Value Added Tax
Basic Concepts and Unresolved Issues

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The VAT is an old idea in tax policy that, despite periodic consideration, has not been adopted in the United States.[1] The absence of a VAT makes the United States unique among developed nations. A VAT is used by all OECD nations other than the United States and by at least 145 countries around the world.[2]

To be sure, the United States does rely on consumption taxes. In 2007 nearly 10 percent of total government revenues (federal, state, and local) were collected through state and local sales taxes.[3] Also, the federal income tax has important consumption-tax-like features, such as tax-preferred retirement accounts and accelerated depreciation for most equipment investment, that eliminate or reduce the tax on a portion of the return to saving and investment.

During the last year, the VAT has drawn new attention in U.S. tax policy discussions. A Tax Notes article recently noted, "The idea of instituting a European-style VAT became even more popular in 2009."[4] The Washington Post also reported last spring about the growing interest in a VAT.[5]

Recommendations that a VAT be considered have been more common than outright endorsements of the tax. The idea surfaced briefly as a possible source of revenue for healthcare reform.[6] House Speaker Nancy Pelosi, D-Calif., recently commented that "it's fair to look at" a VAT, and Senate taxwriter and Budget Committee Chair Kent Conrad, D-N.D., has said that a VAT should be on the table in future tax policy discussions.[7] Two former Federal Reserve chairs have made similar statements: Paul Volcker has referred to a VAT as a "possible approach," and Alan Greenspan has said that it must be considered as a possible way to reduce the deficit.[8]

Two prominent tax reform plans, one by Michael J. Graetz of Columbia Law School and the other by Leonard Burman of Syracuse University, call for the adoption of a VAT accompanied by reduction, but not elimination, of income taxes.[9] A December 2007 Treasury Department report analyzed three reform options, one of which would replace the corporate income tax with a 5 or 6 percent VAT.[10] The "Roadmap for America's Future" proposal, recently introduced by House Ways and Means Committee member Paul Ryan, R-Wis., would replace the corporate income tax with an 8.5 percent VAT.[11] An October 2009 KMPG survey of 600 corporate executives found that two-thirds of them expected Congress to consider a VAT in the next five years.[12]

As one would expect, policy analyses of the VAT have become more common. Tax Notes is publishing an ongoing Views on VAT series, written by members of KPMG LLP's Washington National Tax Office.[13] The American Tax Policy Institute sponsored a conference on structuring a federal VAT on February 18 and 19, 2009.[14]

Some have suggested a VAT as a possible new revenue source to help address the looming entitlement problem, while others see a VAT as an economically efficient alternative source of revenue that could correct some of the worst features of the current income tax. One risk of adopting a VAT is that reliance on this revenue source might fuel the growth of government spending. Indeed, some have observed that VATs abroad have generally grown over time, possibly enabling an increase in the size and scope of government. One prominent study finds empirical evidence that more efficient tax systems contribute to an expansion of government.[15] Even if a VAT were initially adopted to replace the most economically costly features of the income tax system, it might later be used to finance an expansion of government.

A better outcome than adopting a VAT alongside the income tax would be to adopt a consumption tax as a complete replacement for the income tax system. As we recently explained, an ideal way to do this would be to adopt the Bradford X tax, a modified form of a VAT. The X tax can be much more progressive than a conventional VAT, which may make it more politically appealing as a complete replacement for the progressive income tax.[16]

Depending on the availability of alternatives such as the X tax and the safeguards that might be adopted against spending growth, a VAT may or may not be right for the United States. In any case, many problems would have to be resolved before a VAT could be adopted. In this article, we review how a VAT functions, describe the economic benefits of replacing the income tax with a VAT, and discuss some of the major unresolved questions. Because some of these issues should be viewed differently depending on whether the VAT is a replacement for all of the current income tax (complete-replacement VAT), a replacement for a portion of the current income tax (partial-replacement VAT), or a new revenue source (add-on VAT), we discuss the concerns from more than one perspective when necessary.

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Alan D. Viard is a resident scholar at AEI. Robert Carroll is an executive in residence at American University.

Photo Credit: spakattacks/Flickr/Creative Commons

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