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The Brown Political Review is a non-partisan political publication that seeks to promote ideological diversity. All of the views reflected in BPR’s content are views held by authors and not reflective of the views held by the wider organization or the Executive Board.

Value Added Taxes: The Bold Change America Needs?

The great curse of being a US federal budget-watcher is that it is nearly impossible to overstate the severity of the path the country is on, and yet it is also equally difficult to do anything to alter that path. The deficit for 2016 contributed around $587 billion to an already oversized national debt. In the next ten years, government projections expect the nation to consistently fail to take in as much as it spends. By 2026, federal debt held by the public will be 86 percent of the country’s gross domestic product (GDP), more than twice the average over recent history. And, thanks to the rising tide of automation, the tax base itself could continue to shrink if jobs are displaced without being replaced. All told, the long-term prospects for the federal budget are rather dismal.

The US is in the middle of an 80-year-long car crash that the political system seems to be unable to tackle by, for example, reforming entitlements. Assuming for the sake of simplicity that spending reform is truly off the table, the only path to solvency is increasing revenues. In a world where the tax collection scheme is perfectly efficient and rational, increasing government revenues poses a genuine dilemma because it demands burdening the population more than the status quo. Luckily, the US tax system is so broken that there is a simpler alternative to make more money for the government and massively boost economic growth.

That alternative is called a Value Added Tax, or VAT, and it could replace the US corporate income tax entirely. Thanks to the complexities of tax law, the corporate income tax is primarily imposed on large multinational corporations, most of which pay around the top rate of 39 percent, and applies to the money corporations earn after subtracting out the cost of wages and goods sold, plus a fraction of capital investment costs. While the US corporate tax rate is the third highest in the world and much higher than any other developed nation, the US is also one of the only countries in the world to maintain a territorial tax structure, meaning that multinationals which want to bring profits earned overseas back into the country have to pay that entire extra tax burden. The result is that hundreds of billions of dollars of potential investment in the US sits overseas to avoid taxes even as more and more companies “invert” and move their official headquarters to other nations to avoid the tax system altogether. The corporate income tax, even when it is applied, fails to impact owners of capital to such an extent that about 70 percent of the tax burden on companies is shouldered by workers.

That’s the 30,000-foot view. At the ground level, the biggest corporate players successfully engineer tax loopholes for themselves to generate lower “marginal effective tax rates,” or what the market actually believes companies will pay in taxes. In some industries, the METR can be as low as 26 percent. While that is still comparatively higher than many other countries, the fact is that these loopholes are purposefully built to favor only certain incumbent powers and to box out competition. Indeed, the US gives out more “tax breaks” each year than it spends on all discretionary spending.

The VAT, by contrast, is too simple to cheat, preempts inversions and offshoring, builds a framework that can protect workers from the burden they currently shoulder and has the added benefit of not affecting investment adversely, meaning that companies are incentivized to build for future growth. It is applied to the value every business in the chain of production produces.

Now, there is probably sufficient reason to support a VAT simply because it isn’t bad in all of the ways that the current system is, but it is also critical to compare it to the theory of what an ideal tax should look like. Various frameworks go into more depth, but three ideas deserve emphasis. First, there is very real value in making taxation intelligible to the common citizen. When a government lowers the barrier to entry in policy debates, it encourages civic participation and gives every voter the tools to evaluate policy decisions. One reason cronyism in the current tax code is so hard to tackle is that it is indecipherable from the outset. Nearly one in three small business owners admit that they can’t understand the tax burden they face, and almost 90 percent of all small businesses have to hire an accountant. Basically, good-spirited observers simply don’t have the requisite expertise to combat corruption when they see it.

Second, tax burdens ought to be as broad-based as possible. A revenue-neutral VAT would tax everyone at less than three percent, maybe lower than 1.5 percent, and it would apply to absolutely everything in the economy. A low rate tax means that fewer economic actors have their choices constrained by government revenue collection. In other words, companies deciding where or how to invest don’t have to weigh economic return against an overpoweringly large tax burden.

Finally, governments should generally encourage investment, otherwise called savings, above consumption. While consumption has a short-term stimulative effect, it is fundamentally less important to the economy than long-term growth. The US is currently failing at a macro level to save enough for future growth. On a micro level, individuals benefit immensely from having a nest egg for financial emergencies and for retirement, situations for which the average person is underprepared. A VAT does not tax capital investments by companies, so that when United Steel or SpaceX are deciding how to spend money, a new factory is comparatively more attractive because the company can convert all the money it wants to spend into things instead of losing some efficiency through tax. Simultaneously, recall that corporations already pass on their tax burden to consumers and will continue to do so. With a VAT, buying things in the short term looks marginally less attractive thanks to that extra tax, and so the US encourages investment over consumption.

This raises the most potent objection to a VAT: that punishing consumption is regressive. The poor have a higher marginal propensity to consume the dollars they earn because they have to buy the same amount of things that richer citizens do to live life, and thus have less of a cushion of savings if costs go up and because it costs more to be poor in the first place. This critique lacks nuance. Remember that it is possible to simply implement a revenue neutral VAT that would burden corporations equally as the status quo. Presumably, the poor would suffer evenly in both scenarios. However, VAT distributes taxation more evenly, lowering the rate on any given product, which has the potential to actually burden the poor less.

In addition, although it is suboptimal that the poor have a limited amount of money to spend or save in any given time period, it may still be comparatively more advantageous for the poor to put a dollar to work in investment and saving rather than buying something, even if this restraint on consumption leaves them appreciably worse off. More money in the long term might be more utile to any one person because of their circumstances than more money in the short term.

Finally, a dynamic evaluation of the benefits a VAT accrues when the economy gets a chance to respond to the new incentive structure shows that long-term GDP growth increases by about six percent. Layer in the double digit GDP slowdown that accrues from doing nothing about the national debt, and it becomes clear that a VAT has the potential to massively decrease the unemployment rate; Okun’s law says two extra points of GDP growth reduces unemployment by one percent. Basically, even if poor Americans are punished by higher consumption prices, it might make sense to stomach those harms in exchange for higher employment that benefits the least well off more substantially.

What if this defense of the VAT is simply wrong? Is a VAT doomed? Not quite: A little over 20 years ago, economist David Bradford introduced a fully progressive modification called the X Tax. Under this model, when companies go to calculate how much value they added, they get to deduct wages as well as their component costs. As such, companies pay less up front because it appears that they added less value. They probably still continue passing on a portion of their burden to workers, but this burden is certainly less than it is currently. Then, to make up the lost revenue, workers file an extremely simple tax return where they just report their wages. The taxes they pay can be highly progressive as they are now. The bottom 45 percent of earners can continue to pay nothing, while everyone else pays a tax on their income proportionate to their income size. Because interest is not filed as income in the X-tax, the income tax has the added benefit of incentivizing investment.

Generally, reducing the tax on investments is seen as a surefire tell that the tax proposal at play is by the rich and for the rich. But consider what a baseline world with the X-tax actually looks like. The government takes in exactly the same number of dollars as before; companies pay some tax on the value they produce; the wealthier half of society shoulders the rest of the tax burden on the dollars they make while the poorer pays nothing.

So what exactly would layering onto this system a tax on investments do? All the money that gets invested in the market used to be taxable income. All the returns that a given investment produces already factor in the loss companies take from their taxes. At no stage in the investment process is “new” money, or dollars that haven’t already paid what society thinks is a fair share, in play. One practical reason that it is a bad idea to further punish investors with a capital gains tax is that investors are not all millionaires on Wall Street. Indeed, low barriers to entry and limited red tape are factors that can encourage layman investing, a principle that is generally accepted to be an advantage for the economy. It gives anyone, rich or poor, the ability to build a nest egg more quickly and at market rates of return three to five times higher than social security’s dismal two percent return on investment. In the long run, tiny compounded savings offer a path to financial security, healthier spending habits, better credit, and greater economic mobility.

This investment taxation system could also punish the poor. Imagine that there is a 10 percent tax on income earned from investments. A millionaire and someone working minimum wage both invest a little money in the stock market, and one year later both have to buy a new car. The millionaire doesn’t want to incur a tax just yet, and would prefer to let her investment keep compounding. Because she has extra cash, this is no problem for her. Later, although she won’t have any pressing need for the money, she can withdraw that investment for even greater profit and pay the tax then. The poor worker, however, doesn’t have that kind of liquidity, and must sell her investment to pay for the car, and pay the tax in the process. In other words, when you “double tax” investments, the rich can postpone triggering the tax thanks to their income, but the poor can’t.  The poor take a concrete hit to their buying power when they actually need it and the rich still are relatively better off. In a world with no investment tax, the rich person is still relatively better off, but you also aren’t restricting the utility of the poor.

Ultimately, an X-Tax can grow GDP, lower unemployment, and take in trillions of dollars in new revenue to help avoid the looming disaster of public debt. Best of all, it can encourage smarter financial habits among US workers while also protecting the least well-off and taking more from the rich. Bradford made these same exact points decades ago, of course, but we keep inching towards the precipice. It’s time to join the rest of the world.


About the Author

Austin Rose is a staff writer for the Brown Political Review.