Washington: Consuming Debate

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 fewer 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.

Once enacted, however, VATs have lost some of their luster. For one thing, few of the 50 countries that use value-added taxes have kept them simple, relying on single rates. "The only purpose of fooling around with multiple rates," says National Association of Manufacturers Vice President Paul Huard, "is to penalize some products. That's a lousy way to run a tax system."

Consider food taxes. "In Italy," notes National Journal, "the food VAT ranges from 2–18 percent; in the Netherlands, food is taxed from 6–20 percent, with additional excise taxes applying to sugar, alcoholic beverages and tobacco; in Belgium, the food VAT also ranges from 6–20 percent, but lobsters, oysters and caviar are subject to a 25 percent rate; and in France, the VAT on food ranges anywhere from 5.5–33.3 percent." The VAT has become a new way to institute central planning.

A lot of those people who support a single-rate VAT for this country fear what K Street lobbyists might do to a brand new set of tax rules. House Ways and Means chairman Dan Rostenkowski (D–Ill.) has said, "I don't doubt that a good stiff VAT would take care of our deficit….But I am enough of a politician to predict that, at best, a true VAT proposal would emerge from Congress looking like a lace doily."

Free-market supporters also blanch at the prospect of value-added taxes precisely because they do one thing very well: raise money. Where countries have instituted value-added taxes, says Stephen Moore, director of fiscal policy studies at the Cato Institute, "they have become government growth machines."

Unlike retail sales taxes or withholding-based income taxes, value-added taxes are fairly invisible. A VAT is assessed every time a product goes through a stage of distribution. The logger pays tax on lumber; the furniture maker pays tax on the cabinet; the retailer pays tax on the bedroom suite. All of these taxes are supposed to be passed along as higher prices to consumers; but nowhere, even in the final stage of production, does a line on the sales receipt read "tax paid on value added."

VAT supporters recognize that this invisibility tempts big-spending lawmakers. American Council for Capital Formation economist Margo Thorning calls value-added taxes "a powerful way to raise revenue" and says that VATs are attractive to policy makers who are "more concerned about raising revenue than cutting spending." NAM's Huard notes that "the eyes of the members of Congress will start to sparkle once they see [the amount of] money" they can raise with a VAT.

Moore says that's reason enough to oppose value-added taxes. "Every tax Americans pay should be explicit and visible," he says. Moore would replace corporate and personal income taxes with a national sales tax, because "every time Congress raised sales tax rates, taxpayers would see it and feel it immediately. Tax increases ought to hurt."

Will we see a VAT next year? That may depend upon the election results. For more than a year, Bush advisers Nicholas Brady and Michael Boskin have privately floated a plan similar to Danforth's, featuring a small-rate VAT combined with cuts in personal income-tax and capital-gains tax rates.

Cato's Moore says this idea clearly drives a wedge between the "growth" and "austerity" wings of the GOP. "The austerity wing," he says, "doesn't believe the government has enough money. Somehow, if only the government could get more money, the deficit would go away."

However, George Bush needs to restore his flagging credibility with Congress, the press, and the public at large. After repeatedly pledging that he would never raise taxes in his second term, it's hard to imagine Bush supporting a brand new type of taxation—no matter how large the deficit.

Bill Clinton may be different. The Clinton campaign has been conspicuously silent about consumption taxes. His proposals have focused mainly on higher tax rates for wealthy Americans and foreign companies and some targeted tax credits. But the ACCF's Thorning believes Clinton and the Democrats will endorse new consumption taxes because they "see the beauty of using a sales tax or a VAT to do the things they want to do."

Clinton may be playing possum: He won't mention a value-added tax before the election but will enact one nonetheless. NAM's Huard thinks that as long as one party controls the White House and the other Congress, neither party will "back a VAT because [proposing controversial new taxes] would give ammo to the other side." Indeed, Sen. Lloyd Bentsen (D–Tex.) told The Wall Street Journal that a VAT will go nowhere in Congress without the president's support.

If Clinton wins with a Democratic Congress, Huard says, a VAT is on the way. Clinton plans to finance his "play or pay" health-care proposal with payroll taxes. But such wage taxes are visible, regressive, and thus unpopular. The Waxman/Dingell health-care VAT may become an attractive option. (Indeed, New Republic crystal-ball gazer Mickey Kaus envisions this possibility: In "A Clinton Nightmare," Kaus predicts that Clinton will push for a dedicated health-care tax, leading to "the VAT fiasco of 1994.")

Many NAM members favor value-added taxes, Huard says, because they want the tax code to stop penalizing capital formation. Personally, he's a bit leery about the burdens of piling value-added taxes onto a heavily taxed and regulated economy.

Still, he says, "I think a VAT's going to happen because [the United States is] the last holdout. Every other industrialized country has one." That phrase—"The United States is the only industrialized nation in the world without…"—has become the justification for all sorts of nefarious schemes, from mandatory parental leave to national health insurance. As with other well-meaning but intrusive ploys, the VAT fraternity is one club we don't have to join.

Rick Henderson is Washington editor of REASON.