The Case against the Value‐​Added Tax

Updated on June 26, 2022

In recent years, federal spending has risen rapidly, resulting in large budget deficits and a mounting public debt.

Even so, it’s only the beginning. The federal government’s budget will balloon if current entitlement programs and an aging population are not curtailed. Even if tax revenue rises above its historical average, the increase in collections will be much less than the increase in expenditures.

It is impossible to predict how a government will be able to pay back its obligations, but the precedents of Greece, Ireland, and Portugal show what could happen if investors perceive that the government has reached the abyss and is no longer sustainable. A comparable catastrophe will almost certainly be imposed onto American policymakers if they do not want to see it happen again.

Although the long-term budget deficit is due to rising spending, value-added tax is one of the most appealing solutions for lawmakers. Every country on Earth is now subject to the VAT. Like traditional sales taxes, this one is charged on businesses directly rather than being collected at the moment of sale. People aren’t aware that they’re paying taxes on these goods and services because they don’t think about it.

Legislators find the VAT attractive because it can raise a significant amount of revenue. Every year, the United States spends 70% of its GDP. As a result, even if lawmakers included tax loopholes that reduced the revenue base, the federal government would still get a sizable amount of money.

But this is the main reason why a VAT is a bad policy. The country’s financial problems aren’t caused by a dearth of tax revenue; rather, they are the result of excessive government spending. Adding a new tax, especially one that might produce so much money, would be like throwing fuel on a roaring fire, increasing the likelihood that the United States would become a welfare state like Europe. Larger government has a detrimental effect on the general well-being of the population.

In theory, a value-added tax (VAT) could assist to reduce the problem of excessive government borrowing, but in practice it could make things worse. All of Europe’s bailed-out nations and those on the verge of financial disaster have implemented VATs. There is a larger average debt burden in Western Europe compared to the United States. Politicians’ lavish spending was mostly unabated by taxes, which were first implemented in the 1960s. According to Milton Friedman, “in the long run, the government will spend whatever the tax system raises, plus as much more as it can get away with.” The European experience seems to reflect this forecast.

What is a VAT?

Is it legal for corporations to deduct the cost of their employees’ wages from their taxes? To put it another way, that’s how you define value-added tax (VAT). Because it is unable to deduct the VAT from earnings, having this feature is essential. The VAT’s withholding tax on wages and salaries accounts for a significant portion of its revenue. In Monaco, the additional income tax on wages and salaries is exempt.

The VAT is viewed as a consumption tax by public finance academics. This word, on the other hand, needs to be further explained. It is not the responsibility of ordinary taxpayers to pay a consumption tax (also known as a “consumption base”). Savings and investments are exempt from double taxation in “zero-tax” systems. The Social Security payroll tax is not considered a consumption tax because it does not apply to dividends, interest, or capital gains. Former House Majority Leader Dick Armey and Steve Forbes advocate a flat tax because it exempts dividends, interest, and capital gains from double taxation.

“Consumption tax” is a word that refers to a single tax on all earnings. A flat taxation system could make it possible to just tax that revenue once. VAT or the national retail sales tax, for example, can only be assessed once, when the money is spent. The “Haig Simons” strategy, commonly referred to as a “full” tax base, alters the current tax structure.

The Economics of a VAT

Occasionally, economists give the VAT a thumbs-up. That’s not because it’s pro-growth; rather, it’s because the VAT is a less disruptive manner of obtaining revenue than a full income tax. An excellent justification for the VAT, but only if politicians were seriously considering abolishing the income tax altogether.

It’s also dishonest to suggest that VATs aren’t as harmful as the regular income tax. It doesn’t imply that VATs have a beneficial effect on the economy. To put it another way, the economic benefits of replacing the income tax with a VAT are entirely related to eliminating the current Internal Revenue Code. Unfortunately, such a transfer is not feasible in the actual world. A value-added tax (VAT) has never replaced an income tax in any jurisdiction in the world. Furthermore, no one in the United States who supports a VAT plans to do away with the federal income tax.

As a result, analyzing the economic impact of a VAT is only possible if it is applied as a “add-on” fee on top of the current system. In this case, the VAT is clearly detrimental to economic growth. Pre-tax income and post-tax consumption are increasingly separated, reducing incentives for productive conduct. To put it simply, people are less motivated to work hard if they don’t get to appreciate their hard work.

According to the OECD, “Consumption taxes may constrain labor supply in much the same way as a proportionate income tax,” because they diminish the purchasing power of actual after-tax salaries.

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 industrialized countries. Since the VAT was first imposed in Western Europe in the late 1960s and early 1970s, these countries are excellent case studies. Unfortunately, the evidence suggests that a VAT will lead to increased government.

According to the chart, “EU-15” countries bear a much heavier weight of government spending than the United States.

Government spending in EU-15 countries was comparable to the United States’ early 1960s spending levels before VATs were established, making this comparison particularly insightful. Europe’s weight of government spending has increased more than that of the United States, although the disparity is less stark than it was 10 years ago because of the rise in government spending in the Bush-Obama era.

The scholarly literature is divided on whether or not more expenditure is a result of the VAT or if it is the reverse. Does expenditure increase as a result of higher tax rates? Alternatively, does spending increase because of higher tax rates? Intriguing, but not particularly relevant. Politicians that propose a VAT (or raise the rate) in order to enhance government spending are being irresponsible. In addition, it is accurate to say that politicians have spent more in the past, therefore justifying the implementation of a VAT (or an increase in rate). In either situation, the VAT enables the additional spending.

Many supporters of an additional VAT assert that the purpose is to reduce deficits and debt. A new tax may now be more politically acceptable because of this. However, a cursory check at the data shows that European countries with VATs are significantly reliant on debt. Deficits and debt have gotten out of hand, and that is the only reason why countries like Greece, Ireland, and others in Europe are in such a state of default.

Deficits in Europe are now far greater than they were before to the 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. This method, on the other hand, is considerably more devastating for proponents of VAT. The average national government debt in the EU-15 is now significantly larger than it was before to the implementation of VATs.

This graph indicates that the average amount of debt in EU-15 VAT countries is higher than in the US. These figures are all the more noteworthy in light of the fact that the United States has just completed a decade of record deficits. VAT countries in Western Europe still have greater levels of debt, despite all the additional red ink created by Bush’s and Obama’s spending binges.

According to others, this suggests that VATs contribute more to the deficit. It’s possible, but it’s hard to verify or refute something like that. Alternatively, it is possible that VATs have no effect on red ink at all. As a result of political and cultural differences, countries’ inclination to incur debt-financed expenditures differs. Southern European countries, for example, nearly invariably have bigger deficits and debt levels than Nordic countries. Before the VAT was imposed, this was true, and it is true now that all countries have implemented the VAT.

Therefore, a VAT’s real effect is to offer governments the ability to fund more spending, while yet preserving whatever level of deficits are allowed by national circumstances ranging around the world

The VAT is associated with higher tax burdens.

It is common for VAT proponents to argue that it is more of a tax reform than a tax hike. Although this is a theoretical possibility, there is no evidence to support it in the real world. A VAT and an income tax have never been implemented in any political jurisdiction on the planet. It’s been a “add-on” tax since the beginning.

This explains why VATs tend to result in higher total tax loads for taxpayers. The graph depicts what transpired in the EU-15 member states. In Europe before the introduction of the VAT, tax burdens were less than 30% of GDP. Nearly 40% of GDP is accounted for by tax burdens today.

Taxes have risen in non-VAT countries as well, but the growth has been less dramatic. An additional comparison is included in this figure, which shows the rise in the percentage of output that is taken by tax officials in the US and EU-15 countries. According to the graph on this page, Western European countries had somewhat higher taxes than the United States in 1965. In practice, however, the disparity widened considerably after the introduction of the VAT.

However, it’s possible that if the VAT hadn’t been implemented, Europe’s overall tax burden would have increased at the same rate. In spite of this, it’s impossible to comprehend how this could have happened Due to a decrease in taxable income, raising taxes at the “revenue maximizing” level may have the opposite effect. Payroll taxes are also substantial, as are levies on energy, alcohol, and smokes consumption.

Politicians, without a doubt, view the VAT as a simple means of raising cash. European Commission research shows that the average VAT rate has risen substantially since 2008. To avoid having to tighten the federal government’s belt, legislators in the United States may consider the VAT as a method to do so.

The VAT is linked to greater income and profit tax burdens. Proponents of a VAT recognize that it increases overall taxation, but they claim that part of the increased revenue is used to support lower personal and business income taxes. They sometimes admit that this is true. This is definitely a possible outcome. In Europe, however, this has not been the case. Since the VAT was adopted, the tax burden on income and earnings has increased, as can be seen in the graph.

The possibility of lower corporation tax rates persuades businesses to accept the VAT. VAT implementation has led to an increase in corporate tax rates across the EU-15, according to available data.

Even if corporate tax rates have decreased in recent decades, it’s probable that some of the additional corporate tax income is the result of better tax policy. When compared to VATs, which were first imposed in the 1960s, lower tax rates can be traced back to tax competition that began around 1980.

The VAT is not good for trade

“Border adjustment” of a VAT, according to them, is a benefit to a business. In contrast to exports, which are not subject to VAT, imports are (all previous VAT payments are rebated when products are sold to foreigners). Mercantilists concerned about trade imbalances are pleased by these developments. That’s not the worst of it; they have no idea how VATs work.

Taxes and tariffs are equivalent in the minds of protectionists. Domestically manufactured goods are not taxed at a lower rate because the VAT applies to both locally and globally produced goods.

Goods made in the United States or Germany but sold in the United States are not subject to VAT at this time. Goods made in the United States and sold in Germany are both liable to VAT, regardless of where they were made or sold. It’s a level playing field for all. According to the Organization for Economic Co-operation and Development (OECD), German politicians take a bigger share of the country’s wealth than those in the United States.

What would happen if the United States enacted a value-added tax, for instance? (VAT). In Germany, nothing has changed at all. Products created in the United States, like those made in Germany, are subject to taxation by the federal government in the United States. Imports and exports will be unaffected by the German VAT. In the United States, a similar saga is currently taking place. There is now a new tax on imports, particularly those from Germany. However, products manufactured outside of the United States are not subject to this tax. Because the playing field stays level, protectionists will be upset as well. With each sale of a product, politicians in Washington will be happy because of the additional income they will earn.

However, the rebate provided by VATs is said to benefit business and competitiveness because it prevents taxes from being included in the price of American goods. Because of high corporate tax rates, the United States is less attractive as a location for manufacturing and delivering services because of the high expenses. For the purpose of argument, the corporate income tax should be reduced or eliminated.

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

Proponents of a higher value-added tax typically claim that the fee will motivate individuals to save more money. People will save more money as a result of the argument that VAT is a tax on consumption. The problem with this basic view is that it overlooks the simple fact that saving is merely deferring consumption. Taxes are not collected until the product is actually used by the user. You can’t get away with avoiding paying the tax.

Savers typically see some type of reward for their efforts (such as interest, dividends, or capital gains). They will be able to consume more in the future as a result of this. Nonetheless, this does not alter the formula. An consumption-based tax system (on the left) is compared to a comprehensive tax system (like the existing Internal Revenue Code) in the graph above (on the right side). In either situation, the introduction of a VAT has no effect on the incentives to consume now or in the future.

To be sure, if all of the right-side double taxation was repealed, savings incentives would be strengthened. Because the current tax system has anti-savings rules that would be abolished under a new plan. It would have no effect if a VAT were implemented. In a nutshell, the VAT is not a savings incentive.

This isn’t all there is to it, however. As with an income tax or payroll tax, a VAT separates pre-tax and post-tax earnings. When it comes to current and future consumption, a VAT creates a gap between the pre-tax income and the post-tax consumption. With less incentive to earn money, there is less money to save and spend, resulting in a reduction in total savings and consumption.

They claim that other possible tax rises will have an even greater impact on saving incentives than VAT, which they admit will not improve the saving rate or the total amount of saves. It’s true that the other possibilities include greater income taxes, higher corporation taxes and other measures that will worsen the current tax code’s double taxing, such as raising capital gains tax rates. This, however, is not a justification for a VAT. A counter-argument to tax increases in general.

Conclusion

Consumers and employees in the United States would pay a high price if a value-added tax were implemented. Politicians anxious to raise funds for new projects would find the VAT tempting once it was implemented. Politicians might gradually raise the VAT to support promised benefits, which would undermine any effort to reform entitlements.

There is no doubt that the tax rate will rise, allowing the federal government to fund a surge in new spending. The stagnant economy, bigger budget deficits, and fewer jobs for American workers would be the effect of such a policy. However appealing the value-added tax may sound in theory compared to income and production taxes, its implementation would be a burden on an already heavily taxed economy.