Given the current and projected large scale budget deficits of the United States, many people are advocating that the US follow the example of Europe and many other countries, and introduce a value added tax (VAT). President Obama suggested only a few days ago that a VAT for Americans is still on the table. The case for a VAT is that it is a relatively efficient tax that induces less distortion in behavior than say a progressive income tax that raises the same amount in revenue. On the other hand, once introduced the VAT almost always tends to rise over time, which increases the burden of government spending and taxation. If a country were starting a new tax system I would on the whole (I discuss my concerns later) recommend relying mainly on a VAT. However, countries like the US that already have complicated tax systems would make a mistake to simply add a VAT to the tax system without radical surgery in income and other taxes.
Since a VAT is a tax on the value added by companies at each stage of production of consumer and investment goods, it is similar to a sales tax levied directly on these consumer and investment goods. Usually, a VAT is a fixed percent, such as 10 or 20 percent, of the value added by each company, although often medicines and certain other necessities are exempt. A VAT does not distort consumption decisions relative to savings and investment decisions since it taxes consumer and investment goods at the same rate. An income tax, by contrast, discourages savings and investment because it taxes savings twice: once on the income from which any savings are taken, and again on the income earned later on from any savings.
Like an income tax, a VAT does distort the decision whether to work more, or take more leisure and earn less. Since leisure time is not taxed, a VAT encourages an increase in leisure time and a decline in working time. A VAT is usually a flat tax, with the same tax rate for richer people who spend a lot on consumption and poorer persons who spend much less, whereas income taxes are usually progressive, with higher marginal tax rates on higher incomes. The higher the marginal tax rate, the greater the labor-leisure and other distortions-economists call the inefficiencies introduced by these distortions dead weight losses. A flat VAT tax would be more efficient for two reasons than a progressive income tax that raises the same revenue: it does not discourage savings relative to consumption, and it induces fewer distortions on other behavior because it has flat rather than rising tax rates. A flat income tax eliminates the effects of rising tax rates, but still distorts savings behavior.
The downside of a value added tax to anyone concerned about growing government spending and taxing is very much related to its upside; namely, that a VAT is a more efficient and relatively painless tax. As with all taxes, proposals to increase the rate of taxation on value added runs into opposition from individuals and companies hurt by a higher VAT. However, since a VAT is easy to collect and causes fewer distortions in behavior than income and most other taxes, governments have an incentive to raise the VAT over time. In fact, value added tax rates do usually start low, but tend to grow rapidly over time. For example, the VAT rate in Europe started low but now ranges from 15 to 25%, and averages about 20%. In Denmark, for example, the VAT rate was 9% in 1962, but quickly rose to 25% by 1992, and has remained at that level.
So the greater efficiency of a VAT and its easy of collection is a two-edged sword. On the one hand, it would raise a given amount of tax revenue efficiently and cheaply. Since economists usually evaluate different types of taxes by their efficiency and easy of collecting a given amount of tax revenue, economists typically like value added taxes. The error in this method of evaluating taxes is that it does not consider the political economy determinants of the level of taxes. From this political economy perspective, the value added tax does not look so attractive, at least to those of us who worry that governments would spend and tax at higher levels than is economically and socially desirable (see the discussion by Mulligan and me “Deadweight Costs and the Size of Government”, The Journal of Law and Economics, October 2003).
In deciding how to close the sizable fiscal deficits facing the US and other countries, introducing or expanding a VAT appeals to many economists and politicians because of the features already discussed. However, the problems is that a VAT would be introduced not as a partial or full substitute for personal and corporate income taxes, but rather as an additional tax. This would make it much easier to close the fiscal gap by maintaining or increasing government spending and overall tax levels.
Since high taxes and high levels of government spending would discourage economic growth and raise rather than lower the overall distortions in an economy, I am highly dubious about introducing a VAT into the federal tax system unless accompanied by a major overall of this system. One big improvement that does not involve a VAT would be to flatten the present income tax rates and greatly reduce the various exemptions, so that the tax basis is widened. Even then it is necessary to be vigilant about combating the incentives government officials have to increase flat taxes over time, whether they are flat income taxes or flat value added taxes.