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On Saturday, Oct. 26, The Washington Post reported that the
Treasury Department is studying plans to impose a value-added tax (VAT) to
replace the corporate income tax and finance other tax reforms. This is a
dangerous road for the Bush administration to travel, both politically and
The idea of replacing the corporate income tax with a VAT is not
a new one. On a technical economic level, it has much to recommend it. The
corporate tax is a bad tax because it is a double tax on corporate profits
since dividends are also taxed. The result is a higher cost of capital that
lowers investment, productivity and wages. Most economists think it should
The problem is that the corporate tax raises a significant
amount of revenue. This year, it will bring in about $150 billion to the
Treasury, approximately 1.5 percent of the gross domestic product. It is
simply unrealistic, in a time of budget deficits, for the government to give
up this much revenue without replacing it somehow.
A VAT, sometimes called a business transfer tax, could easily
make up the revenue lost by abolishing the corporate income tax. On a broad
base, it might raise $50 billion per year for each percentage point. Thus, a
3 percent VAT could replace the corporate tax.
The VAT works like a sales tax. The difference is that it is not
imposed directly on consumers at the checkout, as state and local sales
taxes are, but rather on producers. The tax is built in to the prices of
goods and services.
One big advantage of the VAT is that it can be rebated on
exports at the border, according to world trade law. U.S. exporters have
complained for years that they are at a competitive disadvantage relative to
countries with VATs for this reason.
Another advantage of the VAT is that it does not fall on savings
or investment. Therefore, a switch from a corporate income tax to a VAT
would lead to a sharp drop in the cost of capital, which would raise
investment and productivity.
Against these advantages, however, are some very powerful
disadvantages with a VAT. To begin, it really wouldn't make much sense to
impose a VAT at just a 3 percent rate. The startup and compliance costs
would eat up a high percentage of the revenue. Therefore, the rate would
probably have to be at least 5 percent to justify the cost of imposing it.
A second problem is that a comprehensive VAT would be very
regressive. That is, it would take proportionally more out of the pockets of
the poor than out of the pockets of the rich. Although over one's lifetime,
the tax would be proportional to income, there is no question that under a
VAT the poor would pay more taxes than they do now.
In most countries, efforts to relieve the poor have involved
exemptions in the VAT. Usually, food and medical services are exempted, but
in different places, there can be a large number of other goods and services
exempted as well. The problem is that this erodes the tax base, requiring
higher rates to achieve the needed revenue, and it greatly increases the
complexity of the tax, thereby raising the compliance cost.
Now, we are up to probably a 10 percent rate for the VAT to
compensate for the compliance cost and exemptions for the poor. So, we
already see the biggest problem with a VAT -- its tendency to ratchet up.
When European countries first imposed VATs in the 1960s, they mostly had
rates around 10 percent. Today, the average rate is about 18 percent,
according to the Organisation for Economic Co-operation and Development.
It has proven too easy for governments to piggyback on inflation
and raise VAT rates as prices were rising anyway. People did not notice the
tax increases because they were hidden in the prices of goods and services.
Consequently, the VAT proved to be a massive money machine that fueled a
vast increase in taxation in every country that has adopted it.
The latest OECD report shows that the overall tax burden in
Europe has reached 42 percent of the gross domestic product, compared to 30
percent in the United States. By contrast, before the VAT came along, U.S.
and European tax burdens were comparable: 28 percent of GDP in Europe and 25
percent in the United States in 1965. Much of the tax growth came from the
VAT, which averaged 4 percent of GDP in Europe in 1965 and is twice that
In 1984, the Treasury Department published a comprehensive study
of the VAT that recommended against its adoption. The reasons laid out in
that report are still valid today. Adopting a VAT, however it is termed,
would put the United States on a slippery slope toward European levels of
taxation and government. The Bush administration will be making a terrible
mistake if it starts down that road.