Wednesday, October 14, 2009

The Value Added Tax

There has been a lot of talk lately about the possibility of a value-added tax, or VAT. See, for example, this article by Henry Aaron and Isabel Sawhill in yesterday's Washington Post. So I thought readers of this blog might be interested in my views of this policy proposal.

From a strictly economic standpoint, a VAT is great. It is essentially a flat consumption tax, like the so-called FairTax, but implemented in a way to reduce compliance problems. Because it is collected in stages along the chain of production, rather than all at the retail level, tax evasion is more difficult.

If you look at the economic effects, a VAT is similar to the Hall-Rabushka Flat Tax, which many economists love. Essentially, the main difference between a VAT and the flat tax as developed by Hall and Rabushka is that firms get to deduct wages as a cost under a flat tax, but then those wages are taxed at the household level. Other than this minor change of shifting the responsibility for the tax on wage income from the firm to the household, the Hall-Rabushka flat tax and VAT have identical economic effects. (There is also an exclusion for the first X thousands of dollars of wage income under Hall-Rabushka, making it progressive in average tax rates, but the same result can be accomplished with a VAT as well by rebating some of the revenue via a demogrant.)

My bottom line: If I could replace our current tax system (including the personal income tax, corporate income tax, payroll tax, and estate tax) with a VAT, I would gladly do it.

Why do some conservatives hate the VAT? For political reasons. They fear it would be a new tax, hidden from many voters, used to expand government. They fear that rather than replacing our existing tax system, a VAT would add to it. Indeed, that is precisely what Aaron and Sawhill are proposing.

Which brings us to Europe. Many European countries have both a VAT and a large government. But here is the hard question: which is cause and which is effect? Did the VAT cause government to become large, as VAT-opponents fear? Or did Europeans adopt large governments and then, needing to finance it, look for a relatively efficient way to raise a lot of revenue? I am inclined toward the latter hypothesis, but I will be the first to admit that it is not entirely clear which way causation runs here.