Would a Value Added Tax Help Reduce the Deficit?

Politicians have been advocating a value added tax (VAT) for decades, and with the huge projected federal deficits interest in a VAT seems to be increasing lately. Last Spring Paul Volker was suggesting one, and David Theroux recently noted in his blog Paul Krugman’s support. Alice Rivlin and Pete Domenici suggest a 6.5% “debt reduction sales tax,” probably phrased that way to avoid saying “value added tax.”

I wrote a study on the VAT for the Mercatus Center this year, which can be found here, and have been to Washington twice in the past few months to give talks to congressional staffers in the VAT, based on my Mercatus paper. My Mercatus paper on the VAT was even referenced in Glenn Beck’s new book, Broke, so the VAT issue appears to be on the radar of lots of people these days.

Will a VAT help reduce the deficit? The evidence seems to lean the other way.

Greece, Portugal, Spain, Ireland, the UK, and France all have substantial VATs, and those countries also have serious deficit problems that have made the news in the past year. So, on the surface, it appears that adopting a tax structure like those countries is not the answer to solving the deficit problem. Look a little deeper, and the reason becomes more apparent.

There is no doubt that the initial effect of a VAT would be to inject major amounts of money into the Treasury. The VAT is known as a revenue machine. Over the longer run, the VAT does not add appreciably to revenues, however.

One reason is that the VAT is a very complex tax. In theory it has the same effects as a sales tax, but in practice the record-keeping required imposes huge compliance costs on taxpayers, and adds substantial administrative costs on government. These costs are a drag on the economy, and reduce income and economic growth. My Mercatus paper gives the details of my reasoning here.

Once imposed, VAT rates tend to rise. I only know of one country (Canada) that has reduced its VAT rate from its initial level; meanwhile, there have been huge increases in country after country. Denmark initially imposed a 9% VAT; it now has a 25% rate. The UK started out at 8% and now taxes 17.5%. Germany started at 10% and now charges 19%. In fact, the EU now requires its members to charge a minimum 15% VAT rate, which while lower than the rates in the EU countries I listed, is higher than all of their initial rates.

Once the VAT foot is in the door, you can be sure VAT rates will rise. That 6.5% rate Rivlin and Domenici propose is just the “special introductory rate.” You can be confident that if the tax were introduced, it would eventually reach European levels.

The burden a VAT would place on the economy would slow economic growth. I did some “back of the envelope” projections in my Mercatus study—as projections of a US VAT have to be, because we don’t know exactly what one would be like—and figure that once a VAT has been in place 20 years, it would raise almost no additional revenue to fund government expenditures.

The reason for this is that while the VAT itself would raise additional revenues, the slower economic growth it would bring with it would reduce revenues from other tax bases. Federal income tax collections would be lower because of slower income growth, and state tax revenues would be especially hard-hit because a VAT would tax the same tax base the state sales tax already taxes.

So, to calculate the net addition a VAT would make to revenues, we need to count the VAT revenue, but subtract out the reductions in other taxes at the federal, state and local level to get the amount the VAT would contribute to revenue on net. By my calculation, after 20 years that would be almost nothing.

Is it reasonable to think that a VAT would slow economic growth? From 1999-2004 the US had an average annual 3% rate of economic growth, while the Euro Zone countries grew at 2.1%. In 2009, US GDP contracted by 2.4%, while the contraction was 4% in the Euro Zone, where all countries have a VAT. No, this isn’t proof of anything, but it is some evidence consistent with the idea that if the US were to adopt a VAT and have a tax structure more like the EU, we might also run the risk of having slower economic growth rates like the EU.

And, back to the VAT, if adopting one slowed our economic growth to EU rates, then projecting out 20 years any additional revenues the VAT brought in would be offset by reduced revenues from other tax bases, so the VAT wouldn’t reduce the deficit at all. However, by slowing GDP growth, it would make government spending as a share of GDP rise.

A VAT is not a good option for the US, and adopting one would not reduce the deficit.