Risky revenue ‘VAT’

Tax reform is high on President Bush’s list of second-term priorities. Considering the mess our tax code has become, this is welcome news. More than 90 years of social engineering and backdoor industrial policy have created a tax system that combines punitive class warfare and special-interest loopholes.

Unfortunately, this silver cloud may have a dark lining. There are signs a few Bush administration people may be sympathetic to a European-style value-added tax (VAT), a form of national sales tax imposed at each stage of the production process. Enacting such a tax in America, though, would be a tragic mistake. A VAT might have some theoretically attractive features, but it a perniciously effective way to raise revenues and inevitably leads to bigger government.

The best evidence comes from Europe. Back in the mid-1960s, the burden of government in Europe wasn’t that much higher than in the United States. Tax revenues consumed about 30 percent of gross domestic product (GDP) in Europe. The United States had a small advantage: Including state and local governments, the tax burden was about 27 percent of GDP.

But then European governments started adopting the VAT. In 1967, Denmark was the first, followed by France and Germany. Many other European nations imposed the tax within five years.

For politicians, the VAT was great news. Besides being a new source of revenue, the VAT has been a disturbingly easy tax to increase since it’s built into the price of products and hidden from consumers. Moreover, even small increases generate a big pile of revenue because the tax base is so broad. The tax has become so easy to raise that VAT rates in Europe average more than 20 percent.

For taxpayers, though, the news has been disastrous. Thanks to this levy, the burden of government in Europe today is much higher than in the United States. On average, taxes consume about 41 percent of Europe’s economic output. While other taxes also have climbed, the VAT certainly has helped finance the explosion of social welfare spending that creates such a drag on European economies.

In the United States, by contrast, the total tax burden as a share of GDP is about where it was 40 years ago — 27 percent (which helps explain why America is growing faster and creating so many more jobs than European nations).

So if the VAT is a money machine for big government, why would anybody inside the Bush administration support it? Money is reportedly the biggest attraction. The president has said tax reform must be “revenue-neutral.” This means the pro-growth, revenue-reducing parts of tax reform — lower rates, alternative minimum tax repeal, and a shift from depreciation to expensing — must be financed by revenue increases.

Ideally, these pro-growth tax reform elements would be “paid for” by eliminating shelters, deductions, exemptions, credits and other tax breaks. But this would be a daunting task. Special-interest groups almost surely would fight to protect the major loopholes, including the deduction for state and local tax payments and exclusion for employee fringe benefits.

That’s why a VAT is alluring. It is a relatively nondestructive way to raise tax revenue. Like a flat tax, it is a single-rate system that doesn’t penalize saving and investment. It’s understandable that officials would be tempted to enact a VAT to finance much-needed income tax reforms.

On paper, this would be a good trade. But in the real world, America would take the first step toward fiscal destruction. Many European governments used the same argument when enacting the VAT. They claimed more destructive taxes would be cut or repealed after the VAT went into effect. In the short term, this was true: As late as 1975, taxes on income and profits were lower in the EU than in the United States.

But this was a transitory phenomenon. Income-tax rates quickly began climbing and almost immediately jumped above U.S. levels. Ironically, the VAT facilitated higher tax rates on income since politicians often argued that a higher VAT had to be accompanied by higher income tax burdens to ensure the tax burden wasn’t being shifted to lower-income taxpayers.

There is only one scenario that would make a VAT acceptable. If U.S. lawmakers were willing to repeal the 16th Amendment and abolish all taxes on income, a VAT would be an acceptable risk. But until that happens, taxpayers should vigorously resist the Europeanization of America.

Daniel J. Mitchell is the McKenna fellow in political economy at the Heritage Foundation.