Economics of a U.S. VAT

A recent lead editorial in one of the world’s most prominent newspapers, the Wall Street Journal, pointed out the risks associated with the United States adopting a national sales tax, or value-added tax (VAT). The problem with the editorial, however, is that it selectively analyzed the tax reform opportunity for the U.S. and conflated different aspects of a VAT, downplaying the real opportunity for the U.S. with respect to tax reform.

Let’s begin with what’s right about the editorial.

There was a limited but nonetheless fairly accurate description of a VAT. Unlike most state-level sales taxes in the U.S., a VAT applies broadly to both goods and services. It’s assessed at each stage of production rather than just at the final purchase. However, the editorial failed to mention that the tax only applies to the value-added at each stage of production.

The editorial also failed to mention that unlike many sales taxes, VATs generally exempt machinery, equipment, and other business inputs. This exemption means that VATs lower the marginal effective tax on business investment, which encourages such activities.

Economists generally prefer consumption taxes like VATs to almost every other type of tax because it has comparatively lower distortionary effects and is generally less expensive to administer. Put simply, VATs are low-cost, efficient ways to finance government, and as long as we all agree that we need some level of government activity, it might as well be financed efficiently.

The editorial also correctly describes the marked run-up in the rate of VATs across the industrialized world. In both Europe, where VATs are required, and in every OECD country, VAT rates have been climbing as countries struggle with budget deficits. For example, the average rate in the EU is now a startling 21.6 per cent.

The editorial also correctly explained why there has been such a marked increase in VAT rates: lack of visibility. ”Because VATs are embedded in the price of products,” it read, “they can often rise unnoticed by the consumer.” In other words, VATs are an easy way to raise more revenue because the end consumer doesn’t see the tax when they purchase goods and services.

Contrary to the inference of the editorial, however, there is nothing in the design or implementation of a VAT that requires it to be embedded in the final price. In this respect the experience of the northern neighbor, Canada, is instructive.

Canada introduced a national VAT, the goods and services tax (GST), in 1991 at a rate of seven percent. And it’s visible to consumers, which is why it’s the single-most hated tax in the country. Every time a Canadian buys a coffee or donut, purchases clothes, goes to the movies, pays their cellphone bill, etc. they see the GST on their receipt. This visibility has made it almost politically impossible for any government to increase the tax. Indeed, in stark contrast to the experiences presented in the WSJ editorial, Canada reduced the national VAT to five percent.

The Canadian experience also contradicts the WSJ editorial’s assertion about the inevitability of big-government spending when a VAT is introduced. Government spending in Canada as a share of the economy declined from 52 percent in 1991 when the GST was introduced to roughly 39 percent in 2007. (It has since increased thanks to the recession.)

The revenues from Canada’s VAT did not finance more government spending. In fact, Canadian governments switched from relying on income to consumption taxes, which made the tax system less economically damaging.

And therein lies the opportunity for the United States: tax reform. The U.S. could shift from its heavy reliance on income taxes (both absolute and comparative) to a consumption tax without affecting the budget deficit.

Ironically, the WSJ paraphrases Ronald Reagan and Milton Friedman regarding their preference for taxes that are hardest for government to raise. Understanding the Canadian experience with our national VAT would lead to an opposite conclusion in the WSJ editorial.