America is one of the few nations without a value-added tax (VAT), but there is growing pressure to impose the levy. In simple terms, a VAT is a type of national sales tax. However, instead of being collected at the cash register, it is imposed on the “value added” at each stage of the production process.
Some like the VAT because it offers a new way to finance bigger government. Others like the VAT because—at least compared to the income tax—it does not impose as much damage on the economy. Some want to use the revenues from a VAT to facilitate tax reform and/or Social Security reform. There are even some people who believe that a VAT will somehow reduce the trade deficit.
However, many people dislike the VAT, often for some of the reasons listed above. Supporters of limited government oppose the tax because it makes it easier for politicians to expand the size of government. By contrast, some on the left oppose the VAT because of its one redeeming feature—it is a consumption-based levy and therefore not as easy to use for economically destructive income redistribution.
Although it is a relatively non-destructive way to collect revenue, a VAT would be a serious mistake for the United States. The only condition that would make a VAT acceptable is complete repeal of all income taxes and a constitutional amendment that prohibits Congress from re-imposing taxes on any type of income. But this is not a realistic option, which is why the VAT should be stopped.
If history is any guide, a VAT will have several adverse effects. Specifically, a VAT will:
Expand the cost of government. Countries with VATs have a much heavier total tax burden than those without VATs. Before the creation of VATs, the burden of taxation in Europe was not that much larger than it was in the United States. However, since the late 1960s, when countries in Europe began to adopt VATs, Europe’s aggregate tax burden has increased by about 50 percent while the U.S. tax burden has remained relatively constant.
Inadvertently increase income tax rates. One of the main arguments for the VAT is that it is a less destructive way to raise revenue. This is theoretically true, but irrelevant. In the real world, the VAT has been used as an excuse to increase income taxes as a way to maintain “distributional neutrality.” Indeed, income taxes in Europe today are higher than they were when VATs were implemented.
Slow economic growth and destroy jobs. A VAT undermines economic growth for two reasons. First, it reduces incentives to engage in productive behavior by driving a larger wedge between pre-tax income and post-tax consumption. Second, it facilitates larger government and the concomitant transfer of resources from the productive sector of the economy to the public sector, diminishing economic efficiency.
A VAT almost certainly is a no-win proposition for America. Theoretically, a VAT would be acceptable if it were combined with ratification of a constitutional amendment that permanently prohibits both the personal and corporate income taxes, but this is an extremely unlikely scenario. It is far more likely that a VAT would be implemented in addition to the income tax—which is precisely why it is such a bad idea.
What Is a VAT?
A VAT is levied on the “value added” to goods and services as they pass through each stage of the production process. There are two ways to impose a VAT, and both require businesses of all types to serve as tax collectors. The most common form, the credit-invoice VAT, operates somewhat like a sales tax. As explained by the Congressional Budget Office:
[The credit-invoice VAT] is typically administered by taxing the total value of sales of all businesses, but allowing businesses to claim a credit for taxes paid on their purchases of raw materials, intermediate materials, and capital goods from other businesses.
By imposing a tax on receipts but then allowing a credit for VAT taxes collected at earlier stages of production, the credit-invoice VAT taxes the “value added” by each business. The total tax, regardless of the stage of production at which it was collected, ends up being added to the final sales price.
No matter how many steps there are in the production process, a fixed percent of the final price of the product would represent the value-added tax, just as a retail sales tax is a fixed percent of the final product price. However, unlike a sales tax, the cost of the VAT to consumers would be hidden. Unless politicians took the unlikely step of requiring retailers to state explicitly the portion of the sales price that is due to the VAT, consumers would be unaware of the tax.
The other approach is the subtraction-method VAT. Businesses pay a tax on their annual receipts, but only after first deducting the money that they spent on new investments and purchases of inputs. This sounds like the corporate income tax,
but there are some very important differences. The subtraction-method VAT does not allow businesses to deduct the cost of employing workers. It does, however, allow businesses to fully deduct (or expense) the cost of new investments.
The credit-invoice VAT and subtraction-method VAT are both consumption-based tax systems, which is a fancy way of saying that they do not double-tax savings and investment. In this regard, both types of VAT have the same tax base as the flat tax and national retail sales tax. All of these systems tax labor and capital income, but only one time—unlike the current personal and corporate tax systems, which are riddled with different forms of double-taxation. The flat tax is levied one time—at one low rate—when income is earned, while the VAT and national retail sales tax are levied one time—at one low rate— when income is spent.
Real-World Impact of a VAT
Theoretical discussion about the advantages and disadvantages of the VAT is useful, but it also is instructive to examine what happens when nations implement this tax. Do they grow faster or slower? Does the aggregate tax burden increase? Are income taxes eliminated, or at least reduced?
Many countries already impose VATs, and the results of this real-world experiment have been dismal. Based on historical evidence and economic research, it is clear that adoption of a VAT will have several adverse consequences.
Effect #1: A VAT triggers more government spending and higher tax burdens.
International evidence clearly shows that a VAT is likely to increase the aggregate burden of government. As Chart 1 illustrates, the burden of government in Europe used to be only slightly larger than it was in the United States. Beginning in the late 1960s, however, European countries began to implement VATs. Since then, the overall tax burden in Europe has climbed rapidly.
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Higher taxes translate into higher spending. As Chart 2 illustrates, government spending in European Union nations consumes a much larger share of economic output. Even if state and local government spending is included, the burden of government spending in the United States is much lower. Interestingly, government debt as a share of gross domestic product (GDP) is also much higher in the EU. This is particularly noteworthy since some incorrectly assert that higher taxes are needed to limit deficits and debt.
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What does this mean for America? With its capacity to generate large amounts of tax revenue, a VAT almost surely would fuel higher government spending. This is precisely what happened in Europe, according to the data. The statistics are echoed in research conducted by the Tax Policy division of the U.S. Chamber of Commerce and published in a 1986 study that examined tax and spending growth between 1965 and 1982. The study found that government spending grew 45 percent faster in VAT nations than in non-VAT countries and that, similarly, the tax burden grew nearly 34 percent faster in VAT countries.
Effect #2: A VAT slows the economy and destroys jobs.
By taking resources out of the productive sector of the economy and transferring them to the government, a VAT would slow economic growth and undermine job creation. The economic damage caused by a VAT is partly due to the increase in the aggregate tax burden.
Additionally, even though it may be less damaging than other forms of taxation, the VAT drives a larger wedge between pre-tax income and post-tax consumption, therefore reducing incentives to engage in productive behavior. As the Congressional Research Service explains:
For households, two out of three major decisions would not be altered by this hypothetical VAT. First, this VAT would not alter choices among goods because all goods would be taxed at the same rate. Thus, relative prices would not change. Second, a VAT would not affect the saving-consumption decision because saving would only be taxed once; that is, when savings are spent on consumption. But the third decision, a household’s work-leisure decision, would be affected by a VAT. Leisure would not be taxed, but the returns from work would be taxed when spent on goods. (In contrast, the income tax affects both the saving-consumption decision and the work-leisure decision.)
The economic damage of a VAT might be avoided if the tax replaced other forms of taxation, but Chart 3 shows that VATs almost always have resulted in a larger aggregate tax burden.
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Furthermore, the economic argument against a VAT is not limited to the resulting larger tax burden. The VAT will also negatively affect economic growth because it means more government spending. Scholarly studies have found that there is a strong negative relationship between government spending and economic performance. The following is a very small sampling of the academic literature:
A study from the Federal Reserve Bank of Dallas noted: “[G]rowth in government stunts general economic growth. Increases in government spending or taxes lead to persistent decreases in the rate of job growth.”