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Value Added Tax: Will it solve our budget woes?

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(Read caption) Leanna Collins calls to supporters as they drive past a Tea Party demonstration in Davenport, IA, Thursday April 15. Demonstrators were protesting the proposed Value Added Tax, among other things. Many conservatives loathe the proposed tax - as do many liberals.

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Lots of chatter in Washington about a Value Added Tax. Paul Volcker, the former Fed chairman and gray eminence of the Obama economic team, was talking up the idea the other day. The Congressional Budget Office is looking at the implications of a consumption tax. And Representative Paul Ryan (R-WI) has included one as part of his fiscal Roadmap.

Deficit hawks see a VAT as a valuable source of new revenue. Economists appreciate that it taxes consumption rather than saving, and thus may help cool the American penchant for spending far too much and saving much too little (recessions aside). And some businesses like that a VAT could be a way to lower our uncompetitive corporate tax rate.

That’s not to say a VAT is hugely popular. Many conservatives, Ryan excepted, loathe it. And it has few friends on the left. Back in his academic days, Obama economic adviser Larry Summers joked that a VAT was opposed by conservatives who saw it as a money machine and opposed by liberals who feared it was regressive. It will win broad support, Larry predicted, once liberals realize it is a money machine and conservatives recognize it is regressive.

A new paper by my Tax Policy Center colleagues Eric Toder and Joe Rosenberg does a nice job of clarifying many of the issues surrounding the VAT. They make several key points:

*A VAT could generate a bundle of revenue. A broad-based 5 percent VAT that covered about 80 percent of goods and services would raise about $260 billion in new taxes in 2012.

*The U.S. is the only developed country in the world without some form of national broad-based consumption tax, such as a VAT.

*A VAT would raise taxes roughly equally across-the-board—with one exception. The tax is a boon to high-income taxpayers, who make much of their money from VAT-free savings and investments. On average, the 5 percent VAT would reduce after-tax income by about 2.7 percent. The lowest earners would face an income loss of 2.8 percent while middle- and upper-middle class taxpayers would lose about 2.9 percent. But the highest earning 1 percent would see their after-tax incomes fall by only 2.1 percent.

How to offset this extra burden on those with low incomes? What may be the most politically popular solution—exempting housing, food, and medical care from the VAT—would make the tax somewhat more progressive, but add a lot of complexity and inefficiency to the system in the process. A better solution would combine a broad-based VAT with a refundable tax credit. Combining the VAT with the credit would cut taxes for those at the bottom, and increase them for the middle-class, who would face a drop in after-tax income of between 1.5 percent and 2 percent. The rich would see their after-tax income fall by about 2.3 percent, while the very rich would face a decline of about 2 percent.

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What if a VAT were used instead to reduce the corporate income tax? Ryan, for instance, would use his to eliminate this levy entirely. Eric and Joe figure revenues from a 5 percent VAT could reduce the corporate rate from 35 percent to 7.4 percent. That would be a big benefit to U.S. companies, and a huge windfall for the wealthy—raising their after-tax income by almost 7 percent-- while boosting taxes for nearly everyone else.

That’s political death. But what if revenues from a broad-based VAT were used to buy down both corporate and payroll taxes? In that case, the corporate rate could be cut to a very competitive 20 percent and the employer contribution to the Social Security payroll tax slashed from 6.2 percent to 3.5 percent.

Of course, we have a huge fiscal problem, so we probably should use a substantial share of revenues from a VAT to reduce the deficit, rather than just to cut other taxes. Still, Eric and Joe’s paper provides a good sense of the relative gains and losses of a VAT for different taxpayers as policymakers think about what to do with its substantial revenues.

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