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Samuelson: What's Up with VAT?

Robert Samuelson is one of the best economics/business writers around.  In today's column he takes on the reality behind the value added tax (VAT) rhetoric.

The implicit, though often unstated, message is that a VAT could raise so much money it could eliminate future deficits by itself. This reasoning, if embraced, would create staggering tax burdens and exempt us from a debate we desperately need.

How big a government do we want -- and what can we afford? In closing deficits, what's the best mix between tax increases and spending cuts? What programs are outmoded, ineffective or unneeded? How much should we tax the young and middle-aged to support the elderly? Should wealthier retirees receive skimpier benefits? Should eligibility ages for benefits be raised?

The basic budget problem is simple. For decades, the expansion of Social Security, Medicare and Medicaid -- programs mostly for the elderly -- was financed mainly by shrinking defense spending. In 1970, defense accounted for 42 percent of the federal budget; Social Security, Medicare and Medicaid were 20 percent. By 2008, the shares were reversed: defense, 21 percent; the big retirement programs, 43 percent. But defense stopped falling after Sept. 11, 2001, while aging baby boomers and uncontrolled health costs keep retirement spending rising.

Left alone, government would grow larger... In 2020, the deficit (assuming a healthy economy with 5 percent unemployment) would be 5.6 percent of GDP. To cover that, taxes would have to rise almost 30 percent.

A VAT could not painlessly fill this void. Applied to all consumption spending -- about 70 percent of GDP -- the required VAT rate would equal about 8 percent. But the actual increase might be closer to 16 percent because there would be huge pressures to exempt groceries, rent and housing, health care, education and charitable groups. Together, they account for nearly half of $10 trillion of consumer spending... 

Does anyone believe that Americans wouldn't notice 16 percent price increases for cars, televisions, airfares, gasoline -- and much more -- even if phased in? As for a VAT's claimed benefits (simplicity, promotion of investment), these depend mainly on a VAT replacing the present complex income tax that discriminates against investment. That's unlikely because it would require implausibly steep VAT rates. Chances are we'd pay both the income tax and the VAT, making the overall tax system more complicated.

Europe's widespread VATs aren't models of simplicity. Among the European Union's 27 members, the basic rate varies from 15 percent (Cyprus, Luxembourg) to 25 percent (Denmark, Hungary and Sweden). But there are many preferential rates and exemptions. In Ireland, food is taxed at three rates (zero, 4.8 percent and 13.5 percent). In the Netherlands, hotels are taxed at 6 percent. An American VAT would stimulate ferocious lobbying for favorable treatment...

A VAT is no panacea; deficit reduction can't be painless. We'll need both spending cuts and tax increases... [W]what's wrong with the simplistic VAT advocacy is that it deemphasizes spending cuts. The consequences would be unnecessarily high taxes that would weaken the economy and discriminate against the young. It would become harder for families to raise children. VAT enthusiasts need to answer two questions: What government spending would you cut? And how high would your VAT rates go?




Disclosure: Fully invested in the American economy, with a little Canadian mining mixed in to keep things dirty.