The Value-Added Tax Is Wrong for the United StatesCurtis S. Dubay

Abstract: In the context of unprecedented U.S. budgetdeficits, some proponents of the value-added tax (VAT) arecalling for the U.S. to levy a VAT to close the federal deficit.They are seriously mistaken. While a VAT has someadvantages to the current U.S. tax code, adding the VATto current federal taxes—as proponents propose—wouldrealize none of these benefits and would instead depress theeconomy. The real cause of the massive federal deficit isCongress’s overspending, not a lack of taxation.

The value-added tax (VAT) is a major source of taxrevenue for every industrialized country in the worldexcept the United States. The Domenici–Rivlin DebtReduction Task Force has issued the latest call for theU.S. to adopt a VAT to solve its growing debt prob-lem.1 Some argue that a large tax increase is necessarybecause Congress cannot reduce spending enough tocut the deficit to more sustainable levels.2 On thisflawed line of reasoning, the VAT is the logical choicebecause it can raise large amounts of revenue andbecause the United States is the only developed coun-try without a VAT.

Proponents often cite the economic virtues of theVAT as an additional reason for the United States toadopt it. While the VAT has some economic advan-tages compared to other tax systems, these theoreticaladvantages would apply only if it replaces all otherfederal taxes. If Congress simply added a VAT on topof other federal taxes, its comparative advantageswould disappear. It would substantially raise taxes,

No. 2503December 21, 2010

Talking Points

This paper, in its entirety, can be found at: http://report.heritage.org/bg2503

Produced by the Thomas A. Roe Institute for Economic Policy Studies

Published by The Heritage Foundation214 Massachusetts Avenue, NEWashington, DC 20002–4999(202) 546-4400 • heritage.org

Nothing written here is to be construed as necessarily reflecting the views of The Heritage Foundation or as an attempt to

aid or hinder the passage of any bill before Congress.

• The idea of levying a value-added tax (VAT) isreceiving serious consideration in Washington.

• A VAT is similar to a nationwide sales tax,and every other industrialized country leviesa VAT.

• Adding a VAT on top of the current U.S. tax codewould impose a colossal tax increase andbecome an enormous drag on the economy.

• The VAT has some attractive features com-pared to the current tax code. If the VATreplaced the current system, it could be animprovement, but proponents see it as anadd-on to the current system, not as areplacement.

• A VAT added on top of the current tax systemwould permanently increase the size of gov-ernment, slow economic growth, and depressthe U.S. standard of living.

• Americans are already overtaxed. Adding aVAT is unnecessary because the growing U.S.deficit is caused by overspending, not a lackof taxation.

No. 2503

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December 21, 2010

perpetuate the current tax system’s many problems,and create a host of new complications. Even as atotal replacement for the current tax code, a VATwould pose several challenges for the nation.12

What Is the VAT?The VAT is a consumption tax that taxes the

value added by businesses at each point in the pro-duction chain. It can apply to both manufacturedgoods and services. This contrasts with the morefamiliar income tax, which taxes salaries, wages,and the returns to savings, but does not tax pur-chases. Because the VAT is a consumption tax, itwould closely mirror the sales taxes that mostAmericans pay at the state and local levels. In fact,consumers would experience no difference betweena national sales tax and a VAT. A sales tax and a VATdesigned to raise equal amounts of revenue wouldraise the final price of purchases by roughly thesame amount.

Credit-Invoice VAT. In the credit-invoice method,the most common form of the VAT, a business paysVAT on its purchase of inputs and collect it on itssales whether those sales are to another business orthe final consumer. The business then submits theinvoices that it receives from its suppliers to the gov-ernment’s revenue agency. The invoices detail theamount of VAT that the business paid to its suppli-ers. Once the revenue agency verifies that the busi-ness remitted the proper amount of tax on its salesand that the submitted invoices match the suppli-ers’ filings, the agency refunds the business forVAT paid. The filings by businesses give the revenueagency a simple way to ensure that businesses paythe required amount of VAT.

As long as the business can pass the tax on to itscustomers, which is typically the case, the businessultimately pays no tax. It acts solely as a collectionagent for the government, collecting VAT on its salesand remitting to the government the difference

between the VAT it collects and the VAT it paid oninputs. The burden of the tax moves up the produc-tion chain until the consumer bears the full burden,just like under the sales tax. Chart 1 shows how acredit-invoice method VAT could apply in the pro-duction of a shirt.

A credit-invoice VAT is generally easier for reve-nue agencies to enforce than sales taxes and there-fore enables more efficient revenue collection. Themethod of revenue collection makes it more effi-cient. A sales tax is collected only when the final userof the product makes a purchase. For instance, cus-tomers buying a new pair of shoes or a new televi-sion pay the price of the item plus the sales tax,which is an additional percentage of the sales prices,at the point of purchase. However, businesses do notpay sales taxes on the items they purchase so that thesales tax does not “pyramid” inside the cost of goodsand raise their prices surreptitiously. In practice,businesses end up paying sales taxes in many cases,but they should be completely exempt from payingsales taxes according to sound tax policy.

Because a sales tax is collected at only one pointin the production process, customers and sellerscan work together more easily to evade it. The onlycheck to make sure the seller collects the tax is anaudit by a revenue authority. A credit-invoice VAT ismore resistant to tax evasion because businessescollect and remit the tax at every stage of the pro-duction process.

Subtraction-Method VAT. Another viableapproach to levying VAT is the subtraction-methodVAT, which is economically equivalent to the credit-invoice VAT. Each method has positives and nega-tives, but almost every country that levies a VAT haschosen the credit-invoice method as the best way toapply the VAT in practice. Of the approximately 150countries that levy a VAT, only Japan uses the sub-traction method.3

1. Congressional Budget Office, “Federal Debt and the Risk of a Financial Crisis,” July 27, 2010, at http://www.cbo.gov/ftpdocs/116xx/doc11659/07-27_Debt_FiscalCrisis_Brief.pdf (July 30, 2010), and Debt Reduction Task Force, “Restoring America’s Future,” Bipartisan Policy Center, November 2010, at http://bipartisanpolicy.org/sites/default/files/FINAL%20DRTF%20REPORT%2011.16.10.pdf (December 9, 2010).

2. Catherine Rampell, “Many See the VAT Option as a Cure for Deficits,” The New York Times, December 11, 2009, at http://www.nytimes.com/2009/12/11/business/11vat.html (June 1, 2010).

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No. 2503 December 21, 2010

The subtraction-method VAT is similar inpractice to the business income tax that theUnited States and most other countries levy.Businesses calculate their taxable base by sub-tracting their expenses from their sales (grossincome). The major difference between the sub-traction-method VAT and the business incometax is that the cost of labor is not deductibleunder the subtraction-method VAT. Labor’s con-tribution to output is an integral part of the valueadded by the business. Among other key differ-ences, all purchases from other businesses arededucted immediately under the subtraction-method VAT, including purchases of long-livedassets (no depreciation system), but interestexpense is not deductible.

The most important difference between thecredit-invoice VAT and the subtraction-method VATis how they are collected. Instead of collecting theVAT each time a transaction occurs, under the sub-traction-method VAT businesses would pay VAT ontheir taxable base, which is calculated by totalingtheir gross receipts and subtracting the cost ofinputs purchased from other firms.

A subtraction-method VAT would have the sameeconomic effects as a credit-invoice VAT becausebusinesses still pay the tax on the differencebetween the sales of their goods and costs of theirinputs. However, the subtraction-method VATeffectively prevents showing the tax embedded inthe prices of goods and services. While most coun-tries that levy a credit-invoice VAT do not require—

3. Harley Duncan and Jon Sedon, “How Different VATs Work,” Tax Notes: Views on VAT, December 21, 2009, at http://services.taxanalysts.com/taxbase/magdailypdfs.nsf/PDFs/125TN1367.pdf/$file/125TN1367.pdf (June 2, 2010; subscription required).

Sale Price

VAT Collected by SellerCredit from Previous Stage

Net VAT Collected

STEP 1

$1.00

$0.10

Farmer growscotton and sells to textile maker for

$0.10–– $0.00

STEP 2

$5.00

$0.40

Textile maker makes fabric and sells to clothes maker for

$0.50–– $0.10

STEP 3

$10.00

$0.50

Clothes maker sews a shirt and sells to

retailer for

$1.00–– $0.50

STEP 4

$20.00

$1.00

Clothing retailerprices shirt

for

$2.00–– $1.00 TOTAL VAT

COLLECTED

WHO PAYS?

When the customer buys the shirt, the

$2 value-added tax is added to the final sale price ($22), effectively making the

customer pay the full cost of the 10 percent

VAT.

$2.00

heritage.orgChart 1 • B 2503

How the Value-Added Tax WorksBusinesses collect the value-added tax (VAT) on their

sales and pay it on their purchases from other businesses. This effectively turns them into tax-collecting agencies. The VAT moves up the production chain until consumers

ultimately pay the entire cost of the VAT. Consumers are often unaware that a tax was levied at all because the VAT is often embedded in the price of goods. This is why the VAT is often referred to as a “hidden tax.”

In this example,a 10 percent VAT is applied to the production and sale of a shirt.

Source: The Heritage Foundation.

No. 2503

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December 21, 2010

and in some cases even prohibit—displaying the taxon sales receipts, displaying the tax in a subtraction-method VAT is impracticable, making the taxopaque to taxpayers.

That most countries’ choose the credit-invoicemethod over the subtraction method reflects theeconomic circumstances and the consequences ofpast tax policy decisions. For example, because thesubtraction-method VAT bears a strong resem-blance to a traditional income tax, it could be a bet-ter, although still problematic, tax system than anincome tax, but it would be a poor choice as anadditional new tax. Many countries that haveadopted a credit-invoice VAT already had some kindof national consumption tax. In searching for extrarevenue, replacing a confusing array of minor salestaxes with a comprehensive, operational nationalretail sales tax in the form of a VAT would makegood sense.

Further, all countries have problems with taxevasion. Tax evasion is still a problem under acredit-invoice VAT, but the tax is far less susceptibleto evasion than most taxes because of the credit-invoice paper trail. The relative difficulty of evadinga VAT is particularly important when governmentsimpose high tax rates.

Addition-Method VAT. The addition-methodVAT is not used anywhere in the world. As its nameimplies, the addition method is the opposite of thesubtraction method. Like the subtraction method, itis applied only once in the production process, andits cost is entirely hidden from individual taxpayers.Yet unlike the subtraction method, businesses addthe costs of their inputs, instead of subtracting themfrom their sales to calculate their tax base subject tothe VAT. Inputs could include labor costs, costs ofgoods and services purchased, and even profits insome cases.4

The addition method is more of a theoreticalapplication of the VAT and is not used in practice.

Even though it is no different in theory from theother types of VAT, when actually applied, the addi-tion method creates problems that the other meth-ods do not. Some businesses, such as businesseswith labor-intensive production processes, wouldpay higher tax bills because their unique circum-stances require them to add more to their taxablebase. Unsurprisingly, such businesses would seekrelief from the government in the form of carve-outsfor their specific industry. However, when the gov-ernment grants relief to one industry, the pressure tooffer similar exemptions to other industries soonbuilds. Special treatment of particular industriesquickly spreads and destroys the VAT’s advantage ofexerting minimal influence on the market. As aresult of these exemptions, the addition-methodVAT would create a substantial drag on the econ-omy, unlike the other types of VAT.5

VAT StrengthsThe VAT has some key meritorious features. The

most important is that it excludes saving and invest-ment from the tax base. Saving and investing arevital for economic growth because businesses usecapital to expand their operations. Entrepreneursuse them to begin businesses. Both activities createjobs and grow the economy. Taxing savings andinvestment reduces their attractiveness to individu-als and increases the cost of raising capital for busi-nesses. This reduces the amount of saving andinvesting and therefore the number of jobs created.Because the VAT taxes only consumption, notreturns from saving and investing, it is a better alter-native than other taxes that tax saving and investing.

Another positive feature of the VAT is its “borderadjustability.” All countries that employ a VAT eitherexempt exports from the VAT or rebate the entireVAT paid on exports. Similarly, all countries thatlevy a VAT also levy the VAT on their imports. Thishas two positive effects. Domestically, all goods soldin a country with a border-adjusted VAT pay the

4. Ibid.

5. In 1976, Michigan enacted the Single Business Tax, a state addition-method VAT, to consolidate a variety of other state business taxes. The tax quickly became a serious drag on Michigan’s economy, and the state was eventually forced to abolish the tax. See Chris Atkins and Jonathan Williams, “Tax Reform in Michigan: Replacing the Single Business Tax,” Tax Foundation Special Report No. 149, January 2007, at http://www.taxfoundation.org/files/sr149.pdf (July 29, 2010).

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No. 2503 December 21, 2010

same amount of tax regardless of country of origin.Second, in the global market, a border-adjusted VATplaces exports on an equal footing with productsfrom other countries because they will all face thesame amount of tax regardless of where they aresold. In contrast, a business income tax raises therelative price of exported goods because it is notrebated like a VAT. Similarly, the individual incometax is rolled into the prices of goods produced bybusinesses that pay individual income tax instead ofbusiness income tax. There is no practical way torebate the portion of the higher price due to eitherincome tax from the good’s total cost. When a busi-ness exports that product it must therefore sell at ahigher price, making its product less competitive inglobal markets.

All taxes create distortions in the market becauseall taxes change the behavior of individuals and busi-nesses. The best taxes affect the behavior of individu-als and businesses the least. A structurally sound VATmeasures up well against other taxes because it exertsrelatively little influence on the decisions of busi-nesses and individuals. Yet this feature holds true onlyif it applies uniformly to all goods and services in aneconomy because it raises the prices of everythingproportionally. In this way, no product or service gainsan artificial comparative advantage over another. Themoment one good or industry secures an exemptionfor its goods or services, this relative advantage of aVAT dissipates rapidly. Border adjustments supportthe neutrality of the VAT because it ensures that allgoods face the same level of tax regardless of wherethey are manufactured.

The final strength of the VAT is its relatively lowcost of enforcement. Because calculating the VAT isstraightforward and businesses need to produceinvoices to receive their refunds, enforcing the VATcosts revenue agencies less than enforcing othertypes of taxes.

VAT FlawsWhile the VAT has some advantages over other

taxes, it is far from trouble free. The VAT has severalinherent problems.

Hidden Tax. The VAT’s biggest flaw is that,unless mandated otherwise, the amount of VATpaid by taxpayers is hidden. (See Chart 1.) In thisexample, the consumer knows only that the price ofthe shirt is $22.00. Because the VAT is typically notprinted on the sales receipt, the consumer does notknow that the price includes a 10 percent ($2.00)VAT. One fundamental principle of sound taxationis transparency, and most nations’ VATs flagrantlyviolate this principle.

State and local sales taxes are explicitly shown onsales receipts so consumers know the cost of thegood before and after the tax. Even though a VATwould raise the final cost of goods and services inthe same way, the VAT is typically not shown onsales receipts because politicians hide the steepprice of the VAT and their policies from taxpayers.

Even if the VAT is shown on receipts, taxpayersare highly unlikely to keep their receipts and totaltheir VAT for the year. Politicians especially like theVAT because it obscures the tax burden and the truecost of government services from taxpayers. Thiscan lead taxpayers to demand more governmentservices because they wrongly perceive that theprices of such services are lower than they are. In ademocratic state, the cost of taxes and governmentshould be as explicit as possible so that taxpayersand voters can make fully informed decisions aboutthe size of government.

Taxing Services. The U.S. economy is becomingincreasingly service-based, but the VAT has diffi-culty taxing services. In fact, all consumption taxes,including state and local sales taxes, struggle to taxservices because tax authorities have difficultydetermining actual sales when no physical propertychanges hands. Many state and local governmentsin the United States often forgo levying sales tax onmost services because of this difficulty.

Compared to the cost of their services, serviceproviders generally purchase low-cost inputs fromsuppliers. For example, doctors provide relatively

_________________________________________

Because the VAT taxes only consumption, not returns from saving and investing, it is a better alternative than other taxes that tax saving and investing.

____________________________________________

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high-cost services for patients, but have low inputcosts compared to automotive manufacturers. Automanufacturers must purchase costly inputs such assteel to produce each car. Doctors need equip anoffice only once to provide their services. The sameapplies to other service providers, such as attorneys,accountants, and financial service providers. Thismeans the value added (the price of the serviceminus the cost of inputs) is high for service provid-ers and the VAT they owe as a share of gross receiptsis also high compared to traditional manufacturingbusinesses. This creates a strong incentive for ser-vice providers and their customers to collude toevade the VAT by transacting in cash. Alternatively,the service provider can underreport sales to cap-ture all the benefit of evading the tax. In both cases,authorities would have difficulty proving tax eva-sion without on-site monitoring and inspections.

Because services are a large and growing portionof the economy, exempting them from a VAT wouldnecessitate raising the VAT rate considerably higherto collect the expected amount of revenue, anothermajor problem of the VAT.

State Sales Taxes. Forty-six states levy a salestax. A VAT at the federal level would be similar tostate sales taxes. States would likely strongly resistany federal attempt to usurp their sales tax authoritybecause they rely on sales tax revenue. A VAT at thefederal level would likely force states to apply theirsales taxes to a uniform set of goods and services.This would take from the states their ability to tailortheir sales taxes to their desires and each state’sunique economy. States would also be forced tokeep their rates within a narrow range. Because theVAT rate would likely begin relatively high, it wouldleave states little room to lower their sales tax rate toincrease their competitiveness compared to otherstates. Further, a federal VAT would increase salestax evasion, thus reducing state tax receipts, possi-bly significantly.

Underground Economy. No tax is 100 percentenforceable, and the VAT is no exception. The VAT’s

ease of enforcement is not an absolute designation.The VAT is easier to enforce than other taxes that donot generate an easily auditable paper trail. Yet somewould undoubtedly find ways to evade a VAT. Infact, a VAT would encourage development of a largeunderground economy. Saving up to 20 percent ormore on every transaction would be a powerfulincentive for consumers and businesses to worktogether to evade the VAT. They could evade theVAT by conducting transactions in cash or by bar-tering goods and services. Neither tactic wouldleave a paper trail, making it difficult for authoritiesto prove abuse.

Europe’s experience with the underground econ-omy confirms this. Informal transactions and buy-ing and selling on the black market are common inEurope. Avoiding the VAT is part of the culture. Inmany cases, citizens evading the VAT are not evenaware that they are escaping taxation because theirevasion methods have become part of their every-day lives.6 Similar behavior would quickly becomeendemic in the United States if it adopts a VAT.

Fraud. A credit-invoice VAT has an inherent self-enforcement mechanism because of the trail ofpaperwork required, but even then fraud would stillbe prevalent. Fraud is different from the under-ground economy. It consists of businesses engagingin schemes to secure larger refunds than those towhich they are entitled, rather than evading it out-right like in an underground economy. No matterhow well constructed, VATs are always susceptibleto scams that allow businesses to claim largerrefunds than they are entitled. VAT fraud can takethe form of false claims of taxes paid, refundsclaimed for nonrefundable purchases, businessesset up only to issue false invoices of taxes paid, andhidden sales.7

6. Amity Shlaes, “A VAT Will Make Us Eurotrash,” Tax Notes: Policy Perspectives, January 11, 2010, at http://services.taxanalysts.com/taxbase/magdailypdfs.nsf/PDFs/126TN0251.pdf/$file/126TN0251.pdf (July 28, 2010; subscription required).

_________________________________________

The VAT’s biggest flaw is that, unless mandated otherwise, the amount of VAT paid by taxpayers is hidden.

____________________________________________

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No. 2503 December 21, 2010

European countries have a long history ofadministering the VAT, but they still experienceconsiderable VAT fraud. Countries in the EuropeanUnion (EU) lose approximately $107 billion annu-ally in uncollected VAT. This amounts to a tax gap—the percentage of tax revenues that a tax should col-lect—of 12 percent,8 which is a high rate of non-compliance for a consumption tax.

Tax authorities will always struggle to gain theupper hand on criminals that game the VAT totheir advantage. The monetary gains that the crim-inals can enjoy by abusing the VAT are a strongincentive to stay one step ahead of law enforce-ment. For instance, the EU is working to thwartVAT-related fraud and abuse in carbon dioxideemission permits, which are the staple of the EU’scap-and-trade program.

For example, in “carousel fraud,” criminals setup a fake company that purchases the carbon-emit-ting permit from a company in another country. Thefake company then quickly trades the permit toanother company in its country, pockets the VATthat it collects from the company purchasing thepermit, and quickly disappears with the VAT pro-ceeds. This scheme can use any easily moved good.

The fraud involving carbon emission permitsalone cost EU countries $7.4 billion over a recent18-month span.9 The carbon emitting permits arethe latest trend in VAT fraud, but certainly not bethe last. Tax evaders will quickly move on to a newscheme once authorities clamp down on this typeof fraud.

Economic Drag from Exemptions. Manywrongly claim that the VAT is regressive. They arguethat the poor consume a higher percentage of theirincome and therefore would pay a larger portion oftheir income as VAT than the rich would pay. Whilemeasuring income tax paid relative to income is rea-

sonable, measuring VAT tax paid relative to con-sumption is also reasonable because consumption isthe base of a VAT. On this basis, a VAT is propor-tional because all taxpayers would pay the sameamount of tax as a share of their consumption. Thisis an important distinction because, if lawmakersfall for the flawed regressivity argument, then anyVAT law would likely exempt certain necessities,such as food and shelter, which often constitute alarger portion of a low-income person’s consump-tion spending.

One major advantage of the VAT in the abstract isthat it exerts less influence on the decision makingof individuals and businesses. However, once cer-tain goods and services receive preferential treat-ment, the advantages of a VAT rapidly dissipatebecause some businesses—more accurately, thegoods and services they produce—receive morefavorable tax treatment than others.

Businesses that receive such exemptions can selltheir goods at lower prices than their competitors’goods, which would be subject to the VAT. Thiswould increase the profit margins of VAT-free busi-nesses compared to businesses that must pay theVAT, attracting more investment to the VAT-freebusinesses. Thus, exemptions would distort invest-ment, and this misallocation of resources would ulti-mately lead to less value produced from the nation’sresources than would occur if there was no VAT.

More Power to Government and Lawmakers.The more government spends and uses tax and reg-ulatory policies to micromanage economic affairs,the more power it amasses. Private citizens and

7. Curtis S. Dubay, “Value-Added Tax: No Easy Fix for the Deficit,” Heritage Foundation WebMemo No. 2772, January 21, 2010, at http://www.heritage.org/Research/Reports/2010/01/Value-Added-Tax-No-Easy-Fix-for-the-Deficit.

8. Reckon LLP, “Study to Quantify and Analyze the VAT Gap in the EU-25 Member States,” European Commission, September 21, 2009, p. 9, at http://ec.europa.eu/taxation_customs/resources/documents/taxation/tax_cooperation/combating_tax_fraud/reckon_report_sep2009.pdf (December 21, 2009).

9. Joe Kirwin, “EU Ministers Back VAT Reverse-Charging for Greenhouse Gas Emission Trade Sales,” Daily Report for Executives, December 3, 2009.

_________________________________________

European countries have a long history of administering the VAT, but they still experience considerable VAT fraud.

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businesses react to the government’s accrual ofpower by seeking more access to decision makers.The large benefits that businesses can gain fromreceiving a VAT exemption for their product willcause them to seek VAT relief from the government.Carve-outs for businesses will give governmentmore power to pick winners and losers in the mar-ketplace and make business success more depen-dent on procuring government favors rather thanproviding a product demanded by the public. Thisconcentrates more power in government andincreases the power of businesses and industrieswith strong lobbies at the expense of those with lesspolitical sway. This will only increase the alienationthat many feel from the government that is increas-ingly beholden to the powerful.

Government-Growing TaxA VAT can collect a staggering amount of reve-

nue. In the present budgetary context, some expertsare calling for a VAT large enough to close massivecurrent and future deficits.10 For example, theDomenici–Rivlin Task Force report calls for a 6.5percent “deficit reduction sales tax,” which is inreality a VAT. The additional revenue needed toclose the existing budget gap would require a VATbetween 15 percent and 20 percent,11 which wouldbe in line with VAT rates in other economicallydeveloped countries. In fact, the EU requires itsmembers to levy a VAT of at least 15 percent, and insome countries, the VAT is as high as 25 percent.12

At 15 percent, a VAT would collect about 6 per-cent of gross domestic product (GDP). In 2019, this

would mean more than $1.2 trillion in higher taxes.If the rate was 20 percent, the VAT would raise 8percent of GDP, just under $1.7 trillion in highertaxes in 2019.13 A tax increase of this magnitudewould raise the federal tax burden between 33 per-cent and 44 percent above its historical average.

Once a VAT is in place, Congress could easilyincrease the VAT any time it wants more taxpayermoney to pay for new programs. Continuallyincreasing the size of government would becomeconsiderably less painful because small increases inthe VAT rate could raise substantial sums of reve-nue. An increase of just 1 percent would raise morethan $80 billion per year by the end of the decade.

The ability of the VAT to raise money will almostcertainly prove irresistible to Members of Congress.The experience of other industrialized countriesbears this out. As Table 1 shows, 29 of the 30 coun-tries in the Organisation for Economic Co-opera-tion and Development have implemented VATs.The United States remains the lone exception. Inthe years since they began their VATs, 20 of the 29have increased their rate by at least 1 percentagepoint. Denmark leads the group with a 10 percent-age point increase from 15 percent to 25 percent.On average, the 20 countries have raised their VATrates by 4.5 percentage points.

10. See Alan J. Auerbach and William G. Gale, “The Economic Crisis and the Fiscal Crisis: 2009 and Beyond—An Update,” Brookings Institution, September 2009, p. 3, at http://www.brookings.edu/~/media/Files/rc/papers/2009/06_fiscal_crisis_gale/06_fiscal_crisis_gale_update.pdf (June 1, 2010); Lori Montgomery, “Once Considered Unthinkable, U.S. Sales Tax Gets Fresh Look,” The Washington Post, May 27, 2009, at http://www.washingtonpost.com/wp-dyn/content/article/2009/05/26/AR2009052602909.html (June 1, 2010); and Henry J. Aaron and Isabel V. Sawhill, “Bend the Revenue Curve,” The Washington Post, October 12, 2009, at http://www.washingtonpost.com/wp-dyn/content/article/2009/10/12/AR2009101202389.html (June 1, 2010).

11. Auerbach and Gale, “The Economic Crisis and the Fiscal Crisis,” p. 3.

12. Council of the European Union, “Council Directive 2006/112/EC of 28 November 2006 on the Commons System of Value Added Tax,” Official Journal of the European Union, December 11, 2006, p. 3, at http://eurlex.europa.eu/LexUriServ/site/en/oj/2006/l_347/l_34720061211en00010118.pdf (June 1, 2010).

13. Author’s calculations based on Tax Policy Center, Revenue Tables: 2009, Table T09-0442, at http://www.taxpolicycenter.org/numbers/displayatab.cfm?DocID=2517 (June 1, 2010). The VAT base excludes education expenditures, rent, housing, and religious and charitable services.

_________________________________________

Once a VAT is in place, Congress could easily increase the VAT any time it wants more taxpayer money to pay for new programs.

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Permanently Slower Economic GrowthAdding a VAT to the taxes currently in place

would permanently slow U.S. economic growth forseveral reasons.

First, the VAT would transfer tril-lions of dollars per year from produc-tive private hands to the less efficientpublic sector. Over the long term,fewer resources in the private sectorwould produce a lower standard ofliving for succeeding generations thanthey would have enjoyed without aVAT. This lower standard of livingresults from the government allocatingthe VAT revenue for political reasons.On the other hand, if the private sectoris allowed to keep these resources, itwould allocate them based on marketconsiderations. A politicized alloca-tion is generally less efficient thanmarket-based allocation because polit-ical decisions do not consider thehighest-value use of resources, whilethe market considers such issues andtherefore does a better job of assigningresources where they will contributethe most to economic growth.

Second, the VAT would weaken theeconomy by weakening the incentivesto work. VAT proponents often high-light that the VAT, unlike the incometax, is neutral between saving andconsumption. However, they down-play that fact that the VAT, like theincome tax, discourages work. Thislong-established fact may not beimmediately obvious, but it is evidentafter analyzing why people work.

People work for many reasons, buteconomically, the primary reason is toearn income to purchase food, cloth-ing, housing, health care, and all ofthe other goods and services of mod-ern living. Given an individual’s skillsand capabilities and the availablemarket opportunities, each individual

can command a wage commensurate with the eco-nomic value that they can create. Given that wage,the individual then knows how much he or she canearn by giving up a certain amount of free time or

VAT Rates Typically Rise After ImplementationOf the 29 countries in the OECD with a value-added tax (VAT),20 increased the tax rate after the tax was implemented.

Sources: Organisation for Economic Co-operation and Development, VAT/GST rates in OECD member countries, Table IV.1, at http://www.oecd.org/dataoecd/12/13/34674429.xls (June 7, 2010).

Table 1 • B 2503Table 1 • B 2503 heritage.orgheritage.org

CountryYear VAT

ImplementedVAT Rate in First Year

CurrentVAT Rate*

Change, in Percentage

PointsDenmark 1967 15% 25% +10.0Italy 1973 12% 20% +8.0Germany 1968 11% 19% +8.0Turkey 1985 10% 18% +8.0Sweden 1969 17.7% 25% +7.3United Kingdom 1973 8% 15% +7.0Luxembourg 1970 10% 15% +5.0Mexico 1980 10% 15% +5.0Norway 1970 20% 25% +5.0Spain 1986 12% 16% +4.0Portugal 1986 17% 21% +4.0Belgium 1971 18% 21% +3.0Greece 1987 16% 19% +3.0Iceland 1989 22% 25% +2.5New Zealand 1986 10% 12.5% +2.5Austria 1973 18% 20% +2.0Japan 1989 3% 5% +2.0Ireland 1972 20% 21.5% +1.5Switzerland 1995 6.5% 7.6% +1.1Netherlands 1969 18% 19% +1.0Australia 2000 10% 10% 0.0Finland 1994 22% 22% 0.0Korea 1977 10% 10% 0.0Poland 1993 22% 22% 0.0France 1968 20% 19.6% –0.4Canada 1991 7% 5% –2.0Czech Republic 1993 23% 19% –4.0Hungary 1988 25% 20% –5.0Slovak Republic 1993 25% 19% –6.0

Increased VAT rateDecreased VAT rate

* As of 2009.

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leisure and can choose what work to perform, howlong to work, and how much leisure to take. This isthe essence of the labor–leisure tradeoff in theabsence of taxation. Of course, it is also a broadabstraction and simplification of complex marketprocesses, but is nevertheless a reliable portrait ofthe issues in this argument.

When government taxes wages, such as with apayroll tax, the tax reduces a worker’s after-taxwages and therefore reduces the return to work or,equivalently, reduces the “price of leisure.” Such atax predictably reduces the number of hours thatworkers desire to work. Consequently, workershave less after-tax income to consume or save, lim-iting their ability to buy goods and services.

If the government imposed a VAT in lieu of apayroll tax, the worker’s after-tax income would beunchanged, but the VAT would cause prices toincrease, reducing the worker’s ability to purchasegoods and services. In this case, the true value of theworker’s wages has declined because their purchas-ing power has declined. From the worker’s perspec-tive, what matters is what he or she can buy inexchange for a certain amount of work. Whetherthrough a payroll tax reducing after-tax wages or aVAT raising consumer prices, both taxes disadvan-tage the worker equally, reducing the worker’sincentive to work. Economically, the VAT is equiva-lent to a payroll tax. Both reduce work effort andtherefore output and incomes.

Six VAT MythsIn addition to damaging the economy, levying a

VAT on top of all of the other federal taxes thatAmericans already pay would overwhelm all of theVAT’s theoretical advantages. While the economy

could conceivably be stronger if the VAT completelyreplaced the entire income tax code,14 fundamentaltax reform is not a high priority in Congress in thecurrent budget environment. If Congress considersa VAT, it would most likely be as a method to raisemore revenue to close the deficit. The inefficienciesof the income tax would remain and the inefficien-cies unique to a VAT would be added on top to cre-ate an even heavier drag on the economy andburden on taxpayers.

Six myths are commonly submitted in defense ofthe VAT. Most result from a misunderstanding of thedifference between a VAT as a replacement for allcurrent income taxes and a VAT as an addition tothe current taxes.

Myth #1: A VAT would increase the savings rate.

Some argue that a VAT would encourage savingbecause it would raise the prices of everything webuy. In this line of thinking, Americans would buyfewer goods and services and therefore save moneythat they formerly spent.

A VAT would undoubtedly raise the prices ofeverything that consumers buy, but this would notincrease the savings rate. The low savings rate is notthe result of low prices, but of the current tax codethat discourages savings by taxing returns of invest-ment through taxes on capital gains, dividends, andinterest. Adding a VAT would not change this. Aslong as the income tax continues to tax capitalincome and capital gains, the tax code will continueto discourage saving.

In fact, adding a VAT to the current tax codewould reduce savings for an extended period andresult in a permanent loss in wealth and growth. AVAT would potentially raise the prices of consumergoods and services between 15 percent and 20 per-cent. To sustain as much of their current consump-tion as possible, families would need to save lessand even dip into previous savings to purchase thesame amount of goods and services that they con-sumed before the VAT.

14. This should include the repeal of the 16th Amendment to ensure that the income tax stays repealed and that taxpayers are not forced to pay both an income tax and a VAT.

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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.

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No. 2503 December 21, 2010

Myth #2: A VAT would increase investment.

Since some argue the VAT would increase sav-ings, they subsequently argue that it would alsoincrease investment. Once again, they confuse theeffects of a VAT as a replacement for the current taxcode with the effects of adding a VAT to the currenttax code. Investment would likely decrease if Con-gress added a VAT to the current tax system, espe-cially in the short term, because households wouldneed to cut back on savings and withdraw previoussavings to maintain current levels of consumption.

Myth #3: A VAT would encourage economic growth.

Few economists argue that tax hikes encourageeconomic growth. Yet some argue that a VAT wouldimprove economic growth because it would taxconsumption instead of income. The income tax’shighly progressive structure15 and the double taxa-tion of capital income and capital gains strongly dis-courage working, saving, and investing, which areessential to economic growth.

If Congress added a VAT on top of the currentsystem, the disincentives to work, save, and investwould persist. In fact, the disincentives to work andsave would actually increase further. The VATwould likely reduce the savings rate for an extendedperiod. In terms of growth effects, the VAT is eco-nomically equivalent to a tax on labor and so itwould discourage work even more.

Myth #4: VAT promotes exports.

Because the VAT is rebated on exports andimposed on imports (the border tax-adjustmentsystem), some contend that the VAT would makeAmerican products more competitive in the globalmarket. This is false. A VAT would have no effect onthe competitiveness of United States exports. Onceagain, proponents are confusing the potentialadvantages of a VAT as a replacement for the incometax with the realities of a VAT as an add-on tax. Evenif the VAT itself is internationally neutral because of

border tax adjustments, adding a VAT does notreduce the disadvantages imposed by the incometax, which lacks these border tax adjustments and istherefore detrimental to U.S. competitiveness.

Myth #5: VAT allows for lower income taxes.

Some proponents tout the VAT as a solution tomassive deficits. Without cutting spending to lowerthe deficit, Congress will have little room to reduceincome taxes because all the income tax revenueplus the VAT revenue will be needed to bring thedeficit under control. Nevertheless, if Congress

were to pass a VAT, it would likely include someminimal and temporary reductions of the incometax to buy support from the American people andcertain lawmakers. However, as long as Congressretains the power to levy an income tax under the16th Amendment, future Congresses could alwaysraise it back to its previous levels or even higher.

This has been the experience in Europe. Incometaxes have actually increased after the countriesimplemented VATs, despite promises to the con-trary.16 The combination of a VAT and the incometax in the United States would likely lead to similarincome tax increases as successive Congresses lookfor more revenue to spend. This would lead to fur-ther increases in the tax burden and the slower ratesof economic growth from higher taxation.

The only way the VAT or any other national con-sumption tax could be acceptable is if the 16thAmendment were simultaneously repealed.

Myth #6: VAT would close the deficit.

Congress spends every dollar of tax revenue plusas much as it can borrow from credit markets.17 It ison track to push the limits of credit markets. There

15. Curtis S. Dubay, “Income Tax Will Become More Progressive Under Obama Tax Plan,” Heritage Foundation Backgrounder No. 2280, June 1, 2009, at http://www.heritage.org/Research/Taxes/bg2280.cfm.

16. Daniel J. Mitchell, “Beware the Value-Added Tax,” Heritage Foundation Backgrounder No. 1852, May 16, 2005, at http://www.heritage.org/Research/Reports/2005/05/Beware-the-Value-Added-Tax.

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The only way the VAT or any other national consumption tax could be acceptable is if the 16th Amendment were simultaneously repealed.

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December 21, 2010

is little reason to believe that Congress would sud-denly discover fiscal discipline after levying a VAT.More likely, it would spend the VAT revenue on newprograms and continue borrowing as much as pos-sible. Giving Congress more taxpayer money tospend would likely worsen the current fiscal crisisuntil credit markets decide to stop lending to theUnited States because they no longer are confidentthat it can repay its debts.

Greece is a good example of how this could hap-pen. Despite its 19 percent VAT, credit markets havestopped lending to it at reasonable rates because ofits chronic and unsustainable overspending. Thecredit market may soon stop lending to other simi-larly fiscally troubled countries that levy substantialVATs, including Portugal (21 percent), Italy (20 per-cent), and Ireland (21.5 percent). Given the politi-cal realities, the only way to close a budget deficit isto reduce spending. Higher taxes consistently leadto higher spending.

An Unnecessary TaxThe current and future deficits are threatening

the stability of the U.S. economy and haveprompted some camps to consider the VAT as a wayto eliminate the deficit. Congress’s overspending hascaused the threatening deficits, not a lack of tax rev-enue. If Congress permanently extends the 2001and 2003 tax relief for all taxpayers and patches the

alternative minimum tax (AMT) so it does not affectmiddle-income families, federal tax revenues willstill exceed their historical level of 18 percent ofGDP in the coming years. On the other hand, underPresident Barack Obama’s budget, spending willrise to 24 percent of GDP by the end of thisdecade—a considerably higher level than the his-torical average of 20 percent of GDP. Uncheckedentitlement spending will push this level evenhigher in the coming decades. Unless Congressrestrains spending, ever-higher tax levels will berequired to close the deficits. Yet as Europeannations are discovering, even the VAT cannot solvetheir problems. They need to fundamentallyrestructure their entitlement and welfare spending.

Congress should ignore misguided siren calls fora VAT and instead immediately address its spendingproblems. Tax increases will never reduce the gap.Instead, Congress must cut spending to 20 percentof GDP or lower. This would reduce the annualbudget deficit to a more manageable level. Thenational debt would stabilize as a percentage ofGDP and the threat that credit markets will stoplending or raise interest rates would abate. None ofthese necessary steps requires a VAT.

—Curtis S. Dubay is a Senior Analyst in Tax Policyin the Thomas A. Roe Institute for Economic PolicyStudies at The Heritage Foundation.

17. J. D. Foster, “Tax Hikes, Economic Clouds, and Silver Linings: A Review of Deficits and the Economy,” Heritage Foundation Backgrounder No. 2095, February 25, 2008, at http://www.heritage.org/Research/Reports/2008/02/Tax-Hikes-Economic-Clouds-and-Silver-Linings-A-Review-of-Deficits-and-the-Economy.