Why the Valued Added Tax Is Coming On Top of the Income Tax

By Uwe E. Reinhardt 


There are plenty of reasons to shudder at the idea of higher taxes. There are also plenty of reasons to expect them nonetheless.

It is understandable that everyone dislikes paying taxes, because they are a forced personal outlay for things one does not necessarily appreciate.

Economists, for their part, teach their students that in addition to this understandable opposition to taxes, taxes also tend to change economic behavior, mainly in undesirable directions.

A tax on wages and salaries, for example, lowers the net reward to supplying hours of work to the economy. Sometimes, to be cute, economics professors style that tax as a “subsidy for consuming leisure,” just to drive home the point.


With few exceptions all other taxes have some effect on economic behavior as well. The main exceptions are (1) a so-called per capita head tax, which almost never prompts people to cut off their heads to avoid the tax, and (2) a tax on unimproved land, because that land simply is there. The improvements human make on land, however, can be affected by taxation.

Occasionally a tax can help curb behavior society may wish to curtail. A sales tax on tobacco, for example, is known to reduce smoking, especially among teenagers. A tax on the output from polluting production can induce firms to clean up their production processes, thus curbing pollution, or simply to reduce production. Taxes designed to curtail undesirable behavior are known in the vernacular as “sin taxes.”

But for the most part, taxes tend to curtail some desirable economic behavior, be it working or investing in productive capital, or trading for mutual advantage. Taxes then entail what economists call a “deadweight loss.”

By “deadweight loss” economists have in mind the fact that when a tax reduces desirable economic behavior — e.g., the building of boats, or producing some other valued output — the value of the output to society thus lost usually exceeds the value of the resources that are no longer sacrificed to produce that lost output.

The difference between the two is considered by economists to be an overall loss of human welfare.  Depending on how sensitive the economic activity in question is to taxation, that deadweight loss can be non-trivial. Furthermore, that deadweight loss is thought to increase more than proportionately with tax rates.

So why then do we have taxes at all, given that they entail this undesirable “deadweight loss”?
The answer is that in their infinite wisdom, voters in a democracy demand that government spend money on them, and their elected representatives in Congress oblige. That spending must be financed.
In principle, government spending program should be financed with taxes. The exception would be spending by government on long-lived investment projects — for example, roads, airports, research and development, schools — that should be financed with long-term public debt, which in turn will then be paid off in good part by future taxpayers who also benefit from using the long-lived public asset.

A government’s current operations and transfer payments, however, should be fully tax-financed, at least over the business cycle. The most policy makers can do is to select the combination of taxes that minimizes the nation’s overall “deadweight loss” from taxation, albeit with due regard to what is considered “fair” at the moment.

It so happens that in recent history American voters have wanted the federal government to spend more on them than they are willing to finance with taxes. One can see this clearly by examining the famous state-by-state spending-to-tax ratios published regularly by the Tax Foundation.

The graph below illustrates this penchant as well, at a more aggregate national level. The data in that graph exclude the operations of the Social Security and Medicare Trust Funds. The data are routinely published in the annual editions of the Economic Report of the President.

There is now widespread agreement that at some point the federal government must stop piling on the federal debt. On the campaign stump, political candidates all agree.

But would a politician dare openly to advocate cutting specific programs – for example, agricultural subsidies for the rural states whose voters have disproportionate voting power, or cuts in military spending that would kill jobs in particular states, or spending on Medicare, which in many parts of the country has been a major source of employment?

Now, if it is politically impossible to cut spending — as it has been so far — then taxes will have to be raised sooner or later.

So, my friends, get ready for the inevitable: Before this decade is out, whether you like it or not, the United States will have a value-added tax, just as they have long had in most of the world. The VAT will not be a substitute for the income tax (which, ideally, I wish it would be), but a complement to it, to supplement what can be had through income taxes.

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