What is a 'value-added tax' and what can it mean for the economy?

A well-designed Value-Added Tax could simplify the tax code for most households and finance significant reductions in corporate and individual income tax rates without adding to the budget deficit. And it could be a key piece of a revenue system that is both progressive and less intrusive in economic decisions than today’s law.

That’s the conclusion of a new study by my Tax Policy Center colleagues Eric Toder, Jim Nunns, and Joe Rosenberg.

The VAT, a national consumption levy that would tax household purchases of all goods and services, is hardly perfect—no tax is. But properly structured, it could be a vast improvement over what we have.

In a project funded by the Pew Charitable Trusts, TPC modeled a sweeping reform of the federal tax system that includes a VAT. The plan was authored by Columbia Law School professor Michael Graetz . While there are many forms of consumption taxes (Herman Cain’s 9-9-9 tax included several), Graetz’s is similar in structure to the one used by most other countries. In effect, every business pays tax on its sales and gets a credit for any tax that is included in the price of what it buys from other firms.

Graetz does not eliminate the existing income or payroll tax. This no doubt disappoints some reformers, but helps fix a problem that is common to many consumption taxes—they hit poor people (who spend nearly all of their income) more than rich people (who don’t).

Mike’s solution is two-fold: First, he creates a family allowance of $100,000 ($50,000 for single filers), which wipes out all income tax liability for 8 out of 10 households. To ease the burden of the VAT on low-income families, he also creates a rebate tied to wage and self-employment income. But he does not exempt items such as food or housing from the tax.

Graetz sets two income tax rates–16 percent and 25.5 percent—that apply to all income, including capital gains and dividends. He’d repeal the Alternative Minimum Tax. He’d also eliminate the standard deduction and all family-based provisions, such as personal exemptions and the child credit and earned income credit, which he’d replace with the rebates.

He’d allow deductions for charitable gifts and mortgage interest only if they exceed 2 percent of adjusted gross income. Of course, these wouldn’t matter for those making $100,000 or less, since they’d owe no income tax anyway.

Finally, Graetz would cut the corporate rate to 15 percent, eliminate all business credits except the foreign tax credit, and end many deductions and exemptions.

Eric, Jim, and Joe figure Graetz could do all this with a relatively low VAT rate of 12.3 percent. That would raise the same amount of money as the 2011 tax law and be just about as progressive. People in various income groups might pay a bit more or less on average than they do today, but the changes would be surprisingly small.

Besides fairness, economists always look at how much any tax law distorts economic decisions. The current code is a swamp of subsidies aimed at encouraging or discouraging specific economic behavior. By contrast, a well-designed VAT mostly keeps government out of these decisions. It would reduce effective marginal taxes on labor, thus encouraging people to work. And it would reduce overall effective tax rates on capital.

The VAT does have issues. While it would reduce compliance costs for individuals, it would also create new administrative burdens for businesses that have to collect it.

But the biggest question is whether Congress would ever pass such a levy in anything like its ideal form. Any consumption tax must have a very broad base to succeed and this one does. It would apply to new home construction, health and education spending, and purchases and payrolls of non-profits and state and local governments. If Congress buckles under the inevitable pressure to exempt some or all of this consumption from tax, it would have to raise the rate.                                                                                                   

Still, at a time when the campaign trail is awash in tax “reform” plans that are more surreal than serious, it’s nice to see a proposal that has the potential to vastly improve the revenue code without adding trillions to the deficit or providing a windfall to those who need it least.