Why America Needs a VAT

The deadline for filing individual federal tax returns (though not estimated tax payments) has been extended until May 17 this year. But for millions of Americans, April 15 is and always will be Tax Day, so it’s a good opportunity to discuss what U.S. progressives and conservatives get wrong about taxes. “Soak the rich” remains as perennially popular on the left as “starve the beast” is on the small-government libertarian right. But neither approach is practical.

For the past generation, successful Democratic presidential candidates have promised that ambitious new spending programs will be paid for by soaking the rich with higher taxes, while defining the rich to exclude all but a few Americans. In 1993, President Bill Clinton boasted that under his proposed tax plan 98.8% of Americans would “have no increase in their income tax rates.” In 2015, Democratic presidential candidate Hillary Clinton similarly promised that no family making less than $250,000 a year would pay higher taxes. In an interview with George Stephanopoulos on March 16, 2021, President Joe Biden promised that “Anybody making more than $400,000 will see a small to a significant tax increase. If you make less than $400,000, you won’t see one single penny in additional federal tax.” In that and other statements Biden was clearly referring to individuals, although White House Press Secretary Jen Psaki later claimed that the president meant to say “families.”

No serious scholar believes—even in the unlikely event of robust, prolonged economic growth in the future—that the U.S. government can simultaneously spend more on social insurance, education, and infrastructure, and close future shortfalls in Social Security funding solely by raising taxes on the top 1% or 2% of American individuals or families. Progressives like to point to the welfare states of Scandinavia as their models, but those programs are paid for by higher taxes on the middle and working classes, not just the rich.

In addition to being bad math, the idea of paying for massively expanded government solely by taxing the rich few is bad political strategy on the part of progressives. Perversely, increasing the reliance of government on revenue from a tiny number of taxpayers makes it even more dependent on the prosperity of the rich. By contrast, paying for government programs with broad-based taxes that fall on the majority increases the financial independence of the government from wealthy individuals and corporations alike.

Speaking of corporations, bashing businesses and banks is popular among both elite progressives and conservative populists. And there is much to bash, given the propensity of multinational firms to avoid taxation with the help of offshore tax havens like the Cayman Islands, Panama, Ireland, and the island of Jersey.

But corporate taxes do not produce much revenue anywhere in the world. On average among OECD countries, corporate taxes raise only 9.6% of national revenue; the number in the United States is slightly less, about 7%. Even worse, multinationals can easily avoid corporate income taxes, while small businesses and manufacturing firms located in the United States are more likely to pay the full rate. Most economists agree that individuals—shareholders, managers, workers, and consumers—ultimately pay the cost of corporate income taxes. It is better to impose higher taxes directly on individuals.

What about taxing wealth? Since the 1990s, a number of countries with wealth taxes have repealed them. In 2021, only five OECD countries have net wealth taxes—Colombia, France, Norway, Spain, and Switzerland—and the rates are very low, between 0.1% and 1%. Other than taxes on real property, wealth taxes are hard to administer. The resistance of homeowners and businesses explains why property taxes make up only about 5% of national tax revenue in OECD countries. Property taxes tend to be used to fund local goods and services like public education, so that the visible benefits to local taxpayers outweigh any objections.

The challenges to the left’s “soak the rich” strategy are matched by the obstacles to the realization of the small-government right’s “starve the beast” approach. Ever since the Reagan years the mainstream Republican right, when in power, has cut taxes while promising to cut spending later. But Republican politicians know that cutting taxes is more popular than actually shrinking government until it is small enough to drown in a bathtub, to use the phrase of anti-tax ideologue Grover Norquist.

Polls consistently show that Republican voters are opposed to cutting popular universal programs like Social Security and Medicare. Even though the Republicans controlled Congress and the White House at the time, President George W. Bush’s second-term priority of partially privatizing Social Security was dead on arrival. It is true that means-tested programs for the poor tend to have less public support, but they do not cost much and their elimination would not save much money. In any case, neither Republican nor Democratic voters seem to object to the larger status quo, in which four-fifths of the federal budget is consistently spoken for, with Social Security, Medicare, Medicaid, and other mandatory outlays, leaving little room for nondefense discretionary spending.

What about the deficit? As long as interest rates make the cost of borrowing low, the United States can roll over the national debt indefinitely and never needs to completely balance the budget. Fears that public spending will crowd out private spending, raising interest rates and spurring inflation, seem anachronistic in light of a glut of global capital chasing safe assets like U.S. Treasurys, to say nothing of two near-depressions in a single decade, as a result of the 2008 financial crisis and COVID-19, during which government spending has had to shore up economic demand.

It can still be argued that in the long run tax inflows and outlays should approximately balance, or at least that deficit spending should be limited. Even avant-garde advocates of modern monetary theory (MMT) concede that there are limits to the ability of the government to simply print and spend money. MMT calls for raising taxes in the case of “demand-pull inflation,” when demand outstrips supply.

If the beast is not going to be starved into massive weight loss and cannot be fed by soaking the rich or by helicopter money, then we will need to feed it by raising taxes at some point in the medium- to long-term future, assuming the economy recovers from the pandemic and its economic consequences. The important question is what kinds of taxes should be used.

Among experts there is a general consensus that the most politically sustainable forms of taxation are inescapable, invisible, and recurrent rather than highly transparent. As Louis XIV’s finance minister Jean-Baptiste Colbert observed, “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”

With this in mind, anti-statists on the right sometimes propose that taxes be made as transparent as possible in the hope that tax revolts will keep rates low. But even small government conservatives and libertarian advocates of a night-watchman state (“minarchists”) support basic government functions like defense, policing, and law enforcement. If they are rational, even these right-wing proponents of minimal government should want the legitimate functions of the state to be funded by taxes which do not frequently trigger anti-tax rebellions by voters.

From a Colbertian goose-plucking perspective, the ideal tax is a broad-based consumption tax like a sales tax or a value-added tax (VAT). Consumption taxes are inescapable, unless you take up permanent diplomatic asylum in an airport duty free zone. In addition, consumption taxes are effectively invisible; even if sales taxes or VATs are listed on a receipt, few buyers pay any attention. Finally, consumption taxes are recurrent, so taxpayers do not experience the kind of “sticker shock” every year on Tax Day that inspires them to march to the legislature with pitchforks and torches.

This explains why over 160 out of the world’s 195 countries, and every First World industrial nation other than the United States, rely on a VAT (a kind of cumulative sales tax charged at each stage of production) for a large portion of their tax revenue. In 2019, consumption taxes—chiefly in the form of VAT—were the most important source of revenue for advanced OECD countries (32.3 %), followed by social insurance taxes like payroll taxes for retirement programs and health care (25.7%) and individual taxes (24%).

The typical advanced capitalist nation’s tax system, then, is a three-legged stool, resting on consumption, social insurance, and individual taxes. But the U.S. federal government in 2019 was overwhelmingly dependent on only two sources of tax revenues: the federal income tax (50%) and the social insurance payroll tax (36%), with corporate taxes at 7% and excise and other taxes at 8%. Because consumption taxes, in the form of sales taxes, are levied by American state and local governments, the consumption tax share goes up slightly to 18% of the U.S. total when federal, state, and local tax revenues are viewed in combination.

Ill-informed conservatives sometimes claim that this proves that a VAT is a money machine that enables European-style big government while its absence keeps American government small. But in fact, when it comes to government expenditures as a share of gross domestic product, the U.S. government is not particularly small. In terms of spending the United States is in the middle of the pack among industrial democracies, when off-budget tax expenditures are counted as spending. (The largest tax expenditures are the exclusion of employer contributions for health insurance, the exclusion of net imputed rental income, defined contribution employer plans, and capital gains tax exclusions.)

On the left, some might object that flat consumption taxes are regressive, with the poor paying a larger share of their income on VAT or sales tax than the affluent. But a flat national VAT in the United States could be made less regressive in several ways.

Necessities like food and utilities could be exempted from the VAT, although this would require a somewhat higher nominal rate. In addition, VAT revenues could be earmarked for spending programs that disproportionately benefit the working-class majority and the poor. Alternately, money from a federal VAT could be used to reduce regressive payroll taxes for Social Security, Medicare, and Medicaid, though some payroll taxes should be maintained for the political purpose of enabling citizens to claim that their social insurance benefits are “earned benefits.”

And then there is revenue sharing. The federal government could distribute some of the revenues raised by a national VAT to state and local governments on a per capita basis, enabling those governments to reduce their own regressive sales and property taxes. In practice revenue sharing would be highly progressive in its effect, inasmuch as VAT revenue would be raised largely in a few areas where most rich and affluent Americans live and consume goods and services, and then spread across the country. As Sir Francis Bacon observed in 1625, “Above all things, good Policie is to be used, that the Treasure and Moneyes, in a State, be not gathered into few Hands. For otherwise, a state may have a great Stock, and yet starve. And Money is like Muck [manure], not good except it be spread.”

In honor of Bacon, then, let us call the smart alternative to either soaking the rich or starving the beast the “spread the manure” theory of taxation.