March 8, 2005
Considering The VAT
By Bruce Bartlett

Federal Reserve Chairman Alan Greenspan's comments last week before the tax reform commission regarding the desirability of a consumption-based tax system are fueling new interest in the value-added tax (VAT), a type of consumption tax used in virtually every major country except the United States. House Ways and Means Committee Chairman Bill Thomas has also hinted that the time may have come for serious debate on this topic.

The VAT was invented in Europe mainly to facilitate trade. It needed a tax that could be applied at the border on imports and rebated at the border on exports. This was necessary to prevent taxes from being levied on top of taxes every time a good passed through a country. The VAT solved this problem by being applied incrementally at each stage of production or distribution, with an invoice trail showing precisely how much tax was embedded in the prices of all goods.

Economists have always liked the VAT because it is a highly efficient tax. That is, it discourages less output per dollar of tax than any other major tax in existence. Some taxes are estimated to discourage $1 of output for every $1 raised. Overall, the U.S. tax system has what economists call a "deadweight cost" of about 20 cents per tax dollar, meaning that every tax dollar costs the economy $1.20. The VAT, however, has a deadweight cost of just a few cents per dollar.

Economic theory tells us that the more efficient a tax system is, the more revenue it will raise. Thus, many people have fought introduction of a VAT here on the grounds that it would be a "money machine" that would fuel the growth of government. The Wall Street Journal routinely rails against the VAT on these grounds. As President Reagan put it in a Feb 21, 1985, press conference, "A value-added tax actually gives a government a chance to blindfold the people and grow in stature and size."

While there is no question that most countries with VATs are high-tax countries, the fact is that almost all were high-tax countries before they adopted the VAT. And while it is true that most countries have raised their VAT rates over time, it is important to distinguish among those countries. In general, those countries where the money machine argument is most valid are those that instituted a VAT before the great inflation of the 1970s, which disguised VAT increases from public view.

By contrast, countries that have adopted VATs since inflation subsided have been much more restrained in raising their VATs. And those that have adopted VATs during the era of relative price stability that we have enjoyed for the last 20 years show no money machine evidence at all. Indeed, some of them are even starting to cut their VAT rates. Slovakia and the Czech Republic have both recently cut their VATs from 23 percent to 19 percent.

Looking at the data, we see that the average increase in VAT rates for countries where the tax was established before 1974 is 7 percentage points and the median is 6.5 percent. For those where the VAT was established later, the average is just 1 percent and the median is zero.

Furthermore, not all countries introducing VATs have seen their overall tax burden rise. Taxes as a share of the gross domestic product have fallen from 29.8 percent in Japan the year its VAT was introduced to a current level of 25.8 percent. In Canada, the tax-GDP ratio fell from 36.4 percent to 33.9 percent. Other countries where the ratio has fallen since the VAT was introduced include Australia, the Czech Republic, Finland, Ireland and Poland.

Serious academic studies have concluded that the VAT cannot be blamed for raising the overall burden of taxation even in countries where it was a new tax and not a replacement for some existing tax. Writing in the prestigious National Tax Journal in December 1985, economist J.A. Stockfisch found no support for the view that VATs raise either the tax level or government spending.

A 1990 study for the American Petroleum Institute by Diana Fuchtgott-Roth, now chief economist for the U.S. Department of Labor, came to the same conclusion: "VAT rates and revenues have increased in OECD countries with VATs. However, these increases have been offset by a slower growth of other forms of taxes, leaving the aggregate growth rate of taxes the same."

The VAT may or may not be a good idea for the United States. But it should not be casually dismissed as a money machine without serious analysis of the trade-offs. It may turn out to be the least bad way of financing needed tax reforms and the massive growth of federal health care spending that neither the White House nor Congress shows any interest in restraining.

Copyright 2005 Creators Syndicate

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