It is time to seriously consider a value added tax

Many Americans are unfamiliar with a value added tax (VAT) and therefore are apprehensive about such a tax. It is erroneous to think of VAT as a national sales tax. To understand VAT, first we have to understand the concept of value added (VA). VA is one of the ways Net National Product (NNP) is measured. If we add depreciation to NNP, wear and tear of capital goods (for example, machines and buildings), we get Gross Domestic Product (GDP). GDP is the market value of output of final goods and services produced in the country within a certain time period.

Since depreciation is replacement of capital, it does not represent addition to the output of the country in any given year. Hence it is the NNP, which represents net addition to output, that is the sum of value added in the country. On the income side VA is the sum total of wages, interest, rents and profits. To measure NNP we do not count the same goods and services twice in the output of final goods. For example, when we include the output of automobiles we do not count value of tires, plastic, steel, aluminum and other such goods. Automobiles are final goods and other goods, which are used to produce automobiles, are called intermediate goods. Therefore, to calculate VA of final goods we must subtract the value of intermediate goods. The sum of VA of final goods, which are not subject to further processing, is NNP.

Value added tax is a tax on the value added of final goods. A general VAT is a tax on the country’s output (NNP). It is also different from personal income tax and sales tax. Income tax is on income earned and not produced and/or consumed and sales tax is on sales’ prices of goods, including intermediate goods.   Therefore, sales tax is taxing intermediate goods twice and thus leads to higher retail sales prices.

As Professor David Hyman points out in his book on public finance, the most common method of administering VAT, found in most European countries, is the invoice method. At each stage of production sales are taxed at a fixed proportionate rate, and taxpayers can then deduct the tax on intermediate goods from the taxes they have paid on sales to determine their tax liability. Businesses are also permitted tax credit for taxes paid on capital goods such as machines, tools, and buildings. However, when individuals buy final goods they have no intermediate goods’ values to deduct from their taxes, hence they will pay prices that include VAT.

A consumption-type VAT encourages saving and will reduce the cost of capital; hence it will stimulate investment and capital formation, essential to build productive capacity of the country. Since it encourages saving, it will also help reduce our trade deficit and at the same time reduce our dependence on countries like China to finance our public debt. Professor Hyman reports a study that compares less distortionary income tax surcharge, raising $150 billion in revenues, with a consumption-type VAT that also raises $150 billion in revenues. It found that VAT, which raises the same revenue, would increase annual savings rate by 0.4 percent, capital stock by 5 percent and income growth by 0.8 percent per year in the long run.   Since the US economy and manufacturing sector in particular, are becoming more capital intensive, VAT will further contribute to the future growth of the economy.

VAT will require efficient management to minimize the cost of administration. Efficiency in administration can be achieved by having a single rate of VAT. If VAT is implemented, then some other taxes have to be reduced and/or eliminated to neutralize the excess burden of taxes by limiting, for example, the tax brackets of personal income tax with lower marginal rates, and reducing/and or eliminating corporate income tax. Tax exemptions must be limited otherwise it would cause distortions in consumption decisions. Exempting essentials like food products can minimize the regressive effect of VAT. As opposed to income tax, VAT will also provide incentive for work, as it does not tax income earned.  It will also increase the tax base by covering more people and businesses including on-line sales. VAT requires serious consideration by this administration. It is high time that we become a high saving country and not just a high consumption country.

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5 Responses to It is time to seriously consider a value added tax

  1. Bob Becker says:

    Certainly makes sense as something to be seriously considered as a means of increasing federal revenues, encouraging investment and savings. But it’s DOA politically because it’s a “Value Added Tax.” That just won’t do. Completely unacceptable to the Republican Right.

    Perhaps we might draw then on the wisdom of Ronald Reagan, who noticed that the supply-side-economics Laffer Curve bilge he’d been sold by his own party in Congress [i.e. that cutting taxes increases federal revenues] had blown a huge deficit hole in his budgets, and who quite reasonably figured out that he’d have to find a way to increase revenues and pronto. But he was on record as being against raising taxes. He hit on a brilliant scheme: he’d raise taxes, but he’d call them something else. He called them “revenue enhancements.”

    President Regan has shown VAT advocates the way. Stop proposing a Value Added Tax and propose instead Value Added Revenue Enhancements [VAREs].

    Why not? Worked for the Gipper.

  2. CanuckinCT says:

    Or just call it the Goods and Services debt reduction fund and do what Canada did with its VAT (they called it something different for a start) and have the net revenue’s go towards paying off the federal debt (debt reduction). Its not rocket science and it’s not an evil European import either (unlike the convoys of BMWs, Mercs, Audis and Volvo’s clogging the roads)

  3. Owain says:

    What’s not to like?

    Ask the Wall Street Journal

    Or Forbes

    The Heritage Foundations aren’t fans:

    The New York Times says Democrats used to hate it, because they feared it would target people other than then ‘evil rich’.

    Maybe the VAT isn’t all that it’s cracked up to be, but then again, I don’t think I’ve ever agreed with Vijay on anything else he’s written, so he has that perfect record going for him.

  4. Charles Trentelman says:

    hey owain, you never agree with vejay, but you never agree with me either so get out of this one: I am darkly suspicious of the value-added tax.

    Don’t trust it precisely because of that long list of things Vejay says it will do — not a shred of proof that any of those things will come true. Much like the Laffer Curve, it sounds good, but sounds aren’t reality. He thinks he’s got all the angles covered, but as Rumsfeld very accurately said, it’s the unknown unknowns that bite you in the butt.

    I don’t think the rich are evil, owain — I just think they are given far too much credit for doing good with their money — notice how the GOP is, once again, saying Obama wants to create “job creators” without, once again, showing us how those so-called job creators will actually create more jobs if they aren’t taxed? With unemployment at 9 percent nationally, seems to me if they were going to do any job creation, now would be the time and THEN, maybe, we could talk tax cuts.

  5. Charles Trentelman says:

    i mean obama wants to punish, not create. silly me.

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