Consuming Debate

Rick Henderson from the December 1992 issue

Both George Bush and Bill Clinton practice voodoo economics every time they discuss their own proposals. Bush says he can cut taxes and reduce the deficit without slashing entitlements. Clinton promises to send an extra $50 billion to big-city bureaucrats, enact national health insurance, boost education and infrastructure spending, and halve the deficit by raising taxes only on foreigners and "the wealthy."

I don t think so.

Whoever wins the election will have to scale back his promises or come up with more money to pay for them. Bet on the latter.

As the nation's population ages, and as politicians continue to promise that Washington, D.C., can cure any ill, demands on the federal government to provide services will increase. However, the current income-tax code may be squeezing all of the money it can from the economy. Without major spending cuts, federal policy makers will have to find new sources of tax money. New taxes on consumption--probably including some form of a value-added tax--will likely be part of the recipe.

The federal government has always relied on narrowly targeted excise taxes (such as alcohol, cigarette, and other "sin" taxes) or tariffs for some of its revenue. Yet it has never used broad-based consumption taxes. For more than a decade, some members of Congress have tried to change that.

In 1979, House Ways and Means chairman Al Ullman (D-Ore.) devised a VAT and forcefully pushed it. His proposal went nowhere. But Ullman soon (unwillingly) left Washington: He narrowly lost the 1980 election to Republican Denny Smith. As National Journal notes, Ullman's defeat can be attributed to more than his support of a VAT--Smith portrayed Ullman as an aloof Beltway insider, and Jimmy Carter conceded his re-election bid before the Oregon polls closed. Still, many potential supporters of a value-added tax link Ullman's high-profile campaign for a VAT with his demise.

Others in Congress proceed undaunted. Sen. Ernest F. Hollings (D-S.C.) calls for a 5-percent VAT to pay for deficit reduction. Sen. John Danforth (R-Mo.) would use a VAT to pay for a cut in capital-gains taxes and to gain other tax incentives for investors. Reps. Henry Waxman (D-Calif.) and John Dingell (D-Mich.) want a 5-percent VAT to pay for national health insurance. Rep. Robert Wise (D-W.Va.) would use his VAT to pay for debt reduction, middle-income tax relief, and infrastructure spending.

These proposals are little more than vaguely stated goals. No one has clearly spelled out how his consumption tax would work. But consumption taxes are being discussed more frequently--and more seriously--on Capitol Hill. "In the seven years I've been here," says a staff member of a congressional tax-writing committee, "this issue has come up more this year than ever before." Bob Ragland, chief tax counsel for the National Chamber Foundation, says, "The business community would be well advised to define a transactions-based tax they can live with and support it. There's a VAT in our future."

Value-added taxes, especially when they're contrasted with income taxes, are pretty popular among economists. In its simplest form, a VAT does a lot of things economists like. For one, a VAT should be easy to calculate and collect. A firm would tally its sales, subtract the value of raw materials and other purchases, and multiply this sum (the "value added") by the tax rate.

A single-rate VAT would also cause ewer economic distortions than the current income-tax code. The crazy-quilt nature of the Internal Revenue Code often encourages businesses (and individuals) to make investments or purchases because the tax code favors them, not because they make economic sense. Companies buy Lear jets and use them as tax write-offs; profitable conglomerates buy money losing sports franchises to reduce their tax burdens; huge agribusiness concerns get tax breaks to produce ethanol.

And the income-tax code is likely to get more complicated. Such politically popular ideas as targeted investment-tax credits, expanded (and mainly bogus) enterprise zones, and tax breaks for long-term savings all encourage investments that are tax-worthy, but not necessarily profitable. A single-rate VAT that replaced the corporate income tax would sweep away all these distortion-causing measures.

Finally, a VAT is designed to tax consumption instead of saving. The corporate income tax penalizes success: Companies that make profits have to pay taxes on their earnings. And firms can write off losses, so the government indirectly subsidizes failure.

Economists across the spectrum blame much of the economy's recent sluggishness on our low rate of capital formation. A recent study by Harvard business professor Michael Porter blames stagnant capital formation on investors who, understandably, are reluctant to stick with their portfolios over the long haul. Porter reports that 30 years ago, a shareholder held the average stock for seven years; today, the average investor gets rid of a share of stock in two years. During this time, investment has languished at half the rate of earlier postwar decades.

Taxing consumption, rather than savings, income, and employment, economists argue, would encourage a robust recovery. Murray Weidenbaum, president of the Center for the Study of American Business, defends consumption taxes because they put "the fiscal burden on what people take from society--the goods and services they consume--rather than on what they contribute by working and saving." (Weidenbaum does not advocate value-added taxes; instead he would retain the current income-tax structure and allow businesses to deduct capital spending and other investments.)

The U.S. government receives 18 percent of its revenue from consumption taxes. By contrast, consumption taxes account for 26 percent of revenue in Germany, 29 percent in France, and 31 percent in the United Kingdom. Many U.S. manufacturers continue to believe they could be more competitive overseas if the tax code focused on consumption rather than capital formation.

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