve tough political negotiation between federal and state lawmakers, since most states fund an important percentage of their operations with a sales tax. To keep tax collection efficient, a federal VAT would require some coordination between the collection of the VAT and state sales taxes. These problems can be surmounted, as they have been in other OECD countries, but the solutions would not be painless.

A rational analysis of the nation’s budget problems leads inevitably to the conclusion we will have to both trim currently planned spending and increase government revenues, assuming we want to make the cost of government sustainable. If the resolution of the budget problem requires a large increase in taxes, a new VAT is a very attractive way to raise new revenues. In the unlikely event we find a budget solution that requires little new revenue, a low-rate VAT would make no sense. I believe a substantial amount of revenue will be needed to fix the nation’s deficit problem, so I think a VAT is desirable.

Few opponents of the VAT argue the VAT is a less efficient or more burdensome tax than other kinds of taxes, including the taxes we already pay. They argue instead that the VAT will be a rich and inviting source of funding for unneeded public programs. Many of these critics would apparently prefer that taxes be collected in particularly obnoxious and unpopular ways so that voters will fiercely resist higher tax rates.

It’s worth remembering that many VAT critics oppose raising taxes, whether the revenues are collected from a new or an old revenue source. They believe long-term budget balance should be achieved solely through cuts in public spending. Many of them supported tax cuts in 2001-2003 that contributed immeasurably to the nation’s current budget fix. I doubt whether their preferred solution to our budget problem is politically feasible. Since Ronald Reagan’s election in 1980 we’ve accumulated 30 years of evidence about the effects of lower and higher tax rates on the budget deficit. The only periods in which we saw progress toward a sustainable budget path were ones in which Congress combined spending discipline with higher taxes. Until the opponents of the VAT identify the government programs they propose to slash for a sustainable budget path, we should take their objections to the VAT for what they are: Objections to a tax hike rather than to a VAT.

Authors

Gary Burtless

Publication: National Journal

VAT or Not?

Isabel V. Sawhill — Mon, 26 Apr 2010 14:30:00 -0400

A VAT has a lot to recommend it. It is a relatively efficient way of raising revenue, producing far fewer distortions than the current income tax. Moreover, by encouraging saving and productivity, it is exactly what the nation needs to raise future standards of living. A 10 percent broad-based VAT could produce in the neighborhood of $500 billion a year by 2012 according to the Brookings-Urban Tax Policy Center.

In my view, the way to make this politically palatable while advancing other policy goals is to use some of the revenues to provide a refundable credit to lower-income households, thereby offseting the regressive features of the tax, some to lowering the corporate tax rate to make the U.S. more competitive with other countries, and some to eliminating income taxes for many in the middle class, thereby greatly simplifying their lives and making April 15 just another day on the calendar. More affluent Americans would continue to pay income taxes.

Most importantly, the rate of the tax should be linked as closely as possible to the growth of health expenditures over time. Even if the new tax did not reduce the deficit very much or at all in the short-run – something that would be desirable as long as the economy is depressed – it would begin to bite over time, and provide financial markets with a reason to have some confidence that we have gotten our fiscal house in order. The key here would be to make the linkage as automatic as possible so that any further increases in health care spending (as a proportion of the economy) would be fully paid for. To be sure, Congress could delink the two at any time if it so chose, but if the VAT rate was triggered, with some lag, by recent increases in health care spending, as determined by an independent body such as the new Medicare commission, this just might work. If the public rebelled against the higher rates, this would create pressures to rein in health care costs which in the absence of such constraints are likely to rise very rapidly over the next few decades. Coupled with continued innovations in the delivery and financing of health care this could help to bring the rate of growth of health spending within more reasonable bounds. If it didn’t, then at least we’d be paying for the health care we’re collectively consuming.

The big advantage of this plan is that it devotes virtually all of the new revenue initially to lowering other taxes, not to increased spending. But at the same time, it deals with unsustainable budgets by linking the rate of the tax to health care spending, the major driver of unsustainable deficits. The law could even specify that none of the revenues from the VAT could be used to fund new spending programs and that all of the initial revenues would have be used to reduce existing taxes, especially if this is what it would take to get bipartisan agreement on such a plan.

If we could substantially broaden the base of the current income tax, I’d be all in favor of doing so. But the political challenges of doing so should not be underestimated. With this in mind, a clean start with a broad-based consumption tax linked to health care spending, and partially offsetting existing corporate and personal income taxes with some relief for lower-income families, makes a lot of sense.

Authors

Isabel V. Sawhill

Publication: National Journal

Conservatives and the VAT

Ted Gayer — Thu, 22 Apr 2010 12:22:00 -0400

I share the criticism of Tax Policy Center’s Howard Gleckman of the Senate proposition that characterizes a Value Added Tax (VAT) as “a massive tax increase that will cripple families on fixed income and only further push back America’s economic recovery.” However, my problem with the Senate vote isn’t that it opposes a VAT; rather, it’s that it rules out any VAT, even one that is part of a broader tax reform that reduces distortionary income and corporate taxes.

Howard says that conservatives’ arguments against the VAT don’t “make a lot of sense.” It’s important to remember that conservatives by and large have favored a shift towards a consumption tax. But consumption taxes take a variety of forms, and many conservatives have advocated for a Hall-Rabushka flat tax, which also has a consumption base and can easily be designed to be more progressive than a VAT. The reason for preferring consumption rather than income as the base for taxation is fairly straightforward: unlike an income tax, a consumption tax does not distort savings decisions, and thus is more efficient.

The conservative argument against a VAT is primarily political. The concern is that a VAT is less visible and less salient to the electorate than other taxes, and will therefore inure citizens to an inefficient growth in government. Milton Friedman famously regretted his role in helping to introduce income tax withholding because he felt that it led to growth in government. He also opposed a VAT because it “would be concealed in the total price the consumer paid and hence not perceived as a direct tax burden.” Another Nobel Laureate, James Buchanan, observed that excise taxes, which are included in the prices of goods, leave taxpayers “quite ignorant of the amount of tax that is paid,” and thus “the opportunity cost is not sensed by the taxpayer.” It is worth noting, however, that this “fiscal illusion” concern can work both ways – if the benefits of government programs are not visible, then the size of government can be inefficiently small due to lack of citizen support.

Unlike Howard, I don’t think this concern is baseless. The evidence for the fiscal illusion hypothesis is indeed mixed (Wallace Oates offers a good survey), as it is difficult to identify the direction of causality between the prevalence of insalient taxes and the size of governments. But a recent study by Amy Finkelstein, appearing in the Quarterly Journal of Economics, does offer some interesting evidence. Finkelstein examined the effect of tax salience by studying the impact of the adoption of electronic toll collection on toll rates. Electronic toll collection automatically deducts tolls as cars drive through toll plazas, and is thus less salient than manually paying cash at a toll booth. Finkelstein finds strong evidence that toll rates increased due to the adoption of the less salient electronic toll collection, supporting the hypothesis that there is a link between tax insalience and the size of government.

That said, concerns about the insalience of a VAT should not torpedo any consideration of a consumption tax. A Hall-Rabushka flat tax shares the efficiency advantages of a VAT and is more salient than a VAT because households have to file an annual tax return. More generally, with any given tax, policymakers have some control of the level of salience. With a VAT, for example, salience to taxpayers can be increased by such things as separately identifying the tax level on each sales receipt. Whether policymakers want to deliberately increase the salience of a tax is an interesting question.

Finally, I note in passing that given that the anti-VAT proposition passed with 84 (!) votes in the Senate, it seems odd that the title of Howard’s blog post is “Conservatives and the VAT.” Clearly, concerns about the possible negative effects of a VAT are widespread.

Authors

Ted Gayer

Publication: Urban-Brookings Tax Policy Center

The VAT Is Almost Inescapable

Henry J. Aaron and Isabel V. Sawhill — Wed, 14 Apr 2010 09:29:00 -0400

Almost everyone recognizes that the United States faces a serious long-term budget challenge that will require a good deal of fiscal belt-tightening. That belt should not be tightened this year or even next, as premature fiscal restraint could abort the economic recovery that remains all too fragile. But now is the time to start planning for how deficits should be cut when economic recovery is well established.

The first step is to recognize how much needs to be done and when. The federal budget deficit is nearly 10 percent of gross domestic product (GDP). Economic recovery will erase part of that gap, as tax collections rise and spending on unemployment benefits and other recession-related outlays ends. But recovery will not solve the whole problem.

Additional and politically difficult shifts in policy will be necessary to stop debt from growing so fast that simply paying the interest on that debt becomes unaffordable, creating the preconditions for an economic crisis even more dangerous than that of 2008-2009. To avoid such a scenario, most experts believe that the federal deficit needs to be reduced by about 5 percent of GDP over the next 10 to 15 years.

Some people think that spending cuts can do the job. But that is just not in the cards.

Congress has labored mightily to pass a health reform bill. The Congressional Budget Office estimates that the health bill will cut deficits, but not by much over the next decade. Since the growth of health care spending is the major driver of future deficits, additional measures to rein in this portion of the budget are needed. Given legislative fatigue, however, Congress is unlikely to revisit this issue anytime soon.

Even if Congress decided to cut future Social Security benefits, most members of Congress of both parties are loath to cut benefits for current retirees or people nearing retirement, defined as over age 50 to 55. That means that pension cuts will contribute little to deficit reduction over the next 10 to 15 years.

Defense spending is likely to be driven by external events. Few members of either party are prepared to play Russian (or Chinese or Iranian) roulette with American security.

Furthermore, there are some things on which the United States does not spend nearly enough, such as investments in education, infrastructure and innovation that are needed to reduce inequality and improve American productivity.

None of this suggests that spending restraint is impossible. But it does mean that spending cuts will not come close to reducing deficits by 5 percent of GDP.

A major portion of deficit reduction over this period is going to have to come from tax increases. The cleanest way to raise enough revenue to prevent fiscal crisis is to do what every other developed nation in the world has already done -- impose a broad tax on most consumption.

Such a tax should be collected at all stages of production in comparatively small amounts, based on the value added at that stage of production. What this means is that a producer that buys $70 worth of inputs from other companies and sells its product for $100 pays tax on the $30 of "value added." If all producers, including retailers, pay this tax, the full value of each good that consumers buy is taxed.

Liberals fear that a consumption tax is regressive, and conservatives fear that it would stimulate greater government spending, but the evidence from other countries suggests both fears are exaggerated.

Given both the importance of preventing debt from ballooning at a rate that could produce another financial crisis and the constraints on filling the budget gap with spending reductions alone, a value-added tax seems almost inescapable.

Winston Churchill once said of democracy that it is the worst form of government except for all the others. Much the same can be said of the value-added tax. It is the worst way to prevent excessive growth of public debt, except for all the others.

Authors

Publication: AOL News

Consider a Value-Added Tax

Isabel V. Sawhill — Wed, 07 Apr 2010 15:25:00 -0400

The voices in favor of a value-added tax (VAT) as a new revenue source for the U.S. are getting louder. The latest person to weigh in on the topic is Paul Volcker who, according to Reuters, floated the idea at an event in New York on Tuesday, saying “if at the end of the day we need to raise taxes, we should raise taxes.”

Volcker is so right. We badly need more revenue. Last year federal government spending was 26 percent of GDP and revenues were 15 percent of GDP for a staggering gap of 11 percent. Some of this gap is the result of the recession but even in a fully recovered economy, the gap will still be in the neighborhood of 6 percent. We are risking another financial crisis if we don’t address this enormous hole in our public finances.

Some but not all of the gap should be filled by cutting spending. New or higher taxes have to be part of the bargain, and a VAT is gaining traction as one way to get the needed revenues. If the proceeds of a VAT were earmarked for federal health care spending this would link health expenditures to taxes in a very visible way and put a natural brake on such spending. If the public insists on having more and more expensive health care paid for by the government, they would have to agree to a higher VAT rate.

As Henry Aaron and I have argued, a VAT has a lot of advantages. First, if it were proposed this year or next but phased in slowly as the unemployment rate dropped, it would encourage more consumption as households rushed to buy everything from ipads to new cars while these goods were still “VAT-free.” Without higher spending by consumers, we face the possibility that the economic recovery will falter. Second, over the longer-run a VAT would encourage saving – just what the country needs if we want to remain competitive by investing in new technologies and new products. Third, a VAT is relatively easy to administer and more economically efficient than an income tax. It’s true that a VAT is regressive but this problem can be addressed by making other, more progressive, changes to taxes or spending. One option would be to reduce payroll taxes and another would be to provide refundable credits to low-income households. Ways would also need to be found to make a VAT consistent with state and local sales taxes, perhaps by allowing states to piggyback on the federal VAT or by returning some of the revenue to lower levels of government.

The big challenge, of course, is making all of this politically palatable. What might it take? In my view, the key to success is to greatly simplify the system. Most people hate the current system not just because we all like to keep more of what we earn but also because filing income tax returns makes cleaning out the basement seem like fun. Michael Graetz, a professor at the Yale Law School, has proposed a VAT [PDF] that would replace income taxes for everyone with an income of less than $100,000 a year and would eliminate 100 million tax returns. As April 15 draws nearer, almost everyone can appreciate why this would be a popular step. The business community, along with many Republicans, could be brought on board by a promise to lower the corporate rate.

In the end, any tax increase will be a heavy lift in a country that seems allergic to paying its bills. But it will have to happen sooner or later and sooner would be much better. As Larry Summers once noted, Republicans don’t like value-added taxes because they are a revenue machine and Democrats don’t like them because they are regressive. We will get a VAT when Democrats realize that they are a revenue machine and Republicans realize that they are regressive.

In the meantime, three cheers for Paul Volcker!

Authors

Isabel V. Sawhill