“The United States federal budget has become so large that a tax system like the one the U.S. has used for the past 99 years cannot possibly raise enough revenue to balance it. (…) the U.S. government will eventually be forced to institute a Value Added Tax on top of the income tax.”
Brian Wesbury, First Trust Advisor Chief Economist
When looking at the OECD countries tax systems, one gets surprised when notices that the USA is the only country which do not have a Value-Added tax. We are used to think that the VAT is universal since we are so used to deal with it in each transaction we do every single day. But after all why doesn’t the US have a VAT? And, most important, does the US need VAT?
By looking to US public finances data over the last years, it is not difficult to understand that in fact expenses are really high when compared to government revenues. This huge gap, translates into a severe public deficit and an increase in public debt to dramatic levels (over 100% of GDP). What can be done to control public finances? The answer is quite simple: either to increase revenues through taxes or reduce public expenses. Most economic predictions states that US public expenses are expected to increase mainly due to the raise of medical and elderly costs, as the baby boom generation starts aging. The demographic situation makes the reduction on expenditure scenario as a difficult and not enough way to correct deviations. Therefore we should focus our attention also in the revenue side: taxes. And when we think about how to increase tax revenue minimizing damages in the economy the answer is quite clear: VAT.
But what is VAT and how does it work? Broadly speaking it is a tax on consumption. All agents involved in the production process will pay a share of the tax until the product reach consumers. This tax is one of the major revenue sources for some European countries and the tax rate may reach 25% in some countries when, for instance in Canada, the VAT rate is only of 5%.
In terms of efficiency, if the VAT tax was uniform over all goods it wouldn’t have any distortion on consumption since the relative prices of goods would stay the same – people would do the same choices regarding consumption. However with all tax exemptions, different rate levels and international trade this assumption is likely to fail and some economic distortion may therefore be expected. The VAT also changes the choice each individual makes between work and leisure time. Therefore there are some economic distortions associated with the tax, although according to economic theory they are small when compared to income taxes. Thus, in terms of economic efficiency, VAT seems to be quite a good option.
Opponents claim this is a regressive tax which does not promote redistribution. Moreover, they claim it consists on double taxation since consumers pay for goods with income which was already taxed. This tax may also affect competitiveness although it may induce changes in consumer behavior with severe consequences for some industries (for instance restaurants usually have a higher tax than supermarkets).
In the American case the implementation of VAT would bring significant improvements in the country’s public finances. The US is on the path for more spending in the near future and there are not that many ways to finance this huge amount of expenditures. Experts say that due to the broad tax base a tremendous amount of revenue could be attained through VAT. In fact a 10% VAT could raise up to $750 billion a year which corresponds to 20% of the federal budget1. This huge amount of revenue could be used not only to correct public finances imbalances but also to relief some other taxes. Also, VAT has less economic inefficiencies associated, as stated above, and it is relatively easy to enforce and hard to completely evade.
So if this tool may solve the government deficit and challenges in an efficient and quite simple way, we return to our first question: should Americans pay VAT?
Unfortunately there is not a final and clear answer. There are some additional issues regarding this tax. First of all there is a political cost which is no less real than economic restrictions. After all, Americans will not be happy upon the announcement of a brand new tax. Secondly the introduction of VAT would have huge costs on establishing a new tax collection administration. Changes in consumer behavior are also a reason for some concern, as well as damages on competiveness of the US. Finally, the timing of a new tax on consumption is not perfect since US government is trying to promote consumption and this tax would have the opposite effect!
VAT is a very good instrument to generate the amount of revenue the government needs, although it may not be that easy to implement. Pushing this decision forward may be a short-run solution, but It will only delay and increase the problem. Putting all together, should Americans pay VAT? I believe so, at least because so far, it seems the only reasonable and sustainable solution.
Master in Economics 689