We don’t need a VAT to balance the budget

Gretchen Hamel Executive Director, Public Notice
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Riots in Greece and a stock market spooked by the growing risk of government default has increased attention in the United States on the need to reduce our own national debt. The President’s National Commission on Fiscal Responsibility launched this month and commission members took turns describing the gravity of our economic situation. Concern about the level of U.S. debt is certainly warranted, but it shouldn’t be used as an excuse for passing tax increase, or even worse, for creating a whole new extra system of taxation, like a value-added tax (VAT).

The VAT is a staple of European countries, having been first adopted by France in 1956. The VAT works by taxing goods and services at every stage of production. Ultimately, the full costs of the VAT are passed on to the consumer, as it is a tax on consumption.

In general, consumption taxes are preferable to taxes on income and investment, because they cause less economic distortion and don’t do as much to discourage productive activities (like work, investment, and saving). However, that is part of the problem: a VAT would be an efficient way to increase government spending, which would ultimately compound our current fiscal problems.

The flirtation with creating a VAT is really a discussion about permanently expanding the size of government. While VAT proponents highlight the possibility of using the new revenue from the VAT for deficit reduction, its real purpose is to spare politicians from making needed cuts to government spending.

When the VAT became common in Europe in the 1960s, average government spending was about 30 percent of GDP, while government spending (federal and state) in the U.S. was about 28 percent of GDP. Today, European government spending averages 47 percent of GDP compared to 35 percent in the U.S. Surely VAT’s ability to raise revenue without taxpayers directly confronting the bill has facilitated Europe’s rapid government growth.

Increased taxes, whether through a VAT or the traditional income tax system, will also affect the economy. A VAT, by raising the costs of all goods and services, will impede economic growth. Businesses will be paying more for the goods that they use, which means there will be less money available for hiring workers, expanding business, or investing in new research and development. Families spending more on everyday goods and services will find their earnings don’t go as far. They’ll have to cut back, which means that businesses will have fewer customers.

The economic effects of higher taxation will at least in part off-set the expected increase in revenue from the VAT, so we’ll likely pay off less debt that one might expect. And as for the argument that the VAT is a government debt cure-all, it’s worth noting that Greece has a VAT of 19 percent. Clearly a VAT alone isn’t enough to balance a budget: it’s the spending side of the ledger that creates the real trouble and that should be the focus of deficit-reduction efforts.

The American public is instinctively skeptical of creating a VAT or trusting that politicians will use additional tax revenues to pay down the debt. When asked about a VAT in a recent poll, voters opposed it by a 67-21 percent margin. Even less than a third of Democrats supported a VAT.

Another survey found that less than one in five voters was willing to have their taxes raised in order to pay down the debt. The voters were wisely skeptical of politicians’ commitment to deficit reduction: Fifty-eight percent thought that if taxes were increased, the government would spend the money on more programs instead of paying down the debt.

While politicians may think that their budget problems are a result of a too-stingy tax system, the American people overwhelming recognize that overspending is the deficit’s root cause. Indeed, 83 percent of voters responded that unwillingness to cut spending, rather than under-taxation, was the cause of the current deficit.

A VAT hasn’t prevented deficit crises in Europe and it won’t solve the budget problems in the U.S. Only reining in government spending, including entitlement programs, will put our fiscal house back in order.

Gretchen Hamel is the executive director of Public Notice, a new independent, bipartisan, non-profit organization dedicated to providing facts and insights on the effect public policy has on Americans’ financial well being. For more information please visit www.thepublicnotice.org.