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.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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