The U.S. faces a large long-term imbalance between projected federal tax revenue and federal spending, an imbalance that has widened during the coronavirus pandemic. Addressing the fiscal gap will require difficult policy measures, including increases in tax revenue. To narrow the fiscal imbalance, we should follow the lead of 160 other countries by adopting a value-added tax (VAT), a consumption tax that is economically similar to a retail sales tax.
The federal debt now stands at 98% of annual GDP, a ratio previously reached only during World War II. The Congressional Budget Office projects that the debt-to-GDP ratio will rise to a staggering 195% in 2050 under current law, as health care and Social Security spending grow more rapidly than tax revenue. CBO warns that the debt buildup will slow long-run economic growth by crowding out investment, reduce Congress’s and the president’s flexibility to respond to unexpected events, and increase the risk of a crisis in which investors lose confidence in the U.S. government.
Adopting a VAT would significantly curb the debt buildup. To be sure, the VAT may seem unappealing at first glance, because it increases taxes on the middle class. However, the need for the VAT becomes clear when the limitations of the leading alternatives—tax increases on high-income households and entitlement benefit cuts—are recognized.
Although tax increases on the affluent place the burden on those with the most ability to pay, they impede long-run economic growth by penalizing saving and investment and distorting business decisions. The economic costs become larger as tax rates are pushed higher. Even commentators who strongly support high-income tax increases acknowledge that such increases have limited revenue potential and that other measures will have to be adopted alongside them.
Although entitlement cuts can promote economic growth, they are severely regressive, placing vastly heavier burdens (relative to income) on lower income households. They also face formidable political obstacles. President-elect Joe Biden supports increasing entitlement benefits—he succeeds a president who vowed not to cut the major entitlement programs.
Although tax increases on high-income households and entitlement cuts may have important roles to play, they cannot provide a full solution to the fiscal imbalance. Any such measures should be accompanied by a VAT.
The VAT is more growth-friendly than high-income tax increases because it does not penalize saving and investment and poses fewer economic distortions. The VAT is also far less regressive than entitlement cuts. It can even be made mildly progressive if rebate payments are provided to offset the tax burden on low-income households. Researchers at the Urban-Brookings Tax Policy Center found that a 7.7% VAT with rebates would reduce after-tax income by 0.6% for households in the bottom fifth of the income distribution, by 2.9% for those in the middle fifth, and by 3.6% for those in the top 1%.
The VAT occupies a middle ground between tax increases on the rich and entitlement cuts. Although the VAT is not as economically efficient as entitlement cuts, it is more efficient than high-income tax increases. Although the VAT cannot match the strong progressivity of tax increases on high incomes, it avoids the severe regressivity of entitlement cuts.
That combination makes the VAT an attractive basis for the bipartisan compromise that will be needed to address the fiscal gap. The VAT may not be either party’s first choice, but it could be both parties’ second choice, if they ever find a way to work together.
To ensure that the VAT is visible to taxpayers, the tax should be listed as a separate item on customer receipts, as is normally done for state and local sales taxes. The VAT has no insurmountable design problems – every design issue has already been addressed by 160 other countries.
Of course, abrupt deficit reduction would be unwise in light of the current economic weakness. But policy makers should move as quickly as possible to enact a deficit reduction strategy that can be gradually phased in as the economy recovers. The VAT should be a key component of that strategy.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Alan D. Viard is a resident scholar at the American Enterprise Institute.