Consider a Value-Added Tax

The voices in favor of a value-added tax (VAT) as a new revenue source for the U.S. are getting louder. The latest person to weigh in on the topic is Paul Volcker who, according to Reuters, floated the idea at an event in New York on Tuesday, saying “if at the end of the day we need to raise taxes, we should raise taxes.”

Volcker is so right. We badly need more revenue. Last year federal government spending was 26 percent of GDP and revenues were 15 percent of GDP for a staggering gap of 11 percent. Some of this gap is the result of the recession but even in a fully recovered economy, the gap will still be in the neighborhood of 6 percent. We are risking another financial crisis if we don’t address this enormous hole in our public finances.

Some but not all of the gap should be filled by cutting spending. New or higher taxes have to be part of the bargain, and a VAT is gaining traction as one way to get the needed revenues. If the proceeds of a VAT were earmarked for federal health care spending this would link health expenditures to taxes in a very visible way and put a natural brake on such spending. If the public insists on having more and more expensive health care paid for by the government, they would have to agree to a higher VAT rate.

As Henry Aaron and I have argued, a VAT has a lot of advantages. First, if it were proposed this year or next but phased in slowly as the unemployment rate dropped, it would encourage more consumption as households rushed to buy everything from ipads to new cars while these goods were still “VAT-free.” Without higher spending by consumers, we face the possibility that the economic recovery will falter. Second, over the longer-run a VAT would encourage saving – just what the country needs if we want to remain competitive by investing in new technologies and new products. Third, a VAT is relatively easy to administer and more economically efficient than an income tax. It’s true that a VAT is regressive but this problem can be addressed by making other, more progressive, changes to taxes or spending. One option would be to reduce payroll taxes and another would be to provide refundable credits to low-income households. Ways would also need to be found to make a VAT consistent with state and local sales taxes, perhaps by allowing states to piggyback on the federal VAT or by returning some of the revenue to lower levels of government.

The big challenge, of course, is making all of this politically palatable. What might it take? In my view, the key to success is to greatly simplify the system. Most people hate the current system not just because we all like to keep more of what we earn but also because filing income tax returns makes cleaning out the basement seem like fun. Michael Graetz, a professor at the Yale Law School, has proposed a VAT [PDF] that would replace income taxes for everyone with an income of less than $100,000 a year and would eliminate 100 million tax returns. As April 15 draws nearer, almost everyone can appreciate why this would be a popular step. The business community, along with many Republicans, could be brought on board by a promise to lower the corporate rate.

In the end, any tax increase will be a heavy lift in a country that seems allergic to paying its bills. But it will have to happen sooner or later and sooner would be much better. As Larry Summers once noted, Republicans don’t like value-added taxes because they are a revenue machine and Democrats don’t like them because they are regressive. We will get a VAT when Democrats realize that they are a revenue machine and Republicans realize that they are regressive.

In the meantime, three cheers for Paul Volcker!