What's a VAT tax?
VAT stands for Value-Added-Tax. Most European countries have had VATs for decades, and rely heavily on them to finance government expenditures, including national health care. Canada, Mexico, and India also have VATs.
Basically, a VAT is their national sales tax, and the VAT rates in Europe are stiff compared to American sales tax rates. In fact, all European Union countries are required to have a minimum VAT of at least 15% and quite a few countries have VATs up to 25%. Canada's VAT is a more modest 10%.
With such high rates, you'd expect that tax evasion would be a significant problem, but it's not quite as bad as you would think. That's because a VAT has a self-enforcing element. Each business pays VAT only on the value it actually adds in the production process, which effectively means that it gets to deduct the VAT already paid by businesses higher in the pipeline.
So, for example, if you run a Canadian store that sells TVs and you buy inventory for your store that costs $300 a TV and then turn around and sell the TV for $400, you would demand a receipt from your supplier with evidence from the government showing that the 10% tax has already been paid on the $300 wholesale cost of the TV, so you will only owe tax on the $100 of value you are adding at the retail level.
Lots of economists like VATs, and this has been true for many decades. I remember wandering in my college library as a student in the early 1970s seeing a lot of books on the shelves with titles like "Why the US should have a VAT." And they are still saying it, decades later. (See, for example, this opinion piece by Brookings economists Henry Aaron and Isabel Sawhill in yesterday's Washington Post.) What's remarkable now is that a high-profile American political leader, House Speaker Pelosi, is willing to go on record that it's worth considering.
So, what's to like about a VAT?
0) We need the money! The current deficits are not sustainable indefinitely.
1) Our income tax is a huge confused mess, which is hard to enforce, and a VAT seems--at least in principle--like an opportunity for a clean fresh start. To use my favorite terminology, a VAT would have relatively few "bed buffaloes."
2) In our current income tax system, businesses get to deduct lots of expenses which can be difficult to audit. By contrast, the VAT is mostly self-enforcing, because now all those upstream expenses will get directly reported to the IRS, along with remittances of the VAT tax due on those upstream expenses. Of course, final retail sales still provide an opportunity for evasion, but anyone upstream of final retail who tries to evade taxes automatically creates a bigger tax bill for someone else downstream. That gives all downstream businesses powerful incentives to make sure their suppliers are complying with tax law.
3) It taxes consumption and does not tax savings until they are--eventually--consumed. Arguably, that's what provisions like IRAs and 401(k)s already do, but they are cumbersome and complicated to administer, with a lot of paperwork involved.
What's NOT to like about a VAT? Well, because it taxes consumption rather than income, it will fall relatively heavily on low-income folks, most of whom have little or no taxable income right now, but who may make many purchases of goods and services that would be subject to VAT. So, there would probably be some program of grants or rebates to low-income taxpayers. There are also some transitional fairness issues to consider. Dealing appropriately with those issues could add some complexity to the system.
Something else to like about enacting a VAT that would go into effect in a few years is that it would be a HUGE short-term stimulus to purchases of consumer durables that could help break the current economic downturn. If you think you're going to be in the market for a new car, a new furnace, a new refrigerator, or anything else of that nature, you would want to rush out and buy it before the VAT goes into effect.
Of course, that means there could be an economic slump right after it goes into effect, but perhaps some kind of transition rules could help ease that concern.
I'll end this with an excerpt from the Aaron-Sawhill oped, which is well worth reading in its entirety.
The dirty secret, known to responsible fiscal experts of both parties, is that the revenue generated under current tax laws cannot pay for the government services -- health care and everything else -- that Americans want for their children, their parents and themselves.
So here is what we propose: Congress should enact a value-added tax, the equivalent of a broad-based sales tax on all goods and services. It should take effect only after unemployment has fallen to a predetermined level or in, say, five years, whichever comes first. Congress should link revenue from the new tax and other sources directly to public health-care spending through a newly created health-care trust fund. The trust fund would pay for all federal health-care spending. This framework would mean that Americans would get the health care they are willing to pay for. If spending outpaces projections, Congress will have to choose between raising taxes and finding ways to slow the growth of spending.
By balancing revenue and health-care spending, such a reform would help solve America's long-term fiscal problems. In the near term, it would also support and sustain the economic recovery. Consumers would be encouraged to buy now, before the tax takes effect. And by showing financial markets that Congress is determined to put our fiscal household in order, it would help keep interest rates low and encourage investment.