VAT is key to raise revenue to solve federal debt – that reduces risk of inflation.

Q. How large is the long-run fiscal imbalance and what is driving it? How much has the COVID-19 pandemic added to the imbalance?

In June 2019, the Congressional Budget Office (CBO) projected that the federal government’s debt under current law would rise from 78 percent of annual gross domestic product (GDP) in 2019 to 144 percent in 2049.

The fiscal imbalance further widened during the recession accompanying the pandemic in 2020, as tax revenue fell and Congress adopted large spending increases and tax cuts to provide income support and economic stimulus. On March 5, 2021, the CBO projected that the debt would grow to 202 percent of annual GDP in 2051.

That estimate does not include the costs of the $1.9 trillion stimulus and relief plan that became law in March 2021. Congressional action to respond to the pandemic was likely necessary but has added to the government’s debt.

The underlying cause of the long-run fiscal imbalance is that spending on Social Security and the major health care programs (Medicare, Medicaid and Affordable Care Act health insurance premium subsidies) is growing much more rapidly than revenue, due to population aging and rising medical costs.

The CBO projects that, under current law, noninterest spending will rise from 19.2 percent of GDP in 2019 to 23.1 percent in 2051, while revenue will only grow from 16.3 percent of GDP to 18.5 percent. The projected spending increase is highly uneven; spending on Social Security and the major health care programs will surge from 10.2 percent of GDP to 15.7 percent, while all other noninterest spending will shrink from 9.0 percent of GDP to 7.4 percent.

Addressing the fiscal imbalance will require reductions in Social Security and health care spending, revenue increases or both.

Why is the growth of the national debt concerning?

The CBO has explained that higher debt will slow long-run economic growth by crowding out private investment and pushing up interest payments to foreigners who hold Treasuries. It may also increase the risk of a crisis in which investors demand higher interest rates for federal debt. Higher debt may also lead to higher inflation expectations and may reduce flexibility to respond to unforeseen events.

When addressing the fiscal imbalance, time is not on our side. Delay will only make the necessary responses more painful. The CBO estimated in September 2020 that holding the 2050 debt to its 2019 share of GDP would require permanent tax increases or spending cuts equal to 3.6 percent of GDP, if those measures took effect in 2025. The required magnitude of the tax increases or spending cuts would rise to 4.4 percent of GDP if action were delayed to 2030 and to 5.9 percent if action were put off to 2035.

Although it would be unwise to implement major tax increases or spending cuts while the economy is still weakened by the pandemic, action should be taken as soon as possible after the economy regains its strength.

Q. You have proposed implementing a national value-added tax (VAT) to boost revenue. What is a VAT and how does it differ from a retail sales tax?

The VAT is a consumption tax that is used in 160 countries, including all Organization for Economic Cooperation and Development (OECD) countries other than the United States. A VAT is economically similar to a retail sales tax but is collected in a different manner.

While the retail sales tax is collected entirely from the retailer, part of the VAT is collected at each stage of production. The multistage collection ensures that the entire revenue cannot be lost through tax evasion at a single stage of production.

Suppose that a manufacturer sells its output for $500 to a wholesaler, which sells its output for $800 to a retailer, which sells a final product to consumers for $1,000. Of the $1,000 value of the final product, $500 is added at the manufacturing stage, $300 at the wholesale stage and $200 at the retail stage.

Under a retail sales tax, the retailer remits tax on the $1,000 of sales to consumers. Under a VAT, the manufacturer remits tax on its $500 of value added, the wholesaler remits tax on its $300 of value added, and the retailer remits tax on its $200 of value added, yielding the same combined tax payment as the retail sales tax.

Q. A VAT would raise taxes on the middle class. Could this be avoided by relying instead on tax increases that target corporations and high-income households? What about benefit cuts?

Although tax increases on corporations and high-income households as well as benefit cuts could be part of a debt-reduction package, they cannot provide a full solution to the long-term fiscal imbalance.

High-income tax increases would reduce inequality and place fiscal burdens on those with the greatest ability to pay, but they would also induce economic distortions, thus threatening long-run growth. The individual income tax and the estate and gift tax penalize saving. The corporate income tax distorts decisions about business organization and financing and penalizes investment in the United States. None of those penalties arise under a VAT.

Also, such tax increases would have limited revenue potential. Even commentators who support these kind of measures recognize that they would not raise enough revenue to fully address the fiscal imbalance and would have to be accompanied by other measures.