Tax Notes

A VAT for the United States: Part of the Solution

The United States faces a large medium-term federal budget deficit and an unsustainable long-term fiscal gap. Left unattended, these shortfalls will hobble and eventually cripple the economy. The only plausible way to close the gap is through a combination of spending cuts and tax increases. This paper discusses why a federal VAT should be part of a constructive solution to the fiscal problem.

Under a VAT, businesses pay taxes on the difference between their total sales to other businesses and households and their purchases of inputs from other businesses. That difference represents the value added by the firm to the product or service in question. [1] The sum of value added at each stage of production is the retail sales price, so in theory the VAT simply replicates the tax patterns created by a retail sales tax and is therefore a tax on aggregate consumption. In practice, the key distinction is that VATs are collected at each stage of production, whereas retail sales taxes are collected only at the point of final sale. As a result, the VAT is easier to enforce, and its administrative structure is widely regarded as superior to that of the retail sales tax.

Although it would be new to the United States, the VAT is in place in about 150 countries worldwide and in every OECD country other than the United States. Experience suggests that the VAT can raise substantial revenue and is administrable and minimally harmful to economic growth. It also has potential advantages: A properly designed VAT might help the states deal with their own fiscal problems, and a preannounced, phased-in VAT could accelerate the pace of economic recovery.

Several concerns that have been raised about the VAT can be easily addressed. Although the VAT is regressive relative to current income, the regressivity can be offset in several ways. Although the VAT is not readily transparent in many countries, it would be easy to make it completely transparent to businesses and households by reporting VAT payments on receipts just like sales taxes are reported today. Although the VAT has led to an increase in revenues and spending in some countries, higher revenues are precisely why the VAT is needed in the United States, and efforts to limit spending should be part of an effort to enact a VAT. Making the VAT transparent should also reduce the extent to which a VAT would fuel an increase in government spending, a concern that is sometimes overstated by critics in the first place. While the VAT may lead to a one-time increase in prices, it is not the case empirically that VAT inevitably, or even usually, leads to continuing inflation.

None of this implies that the VAT would unilaterally solve the country’s fiscal problems; nor would it be painless. Nevertheless, the VAT is a relatively attractive choice, given the need to close the fiscal gap and the other options for doing so.

The sections below address each of these issues. We also summarize the Canadian VAT experience, which shows how many of the concerns can be addressed in practice. The final section summarizes our specific recommendations regarding the VAT.

[1] The tax can be administered in different ways. For example, under the credit invoice method, firms receive tax credits for the taxes they have paid on their purchases from other firms. Under the subtraction method, firms can fully deduct all their payments to other firms. For discussion of these and other options, see Bickley (2006) and Cnossen (2009).