How a Value Added Tax Would Harm the U.S. Economy (2024)

In a desperatesearch for new revenues to finance its planned health careprograms, the Clinton Administration apparently is givingconsideration to a version of a national sales tax known as a ValueAdded Tax (VAT).[1]Alternatively, the Administration may urge a VAT as a source ofrevenue for deficit reduction. This is especially likely ifCongress approves the Administration's proposed tax increase ofmore than $300 billion and the result is the same as with past taxhikes - more spending and higher deficits.

Adopting a VATwould be a serious mistake. If history is any guide, a VATwill:

• Expand thesize and cost of government. Countries with VATs have, onaverage, a 40 percent heavier total tax burden than those withoutVATs. Government spending in VAT countries consumes, on average, 42percent more of national economic output than does governmentspending in non-VAT countries.
• Slow economicgrowth and destroy jobs. Adopting a VAT would, in just fiveyears, destroy an estimated 2.1 million jobs and reduce the averagefamily's annual income by $1,000.
• Increase thebudget deficit. Every dollar of higher taxes since World War IIhas resulted in $1.59 of new spending, boosting federal borrowingrather than reducing it.
• Impose heavyadministrative costs. The Congressional Budget Office estimatesa VAT would impose as much as $8 billion in compliance costs on theeconomy. Small business would be especially hard hit.[2]
• Increaseprices. The Congressional Budget Office predicts that a 5percent VAT would cause the Consumer Price Index (CPI) to jump by 3percent. Because many government programs are tied to the CPI,federal spending would jump by more than $11 billion.[3]

A VAT would be ano-win proposition for America. Even to consider such a tax,especially at a time when politicians already are trying to imposea record tax increase of more than $300 billion, is a sign thatpolicy makers have lost touch with the concerns of averagecitizens.

WHAT IS AVAT?

A VAT, whicheffectively would impose a national sales tax on U.S. consumers, islevied on the "value added" to goods and services as they passthrough each stage of the production process. While a VAT canoperate several ways, according to the Congressional Budget Office:"It is typically administered by taxing the total value of sales ofall businesses, but allowing businesses to claim a credit for taxespaid on their purchases of raw materials, intermediate materials,and capital goods from other businesses."[4] For a particularproduct, every time there is a transaction which adds value, thatextra value is subject to the VAT.[5] Since businessesreceive a credit for the taxes they have paid, the total tax,regardless of at which stage of production it was levied, ends upbeing added to the final sales price and paid by the consumer.

No matter how manysteps there are in the production process, one or ten, a fixedpercent of the final price of the product would represent the valueadded tax, just as a retail sales tax is a fixed percent of thefinal product price. Unlike a sales tax, however, the cost of theVAT to consumers would be hidden. Unless politicians took theunlikely step of requiring retailers to state explicitly theportion of the sales price due to the tax, consumers would not beaware of the tax.[6]

In theory, a VATcould be imposed on all economic transactions. Many VAT proposals,however, exclude necessities such as food, housing, and medicalcare. This reduces the tax burden on consumers buying these items,but such exemptions add to the accounting complexity and costs forbusinesses. Imagine, for instance, a firm having to categorize allpurchases according to their tax status, and then having to submitnumerous forms to receive the credit due on VAT paid. As thepreceding table illustrates, the VAT's revenue-raising capacityvaries depending on whether the tax is imposed on a "comprehensivebase" or if major consumption items are excluded.

EFFECTS OFA VAT

Enacting a VATwould be a major setback for the American economy. Many countriesalready impose VATs on their consumers and the results have beendismal. Based upon historical evidence and economic research, it isclear that adoption of a VAT will have several adverseconsequences.

EFFECT #1:A VATtriggers more government spending and higher tax burdens.

With its capacityto generate large amounts of tax revenue, a VAT likely would fuelhigher government spending. Indeed, rather than their usual charadeof claiming that the new revenues would be used for deficitreduction, many politicians openly are discussing ways to spend themoney, with increased government spending on health care toppingthe list.

Even if lawmakerspromised that the money would be used to reduce the budget deficit,more government spending almost certainly would be the result. Thisis confirmed by historical data. For every $1 that tax revenuesgrew between 1970 and 1980, federal spending increased by $1.22.Between 1980 and 1990, spending climbed by $1.29 for every $1 ofadditional tax revenue. And during the 1990s, the ratio has growneven worse, with spending climbing by $1.90 for every $1 of newrevenue. A Joint Economic Committee study found that between 1947and 1990 every $1 of higher taxes has associated with $1.59 of newspending.[7]

As the table onthe following page illustrates, adopting a VAT is associated withlarger levels of government spending and heavier total tax burdens.In fact, the average tax burden in OECD (Organization for EconomicCooperation and Development) countries with VATs is 44.3 percent ofgross domestic product, some 12.7 percentage points higher than theaverage tax burden in OECD countries without VATs. Nations withVATs thus impose on their citizens a tax burden that is more than40 percent heavier than those countries without VATs.

The higher taxburden in VAT nations is accompanied by an equally severegovernment spending burden. Governments in nations with VATs onaverage consume 51.1 percent of national economic output, 15.2percentage points higher than the average burden of government innon-VAT countries. In other words, the burden of governmentspending as a percent of GDP is more than 42 percent higher innations that have VATs.

The OECDstatistics are echoed by research conducted by the Tax Policydivision of the U.S. Chamber of Commerce. The Chamber's study,which examined tax and spending growth between 1965 and 1982, foundthat government spending grew 45 percent faster in VAT nations thanin non-VAT countries. Similarly, the study found that the taxburden grew nearly 34 percent faster in VAT countries.[8]

EFFECT #2:A VATslows the economy and destroys jobs.

By takingresources out of the productive sector of the economy andtransferring them to the government, a VAT would slow economicgrowth and slow job creation. According to a study by StotlerEconomics, a Chicago-based economic research firm, a VAT of only 3percent would, by just the fifth year, reduce the typical family'sincome by $1,000 and destroy 2.1 million jobs.[9] The relatively weakperformance of many European economies can be attributed, at leastin part, to such effects of a VAT. The countries of the EuropeanEconomic Community (EEC), all of whom impose VATs, averaged 10percent unemployment in 1992 and expect the joblessness rate toclimb to 11 percent this year.[10]

The VAT's impacton the annual economic growth could be enormous, depending if andhow quickly lawmakers used the new revenue to boost governmentspending. Scholarly studies have found that every percentage pointincrease in government consumption spending as a percent of grossdomestic product reduces the economy's potential rate of economicgrowth by as much as 0.3 percentage points.[11] Without knowing howmuch government spending in the U.S. would increase after enactmentof a VAT, or how much of that spending would represent governmentconsumption outlays, it is impossible to determine precisely howmuch economic damage a VAT would cause. But the impact could beespecially severe if a VAT leads to the high levels of governmentspending found in those countries currently imposing a VAT.

EFFECT #3:A VATincreases budget deficits.

Althoughpoliticians almost always claim that higher taxes are imposed forthe purpose of deficit reduction, history indicates that thedeficit is more likely to rise than fall after taxes are raised.For example, tax increases were enacted in the U.S. in 1982, 1984,1987, and 1990. In each case, politicians promised the money wouldbe used for deficit reduction. Yet in every case the deficit rosethe following year.

There is no reasonto believe that higher taxes in the form of a VAT would work anydifferently. The reason is that tax increases cause higher budgetdeficits for two reasons. The first reason, explained above, isthat politicians cannot resist the temptation to increase spendingfor favored interest groups.

The second-just asimportant as the propensity to spend-is the economic reality thathigher taxes almost never result in the amount of new tax revenuepoliticians forecast. Simply stated, individuals will alter theirbehavior when the tax laws change. Investors scale back theiractivity, businesses hire fewer workers, and consumers reduce theirspending. Wealthy individuals and businesses take money out ofproductive investments and place it in tax shelters or take othersteps to protect their earnings from government. The result:Workers without jobs do not pay taxes. Rich people with lowertaxable incomes pay fewer taxes. Companies that are losing money donot pay taxes.

This does not meanthat tax increases necessarily will result in less tax revenue,though some tax increases, such as the 1990 budget deal, did leadto lower revenue collections than were predicted before taxes wereraised. It does mean, however, that because tax increasesinvariably are followed by lower-than-expected tax collections andhigher-than-expected government spending, the budget deficit willincrease rather than fall.

EFFECT #4:A VATmeans heavy administrative costs on business and taxpayers.

A VAT conscriptsbusinesses to serve as tax collectors for the government. Everycompany and entrepreneur would be forced to keep records on everypurchase and submit detailed forms to the IRS. The administrativeburden of the VAT would be especially severe if policy makerschose, as most proponents of the new tax advocate, to exemptcertain goods and services. The reason for this is that firms wouldhave to segregate records according tax status and submit numerousseparate forms to the tax authorities. The Congressional BudgetOffice notes that allowing exemptions would "substantially increasecosts of enforcement and compliance."[12]

Compliance costsalso would rise if politicians chose to apply different rates todifferent goods and services. Most nations with VATs not onlyexempt certain products altogether, but tax certain goods andservices at different rates.[13] Depending on thecountry, the VAT rates differ for non-alcoholic drinks, candy,sugar, consumer electronics, clocks and watches, furs, jewelry,playing cards, cigarette lighters, matches, toiletries, drugs andmedicines, books and newspapers, insurance, telephone service,advertising, entertainment, hotels, and restaurants. In somenations, there are as many as six separate rates of taxation.[14]

Thus, even thoughadvocates of the VAT use theoretical models to assert that the taxis cheap to administer, the real world evidence suggests otherwise.The Congressional Budget Office estimates that the costs to thegovernment would total as much as $1.5 billion and that the privatesector would face an additional burden of as much as $7 billion.[15] The VAT would beespecially painful for the segment of the economy which generatesmost new jobs-small businesses. Unlike larger firms, whichgenerally have legal and accounting divisions that could be used tokeep compliance costs relatively low, small businesses without suchin-house expertise would face disproportionately high costs,totalling as much as two percent of sales.[16] In Canada, whichadopted a VAT in January, 1991, the complexity of the levy isestimated already to have driven one-fourth of small businessesinto the underground economy.[17]

EFFECT #5:A VATcauses prices to rise.

While a VAT wouldnot necessarily lead to a permanent increase in the rate ofinflation, imposition of the tax would cause at least an initialincrease in the price level. The Congressional Budget Office, forinstance, projects that a 5 percent VAT would cause the ConsumerPrice Index to jump by 3 percent. ("Effects of Adopting a ValueAdded Tax" Congressional Budget Office, February 1992, p. 64.) Thisprice level increase, even if not sustained, would mean fiscaldamage. More than $500 billion of federal governmentspending-programs such as Social Security-is tied to the consumerprice index. The Office of Management and Budget estimates that a 3percent increase in the price level would trigger more than $11billion of new spending. Thus adoption of the VAT would obligatetaxpayers to pay billions of dollars more to fund the higherspending caused by the increase in prices.

It also ispossible that a VAT could lead indirectly to a sustained increasein prices. According to the outdated economic theories upon whichthe Clinton program is based, the economic cost of higher taxes maybe offset by following an expansionary monetary policy. Accordingto this theory, pumping extra money into the economy stimulateseconomic growth, thus offsetting the recessionary impact of taxincreases. There is just one problem with this theory: It is wrong.In reality, a surge on the money supply may cause an illusory spurtin growth, but the final effect, after a year or so, is weakenedeconomic growth and higher prices. The last time this high tax andeasy money approach was used was during the Carter Administration.The result was "stagflation," a pernicious combination of risingprices and recession.

ASELECTION OF VAT MYTHS

In their campaignto impose a new tax on American consumers, proponents of VAT claimthat the tax would have several desirable effects. In most cases,these claims are flatly wrong or grossly inaccurate. In otherinstances, the claim may be true, but the result is not desirable.For instance:

Assertion: A VAT would increase savings by reducing theovertaxation of savings and investment.

Reality: Raising taxes on consumption does not solve theproblem of excessive taxation of savings and investment. Takingmore money out of consumers' pockets, as a VAT clearly would do,necessarily would result in less total savings in the economy.Indeed, a cross-country study of 23 nations in BusinessEconomics, the Journal of the National Association of BusinessEconomists, found that "savings rates are not higher in countriesthat rely more heavily on a VAT for revenue."[18]

Whenever taxes are raised-even if it is consumption that is beingtaxed-the effect is to lower individual savings, since consumerspending patterns are unlikely to quickly change. So the savingsrate tends to fall. Therefore, a VAT actually would exacerbate thetax code's negative effect on savings. Moreover, since impositionof a VAT would reduce economic growth, the incentives to investwould be lower than they would be in the absence of a VAT.

ManyVAT proponents admit that if a VAT were added to existing taxes, itwould reduce total savings. But then they argue that revenues fromthe tax could be used to lower or eliminate other taxes with moredamaging effects on savings and investment. While this is fine intheory, the evidence from Europe indicates that this simply doesnot happen. As the preceding table demonstrates, countries withVATs tax income at heavier rates than do countries without the VAT.The tax, in other words, is added to other taxes. It is not asubstitute for them.

As thepreceding table indicates, income and profit taxes in nations withVATs average 17.8 percent of gross domestic product, 5.8 percentagepoints higher than they are in nations without VATs, representing a48 percent higher tax burden. If Social Security taxes areincluded (which operate the same way as income taxes), income andprofit taxes in countries with VATs average 28.3 percent of grossdomestic product, or 9.1 percentage points higher than they are innon-VAT countries. Using this more comprehensive measure, the taxburden on income and profits is more than 47 percent higher in VATcountries.

Assertion:America is one of the few industrialized nations without a VAT.

Reality: Fortunately for American consumers and workers, theassertion is true. Many VAT proponents imply that America somehowis backward because it lacks a VAT. According to the Organizationfor Economic Cooperation and Development, however, the twowealthiest countries in the industrialized world are the UnitedStates and Switzerland-neither of which has a VAT.

Thenotion that America should mimic the tax policies of Europeannations is especially bizarre since the European Economic Community(EEC) is mired in economic stagnation. Economic growth in the EECaveraged only one percent in 1992 and is expected to be even lowerthis year. Similarly, unemployment in the EEC averaged 10 percentlast year and is expected to reach 11 percent this year. Nor isthis a short-term phenomenon. During the 1980s, the U.S. createdmore jobs than all of the EEC combined.

Assertion:A VAT would make American products more competitive in worldmarkets.

Reality: A VAT would have no effect on the balance of trade.Since a VAT is rebated on exports and imposed on imports, somebelieve that the tax would help sell more American-made products.This belief is not true. Adding a VAT to imports means thatconsumers would have to pay more, regardless of where the productoriginated. A 5 percent VAT, for instance, would not change therelative costs of a Nissan Maxima and Ford Taurus. All that wouldhappen is that they would both be 5 percent more expensive thanksto the tax. Similarly, even though a VAT is rebated on exports, ifthe country importing the product has a VAT, the American exportwill be subject to the levy just as foreign goods would be treatedin America. And if the other country does not have a VAT, Americanexports still would not gain a competitive advantage since both theAmerican products and the host country products would be free ofthe tax.

Supporters of the VAT point out that most other taxes, particularlyincome taxes and payroll taxes, are not rebated on exported goodsand that this policy makes American products more costly and lesscompetitive. While true, the problem is not solved by adopting aVAT. The only way to address the damaging impact of income andproduction taxes is to reduce income and production taxes.

Assertion:A VAT could generate substantial new revenue for the federalgovernment.

Reality: The assertion is true. A VAT would be a huge newsource of taxes for the government. But this is a reason to rejectthe tax. The American people already are overtaxed. Tax revenueshave soared from $517 billion in 1980 to more than $1.14 trilliontoday. Even after adjusting for inflation, this represents anincrease of 26 percent. The deficit exists because spending hasgrown even faster. Indeed, after adjusting for inflation, thefederal budget has increased by 42 percent since 1980.

Notonly have tax revenues grown faster than inflation since 1980, theyare expected to continue growing. According to both theCongressional Budget Office and the Office of Management andBudget, tax revenues are expected to grow by some $70 billion eachyear between now and 1998-without any legislated increase in taxrates or imposition of new taxes. Reducing the budget deficitsimply requires politicians to limit spending growth to less thanthis naturally occurring stream of new revenue.

Discussion of a VAT is even more disconcerting because politiciansalready are considering the tax-heavy Clinton budget package. TheClinton budget, with its more than $300 billion proposed tax hike,will slow the U.S. economy. Adding a giant new tax on top of thisrecord increase could be a disaster.

Assertion: Taxes on consumption do less damage to theeconomy than taxes on income and production.

Reality: The assertion is true, but simply because a VAT isless damaging than certain other taxes hardly qualifies as a reasonto impose the tax. This argument would only be relevant if policymakers were considering wholesale elimination of income taxes andwere seeking an alternative source of revenue.[19] But since politiciansview the VAT strictly as an additional source of revenue, adoptionof the tax simply would compound the damage caused by the currenttax code.

Itis also worth noting that not one of the countries with a VAT hasused the tax to eliminate taxes on income, profits, or production.Indeed, as shown earlier, the tax burden on productive economicactivity is higher in countries with VATs.

Enacting a ValueAdded Tax would be a costly disaster for American consumers andworkers. Once adopted, the VAT would prove irresistible topoliticians anxiously looking for funds to pay for new programs.The tax rate doubtless would climb, financing a surge of newfederal spending. The result: a stagnating economy, higher budgetdeficits, and fewer jobs for American workers. The Value Added Taxmay have some attractive theoretical qualities compared to taxes onincome and production. But in the real world it simply would beanother burden on an already overtaxed economy.

Daniel J. Mitchell, Ph.D., is McKennaSenior Research Fellow in the Thomas A. Roe Institute for EconomicPolicy Studies at The Heritage Foundation.

[1]"VAT Possibility Is Reconsidered at WhiteHouse," The Wall Street Journal, April 15, 1993, p. A16;"Sales tax back as 'possibility'," The Washington Times,April 15, 1993, p. A1; "White House Opens Door to New Tax," TheWashington Post, April 15, 1993, p. A1.