Shaves $3 trillion off the budget.

A consumption tax generally applies to spending on goods and services. There are different forms of such taxes, including value-added taxes (VATs), retail sales taxes, and excise taxes. A VAT is a type of consumption tax levied on the incremental increase in the value of a good or service that occurs at each stage of the supply chain until the final point of sale. For example, a retailer would pay a VAT on the difference between the value of goods it sold to consumers and the value of those goods when it purchased them from manufacturers; the manufacturers would pay a VAT on the difference between the value of the materials used to produce a good and the value of the finished good it sold to retailers. Like a VAT, a retail sales tax is a form of consumption tax collected on the purchase of goods and services, but it is only collected when a consumer purchases the final product. An excise tax, unlike a VAT or a retail sales tax, is generally levied on a smaller set of goods and services and is usually assessed on each unit purchased rather than on the value of the purchase.

The United States does not currently have a broad consumption-based tax at the federal level, although it does impose federal excise taxes on purchases of several types of goods and services, including gasoline, air travel, alcohol, and cigarettes. In addition, most states impose a retail sales tax on many goods and services. By contrast, more than 160 countries—including all members of the Organisation for Economic Co-operation and Development (OECD) other than the United States—have adopted broad-based VATs. In 2020, the average standard VAT rate for OECD countries was 19.3 percent, ranging from 4.5 percent in Andorra to 27 percent in Hungary. Because a VAT is the most common form of broad consumption-based tax, this option focuses on approaches to reducing the deficit by imposing a consumption tax in the form of a VAT.

Key Design Choices

There are many ways to design a VAT. Key design choices include:

Which goods and services to tax,

Whether to apply a uniform VAT rate or different rates to different sets of goods and services,

How to implement the VAT, and

Whether to exempt small businesses from the tax.

Goods and Services to Tax. A VAT generally does not apply to all purchases of goods and services. Most countries exclude certain categories of goods and services from a VAT, either because they serve a social interest (such as education and health services) or because their value added is difficult to measure (as with financial services). In addition, because a VAT is designed to tax domestic consumption, goods and services produced domestically and exported to other countries are generally excluded from the tax; by contrast, goods and services produced abroad and imported from other countries are generally subject to it. Goods and services excluded from the VAT can be either "zero-rated" (that is, taxed at a rate of zero percent) or exempt from the VAT. If a purchased item is zero-rated, the seller can claim a tax credit for the VAT that is paid on the purchased inputs—such as materials and equipment—used to produce the good or provide the service. By contrast, if a purchased item is exempted, the seller cannot claim a credit for the VAT paid on inputs purchased to produce that item. As a result, the value of those purchased inputs remains subject to the VAT.

Tax Rates. Although a standard rate usually applies to most goods or services, some are taxed at lower rates. That subset of goods and services generally includes those that represent a larger share of total consumption for households with lower income, such as food and public transportation services. Many countries impose those lower rates to promote equity, but lower VAT rates can also be applied to encourage consumption of goods and services considered to have a social benefit, including books and cultural and entertainment services, or to stimulate employment in specific economic sectors like hospitality and tourism.

Implementing the VAT. There are two primary ways to implement a VAT: the credit-invoice method and the subtraction method. Under the credit-invoice method, the tax is calculated for each transaction. A business remits the VAT collected on the total value of its sales of a particular good or service and claims a credit for the taxes paid on the purchased inputs. Under the subtraction method, the tax is calculated using information about a business's total activity. A VAT applies to the difference between the value of all taxable sales and the sum of all taxable purchases. Differences in how the VAT is administered can affect its budgetary effects. Because the credit-invoice method is generally easier to administer and enforce, it has been adopted in almost every country currently administering a VAT.

Exempting Small Businesses From the Tax. Most countries exempt small businesses (those with total sales below a specified threshold) from VATs because the tax would impose administrative and compliance costs larger than the revenue that would be raised from those businesses. The exemption threshold varies by country and by sector of the economy. However, small businesses that predominantly sell intermediate goods and services to businesses that are subject to the VAT often voluntarily register and collect the VAT. They do so because businesses that are required to remit the VAT cannot claim a credit for the VAT paid on purchases from VAT-exempt businesses.

Option

This option consists of two alternatives. Each alternative would use the credit-invoice method and go into effect on January 1, 2024—a year later than the other revenue options presented in this volume—to provide the Internal Revenue Service time to set up and administer the tax.

The first alternative would apply a 5 percent VAT to a broad base that would include most goods and services. Certain goods and services would be excluded from the base because their value is difficult to measure. Financial services without explicit fees and existing housing services would be exempted. (Existing housing services encompass both the monetary rents paid by tenants and rents imputed to owners who reside in their own homes. Although existing housing services would be excluded under this alternative, a tax on the purchase of new residential housing would cover all future consumption of housing services.) Primary and secondary education would be zero-rated, as would some other services provided by government agencies and nonprofit organizations for a small fee or at no cost. Expenditures for health care reimbursed by the government—primarily costs paid by Medicare and Medicaid—would also be zero-rated. After accounting for those exclusions, the tax base would encompass approximately 59 percent of household consumption in 2024.

The second alternative would apply a 5 percent VAT to a narrower base. In addition to the items excluded under the broad base, the narrow base would exclude certain goods and services that are considered necessary for subsistence or that provide broad social benefits. Specifically, new residential housing, food purchased for home consumption, health care, and postsecondary education would be zero-rated. After accounting for those exclusions, the tax base in this alternative would encompass about 37 percent of household consumption in 2024.

Effects on the Budget

The staff of the Joint Committee on Taxation (JCT) estimates that the first alternative would reduce the deficit by $3.05 trillion from 2024 to 2032, and the second alternative would reduce the deficit by $1.95 trillion over that same period. The reduction in the deficit under the second alternative would be lower than under the first alternative because the VAT would apply to a smaller tax base.