A dishonest debate on VAT

The debate over a national sales tax, or value-added tax (VAT), to tackle the country’s deficit and debt problems is becoming fiercer as we approach the fall election. Unfortunately, the facts are becoming more obscure, and the narrow scope within which a VAT makes sense is being lost. This should be clarified or the nation will miss an opportunity for reform or impose a tax that makes things worse.

The current debate centers on the European experience. Opponents decry the VAT since it has not solved European deficit problems, rates have steadily increased, and revenues from the VAT have enabled Europe’s large welfare state. All of these arguments are correct but not the end of the story.

VATs are a major source of revenue in Europe. Nations of the European Union are required to impose a VAT as a condition of membership. The minimum rate allowed is 15 percent, which currently only Luxembourg uses. Most member countries have much higher rates, with Denmark, Hungary, and Sweden all imposing the maximum rate of 25 percent.

It is also true that European governments have consistently increased their VATs. However, the increases are a result of the design, which imbeds the tax in the final price of goods and services, where consumers do not see it. Such opacity provides convenient cover for politicians and bureaucrats to increase rates, but this design flaw can be corrected. Our northern neighbor’s experience shows that rate increases are not inevitable.

Canada introduced a VAT, the goods and services tax (GST), in 1991 at a rate of 7 percent, and it’s visible to consumers. That explains why Canadians loathe the GST and why it would be political suicide for any political party to suggest increasing it. Indeed, the rate was recently reduced to 5 percent.

In the United States, promoters argue that a VAT can solve the deficit problem with the least amount of economic damage. This argument is both right and wrong. The increased revenues generated by the VAT in Europe have not solved their deficit and debt problems. European governments simply spent the additional revenues rather than using them to balance their books.

Those arguing for a VAT based on lower economic costs also have a point because not all taxes are the same. Corporate and personal income taxes impose enormous costs on an economy by discouraging work effort, investment and entrepreneurship, which ultimately reduces economic growth. The incentive effects of consumption taxes like the VAT, on the other hand are minor, and thus one of the least costly ways to raise revenue.

Switching from costly taxes like corporate and personal income taxes to a VAT makes a great deal of sense. The key consideration is how resources from the VAT will be used. Here again the Canadian experience is informative.

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 owing to the Great Recession.) In other words, the revenues from the GST in Canada were not used to finance more government spending. In fact, Canadian governments switched from income to consumption taxes, which made the tax system less costly, while also decreasing the overall tax burden.

If the plan were to reduce spending in the United States and concurrently implement tax reform based on greater reliance on consumption taxes in place of corporate and personal income taxes, then a VAT makes sense. Unfortunately, that’s not the argument being made by proponents of the VAT.

They want more government spending and a new revenue source, on top of all the others, to finance it. Such an expansion of government, even if financed by a low-cost tax, will not fix deficits and debt, and will mean less economic prosperity in the future.

Jason Clemens is the director of research at the Pacific Research Institute (www.pacificresearch.org). Prior to joining PRI in 2008, he was a senior researcher at Canada’s Fraser Institute for 11 years.