April 8, 2010

Value Added Tax? Maybe, if...

Many countries have a value added tax (VAT).  It's a tax at each stage of the economic cycle which can be fairly easily explained (see below). In considering the option the United States could easily implement a VAT and it would certainly see some strong gains in government revenue.  For many years until the recession Canada had been running budget surpluses and in large part it was attributable to the Goods and Services Tax (GST) which is a VAT.  But is adding an additional tax, especially in a lingering recession, the right way to go?  That's a lot harder to justify.  Still there's ways it could be done, for example replacing some existing taxation rather than simply piling new taxation on.  And there are reasons conservatives could get on board with that part of the idea.

Firstly, it's worthwhile to provide a brief explanation of how a value added tax works.  Using Milton Friedman's famous pencil example, a logger cuts down a tree and the logging company sells the wood to a lumber mill.  Let's suppose the VAT is 10% (don't worry, no real math will be used here). That sale requires a 10% tax be collected by the logging company.  The lumber mill then cuts the lumber into various pieces of differing sizes.  Some of those pieces are useful for the pencil-making company. When the lumber company sells that lumber to the pencil making company another 10% VAT is applied.  But not on the whole amount because some of it was applied by the logging company.  The lumber company must collect the tax on the portion of value it added to the supply chain. So it must calculate the value of what it sold, subtract what it bought and apply the VAT to that portion only.  How this is done, is the lumber company can deduct the VAT it paid to the logging company from the VAT it collected from the pencil-making company.

The pencil-making company must then do the same, and then the wholesaler they sell it to, and then the retailer, and then finally the consumer gets charged the VAT on the sale price.  Because each link in the chain is charging extra to pay it's tax remittance, the tax is passed along the chain and the consumer is in effect paying the VAT for the entire chain. 

What other impacts are there?  More administrative burden on supply chain companies in the same vein as Sarbanes-Oxley. Which means more overhead and more cost which will be passed on to consumers and therefore a larger amount to collect that VAT on.  In other words, everything gets more expensive for consumers, and more so than just that 10%.  It's 10% plus the incremental administrative costs that are passed along the supply chain.  Some chains can be very lengthy - think automobiles.  

That's bad news for consumers. But assuming the GDP of $14 trillion dollars, that represents a revenue of $1.4 trillion.  That could wipe out a lot of debt. But who wants another $1.4 trillion in taxes?  But what if, that VAT replaced some existing taxes?  According to the Tax Policy Center, in 2008;
In 2008 the federal government collected $2.5 trillion, an amount equal to 17.7 percent of GDP
45% came from Income Tax - $1.125 trillion
36% came from Payroll Tax - $0.9 trillion
12% came from Corporate Income Tax - $0.3 trillion
3% Came from Excise Tax - $0.075 trillion
4% came from other sources - $0.1 trillion ( or $100 billion)

What if we took that 10%, made it 20% and collected $2.8 trillion instead of $1.4 trillion? If companies had a  Tax Registration Number, then all of that VAT processing could be done electronically. There would no longer need to be 100,000+ employees who are needed to manage 7500 letter-size pages worth of tax code at a cost of $10 billion per year. That number could over time conceivably be shrunk by at least 80%.  That's only a savings of $8 billion.  But think of the spin-off benefits.

No corporate taxes means there's one less incentive for companies to offshore their operations, which could stimulate employment.  By simplifying the taxation requirements companies could operate with less overhead and be more competitive internationally.  Not to mention the fact that a 0% corporate tax rate would actually attract some businesses, particularly higher end businesses, from outside the United States to bring their jobs onshore. With skilled labor and low taxes, it's fertile ground for high tech companies to work on.  All of that means good news for unemployment, except in the short term for those 80,000 laid off IRS workers. Another  added benefit would be the dismantling of a government beast, one that is necessary for policing the new health care behemoth. So there's another benefit there as well.

No payroll taxes, and no income taxes means more disposable income for consumers which frees up their money for consumption or investment.  That consumption, would of course be subject to the VAT, but the consumer would have discretion about how to address that situation.  Whether that has a net effect requires some research, but as most conservatives suspect, the private sector is better at allocation than the government.  The liberty to spend how you see fit versus what the government does with your Income and Payroll tax, is inherently a good thing.

The other benefits is that in order to be bi-partisan about it, the GOP could demand that in addition to th VAT replacing those taxes, some government programs have to be cut in order to be on board.  Shrinking government is key to getting costs under control, and the Democrats, in dire need of something bi-partisan might bite on some of the Republican demands.  If not, there's always the available filibuster now.

So is a VAT a bad thing?  Not necessarily.  It's bad if it's just piled on to the status quo.  But everything can be viewed as an opportunity.  A VAT is not exactly a flat tax, but it does represent for the Republicans a chance to be viewed by some on-the-fence voters as something other than the party of 'no'. I'm not a big supporter of a VAT because it never comes as a replacement but as just another tax.  But there's nothing wrong with taking lemons and trying to make lemonade.

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