A VAT does not increase economic growth or improve competitiveness – VAT as an addition to the tax code only exacerbates the existing issues

Six VAT Myths In addition to damaging the economy, levying a VAT on top of all of the other federal taxes that Americans already pay would overwhelm all of the VAT’s theoretical advantages. While the economy could conceivably be stronger if the VAT completely replaced the entire income tax code,[14] fundamental tax reform is not a high priority in Congress in the current budget environment. If Congress considers a VAT, it would most likely be as a method to raise more revenue to close the deficit. The inefficiencies of the income tax would remain and the inefficiencies unique to a VAT would be added on top to create an even heavier drag on the economy and burden on taxpayers. Six myths are commonly submitted in defense of the VAT. Most result from a misunderstanding of the difference between a VAT as a replacement for all current income taxes and a VAT as an addition to the current taxes. Myth #1: A VAT would increase the savings rate. Some argue that a VAT would encourage saving because it would raise the prices of everything we buy. In this line of thinking, Americans would buy fewer goods and services and therefore save money that they formerly spent. A VAT would undoubtedly raise the prices of everything that consumers buy, but this would not increase the savings rate. The low savings rate is not the result of low prices, but of the current tax code that discourages savings by taxing returns of investment through taxes on capital gains, dividends, and interest. Adding a VAT would not change this. As long as the income tax continues to tax capital income and capital gains, the tax code will continue to discourage saving. In fact, adding a VAT to the current tax code would reduce savings for an extended period and result in a permanent loss in wealth and growth. A VAT would potentially raise the prices of consumer goods and services between 15 percent and 20 percent. To sustain as much of their current consumption as possible, families would need to save less and even dip into previous savings to purchase the same amount of goods and services that they consumed before the VAT. Myth #2: A VAT would increase investment. Since some argue the VAT would increase savings, they subsequently argue that it would also increase investment. Once again, they confuse the effects of a VAT as a replacement for the current tax code with the effects of adding a VAT to the current tax code. Investment would likely decrease if Congress added a VAT to the current tax system, especially in the short term, because households would need to cut back on savings and withdraw previous savings to maintain current levels of consumption. Myth #3: A VAT would encourage economic growth. Few economists argue that tax hikes encourage economic growth. Yet some argue that a VAT would improve economic growth because it would tax consumption instead of income. The income tax’s highly progressive structure[15] and the double taxation of capital income and capital gains strongly discourage working, saving, and investing, which are essential to economic growth. If Congress added a VAT on top of the current system, the disincentives to work, save, and invest would persist. In fact, the disincentives to work and save would actually increase further. The VAT would likely reduce the savings rate for an extended period. In terms of growth effects, the VAT is economically equivalent to a tax on labor and so it would discourage work even more. Myth #4: VAT promotes exports. Because the VAT is rebated on exports and imposed on imports (the border tax-adjustment system), some contend that the VAT would make American products more competitive in the global market. This is false. A VAT would have no effect on the competitiveness of United States exports. Once again, proponents are confusing the potential advantages of a VAT as a replacement for the income tax with the realities of a VAT as an add-on tax. Even if the VAT itself is internationally neutral because of border tax adjustments, adding a VAT does not reduce the disadvantages imposed by the income tax, which lacks these border tax adjustments and is therefore detrimental to U.S. competitiveness. Myth #5: VAT allows for lower income taxes. Some proponents tout the VAT as a solution to massive deficits. Without cutting spending to lower the deficit, Congress will have little room to reduce income taxes because all the income tax revenue plus the VAT revenue will be needed to bring the deficit under control. Nevertheless, if Congress were to pass a VAT, it would likely include some minimal and temporary reductions of the income tax to buy support from the American people and certain lawmakers. However, as long as Congress retains the power to levy an income tax under the 16th Amendment, future Congresses could always raise it back to its previous levels or even higher. This has been the experience in Europe. Income taxes have actually increased after the countries implemented VATs, despite promises to the contrary.[16] The combination of a VAT and the income tax in the United States would likely lead to similar income tax increases as successive Congresses look for more revenue to spend. This would lead to further increases in the tax burden and the slower rates of economic growth from higher taxation. The only way the VAT or any other national consumption tax could be acceptable is if the 16th Amendment were simultaneously repealed. Myth #6: VAT would close the deficit. Congress spends every dollar of tax revenue plus as much as it can borrow from credit markets.[17] It is on track to push the limits of credit markets. There is little reason to believe that Congress would suddenly discover fiscal discipline after levying a VAT. More likely, it would spend the VAT revenue on new programs and continue borrowing as much as possible. Giving Congress more taxpayer money to spend would likely worsen the current fiscal crisis until credit markets decide to stop lending to the United States because they no longer are confident that it can repay its debts. Greece is a good example of how this could happen. Despite its 19 percent VAT, credit markets have stopped lending to it at reasonable rates because of its chronic and unsustainable overspending. The credit market may soon stop lending to other similarly fiscally troubled countries that levy substantial VATs, including Portugal (21 percent), Italy (20 percent), and Ireland (21.5 percent). Given the political realities, the only way to close a budget deficit is to reduce spending. Higher taxes consistently lead to higher spending. An Unnecessary Tax The current and future deficits are threatening the stability of the U.S. economy and have prompted some camps to consider the VAT as a way to eliminate the deficit. Congress’s overspending has caused the threatening deficits, not a lack of tax revenue. If Congress permanently extends the 2001 and 2003 tax relief for all taxpayers and patches the alternative minimum tax (AMT) so it does not affect middle-income families, federal tax revenues will still exceed their historical level of 18 percent of GDP in the coming years. On the other hand, under President Barack Obama’s budget, spending will rise to 24 percent of GDP by the end of this decade—a considerably higher level than the historical average of 20 percent of GDP. Unchecked entitlement spending will push this level even higher in the coming decades. Unless Congress restrains spending, ever-higher tax levels will be required to close the deficits. Yet as European nations are discovering, even the VAT cannot solve their problems. They need to fundamentally restructure their entitlement and welfare spending. Congress should ignore misguided siren calls for a VAT and instead immediately address its spending problems. Tax increases will never reduce the gap. Instead, Congress must cut spending to 20 percent of GDP or lower. This would reduce the annual budget deficit to a more manageable level. The national debt would stabilize as a percentage of GDP and the threat that credit markets will stop lending or raise interest rates would abate. None of these necessary steps requires a VAT. —Curtis S. Dubay is a Senior Analyst in Tax Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation