Considering a Value Added Tax

With huge structural deficits looming in the future, many observers feel that the current tax code will not be able to raise enough revenue to balance the budget, even with significant spending cuts. There have been talks of adding new taxes to make sure that revenues will match up with spending. Earlier in the week, we discussed the prospects of a financial transactions tax and an energy tax. Another highly-discussed idea is a value-added tax (VAT).

A VAT is similar to a retail sales tax, except that it is collected at each stage of production, as opposed to just from the retailer in the case of a sales tax. The tax is taken on the value added to a product at each stage of production. The result is that both producers and retailers pay the VAT, and the total tax collected is the same as it would be under a sales tax with the same tax rate. An advantage of a VAT is that even if a retailer fails to pay its portion of the tax, the rest of the tax owed can still be collected from the producers.  Additionally, proponents of the VAT argue that the tax would be much less complicated than the current individual income tax.

The VAT is already used in many European countries and Canada. However, introduction of the tax in the US has come under attack from both sides of the aisle. Liberals don’t like the tax because, like with any consumption tax, it tends to be regressive since lower-income people tend to spend a higher percentage of their income than upper income taxpayers. Current VAT systems address this concern by excluding basic necessities, such as groceries.  The VAT is attacked on the right in part because a consumption tax is less "salient" than an income tax; that is, people are less aware of how much they are paying in taxes.  If that is the case, they believe taxpayers would be less resistant to expansions of government.
Other concerns come from the level of simplicity of the tax. Critics dispute the claim that the VAT would be simpler than the income tax, noting that current VATs and U.S. sales tax systems have numerous rates and exemptions.  The Tax Policy Center highlighted a dispute in Britain over the classification of a certain type of cake that demonstrated this complexity. Additionally, Bruce Bartlett and Pete Davis have pointed out that instituting a VAT would entail large administrative costs and it would take at least a few years for the administration to be in place to collect taxes not only from retailers, but also the producers at each stage of production. 
However, once implemented, the VAT could make a big dent in budget deficits. TPC estimated that a broad-based VAT (including 80% of all consumption) would raise $260 billion in 2012 alone. Even a narrow VAT, carved full of exemptions and including only about half of all consumption, would raise $160 billion in 2012.  
An alternative to the VAT is a progressive consumption tax (PCT). The PCT would be an income tax that would pretty much function as a consumption tax. It would tax the difference between income earned and income saved, essentially “consumption.” The tax could be structured to be progressive like the current income tax is, with higher rates for higher income taxpayers. Also, since it is a tax on income, it would be more salient and transparent than a VAT. 
Given our record on spending cuts and the dire fiscal situation ahead, it is highly likely that we will need to raise more revenue to have a chance at stabilizing the debt.   Whether some type of consumption tax -- be it a value-added tax, a progressive consumption tax, or a simple retail tax -- is the right way to go will certainly be discussed in the years to come. There are good arguments on both sides. And like all other tax and spending options, it should certainly be included in the debate. 
For our other Tax Day posts, click here.