Should There Be a VAT in America’s Future?

For many years sober budget analysts and economists have been warning of the rising future cost of government health and retirement programs. The increase in expected federal outlays is the result of two predictable developments: The rise in the proportion of the population that is past age 65 and the apparently irrepressible surge in the price and quantity of medical services consumed by people who are covered by public insurance (medicaid and Medicare).

The aging of the population will increase spending requirements for social security, Medicare, medicaid, and all other public programs from which the elderly receive an out-size share of program benefits. The tendency of medical care costs to climb faster than the cost of most other consumption and investment items means that government outlays on health insurance will need to grow faster than the overall economy, even if the population eligible for public insurance increased no faster than the population as a whole.

Without increasing the deficit, there are three basic ways of dealing with these developments. We can curb future spending on public health insurance and programs for the elderly, either by cutting benefits or changing the rules to reduce the size of the population eligible to collect benefits. We can increase federal revenues to cover the additional costs of our existing programs. Or we can reduce federal spending on non-health programs and on programs not targeted on the elderly.

To an important degree, past increases in spending on health and on the elderly were financed with reductions in defense spending. Defense spending averaged a little more than 9% of GDP between 1950 and the end of the Vietnam War. It fell to 5.5% of GDP between 1974 and the end of the Cold War in 1990. Since 1991 it has averaged 3.8% of GDP, a decline of 5.3 percentage points since the early post-war years. By spending less on defense we were able to spend more on health and the elderly without raising taxes.   Fueled by the cost of fighting two wars, spending on defense has risen since 2001, but defense spending as a percentage of GDP remains well below the level of the 1950s and 1960s.

Even if spending on defense falls substantially in the future, the savings will not be big enough to pay for expected increases in the cost of public health insurance and federal programs for the elderly. For this reason, the CBO predicts a sizeable increase in total federal spending and in government debt held by the public. If the President’s 2010 budget proposals are adopted, the CBO forecasts that the deficit will shrink substantially in the next four years, falling from 10.3% of GDP this year to 4.1% of GDP in 2014. However, mainly because of rising commitments for health insurance and programs for the elderly and the increasing burden of paying interest on the growing national debt, the predicted deficit will then begin to rise, reaching 5.6% of GDP by 2020. This budget path is not sustainable in the long run. Public spending will eventually have to be cut or government revenues increased if the United States wants to continue selling its debt to prudent investors.

Introducing a value-added tax (or VAT) is one way to reduce the long-term imbalance between spending commitments and revenues. A VAT is similar to a sales tax, except that it is imposed on the value added at each stage of production of a good purchased by consumers. Many economists, including me, consider it an attractive way to increase revenues. Compared with other kinds of taxes, including sales taxes, property taxes, and an income tax with a very high top marginal rate, the VAT probably causes less economic distortion. Compared with the income and sales tax, it is almost certainly harder for taxpayers to evade (or at least to evade completely). Because of these attractive features, the VAT is an important part of the tax system in 29 of the 30 member countries of the OECD, an international organization that includes all of the world’s richest countries. In the most of these countries, the VAT accounts for over one-fifth of tax collections. The United States is the only OECD country that does not have a VAT.

For the U.S. the VAT would have some disadvantages. Introducing the tax would require the nation to establish a new tax collection administration. It would force businesses to set up new procedures to collect the tax and send proceeds to the government. This is a more costly undertaking than boosting tax rates in an existing tax, such as the payroll or income tax. Also, establishing a VAT would involve tough political negotiation between federal and state lawmakers, since most states fund an important percentage of their operations with a sales tax. To keep tax collection efficient, a federal VAT would require some coordination between the collection of the VAT and state sales taxes. These problems can be surmounted, as they have been in other OECD countries, but the solutions would not be painless.

A rational analysis of the nation’s budget problems leads inevitably to the conclusion we will have to both trim currently planned spending and increase government revenues, assuming we want to make the cost of government sustainable. If the resolution of the budget problem requires a large increase in taxes, a new VAT is a very attractive way to raise new revenues. In the unlikely event we find a budget solution that requires little new revenue, a low-rate VAT would make no sense. I believe a substantial amount of revenue will be needed to fix the nation’s deficit problem, so I think a VAT is desirable.

Few opponents of the VAT argue the VAT is a less efficient or more burdensome tax than other kinds of taxes, including the taxes we already pay. They argue instead that the VAT will be a rich and inviting source of funding for unneeded public programs. Many of these critics would apparently prefer that taxes be collected in particularly obnoxious and unpopular ways so that voters will fiercely resist higher tax rates.

It’s worth remembering that many VAT critics oppose raising taxes, whether the revenues are collected from a new or an old revenue source. They believe long-term budget balance should be achieved solely through cuts in public spending. Many of them supported tax cuts in 2001-2003 that contributed immeasurably to the nation’s current budget fix. I doubt whether their preferred solution to our budget problem is politically feasible. Since Ronald Reagan’s election in 1980 we’ve accumulated 30 years of evidence about the effects of lower and higher tax rates on the budget deficit. The only periods in which we saw progress toward a sustainable budget path were ones in which Congress combined spending discipline with higher taxes. Until the opponents of the VAT identify the government programs they propose to slash for a sustainable budget path, we should take their objections to the VAT for what they are: Objections to a tax hike rather than to a VAT.