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The Daily Need

Who are you calling VAT?

Here in the U.S., we mostly think of taxes in terms of what we earn. The federal government, usually your state, and sometimes even your city take a percentage of your earnings to finance their operations. But what if we were taxed less on what we earn and more on what we consume? That’s the basic idea behind the value-added tax, or VAT, which is a type of consumption tax currently in place in more than 140 countries around the world, including every major Western country except the United States.

But some of you may be asking yourselves if we already taxed on consumption. In short, yes. Average sales tax in the United States is nearly 10 percent and like a VAT, sales tax is certainly a consumption tax. But here’s the difference: unlike sales tax, which only applies to the final retail transaction with the consumer, a typical VAT taxes each stage of production, while giving a credit for taxes already paid.

Before we throw our hands up in the air in VAT-induced frustration, let’s borrow a simplified example that Bruce Bartlett, one of the panelists on this week’s tax roundtable, describes in his new book, “The Benefit and the Burden.”

Imagine a loaf of bread and a few of the steps it took to get into your pantry. A farmer grew the wheat and sold it to a miller. The miller ground the wheat into flour and sold it to a baker. And finally, the baker made the bread and sold it to you. Here’s how a hypothetical VAT would work: Each step of the chain – farmer, miller, baker and even you as the consumer – pays a tax on what was purchased, kind of like a sales tax. But instead of turning that entire sum over to the government, each step of production gets reimbursed for the taxes that they have already paid. The bottom line, as Bartlett summarizes, is that “what is being taxed at each stage is the value being added to the original raw materials.”

In Bartlett’s example, the value being added at each step was the labor of each craftsperson. Of course, the consumer, who, alas, doesn’t add any value by eating the bread, does not get reimbursed for any part of their tax payment. And unlike a traditional sales tax, with a VAT there’s also a strong built-in incentive to comply. After all, you can’t get credit for your earlier tax payment if you don’t charge taxes to the next link in the chain.

The primary reason that many, including Bartlett, support a VAT is that it is – in his words – “generally considered the best tax ever invented…from the point of view of efficiency.” “It raises more revenue at less economic cost than any other tax,” he adds. So a package where a new VAT raised revenue, while other types of taxes – like income, for instance – are cut, might be a desirable trade-off.

Another big reason that many people support a VAT is that it can potentially raise a lot of money. Because a consumption tax like the VAT would affect all consumers and apply to so many products and services, the amount of money raised could go a long way to shrinking our record budget deficits, even if instituted at a low rate. Last March, the Congressional Budget Office (pdf) looked at options for lowering the deficit and estimated that a 5% VAT could raise $2.5 trillion in new revenue over the next decade.

Of course some of those same attributes – a broad based tax that raises a lot of money – are seen by others as negatives to instituting a VAT. Dan Mitchell, an economist at the Cato Institute and another panelist on this week’s program, argued in the Wall Street Journal that a VAT, regardless of its efficiency benefits, will eventually end up financing bigger government. “Simply stated, there is no way to turn America into a European-style welfare state without this new source of revenue,” he wrote.

At the same time, many progressives have argued that a VAT is too regressive, meaning it takes way more – as a percentage – from lower-income people than it does from the rich. Which makes intuitive sense: people who earn less money spend more of it on everything from housing to food to transportation. Others have argued that another potential drawback is that with an economy still struggling to recover from the worst recession in a generation, adding a new tax that applied broadly to goods and services could have an extremely high economic cost.

As one of the only developed economies without a VAT and with tax revenues near their lowest point  since the early 1950s, we may just be hearing a lot more about VATs in the future.

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