Nancy Pelosi says a VAT tax is "on the table"

Last week House Speaker Nancy Pelosi told the country that a VAT tax is on the table.

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.

The writing on the wall...

from Howard Gleickman at the TaxPolicy Center:

The projections are depressingly familiar. Within a decade, the ratio of debt to GDP is likely to reach heights unseen since the end of World War II. In a couple of decades, interest payments alone much owed to foreign investors-- will vastly exceed any conceivable ability of the government to raise tax revenues. Massive government borrowing will almost surely crowd out the ability of private companies to raise needed capital. And the potential will grow for hyper-inflation and a ruinous devaluation of the dollar. After a few minutes of this, it was no wonder Ornstein called this crowd the real death panel.

Yet, policymakers do nothing. Well, they do something. They make the problem worse. Massive tax cuts, a huge Medicare drug benefit, unfunded wars, and now a costly new health insurance reform that is very likely to be underfinanced. Then, of course, there is the staggeringly large fiscal stimulus, some of which will almost surely be made permenant.

Why can't pols see what is so obvious to people like Penner, Burman, Reischauer et al?
In part, as Reischauer says, their fears have become almost trite. For years, deficit hawks have warned about the dire consequences of profligacy. Yet, the world still spins on its axis, the sun rises in the morning, and Treasury sells its debt with ease. Indeed, yields for 30-year Treasury bonds are well below 5 percent—a signal that investors are hardly worried about Washington's ability to raise money.

Mussa, who spent a decade at the International Monetary Fund and is currently a senior fellow at the Peterson Institute for International Economics, figures it could be years before overseas investors turn bearish on the U.S. In part, he says, that's because net foreign lending has actually fallen in the past two years their huge increases in investments in Treasury paper have been more than offset by shrinking portfolios of private debt.

But that won't last. Once the economy begins to get back on track, private capital and government will again compete for the same foreign money bad news for everyone seeking funds.

Is there any way out? Ornstein sees little chance that a hyper-partisan Congress will confront the budget crisis in the absence of a financial market crisis, or even in the face of one. Interestingly, Burman, Mussa, and Penner think that when the fix finally comes, it will include a Value-Added Tax. Penner calls it almost inevitable.

Our federal tax system is badly broken, and unsustainable in the long run. If we had the political will to reform it by slashing the crazy-quilt of tax expenditure preferences that ultimately cost far the economy as a whole far more than the tax savings they generate for their special interest constituencies, we could get our country's economic life onto a balanced sustainable course.

But it's far more tempting for politicians to generate "just one more" tax preference than to get rid of any of the great number of crazy tax preferences we already have.