Friday, April 23, 2010

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.

Read the rest here.


  1. I recognize a "pragmatist" when I read one, but to suggest that taxes are due to the fact that "in their infinite wisdom, voters in a democracy demand that government spend money on them..." shows Reinhardt is missing much of the picture. I used to vote and I never asked the government to spend more money. In fact I asked they cut both taxes and spending. And I am not alone. However, I am in the minority and the politicians ignored me and my fellow realists.

    So rather than getting "ready for the inevitable" as Reinhardt suggests, I propose we stop voting entirely. 30% to 40% of the population is already too apathetic to vote consistently so pushing the non-vote to 60% to 70% should be doable. And at that point we can make the case that the system is no longer legitimate and can be ignored. This will enable the power to flow back to the people at the local level where decisions can be made on the voluntary basis of live and let live. Lets starve the Beast of power.

  2. @Efinancial

    Hmmm pushing the non-vote to 60-70% might be doable. I think you have a movement.

  3. I don't think the populous at large wants the government to spend much on them. Not that people that favor all kinds of welfare don't exist, but their power over politicians, I think, is limited.

    I think the reality is more like, a minority of politically connected interests, usually companies that dislike the competition of a free market, lobby politicians to spend money on them.

    Extra taxes are just more wealth destruction. The current path is unsustainable even with the unholy VAT he's talking about. Part of the competitiveness of the US is the fact a VAT doesn't exist. A VAT will decrease or worse, kill off any future productivity gains.

    The answer is cuts. Massive cuts. Massive rollbacks on the trillions that are presently going down the toilet. That along with keeping taxes at the current rate or even better, lowering them to for the investment and productivity gains.

    At some point, reality is going to come knocking, and extra taxes, no matter what they are, they aren't going to change things.

  4. Oh please, as if most Government spending derives from "voting power." Votes are largely determined by ability to advertise, which is in turn largely determined by the ability to fund-raise.

    It's campaign contributors who are increasingly the true beneficiaries of Federal spending, and to the extent that those same people are also T-Bill holders, those are the same people who are lobbying for higher taxes.

    I'd imagine that the proposition to inflate away the debts could win a popular referendum, not that anyone is asking the plebes for their input.

  5. Wenzel - I have a dream....

  6. The roads are not maintained, education worsens, the water systems are in disrepair, lame public transport in most of the country, subsidies go largely to wealthy business and individuals, who are the people that want this spending?

    The people who are paid by this spending. A nation of government employees, is doomed.

  7. As for myself and everyone I have talked to, if the VAT tax is implemented in our country we will immediately cease all unnecessary spending.
    We will buy nothing but food and enough gasoline to get to work. Every available free cent we cease to spend will be used to pay off our debts until we owe nothing to anyone.
    We will plant backyard gardens complete with chickens and hogs. Eventually we will cease to buy a large majority of the food we once did.
    We will institute a barter network, and trade for what we need (no tax on a trade).
    I imagine most people will follow along and cut the vast majority of their unnecessary spending. This will destroy the country as we know it. We'll go from third world to "fourth world" almost overnight.
    Bring it on, and let's "go for broke"!

  8. Probably one of the best descriptions of "deadweight loss" that I've seen. Many economists can't seem to explain the concept except to point to a shaded area on a supply/demand graph.