Conservatives and the VAT

Ted Gayer
Ted Gayer
Ted Gayer President - Niskanen Center, Former Executive Vice President - The Brookings Institution

April 22, 2010

I share the criticism of Tax Policy Center’s Howard Gleckman of the Senate proposition that characterizes a Value Added Tax (VAT) as “a massive tax increase that will cripple families on fixed income and only further push back America’s economic recovery.” However, my problem with the Senate vote isn’t that it opposes a VAT; rather, it’s that it rules out any VAT, even one that is part of a broader tax reform that reduces distortionary income and corporate taxes.

Howard says that conservatives’ arguments against the VAT don’t “make a lot of sense.” It’s important to remember that conservatives by and large have favored a shift towards a consumption tax. But consumption taxes take a variety of forms, and many conservatives have advocated for a Hall-Rabushka flat tax, which also has a consumption base and can easily be designed to be more progressive than a VAT. The reason for preferring consumption rather than income as the base for taxation is fairly straightforward: unlike an income tax, a consumption tax does not distort savings decisions, and thus is more efficient.

The conservative argument against a VAT is primarily political. The concern is that a VAT is less visible and less salient to the electorate than other taxes, and will therefore inure citizens to an inefficient growth in government. Milton Friedman famously regretted his role in helping to introduce income tax withholding because he felt that it led to growth in government. He also opposed a VAT because it “would be concealed in the total price the consumer paid and hence not perceived as a direct tax burden.” Another Nobel Laureate, James Buchanan, observed that excise taxes, which are included in the prices of goods, leave taxpayers “quite ignorant of the amount of tax that is paid,” and thus “the opportunity cost is not sensed by the taxpayer.” It is worth noting, however, that this “fiscal illusion” concern can work both ways – if the benefits of government programs are not visible, then the size of government can be inefficiently small due to lack of citizen support.

Unlike Howard, I don’t think this concern is baseless. The evidence for the fiscal illusion hypothesis is indeed mixed (Wallace Oates offers a good survey), as it is difficult to identify the direction of causality between the prevalence of insalient taxes and the size of governments. But a recent study by Amy Finkelstein, appearing in the Quarterly Journal of Economics, does offer some interesting evidence. Finkelstein examined the effect of tax salience by studying the impact of the adoption of electronic toll collection on toll rates. Electronic toll collection automatically deducts tolls as cars drive through toll plazas, and is thus less salient than manually paying cash at a toll booth. Finkelstein finds strong evidence that toll rates increased due to the adoption of the less salient electronic toll collection, supporting the hypothesis that there is a link between tax insalience and the size of government.

That said, concerns about the insalience of a VAT should not torpedo any consideration of a consumption tax. A Hall-Rabushka flat tax shares the efficiency advantages of a VAT and is more salient than a VAT because households have to file an annual tax return. More generally, with any given tax, policymakers have some control of the level of salience. With a VAT, for example, salience to taxpayers can be increased by such things as separately identifying the tax level on each sales receipt. Whether policymakers want to deliberately increase the salience of a tax is an interesting question.

Finally, I note in passing that given that the anti-VAT proposition passed with 84 (!) votes in the Senate, it seems odd that the title of Howard’s blog post is “Conservatives and the VAT.” Clearly, concerns about the possible negative effects of a VAT are widespread.