Many people are busy filing their taxes for income earned in 2018. It can be a painful process. It’s not just that it’s hard to give up money that one thought one had earned. The rules are so complex that even those of us with advanced degrees in economics aren’t always sure which way is up. The new tax law enacted in 2017 helped a little, in this regard at least, by expanding the standard deduction and so reducing the number of people for whom itemizing deductions makes sense (although many of its other provisions – especially those for businesses – added to the complexity).
One way to simplify matters would be to enact a value-added tax (VAT). But before we get to tax reform, we have to give a shout out to our colleague William Gale’s new book, Fiscal Therapy.
Fiscal therapist: Bill Gale
Gale addresses the need to reduce the national debt, and to invest more in the future. The four chapters on taxes are as clear and concise an explanation you will find anywhere on how the system works now and what we need to do.
Gale proposes raising taxes on high-income households; eliminating or curtailing many deductions and preferences such as the mortgage interest deduction and lower capital gains tax; reversing some of the 2017 rate cuts; and converting the estate tax into an inheritance tax. He calls for more resources for the IRS so they can collect some of the roughly half a trillion dollars in taxes that are owed, but not paid. He also suggests raising the corporate rate to 25 percent but allowing full expensing of business investment along with making interest nondeductible. Expensing of purchases of plant and equipment would directly encourage something we want (more investment) and not something we already have (profits on previous investments). Gale also calls for a tax on carbon to combat climate change and a VAT (the equivalent of a national sales tax).
Time for a Value Added Tax
This last idea is especially worthy in our view (see Sawhill’s book, The Forgotten Americans). First, it would raise a lot of revenue in a transparent, simple fashion. It could, if desired, replace the income tax for everyone earning less than a six-figure income. April 15 for the 125 million taxpayers in this category would then, to quote Columbia law professor Michael Graetz, become “just another spring day.” It would reduce the anxiety of most middle-class families caused by the uncertainty of how much tax they will owe, and perhaps their fear that they are missing out on some deduction that other people are getting.
Second, we know a VAT works. Why? Because every other OECD country has one.
Third, it would be more efficient and more growth-oriented than the income tax, encouraging saving among today’s young adults who are putting aside less of their income than previous generations.
Finally, it could be border adjusted, potentially making American goods more competitive in global markets.
Making a VAT fair
But would a VAT be fair? The answer is that it can be, if:
- we retain an income tax for the most affluent (people earning more than $100,000, for example)
- the reformed law includes exemptions for certain necessities, such as groceries, rent, and medical care (although as Gale notes, this undermines the tax’s yield); and
- we use some of the revenues to compensate lower-income households for the higher prices everyone would have to pay.
Gale wants to use most of the revenues to reduce deficits, a worthy goal for sure, but one that conflicts with trading it off against lower income taxes and so making it more politically attractive. This brings us to the biggest issue of all: could a VAT ever be enacted? Granted, that’s the hard part. Larry Summers said it best: “Liberals think it’s regressive and conservatives think it’s a money machine.” He went on to suggest we would get a VAT when liberals realize it is a money machine and conservatives realize that it is regressive.
It’s worth noting in this context that many Republicans have embraced a value-added tax. It’s just that they call it something different. Senator Ted Cruz, for example, called it a business transfer tax during the 2016 debates and a number of Republicans advocated a “cash flow tax” — a variation of a VAT — in the debates leading up to enactment of the 2017 law. On the left, many Democrats have no problem with regressive taxes so long as the benefits they provide are progressive. Social Security payroll taxes are a case in point. Surveys and focus groups suggest that many Americans support flat taxes, and a VAT is a first-cousin of a flat tax.
The important point is that labels and messages matter. Imagine a 2020 presidential candidate saying, “I promise that if I am elected, I will eliminate your income taxes if you make less than $100,000 a year.”
Admittedly, prices would be higher under a VAT. But as behavioral research has shown, context matters. You might pay a little more for a new TV, a cell phone, or a living room chair, but you are getting something you want in return. That’s a subjectively different experience than getting a W-2 in the mail, showing how much of your hard-earned money has gone to the government with nothing very tangible to show for it – a perception heightened by growing distrust in government. Instead, all you are getting on April 15 is a variety of headaches and worries, depending on your circumstances. Should you itemize? If so, can you find all the documents you will need and figure out how much you owe? Did you end up paying more than you should have? Did you get a refund?
So: Happy April 15th. But if you would like more time in the spring sunshine and little less time fretting over tax forms, next time you hear a politician talking about a VAT, listen up.