Commentary: Why the U.S. Should Adopt a Value-Added Tax

Everyone wants tax reform and an end to rising deficits. The VAT is a great solution to both problems.

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Europe would seem like about the worst place for the U.S. to find fiscal lessons. But as the need for new revenue intensifies and the call for tax reform grows louder, it may be time to adopt an idea from abroad: the value-added tax.

It's not just Europe; in fact, the U.S. is the only country in the OECD, a group of developed nations, that has not adopted a VAT. Anyone who's ever gone shopping in a foreign country and spotted a "VAT" at the bottom of the receipt has paid into this type of system, which functions essentially like a sales tax for consumers, adding a surcharge onto their purchases.

Instituting higher taxes is already a difficult proposition in the U.S, and tacking yet another tax onto the system could be next to impossible politically, it's true. But the U.S. should do it anyway. Here's why:

We're Going to Need the Revenue

Why institute a VAT at all? To put it bluntly, we're going to need the money.

"We're going to be spending more. That's because of the aging baby boomers," says Leonard Burman, a professor of public affairs at Syracuse University and a member of the Bipartisan Policy Center's Debt Reduction Task Force. "It will be way better to raise that revenue with a VAT than just with continual increases in income tax rates."

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There are some worries that more revenue simply leads to more government spending. But Burman believes the amount of new revenue that will be needed in programs like Medicare due to aging boomers will simply necessitate sizable new revenue sources. The rates in different countries vary; Canada's VAT is 5 percent, but some European countries have VATs of 25 percent or higher. Whatever the rate, experts say it would be an efficient way to increase revenue.

"There's a broad tax base, it's on sales, so it raises a tremendous amount of revenue," says Will McBride, chief economist at the Tax Foundation. "We're on the path of more and more spending, so to the degree that it has to be funded by tax revenue rather than borrowing...about the only way to get that sort of revenue is with a VAT."

According to the Urban Institute-Brookings Tax Policy Center, a 5 percent VAT would have yielded $277 billion in revenue for fiscal year 2011. By comparison, corporate income tax revenues were around $181 billion that year, and individual income taxes yielded around $1.1 trillion in revenue.

It's Easily Enforceable

The idea behind the value-added tax is that each step in the production chain pays a tax on how much value it added to the product (hence the clever name).

Here is an example of how it might work: let's say there's a VAT of 10 percent and a pound of butter costs $2. A farmer produces cream and sells it to the factory that makes the butter for 30 cents. The factory pays the farmer 33 cents, 3 cents of which the farmer hands over to the government. The plant makes the butter and sells it to a grocery store for 80 cents. The supermarket pays 88 cents, and the butter factory sends the government 5 cents. That's because it received 8 cents in tax but gets a credit of 3 cents that it already paid in taxes. The grocer sells the butter for $2, and the customer pays $2.20. The store then sends 12 cents to the government­—20 cents minus the 8 cents it paid before.

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All of which is to explain why proponents say that a value-added tax, with its chain of taxpayers, has a sort of built-in enforcement. Because it causes a "paper trail" of payment, each actor in the production chain must pay. This also makes government enforcement costs cheap. The relatively simple tax, combined with a broad tax base (i.e., all consumers), can mean a large amount of revenue with little effort.

It Can Balance Out Income Tax's Failings

It doesn't take a tax expert to understand that the income tax system isn't perfect—it's complicated, and some economists believe that higher income tax rates would discourage economic activity. Some also argue that the income tax system also double-taxes savings and investment—a worker earns the money and pays tax on it, then invests it and pays tax on the interest or dividends.