Op-eds

America Badly Needs a Value Added Tax

by Paul L. E. Grieco, Peterson Institute for International Economics
and Gary Clyde Hufbauer, Peterson Institute for International Economics

Op-ed in the Financial Times
April 21, 2005

© Financial Times

 


When Bill Thomas, Republican congressman and chairman of the House Ways and Means Committee, floated the idea of replacing the US corporate income tax with a value added tax this year, he provoked a conservative howl of protest. Conservative-minded opponents of value added tax (VAT) place great weight on the "money machine" argument. They claim that VAT would raise so much money that it would provoke a splurge in federal spending. That would be a powerful argument if true—but it is not.

We are waist-deep in the splurge, without any help from VAT. In 2004, George W. Bush, US president, and a Republican Congress gave the country Medicare prescription benefits costing more than $1,000 billion over 10 years. That comes on top of existing Medicare, Medicaid, and veterans' benefits—all growing without limit. VAT played no role in these programs. Yet the United States has already legislated entitlements that severely outrun the historical limit on federal taxation, 20 percent of gross domestic product.

Since American experience can provide no support for the money machine argument, conservatives invoke the plight of Europe. They assert that VAT would consign the United States to the smothering embrace of a costly European welfare state. By this questionable logic, VAT might also prompt Americans to cultivate an unhealthy affection for Jerry Lewis.

VAT revenues have grown rapidly in Europe. But steep revenue increases are a feature across the European tax landscape, not a peculiarity of VAT systems. VAT did not encourage the growth of European government. Instead, European welfare programs grew in response to popular demand and forced European leaders to find less distorting taxes with lower rates and broader bases. Doubling the tax rate will lead to about four times the distortion. Unlike the corporate income tax, levied at a federal rate of 46 percent until the Reagan administration, VAT rates tend to be about 15 percent.

Dale Jorgenson, the economist, estimates that distortions caused by the current corporate income tax (at 35 percent) already reduce US income by an average of 24 cents for every dollar collected. If the United States tries to satisfy even one-third of future revenue needs with higher corporate tax rates, the result could be economic meltdown.

Another conservative charge is that VAT would add to existing federal taxes, not contribute to tax reform. This allows critics to ignore the harsh fact that US corporate income tax drives companies to other countries with lower rates. It also ignores the forceful personality of Thomas. He has no intention, in his last term as chairman, of simply adding another tax to the existing mess.

Conservatives should instead focus on differences between the two main VAT systems. The credit-invoice method used in Europe assesses VAT on each transaction but allows a credit for VAT paid by companies on their purchase of intermediate goods. This requires a chain of invoices and results in a system that looks similar to a sales or turnover tax. Under the subtraction method, used in Japan, companies pay VAT on their value added, calculated as the difference between final sales and purchases of intermediate goods. Administratively, this system closely resembles the corporate income tax—and is better suited to the United States.

European countries implemented VAT to replace their archaic turnover taxes, so they applied the familiar credit-invoice system. There is no reason to create such a system at the federal level in the United States. It would overlap with state retail sales tax systems and impose accounting burdens on 25 million small- and medium-sized companies.

By contrast, a subtraction-method VAT would inherit the administrative system of the corporate income tax. With proper design, no more than 200,000 large companies would file returns. Subtraction-method VAT is less susceptible to an array of differential (and distorting) rates than credit-invoice VAT and its adverse impact on low-income households can be offset by a complementary system of tax credits.

The conservative case against VAT is an argument that taxes should remain as painful and inefficient as possible, lest Americans grow to like them. Conservatives are right that public spending must be restrained but wrong to think they can achieve restraint through perversions in the tax code. If fellow conservatives thwart Thomas, they will lay the groundwork for future corporate tax increases that will make them long for VAT.



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