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).