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Joel Slemrod
  Joel Slemrod
 

The ABCs of the VAT

5/24/2010 --

The value-added tax enters the discussion as the U.S. faces severe long-term deficits.

ANN ARBOR, Mich. — Flying a little under the Washington, D.C., radar is a presidential commission assigned to deal with the issue of the country's long-term deficit. Professor Joel Slemrod says the gap between promised spending and the taxes we have in place is between $41 trillion and $76 trillion over the next 75 years. One of the options being discussed, and not completely ruled out by President Barack Obama, is a value-added tax (VAT). A VAT is a flat-rate tax applied to all businesses on a base of sales minus purchases from other businesses that is equivalent to a levy on household consumption. Slemrod, the Paul W. McCracken Collegiate Professor of Business economics and Public Policy, says that while a VAT can raise a lot of money, it comes with its own set of pluses and minuses. The U.S. Senate passed a resolution by a wide margin opposing a VAT. But while it looks like an uphill battle for now, the idea persists because it has some advantages.

Why are we talking about a value-added tax?

Slemrod: The reason people in the country, or at least in Washington, are talking about it is the long-term fiscal imbalance we face, which is enormous. The taxes in place relative to the spending commitments for Social Security and Medicare don't come close to covering the cost, and this fiscal imbalance can lead to a host of economic problems. Most people think that if we're going to close that gap, it'll include cutting back on entitlements some and raising taxes some. If we're going to raise taxes, one option is to collect more from the existing taxes, primarily the income tax. But the income tax is riddled with problems and is quite distortive. So there's another tax out there, the value-added tax. Most countries use it, more than 150 of them. Of the G-20 countries, only the United States and Saudi Arabia don't use it, and Saudi Arabia hardly needs tax revenue. It's been around for more than 50 years, and we know it's a proven revenue raiser. It could raise $50 billion per percentage point, which means a European-style VAT at a rate of 20 percent could raise about $1 trillion a year. We know some of the problems with it, too. So some think it should be considered as an add-on tax as part of a grand compromise to address the long-term fiscal imbalance.

So why is there so much opposition?

Slemrod: In the current political climate, it's political suicide to favor increasing taxes. To favor a whole new tax probably carries even more political baggage with it. I don't think a politician is going to come out for it except as part of a grand compromise where government spending is cut, entitlements are cut, and there's some tax increase. One way a VAT may appear on the political radar screen is if the commission Obama has created to look into the long-term deficit problem recommends a VAT as one part of a compromise solution.

What kind of an impact would a VAT have on businesses, and what are their responsibilities in such a system?

Slemrod: In terms of who pays the dollars to the IRS, all businesses, in principle have to remit. In that way it's different from a retail sales tax, which is just remitted by retailers on final sales to consumers, and different from an individual income tax where you personally file. As for its effects on businesses, the pure form of the value-added tax is much less distorting on business decisions than, say, a corporate income tax, and shouldn't change what investments are profitable: If an investment is profitable without the value-added tax, it should be profitable with it. In contrast, with an income tax there may be some marginal investments a business wouldn't want to make with one that it would make absent the tax. A value-added tax doesn't have that feature.

What kind of effect would it have on consumers and retail sales?

Slemrod: Just to give a concrete example, think of a 10-percent value-added tax. It would mean a 10-percent increase in all prices for goods and services. The impact on prices, and therefore on consumer purchases, wouldn't be much different than a 10-percent retail sales tax.

So the economic effects are the same, but the only difference is between who remits it, all businesses or retailers?

Slemrod: At first blush, that's true. But the difference in who remits the tax is a key difference. And it's why 150-plus countries have value-added taxes, and none have retail sales taxes over 10 percent. VAT has a key administrative advantage over a retail sales tax, one that might seem counterintuitive at first, because under a value-added tax all businesses have to remit, not just retailers. That makes it sound like a VAT would be more expensive and more complicated. But the Achilles' heel of the retail sales tax is that it's a tax on final sales from businesses to consumers only. It's not supposed to be on B-to-B sales. To implement that, a retailer has to distinguish whether the buyer is a business or a consumer. In Michigan, business purchasers make use of an exemption certificate, real or electronic, to exempt them from tax, and there's a lot of potential for abuse. If there's abuse now at average rates of about six percent, imagine what it would be at 10 percent or 20 percent. Lots of people would be tempted to turn into a business for tax purposes. Experience suggests that the implementation issues favor a value-added tax over a retail sales tax. But other than that, the economic consequences are very similar to a retail sales tax.

What kind of an effect would that have on economy that's still in recovery?

Slemrod: Well, I probably wouldn't want to enact a 10-percent value-added tax now, just because it might crimp aggregate demand during a fragile recovery. I don't think anybody is contemplating enacting a VAT this year or next year. Indeed, I'm not optimistic we're going to see it any time in the near future. But if we were to see it in the future, it would probably be implemented over a long period of time.

How is the value-added tax handled in other countries? Do they do it in place of an income tax or in addition to the income tax?

Slemrod: It depends. In Europe, where it originated 50 years or so ago, taxes comprise a significantly higher fraction of GDP than here (as do government programs such as free daycare). The tax take is more like 40 percent of GDP, compared to 30 percent here, and in Scandinavian countries it's close to 50 percent. These countries have a substantial value-added tax and an income tax at rates comparable to what we have here. Canada and Japan have relatively low-rate value-added taxes.

Is it a regressive tax? Slemrod: I think it is regressive, so that the burden of the tax, as a fraction of income, is somewhat higher for lower-income households. It's probably not as regressive as critics say. But I think on balance it's probably slightly regressive.

What would that mean in terms of political support?

Slemrod: The regressivity of a VAT is less of an issue for most conservatives, but they don't necessarily like it. They just dislike it less than a new, highly progressive tax. Whether Democrats can support it in view of the fact that it's slightly regressive isn't clear. Some favored having a value-added tax to pay for healthcare reform, which makes some sense because the benefits of the healthcare bill are skewed toward lower-income people, and so the tax would roughly offset the benefits. But it's too late for that now — we have the healthcare bill and other ways to finance it. So to get Democratic support for a value-added tax, you might have to offset its regressivity with increased low-income support, like an earned-income tax credit. Of course, that means you'd collect less revenue.

Why is a value-added tax being discussed as an alternative to increasing the income tax?

Slemrod: We could raise more revenue with the income tax; the question is whether we want to. What we probably couldn't do is what we've done this past year: raise more money almost exclusively from high-income people. There's just not enough money out there for that. Right now about 40 percent of federal income tax revenue comes from the top one percent of income earners. So there's a limit there. A grand compromise that cut entitlement spending and raised taxes would probably have to raise taxes from a broad swath of the population.

What would be more effective for addressing the fiscal imbalance?

Slemrod: The problem with the income tax we have is that it's pretty creaky with all the exemptions, preferences, and credits. It's distortive of economic activity. To increase the rates even higher just makes all of those distortions worse. Ideally one would fix the income tax and raise much of the money in a grand compromise from an improved income tax. If that's not possible, and if one had to choose between the current income tax and a value-added tax, I would be inclined to choose the value-added tax. One worrisome aspect of the current tax structure is that a lot of government programs are delivered through the tax system. And a lot of them would never pass if they were presented as stand-alone programs. That makes the tax system way more complicated than need be. I'd prefer a tax system that is a lot simpler than the one we've got now.

How difficult will it be to come to this grand compromise, a combination of benefit cuts and gradual tax increases?

Slemrod: There is precedent for cutting entitlements and adjusting taxes. In the 1980s the Greenspan Commission addressed the solvency of Social Security. It suggested a combination of payroll tax increases and benefit cuts that Congress enacted. Now I imagine the political will has deteriorated, but the Greenspan Commission shows there's a precedent for that sort of thing. Representative Paul Ryan, a conservative Republican congressman from Wisconsin, has a laid out a set of proposals called the Roadmap for America. It includes a radical re-shaping of our entitlement programs, which would save a lot of money, and a value-added tax at a rate of 8.5 percent, along with lowering the top income tax rate. It's clear the Republican establishment isn't listening to Paul Ryan right now, but his proposal is out there and is generating some buzz. But the recent resolution in the Senate condemning the VAT is a sobering reminder that crafting a grand compromise isn't going to be politically easy, with or without a value-added tax.

—Terry Kosdrosky



For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu