Value added tax: It can work if used correctly, but would not close U.S. deficit

Along with federal budget deficits and state budgetary problems, we hear more and more in the news about tax reform. This was discussed, though not enacted, by Kentucky's General Assembly this winter and there is now talk at the federal level of changes in taxation to include a value added tax, or VAT. The discussion, however, has caused much confusion over reforming taxes versus raising taxes.

Tax reform normally refers to changing the manner in which a given amount of tax revenue is raised. The way in which taxes are levied to fund the functions of government is important. Taxes cause losses in economic efficiency and can cause inequities as well. The former occurs because taxes induce businesses and individuals to undertake activities that they otherwise would not want to do. For example, taxes on certain items that firms purchase, such as labor services and materials, can induce them to deviate from an efficient production method simply because taxes make it too expensive.

Similarly, taxes on consumers that favor one good relative to another can cause consumers to change their purchases from what they really want to avoid the taxes.

With a poorly designed tax system, one can easily see that it can induce inefficient production by firms and leave consumers with a less desirable set of purchases. Thus, it is important to have a tax system that minimizes these problems, as well as remaining equitable.

One simple approach that addresses many of these problems is summed up with the phrase "broad base, low rates." This means having a low tax rate, but on all goods and services. A low enough rate makes it such that the tax is not punitive and the identical percentage tax rate on everything avoids tax-induced deviations from the most desired purchases. A value added tax, in and of itself, could be designed along these lines.

The VAT, in its simplest form, is equivalent to a tax on the final consumption of all goods and services. The tax is levied on firms and, of course, is passed along to consumers. But the tax is on the sales of the firm net of its cost of materials, or to say, on its value added, so the tax is not repeatedly paid on materials costs. With the same, presumably low, tax rate on all goods and services, it meets the "broad base, low rates" criteria for minimizing economic distortions in purchases.

The VAT, and similar tax systems, has been criticized by some, who argue that it is unfair to expect the poor to pay this level of taxation. However, this might be addressed by allowing individuals to file for a tax credit based on their income.

Though the VAT, when properly designed, can be a sensible way to raise revenue, taxpayers get nervous when tax reform is discussed, fearing that its supporters really want a tax hike. This anxiety is heightened when the calls for reform are loudest because the government is short on funds.

News reports indicate that the current supporters of the VAT for the United States suggest that it would be in addition to the current set of taxes we already have. There is no doubt that this would constitute a tax hike. Additionally, the current federal tax code has numerous exemptions and deductions, as well as varying tax rates, which distort many economic decisions away from their most desirable. A VAT on top of this tax system does nothing to address these problems.

The VAT is not a "free lunch." It is not a costless way to raise funds to close the federal deficit. Whether one thinks the VAT, or any other tax, ought to be used to raise more tax revenue presumably depends on whether one perceives if the value of the government expenditures are worth the additional tax dollars.

Higher spending means eventually paying higher taxes and it is sensible to raise taxes only if the higher spending is worth it.