Most proposals for a VAT in the United States call for part, or all, of the resulting revenue to be used to reduce other taxes. In this essay, I discuss the possibilities of using a VAT to finance reductions in the corporate income tax, payroll and self employment taxes, and the individual income tax. I also describe changes to the Social Security system that would need to accompany the adoption of a VAT.
If a VAT is adopted, it should be used to eliminate the corporate income tax and its assortment of economic inefficiencies. It should also be used to eliminate the Medicare component of the payroll and self-employment taxes. Replacement of the Social Security component of those taxes should be avoided, however, because it would be difficult to reconcile with the current design of the Social Security system. A variety of individual income tax reductions could be added to the corporate tax and Medicare tax reductions to achieve the desired mix of efficiency and distributional goals.
Repeal the Corporate Income Tax
Several recent VAT proposals have called for repeal or reduction of the corporate income tax. The Treasury Department (2007) analyzed three reform options, one of which would replace the corporate income tax with a VAT. The Roadmap for America's Future proposal introduced by Rep. Paul Ryan, R-Wis., would also replace the corporate income tax with a VAT. Prof. Michael Graetz's (2008) VAT proposal calls for a reduction in the corporate income tax rate to 15 or 20 percent.
On efficiency grounds, the corporate income tax is a prime candidate for full or partial replacement. Like any other tax on capital income, and unlike the VAT, the corporate income tax penalizes saving for future consumption, relative to current consumption. But the tax induces a wide variety of additional distortions not imposed by other taxes on capital income.
Some of the distortions arise from the fact that the corporate income tax essentially applies only to equity-financed investment by corporations, not to corporate debt-financed investment or non corporate investment. To be sure, corporate equity enjoys advantages at the individual level because reinvested earnings are not taxed until gains are realized and because dividends and capital gains are taxed at preferential rates, although the dividend preference is scheduled to expire at the end of 2010. On the whole, though, corporate equity-financed investment is taxed more heavily than other investment. As a result, the corporate income tax distorts the choice of organizational form and the choice between debt and equity.
The corporate income tax also penalizes the location of investment inside the United States. For foreign-chartered firms, the tax applies only to income derived inside the United States, giving those firms an incentive to operate abroad rather than here. In an effort to keep investment in the United States, the current system taxes U.S.-chartered firms on their foreign, as well as their domestic, income. At least in the long run, however, this charter based taxation (misleadingly called ''global'' or ''worldwide'' taxation) probably does little to keep investment in the United States and instead simply encourages investment abroad to be done through foreign- rather than U.S.-chartered firms. This doubtlessly explains why charter-based taxation is being abandoned by many countries and why the United States' application of it has always been diluted by the deferral of tax on overseas earnings.
All of these considerations suggest that the United States should join the international movement toward lower corporate tax rates. Given the lack of a coherent argument for why corporate equity investment should be singled out for taxation, outright elimination of the corporate income tax would be ideal. The resulting flow of investment to the United States would ultimately make labor more productive and thereby boost real wages. Treasury (2007) estimated that replacement of the corporate income tax with a VAT would increase long-run output by 2 to 2.5 percent.
The repeal of the corporate income tax should be accompanied by a significant strengthening of the undistributed earnings tax to protect the individual income tax base from erosion. Also, preferential individual income tax treatment of dividends, relative to other types of capital income, would no longer be needed once there was no corporate tax to offset.
There might be resistance on distributional grounds to the use of the VAT to finance a repeal of the corporate income tax. Those concerns would be misplaced to the extent that the benefits of corporate tax repeal flow to workers in the form of higher wages. In any case, the concerns could be addressed by including individual income tax reductions in the package, as discussed below.
Modify Payroll and Self-Employment Taxes
There would be economic advantages to using a VAT to partially replace payroll and self-employment taxes, which are essentially equivalent to a wage tax. To be sure, wage taxes are relatively simple and relatively efficient because, like consumption taxes, they do not distort the saving decision. Nevertheless, wage taxes are economically inferior to consumption taxes. The consumption tax base effectively includes wages, plus above normal returns on new investment and initial wealth. It is clearly desirable to tax above-normal returns, and it is probably desirable to place some tax burden on initial wealth while using transition relief to modulate the extent of the burden. Therefore, replacing a wage tax with a consumption tax offers at least modest economic gains.
Complications arise, however, because payroll and self employment taxes are tied to Social Security and Medicare Part A. Those complications make it unwise to replace the Social Security component of these taxes but do not pose an obstacle to replacement of the Medicare component.
At the aggregate level, payroll and self-employment taxes are earmarked to finance Social Security and Medicare Part A benefits. Those programs are not authorized to pay benefits greater than the levels that can be supported by current and past taxes, as tracked by a trust-fund accounting mechanism. On the whole, this earmarking appears to have promoted fiscal responsibility and spending restraint, particularly for Social Security. Legislation to restrain Social Security benefit growth was enacted in 1983 when earmarked taxes were insufficient to support scheduled benefits, and discussion of Social Security reform today is driven by the prospect that earmarked taxes will again fall short in roughly three decades.
Could these advantages be retained by earmarking some of the VAT receipts to finance Social Security and Medicare Part A? For Medicare, that approach would indeed be satisfactory. If a VAT is adopted, the Medicare tax should be abolished, as Burman (2008) has proposed, and a portion of the VAT receipts should be earmarked to finance Part A benefits. Unfortunately, that approach would not work well for Social Security. Formidable complications would arise because Social Security benefits are linked to tax payments at the individual level, a linkage that does not exist to any significant extent in Medicare.
Specifically, each worker's Social Security benefits are based on her lifetime earnings (wages and self-employment income) that were subject to Social Security tax. A worker with higher average earnings receives higher monthly benefits, although the increase is less than proportional. The benefit computation includes only earnings subject to Social Security tax; it excludes earnings that exceeded the taxable maximum and those from employment not covered by Social Security, primarily some state and local government employment.
It would be difficult to maintain the current benefit formula if Social Security benefits were financed by a VAT rather than by payroll and self-employment taxes. At a minimum, it would be inappropriate to continue excluding earnings from employment previously exempt from Social Security tax, as those workers would now pay the same VAT as other workers to finance the system. More broadly, the principle of paying higher monthly benefits to those with higher lifetime earnings might be politically untenable in the absence of a visible link between earnings and tax payments. (Of course, there would still be a linkage, because workers with higher earnings would pay higher VAT over their lifetimes.)
One possible response would be to radically revamp the benefit formula, perhaps paying flat monthly benefits to all retirees. But that switch would create its own problems, as it would dramatically change public perceptions of the system's contributory nature. Moreover, there would be no easy way to apply it to current workers, who have been paying earnings related taxes and have been promised earnings-related benefits.
Social Security is often considered the third rail of American politics. Given the political contention that would surround the enactment of a VAT, it would be preferable not to combine it with a politically explosive set of Social Security changes.
Although the Social Security tax should not be reduced or replaced, it will still be necessary to make some changes to the Social Security system. If the system's tax and benefit rules were left untouched, the adoption of a VAT would result in an unintended and capricious tax and benefit reduction. Those effects would occur because of how a VAT affects real wages.
Although a VAT and an individual income tax both reduce workers' disposable incomes below the marginal product of their labor, they do so in different ways. The VAT is a firm-level tax that reduces the real wage paid by the firm; when a firm pays VAT on the output its workers produce, the real wage it can afford to pay falls accordingly. (It makes no difference in this context whether the Federal Reserve accommodates the VAT, allowing the real wage reduction to occur through an increase in consumer prices, or refuses to accommodate, forcing a decline in nominal wages.)
In contrast, the individual income tax does not reduce the real wage paid by the firm, but is instead paid by the worker out of the unchanged real wage. Although this should be a mere difference of form, the current payroll tax design and benefit formula cause it to have real implications for the Social Security system.
Because payroll taxes are imposed on the wages workers are paid by firms, the introduction of a 10 percent VAT would shrink the payroll tax base by 10 percent. (This effect is often referred to as the excise tax offset.) While individual income taxes are not deducted from the payroll tax base, the VAT would effectively be deducted because it would diminish the wage on which the payroll tax is imposed. One way to maintain payroll tax revenue would be to redefine the payroll tax base in terms of VAT-inclusive wages. A worker paid $100 would then be subject to payroll tax on $110, including the $10 VAT paid at the firm level. If this approach is unpalatable, the payroll tax rate could simply be increased.
The need for an adjustment would be even more compelling on the benefit side. Current law effectively indexes each annual cohort's real benefits to the real value of the Social Security Administration's National Average Wage Index in the year that the cohort attains age 60. (In the benefits computation, each worker's earnings in each past year are adjusted to reflect the growth in the wage index from that year to the year in which the worker turns 60.)
The introduction of a permanent 10 percent VAT in, say, 2012, would therefore reduce real benefits, relative to the marginal product of labor, by 10 percent for cohorts born in and after 1952, while leaving untouched the real benefits paid to cohorts born in and before 1951. Real benefits could be maintained by using VAT-inclusive wages in the benefit computation and in the construction of the National Average Wage Index.
It would be irresponsible to fail to offset these effects of a VAT on Social Security. Although a reduction of Social Security taxes and benefits may well be desirable, it would be inappropriate to implement those reductions through the back door in this manner. Letting them take effect would also worsen the system's finances, as the revenue reduction would immediately take full effect for all workers while the benefit reduction would apply only to future retirees. Further, the disparate treatment of those turning 60 in the year of VAT introduction and those who turned 60 in the preceding year would be widely and correctly perceived as capricious.
Reduce Individual Income Taxes
Due to the wide range of potential individual income tax changes, including changes to refundable credits, such alterations should be viewed as a residual that can be tailored to achieve the desired mix of distributional and efficiency goals for the overall tax package. Eliminating individual income taxes for low-and moderate-income households, as Graetz proposes, would promote simplicity and offer distributional advantages, while reductions in marginal tax rates, as proposed by both Graetz and Burman, would provide efficiency gains.
If a VAT is adopted, part of the revenue should be used to repeal the corporate income tax and the Medicare component of the payroll and self-employment taxes. Social Security taxes should not be reduced, however, because any reductions would complicate the operation of the Social Security system. Instead, the earnings measures used in the payroll tax and the benefit formula should be re-normalized to account for the presence of the VAT. Reductions in individual income taxes should also be included, with the specific changes chosen to achieve distributional and efficiency targets. Those measures would help ensure that a VAT paves the way for a better tax system rather than simply facilitating the growth of government.
Alan D. Viard is a resident scholar at AEI.