The Case against the Value‐​Added Tax

Updated on May 23, 2022

TESTIMONY
In the words of Daniel J. Mitchell,

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Recent years have seen a dramatic growth in federal spending, which has resulted in significant budget deficits and rising public debt levels. However, this is only the beginning. To avoid even higher levels of government spending due to an ageing population, reforms must be implemented. Although tax receipts are likely to rise above historical levels, receipts are expected to rise at a rate far less than expenditures.

Debt and deficits have no set limit, but the experiences of Greece, Ireland, and Portugal show what might happen when investors believe a government has crossed a precipice and become unsustainable. To avoid a repeat of the financial crisis in the United States, policymakers will almost likely have to take action to stem the flow of red ink.

Even while rising spending is the primary cause of the long-term budget imbalance, legislators are almost certain to look for new sources of revenue, and a value-added tax is one of the most attractive. An all-encompassing tax, the VAT is now commonplace around the world. However, rather than being collected at the point of sale like with a traditional sales tax, this is actually a company tax. As a result, the tax is incorporated into the cost of the impacted goods or services and is essentially invisible to the public.

The VAT is attractive to politicians because it has the potential to raise significant sums of money. Nearly 70% of GDP, or $10 trillion, is spent on goods and services. As a result, even low tax rates would divert huge sums of money to the federal government, even if lawmakers included loopholes to reduce the tax base.

However, this is why a VAT is a bad idea. Too much government expenditure, rather than a lack of tax money, is to blame for the country’s financial woes. If a new tax were imposed, it would be like throwing gasoline on a blaze and guaranteeing that the United States would become an EU-style welfare state. To put it another way, as government grows, so go the costs of living.

VAT has the potential to worsen rather than improve the issue of excessive government borrowing. There is a VAT in every European country that has been bailed out, as well as countries that are on the verge of financial catastrophe. Indeed, the average level of debt in Western Europe is larger than that in the United States. The introduction of VATs in the 1960s was clearly ineffective in preventing politicians from overspending. As Milton Friedman famously stated, “In the long run government will spend whatever the tax system will raise, plus as much more as it can get away with,” the European experience seems to back up his prediction.

What is a VAT?

A VAT can be defined in a few different ways, but the quickest way is to ask a single question: Can businesses deduct labour costs? Wages cannot be deducted from VAT, which is why this is such an important attribute. In fact, a large portion of the VAT’s revenue comes from the withholding tax it levies on wages and salaries. Only a handful of tiny countries such as Monaco are exempt from this additional income tax on wages and salaries.

The VAT is referred to as a consumption tax by public finance economists. However, this word has to be explained further. Consumers do not foot the bill for a consumption tax (also known as a “consumption base”). Any revenue system that does not tax saved and invested money twice is known as a “zero-tax” system. As an example, the Social Security payroll tax does not apply to dividends, interest, or capital gains, making it a consumption-based tax. Like Dick Armey and Steve Forbes’ flat tax, which exempts dividends, interest, and capital gains from a second layer of taxation.

When it comes to taxing income, a consumption tax is a one-time levy. Flat taxation may allow that income to be taxed only once when it is earned. VAT and national retail sales taxes are two examples of taxes that only apply once, when the money is spent. When it comes to the current tax system, it uses the “Haig Simons” method of taxation that is frequently known as a “complete” tax system.

The Economics of a VAT

Occasionally, economists give the VAT a thumbs-up. This is not because the VAT promotes growth, but rather because it is a less disruptive means to raise revenue than a comprehensive income tax. An excellent justification for the VAT, but only if politicians were seriously considering abolishing the income tax altogether.

Saying VATs are less harmful than traditional income taxes is a terrible understatement, to say the least. It doesn’t imply that VATs have a beneficial effect on the economy. In fact, the elimination of the current tax code is entirely responsible for the economic advantages of implementing a VAT in place of the current income tax. An actual switch isn’t a possibility, unfortunately. To date, no government in the world has ever abolished and replaced an income tax with a value-added tax (VAT). Furthermore, no one in the United States who supports a VAT plans to do away with the federal income tax.

Adding a VAT on top of the current system is commonly referred to as a “add-on” VAT because there is no other realistic method to evaluate its economic impact. When applied to this scenario, the VAT has a clear negative impact on economic output and productivity. Pre-tax income and post-tax consumption are increasingly separated, reducing incentives for productive conduct. It’s a no-brainer that people will work less hard if they can’t enjoy the rewards of their labour.

To put it another way, consumption taxes may have a similar impact on labour supply as a proportionate income tax since they reduce the purchase power of real after-tax wages.

VATs are associated with bigger government

The best method to evaluate the impact of a VAT in the United States is to look at the experiences of other industrialised countries. Since the VAT was first imposed in Western Europe in the late 1960s and early 1970s, these countries are excellent case studies. That research implies that a VAT will lead to a larger government.

Compared to the United States, the weight of government spending in the “EU-15” countries is far greater.

This comparison is particularly telling because, in the mid-1960s, just before VATs were established, government spending in the EU-15 states was very similar to that in the United States. Even while government expenditure has risen dramatically under Bush and Obama, the contrast is less apparent than it was a decade ago since the US and Europe have both grown their burden more than the US.

The scholarly literature is divided on whether or not more expenditure is a result of the VAT, or if it works the other way around. Alternatively, do greater taxes engender higher spending or does increased spending in turn engender higher taxation?- That’s a good question, but it’s basically insignificant. It is a mistake for politicians to introduce a VAT (or raise the rate) so that they can spend more money in the future. In addition, it is accurate to say that politicians have spent more in the past, therefore justifying a VAT (or rate increase). Any way you look at it, the VAT is what allows for the extra expenditure.

Add-on VAT advocates frequently say their goal is to cut deficits and debt. A new tax may now be more politically acceptable because of this. However, a cursory look at the data reveals that European countries with VATs are significantly reliant on borrowed funds. Indeed, the sovereign debt crisis in Greece, Ireland, and other European countries is the result of excessive deficits and debt.

Deficits in Europe today are greater than they were before to the introduction of VAT. One-year snapshots of red ink can be misleading because most countries now are experiencing exceptionally high amounts of government borrowing due to a sluggish global economy.

Since compounded budgetary balances represent both good and bad years, government debt numbers are more accurate. For VAT advocates, this method is even more devastating. Government debt in EU-15 countries has risen significantly since VATs were introduced.

This graph indicates that the average amount of debt in EU-15 VAT countries is higher than in the US. Given that the United States has just completed a decade of record deficits, these data are of particular importance. VAT countries in Western Europe, despite all the additional red ink created by the Bush-Obama spending binge, nevertheless have greater debt levels.

According to others, this suggests that VATs contribute to bigger deficits. It’s possible, but proving or disproving such a hypothesis is tough. It’s also conceivable that VATs have no effect on a company’s bottom line. According to this theory, political and cultural tolerances for red ink influence the willingness of countries to adopt debt-financed spending. As a general rule, countries in southern Europe have higher levels of deficits and debt than those in the Nordic countries. Both previously and now that all countries have introduced a VAT, this has held true.

Therefore, a VAT’s real effect is to offer governments the ability to fund additional spending, while yet preserving whatever level of deficits are allowed by national conditions.

The VAT is associated with higher tax burdens.

Many proponents argue that a VAT is a tax reform, not an increase in taxes. Theoretically, this is possible, but there is no evidence to support it in the real world. No governmental jurisdiction on the earth has ever implemented a VAT and abolished income taxes. In the past, it has always been a “add-on” fee.

This is why VATs tend to result in greater total tax loads. The EU-15 countries are shown in the graph. In Europe before the introduction of the VAT, tax burdens were less than 30% of GDP. Taxes now account for roughly 40% of GDP.

Non-VAT countries have also seen an increase in taxes, but not nearly as much as in VAT countries. Tax authorities’ share of output in the United States and the EU-15 countries is also shown in a graph. Western European countries had slightly higher taxes on average than the United States in 1965, according to the chart on the page. This disparity expanded considerably when VAT was enacted.

Perhaps Europe’s tax burden would’ve risen at the same rate without the introduction of VATs. Even still, it’s hard to imagine how this might have occurred Taxes at the “revenue maximising” level may be already high, and raising them could backfire because of lower taxable income. Payroll taxes, as well as taxes on alcohol, cigarettes, and other intoxicants, are all quite high.

Politicians have shown in recent years that they perceive the VAT as a simple levy to raise. Since 2008, the average VAT rate has increased dramatically, according to a recent European Commission analysis. US lawmakers, on the other hand, have every reason to believe that the VAT is a money-making juggernaut that would allow them to avoid much-needed government budget cuts.

Income and earnings are taxed more heavily under the VAT. However, proponents of a VAT maintain that part of the additional revenue is utilised to decrease personal and/or business income taxes. This is unquestionably a possible outcome. Sadly, this has not been the case throughout Europe. Since the VAT was adopted, the tax burden on income and earnings has increased.

Businesses are being enticed to support the VAT by the prospect of lower corporate tax rates. Corporate tax rates in the EU-15 have risen since VAT was implemented, based on available statistics.

If you look at the “Laffer Curve” reaction to better tax policy, part of the additional corporate tax income may be due to lower tax rates. The reduced tax rates, on the other hand, are the outcome of tax competition that began in the 1980s, whereas VATs were imposed in the early 1960s.

The VAT is not good for trade

Some argue that a “border-adjusted” VAT is a positive thing because it encourages trade. As a result, imports are subject to VAT, whereas exports are exempt (all previous VAT payments are rebated when products are sold to foreigners). This is considered as a favourable quality by mercantilists concerned about trade imbalances. Even more worrisome is the fact that they have no idea how VATs function.

Protectionism appears to believe that VATs and tariffs are the same thing. Imports are subject to VAT, however this does not apply only to domestically manufactured items; imports are subject to VAT as well.

However, under present law, neither German-produced goods nor American-produced goods sold in the United States are subject to VAT. American-produced items sold in Germany are subject to a VAT, much like German-produced goods sold in the United States. The playing field is level. OECD statistics shows that per capita living standards in Germany are only approximately two-thirds as high as those in the United States because German politicians take a larger portion of citizens’ incomes.

What will happen if the United States implements a VAT? In Germany, nothing has changed. Both American and German products sold in Germany are subject to taxation by the German government. Imports and exports are unlikely to change as a result of a VAT, at least not in Germany. United States has the same problem. Imports, especially those from Germany, are now subject to a tax. However, there is a similar tax on domestically produced goods. Protectionists will be upset, too, because the playing field is still level. Politicians in Washington, on the other hand, will be overjoyed because every time a product is sold, they get more money.

Some people, despite this reasoning, insist that a VAT is excellent for trade and competition since the rebate ensures that the price of American exports does not include a tax because of the rebate. It is true that the corporate income tax has a negative impact on competitiveness and makes the United States a less-attractive site for the production of products and services. This is not a case for a VAT, but rather for a reduction or elimination of the corporate income tax.

The VAT is anti‐​saving, not pro‐​saving

Value-added tax supporters frequently suggest that the charge would encourage people to save more money. Because VAT is a tax on consumption, the adoption of such a tax will make saving more attractive, according to this view. But this simple analysis overlooks the fact that saving is simply deferred consumption. It is simply deferred until the product is consumed before taxation will be applied. There is no avoiding the tax.

People who save usually obtain some type of return (such as interest, dividends, or capital gains) (such as interest, dividends, or capital gains). This means they will be able to enjoy more consumption in the future. But that does not change the calculation. The accompanying figure compares a consumption‐​base tax system (on the left side) and a comprehensive‐​type tax regime such as the current internal revenue code (on the right side) (on the right side). In any situation, the application of a VAT does not alter incentives to consume today or consume in the future.

To be sure, incentives to save would be strengthened if all of the double taxation on the right side was repealed. But that’s because anti‐​savings rules built in the current tax structure will e eliminated. Imposing a VAT would have no impact. Simply stated, the VAT is not pro‐​saving.

But this is not the end of the narrative. A VAT, like an income tax or payroll tax, produces a wedge between pre‐​tax income and post‐​tax income. This means, of course, that a VAT also causes a wedge between pre‐​tax income and post‐​tax spending — and this is true for current consumption and future consumption. This tax wedge means less motivation to earn income, and if there is less total income, this affects both total saving and total spending.

Honest VAT proponents typically agree that the levy will not enhance the savings rate or the total level of savings, but they warn that other future tax hikes will have a considerably worse impact on incentives to save. This is true, at least if the other tax options are higher income tax rates, greater corporate taxes, higher capital gains taxes, and other options that will worsen the double taxation in the current tax structure. But this is hardly a justification for a VAT. It’s an argument against raising other taxes.

Conclusion

A value-added tax would be an expensive blunder for both consumers and workers in the United States of America. The VAT would be an appealing proposition for politicians anxious to raise funds for new programmes if it was implemented. Because politicians might gradually raise the VAT to pay for promised benefits, entitlement reform would be undermined by the VAT.

There is a strong likelihood that the tax rate would rise to pay for an increase in federal spending. Economic stagnation, increased deficits, and fewer jobs for Americans are all likely outcomes. There are some theoretical advantages to the value-added tax, but in practise, it would just add to the burden of an already overtaxed economy.