by Duncan K. Foley, Leo Model Professor of Economics and SCEPA Faculty Fellow
With its crumbling infrastructure, decaying public education system, and aging population, the U.S. faces the need for higher federal revenues in the coming decades. A consumption-based value-added tax (a national sales tax which exempts investment along with other intermediate inputs and is collected as part of the price of goods and services sold to final consumers) has several advantages over increased income taxes on personal or corporate incomes or higher excise taxes. The VAT is a broad-based tax (essentially on the whole of GDP) which generates high revenues at low rates, minimizing its distorting effects on work incentives. A consumption-based VAT exempts investment spending, thus encouraging job creation and the modernization of plant and equipment. VAT can under international treaties be refunded on exports and imposed on imports, unlike income taxes, which improves the competitiveness of U.S.-produced goods and services.
Progressives frequently oppose VAT on the grounds that it is less progressive than the income tax. Wealthier households pay more VAT, of course, since they spend more on consumption, but because consumption is a smaller share of income for wealthier households, the proportion of their incomes taken by VAT is smaller. Because VAT is a sales tax, it is impossible to levy at higher rates on wealthier households. VAT can be made more progressive by exempting necessities such as healthy food and clothing, which constitute a larger part of the consumption budgets of lower income households. Such exemptions are a common feature of VATs levied in other countries.
VAT could also be part of a package which taken as a whole would increase the overall progressivity of the U.S. tax system. VAT could be substituted for the more regressive FICA payroll taxes that currently are earmarked for the Social Security and Medicare trust funds. The President's new stimulus proposal already suggests a reduction in payroll taxes for workers, if a temporary one. Whether that remains temporary is of some concern. If it is made permanent, it could provide more argument to those worried about Social Security deficits in the future.
An even broader reform would be to replace both payroll taxes and the corporate income tax with a VAT, thus greatly simplifying the tax structure, eliminating the chronic problems of enforcement and interpretation that accompany the corporate income tax, and securing a broadly-based revenue source to secure the solvency of the Federal government. A VAT is essentially a tax on the whole of national income, including both wages (partially taxed under the current system by payroll taxes) and profits (partially taxed under the current system by the corporate income tax). VATs in many European nations are a major source of revenue.
Under the reform proposed here individual workers would maintain individual Social Security accounts as at present. Their contributions to their accounts would continue to be calculated as under present law, but would be actually paid out of the VAT revenues, which would be earmarked for this purpose. Employed workers contribute to national income by adding value through their labor, so an earmarked VAT would amount in incidence terms to a different method of collecting worker contributions to Social Security and Medicare, preserving the integrity of individual Social Security accounts. The disincentives to job creation that the current payroll tax system creates would, however, be mitigated by a shift to a VAT due to its lower rates and broader base.