A VAT (value added tax) with no other tax — no income, corporate, estate, etc. etc. etc. — is pretty much the economists’ ideal. But how do you make it progressive? A bright — or perhaps lunatic— idea occurred to me.
A progressive VAT
Everyone pays the maximum VAT rate — 40% say, equal to the maximum marginal federal income tax rate. Then, as you spend money over the year, you turn in your receipts — figuratively, we’re going to do al this electronically in a second. So, for the first (say) $10,000 of purchases in each year, you get a refund of all VAT taxes paid. For the next $20,000 of purchases, you get $30 out of every $40 tax payments back, so you pay a 10% rate. And so on. Finally, after (say) $400,000 you don’t get anything back, so you pay the 40% maximum rate.
As you see, I give people an incentive to declare all their consumption. That incentive completes one of the main advantages of a VAT over an income or sales tax. In a VAT, each business in the production chain pays the VAT on its inputs, and charges the VAT on its sales. It then deducts the VAT payments on its inputs against the VAT it has to pay on its sales. That gives the business a strong incentive to collect the VAT on sales, and for its business customers to demand proof the VAT was paid so they in turn can deduct VAT payments against their VAT collections. Now people will also demand “receipts,” proof of tax payment.
Clearly this works only if everything is electronic. I would not inflict expense reimbursement drudgery on the American taxpayer. But that largely is the case. We have a sales tax reporting mechanism, so adding or substituting VAT tax reporting is not that hard.
The big change is that each transaction must report the buyer as well as the seller. As a civil libertarian, this initially struck me as a deal killer. We have already lost far to much privacy and anonymity of transactions. But on second thought perhaps it is not that bad. We already report to Leviathan every source of our income, and under e-verify and other immigration controls we have to ask Leviathan for permission to work. Just how much worse is it to report every purchase too? Especially since, once this progressive VAT replaces the income tax, we no longer have to report sources of income. Furthermore, only the amount of the tax payment needs to be reported, not the nature of the purchase, or even who the seller was.
For those of us who already use debit and credit cards for transactions, this would be easy — the card company can simply forward to the IRS that you paid x much VAT. It does not have to report where you paid it or what you bought. It can separately report that the store paid its tax, without saying who to. For those who don’t use electronic transactions, well, it’s high time they did. If India can set up debit cards and cell phone payments for all its citizens, the US can do so as well. That would make social security, disability, and all other government payments much safer and more secure, and undercut the fees charged by check-cashing businesses in poor neighborhoods. If you pay with cash, swipe your card to record and report the transaction and tax paid. Your incentive to do so is then you get the refund.
I’m sure creative blog readers can do better. Stored value cards or blockchain technology might securely and report taxes paid even better.
It could even be instantaneous. The store pays the VAT electronically, and the Treasury credits your debit-card account with the VAT refund immediately.
Obviously, also, large payments like houses and cars will carry forward over several years, so as not to bump people in to higher expenditure categories.
Of course, reporting individual’s purchases is only required from the desire to make a VAT directly progressive. If you’d be happy with a flat VAT and then achieving redistribution by sending people checks, we don’t have to report anything. Everyone pays (say) 20% VAT, and the government sends checks, on budget, to worthy people.
But I’ll assume that this isn’t enough, and you want to tax the rich more than this allows, so we also have to make the VAT progressive. That goal requires keeping track somehow of how much you consume.
The standard approach to a progressive consumption tax works through the income tax system. Collect information on all income as now, exempt capital income from taxation (dividends and capital gains) then allow people to deduct savings. Roughly, remove all the limits on 401(k) and similar schemes.
This approach is much less clean. People have an incentive to hide income. Furthermore they have an incentive to make what is really taxable labor income look like capital income. Any professional can incorporate and pay him or herself outsize “dividends” on the investment rather than “wages.”
People also have an incentive to make what is really consumption look like business investment. That yacht is really somehow a corporate investment. Well, incorporate yourself, offer just enough paid cruises to keep the IRS happy, and it is. In my world, we pay VAT on investment goods just as we do on consumption goods. And charge VAT on the cruises. If the VAT charged does not cover the VAT paid, it’s consumption and it’s taxed. And many other gnarly problems.
Similarly, my first idea was to track consumption electronically, as above, and then force high-consumers to pay a higher rate at the end of the year. But then they have an incentive to try to hide consumption, which might be easier than hiding income. By paying taxes and filing for refunds, everyone has an incentive to declare everything.
The European system is even less clean; A flat VAT (20% or so), also a payroll tax (40% or so) and also income and estate taxes on top of that (50% or so). They achieve progressivity with the latter, but suffer all the consequences of an income tax.
It's also important not to let the VAT get screwed up by responding to political pressure for different (lower) rates on different goods, to try to transfer income indirectly or to subsidize pet industries.
Why is a consumption tax so important?
Fundamentally there is no reason to tax or to redistribute high incomes. If you want redistribution, you want to redistribute consumption. If you have a high income but leave it all invested in a business and live like a pauper, good for you. The wealth is out there doing good.
Conversely, there is no reason to exempt high consumption that somehow comes from low income. President Trump, according to media reports, managed to get the income tax deductions associated with billions of dollars of his investor’s losses, perfectly legally, and hasn’t paid much tax since. Under a progressive VAT, all those houses and helicopters would be taxed.
The original sin of the US tax code was to tax income not consumption. Once we tax income, we have to tax corporations, since otherwise individuals incorporate to hide their income. (In case you’re late to the party, The right corporate tax is zero. Every cent of corporate tax comes form higher prices, lower wages, or lower returns to shareholders. Since shareholders can most easily avoid it, my bet is all higher prices. If you understand that you pay higher prices because of sales taxes, then it immediately follows that you pay higher prices because of corporate taxes.)
With a consumption tax in place of an income tax, corporate taxes can disappear; the whole issue of non-profits dissappears — goodby Lois Lerner, goodbye shady “charity” tax dodges — there is no need for the vast confusing array of 401(k), 526(b), IRA, 1031 exchanges (rules delaying capital gains realizations) etc. We don’t need health savings accounts — all savings accounts are tax free! This vast simplification appeals to me most of all.
There is also the standard economic argument for consumption taxes. If you tax investment returns, people just save less, the capital stock falls, and the rate of return is the same. People can avoid capital gains in particular by just not selling stock.
An income tax made sense in 1914, when it was a small tax aimed only at high incomes, and when incomes were much easier to measure than consumption. But that is no longer the case.
It is possible. Imagine the huge bonfire of hundreds of thousands of pages of the tax code, replaced by one simple VAT -- essentially a sales tax. Now the obstacle of progressivity is gone too.
Starve the beast?
The main argument I hear against a VAT is that it is too efficient. It can raise so much revenue that government will expand. Starve the beast, these authors say.
I think this is wrong.
First, it is not a great success. Government spending seems hardly constrained in the US by lack of revenue, or the specter of a debt crisis.
Second, think just how little faith this reveals in democracy. Shhh, economists, don’t advocate a much more efficient tax system, because a democracy will always operate at the top of the short-run Laffer curve given its tax structure. If democracy is so incapable of self-governance, we might as well hand the keys to western civilization to the Chinese communist party, as we are doomed.
Third, remember that US government overall (federal state and local) spends about 40% of GDP already. If you add in all the hidden spending — tax expenditures, deductions such as mortgage interest, health insurance, charitable, energy deductions, and mandates on business — we’re probably at least a European 50%. I’m proposing a VAT and nothing else, and let’s put all the cross-subsidies and mandates on budget where we can see them. If we make it progressive, the highest rates hit levels that would please Piketty. I’m not sure there is a lot more to squeeze out of this!
So, I am coming to the opposite view. Not: If you want to cut spending, suffer a vastly complex, growth-killing, disincentive-riddled tax system, which produces little revenue at maximal distortion, so as to try to scare the spenders away with a debt crisis. Yes: if you want to cut taxes, cut spending. Once surpluses pile up, they’ll cut taxes.
But let us admit that economists on both sides of this debate are playing amateur (very amateur) political science. We should stick to economics — The VAT is the most efficient tax system, and here is a way to make it progressive too, if you so wish.
Someone must have thought of this already? If so, let me know who! Or there is a fatal flaw I haven't thought of?
Bob Hall reminds me that the Hall Rabushka tax achieves much the same objective, though by a different mechanism.
Kevin Williamson has an excellent essay in National Review explaining some of the many reasons the corporate tax should be abolished.
Nina Olson has a nice WSJ oped on the complexity of the US tax code. The code includes
six “family status” provisions ..filing status, personal and dependency exemptions, the child tax credit, the earned-income tax credit, the child- and dependent-care credit, and the separated spouse rule. …
“at least 12 savings for education incentives—far too many for most parents and students to make an informed choice.”
There are now at least 15..incentives that encourage savings for retirement (IRA, roth, 401k, etc.)
Of course that’s just the beginning, and even just the beginning of personal income tax complexity, let alone the corporate tax. Oh, and
In 1955, there were 14 civil penalties in the tax code. Today, there are more than 170..Ms. Olson has been the “national taxpayer advocate” since 2001. But even she has to hedge with “at least” and “more than” — apparently even she doesn't really know just how many there are!