President Trump has made some bold and interesting campaign pronouncements regarding the economy: major tax cuts, slashing regulatory burden, a giant infrastructure program. At the same time, he promised increases in military spending and an end to sequester. He has been short of details on how he intends to reconcile large increases in spending, large decreases in federal revenues and balancing conservatives’ concerns with the federal deficit and debt. But even if the President were a magician who could balance the budget tomorrow, (he has until April) the American public would still have 20 trillion dollars in national debt to repay. That’s 3 trillion dollars more than all the wealth the US economy generated in 2016.
Economists typically agree that a “healthy” economy has a debt-to-GDP ratio of not more than 60%, except in times of national emergency. Ours is already at 100% of GDP and growing. That puts us in the company of not-so-healthy economies like Italy and the UK, though not yet in Japan’s league.
It is true that so long as the Federal budget remains balanced and the economy keeps growing, the debt-to-GDP ratio would fall by itself, though slowly. But since 1961, the budget has been balanced or in surplus only 5 times: 1969, 1998, 1999, 2000 and 2001. Notice that each of those fiscal years started with a Democrat in office. That’s 5 years out of 61. So it is safe to say that the pressure to run at least a slight deficit is such that it will happen more often than not.
What Common Sense proposes is a fiscal bazooka that fires straight at the debt. A national Value-Added Tax (“VAT”) whose sole purpose would be to pay down the national debt.
What’s a VAT?
I’m glad you asked.
Americans are already familiar with the sales tax, which most states have, but which the Federal government does not. Well, a value-added tax is pretty much the same thing. The main difference to keep in mind is that the sales tax is only collected at the point of sale (i.e. the Walmart cashier), while the value-added tax is calculated at every stage of production for businesses. For consumers, it’s the same.
The VAT is not an innovation, except in our country. It exists in over 150 nations and in every single OECD country except the United States. Among developed nations, the average VAT rate was 18%, ranging from a low of 5% in Japan to a high of 25% in the Scandinavian countries. (1)
Not only is the VAT ubiquitous, it has some advantages that make it so.
- For one thing, it is cheaper to administer than the income tax, requiring less paperwork, less overhead, less auditing. Evidence from other markets indicates that administering the VAT cost half as much as the income tax, and required far fewer audits. (2) The IRS spends $0.50 for every $100 it collects in income tax revenue, and the total IRS budget for 2008 was $11 billion. (3) That is a large saving to the taxpayer.
- Furthermore, compliance with a VAT is high. OECD estimates place evasion rates at around 12% of revenues generated. (4) This is lower than evasion rates with a straight sales tax because the VAT gives credit to businesses for their intermediate purchases during production, which is an incentive for them to file.
- Another benefit would be to piggyback the current haphazard State sales taxes onto the national VAT. This would bring major benefits to state finances. For one thing, it would eliminate the administrative cost to the states, estimated at 3% of the sales tax revenue generated. (5) A centralized administrative and auditing process would be far more efficient, saving tax payers substantial amounts.
- A unified VAT would also allow the federal government and states to more efficiently tax hitherto difficult to tax transactions, such as online and mail-order purchases. Just as with the proposed harmonization of state and Federal income taxes, a unified VAT would be a purely administrative efficiency measure, and would in no way reduce the competence of State legislatures to join or not join, and to set state VAT rates within the framework of the Federal VAT.
There is an additional factor that makes the VAT attractive: it acts as a tax on imports. Rather than impose a disastrous (and WTO non-compliant) 20% duty on imports, the Trump Administration could raise tax revenues by imposing a value-added tax:
- The more price inelastic an imported product is, the greater the percentage of VAT that must be borne by the manufacturer, rather than passed on to the customer. Foreign manufacturers would also not receive the intermediate production credits of a local manufacturer, potentially generating some advantage for the re-establishment of manufacturers in the U.S. Currently, the Federal government is not generating any tax revenue from the many imports entering the country. Given the interest in reducing the current account deficit and expanding US exports, a VAT might play a significant, legal and non-discriminatory role in attaining this end.
Imposition of a national value-added tax does have its difficulties, of course. However, we only need to go across the border to learn the story of our Canadian neighbors and profit from their example.
In 1991, the Progressive Conservative government of Canada passed a law establishing a national VAT of 7%. Previously, just as in the US, there had been no national VAT, only provincial sales taxes.(6) In 1993, the Progressive Conservatives were trounced by the Liberals, due in large part to anger over the VAT.
However, the new Liberal government did not repeal the tax. Instead, the government proposed to unify the national and provincial taxes into a “Harmonized Sales Tax”. Initially, only three provinces chose to adopt the “HST” structure. (7) In 2010, British Columbia and Ontario had also joined.
By that time, the VAT rate had been lowered twice, due to fiscal surpluses. In July 2006, the tax was lowered to 6%, and again to 5% in January 2008.
One important lesson from the Canadian experience is that the imposition of the tax had very little effect on Canada’s economy. If we look at the trends in GDP and Household Consumption before and after 1991 and in the years when the VAT rate was reduced, there appears to be little correlation.
It’s true that both GDP and household spending in Canada collapsed in 1991. But both indicators were already tanking the year before the VAT was introduced. The US also saw a sharp downturn from 1900 to 1991 — this was when Iraq invaded Kuwait and the First Gulf War broke out, driving oil prices upwards and inflicting pain on every major economy.
Canadian GDP rebounded thereafter and quickly began to mirror US trends, suggesting that the VAT had neither a large, nor a long-term impact on Canadian economic performance. It quickly became the “new norm” for the economy.
The other lesson is that the Canadian electorate was hopping mad, and stayed mad. One reason is that the tax was not “transparent” — it was not included in the final price, but added to the total price at the cashier, in the same way that US sales tax is computed. Experience in other markets suggests that a VAT that is already included in the final price is more acceptable. Customers don’t have to go around multiplying by 1.07 every time they buy a newspaper, groceries or a haircut and thus remind themselves of that damned tax. The tax is still shown on the receipt, but — for some psychological reason — it is still more acceptable. Just as 99¢ drives disproportionately more sales than $1.00 than that penny would indicate.
A final factor may be that the VAT replaced two business taxes, and consumers felt they were getting a raw deal. The revenues were destined for general government expenses, but no particular case was made for the need for these funds. In short, it looks like the Progressive Conservative party did a poor job selling the tax (never an easy proposition, to be sure).
A VAT for You and Me
Common Sense proposes that the President Trump work with Congress to draft and sign into law a National Value-Added Tax with the following characteristics:
- Exclusively for Debt Amortization. By law, the funds generated by this national tax could only be used for the purpose of principal amortization of the national debt. It could not be used to pay for the interest on that debt, which would still have to come out of the Federal budget’s general revenue. It could not be used to balance the Federal budget, or to fund any other program or entitlement.This restriction would hopefully achieve two purposes: it would create less ill-will and greater acceptance on the part of the American people, who as a whole are very concerned with the national debt and would like to see it reduced; and, it would make gathering political support for its passage easier, since it would not be another “tax and spend” measure to expand the federal government;
- Self-Regulating. By law, the national VAT would enter into effect 6 months after it is signed into law, or on the 1st of January 2018, whichever comes first. It would remain in effect until the Debt-to-GDP ratio had reached a level of 40% and would then expire at the end of the same fiscal year in which that goal was achieved. If the Debt-to-GDP ratio rose above 60% for four consecutive quarters, the national VAT would be automatically re-imposed without the need for Congressional action.This measure of self-regulation is necessary from the standpoint of enforcing budgetary discipline on lawmakers. Once the goal was achieved, and the VAT expired, it would be the insanely brave or foolish politician who would allow the Debt-to-GDP ratio to rise above the threshold for re-imposition of the tax. It would undoubtedly cost them their office, and rightly so. It would also protect against the “brinkmanship” displayed during the Obama Administration’s debt ceiling debates with the Republican Congress. Establishing self-enforcing rules protects the budget from the fecklessness of mere politicos.
- Supermajority. By law, the operation of the national VAT would only be alterable with a supermajority vote in Congress. This extraordinary measure is necessary to deter Congress from either repealing the tax too soon through misplaced populism, of continually tampering with it in fits of cronyism (as they currently do with the individual and corporate income tax codes), or of converting it from its strict debt amortization purpose to one of funding general government. In the latter case, it would be better to have no VAT at all.
- Broad base. The VAT should have a relatively broad base, which means that very few goods and services would be excluded from its operation. The narrower the base, the less effective the tax is as a vehicle to generate revenue. The trade-off is that a broader base tends to be more regressive, hurting lower income families disproportionately. Common Sense believes a broad VAT is not only easier to administer and more difficult to evade (8), but its most deleterious effects can be mitigated by “probates” to lower income families based on their annual income tax filings and a needs assessment. This could be combined with the similar measures proposed in the section on reforms to the individual income tax, in order to reduce administrative costs. The benefits of the broader base can then be combined with the mitigating effects of a separate and targeted benefits program for the neediest. The latter is a much more targeted and less costly alternative than the narrow base.
- Moderate rate. Congress will initially authorize a national VAT rate of approximately 7% with a mandated yield ratio of 0.50.(9) A 7% VAT would raise between $450 and $500 billion per year in revenue, all of which would be applied to amortizing the national debt. A 7% rate is very moderate compared to the OECD average of 18%, while the yield ratio is on the high end of the average, which is between 0.30 and 0.40. (10)
Saving the SS Titanic
The United States (still) has the largest economy in the world. Even so, like the SS Titanic, it is not too big to sink. This will happen if federal budget deficits continue to spiral upwards, national debt continues to rise, and markets see no credible plan to control either. At that point, the interest rate demanded for new government debt will begin a self-reinforcing rise, absorbing an ever increasing portion of the federal budget just to service the interest on the debt. Once the United States is taxing 40% to 50% of GDP and 60% of that is going to debt payments, we will have become Greece, and default will be our only option. That this would have catastrophic effects for America and the world should go without saying.
And yet that is the course we are embarked on. Like the officers of the Titanic, Republicans and Democrats argue about whose fault it was that we hit that iceberg. That fact is we hit it and we’re taking on water fast. A ship as big as ours can take on a lot of water, but there comes a point when no amount of plugging and pumping make any difference. We are not yet there, but we’re close.
Common Sense has built a simple model to analyze the policy impacts and sensitivities of various scenarios involving changes in GDP growth rates, budget deficits, interest rates on Treasuries and different VAT rates. It is simple, but the best models often are. The “Current” scenario conforms closely to CBO estimates of the long-term fiscal outlook without reform.
Below is a graph of what our current course may look like if we don’t act quickly to change it: (11)
Our current course is unsustainable. Large yearly budget deficits of 5% of GDP, an unreformed tax system and anemic GDP growth cause the Debt-to-GDP ratio to rise to unsustainable levels of 150%+ by 2025. Long before this, markets will be demanding far higher interest rates on government debt than the current 2% for 10-year Treasuries.
Contrast this with Scenario 4. This assumes that the government is not able to come to a fiscal agreement to bring the deficit down, and it continues at a high rate of 5% of GDP. With the 7% VAT, the US is nevertheless able to stabilize the debt and bring it down slightly to around 105% of GDP.
But what if the next Administration were able to push through enough reforms to bring the budget deficit under control? A 2% deficit is slightly above the long-term average, but nevertheless an ambitious target for the near future, given the scale of Mr. Trump’s proposed projects. With moderate economic growth and a low deficit, the 7% VAT pays down the national debt to 60% of GDP in 20 years. That’s better than most mortgages.
We Called the Tune, Now We Pay the Piper
Americans as well as our government have been living beyond our means for decades, but since 2000 we took out all the stops. We gave ourselves huge tax cuts in 2001 and 2003 without thinking where the money was going to come from; we paid for two long wars with borrowed money; we maxed out or credit cards, took out second and third mortgages, and used the money to buy Gulf oil and Chinese knickknacks. Now the creditors are knocking at the door and it’s time to ante up.
That’s the bad news. The good news is that America is still a very wealthy country. What’s more, it is still a country full of hard-working, innovative, entrepreneurial people. We have the means to pay our debts and return to solvent, prudent management. It will be difficult; it will be painful; but if we do it right, it will be fair. And we won’t have to pass this mess on to our children.
(1) OECD. 2008. “Value Added Taxes Yield, Rates and Structure.” Consumption Tax Trends 2008: VAT/GST and Excise Rates, Trends and Administration Issues.
(2) In the United Kingdom, VAT administrative costs were half those of the income tax. In New Zealand, audits were required in 3% of VAT returns compared to 25% of filings for the income tax. Government Accountability Office. 2008. “Value-Added Taxes: Lessons Learned from Other Countries on Compliance Risks, Administrative Costs, Compliance Burden and Transition.” GAO-08–566.
(3) 2009 IRS Data Book.
(4) Cite OECD source.
(5) PriceWaterhouseCoopers.2006. “Retail Sales Tax Compliance Costs: A National Estimate.” http://www.bacssuta.org/Cost%20of%20Collection%20Study%20-%20SSTP.pdf.
(6) There was no national sales tax, but the new VAT did replace a Manufacturers Sales Tax and a Federal Telecommunications Tax. Every province but Alberta had a retail sales tax collected at point of sale.
(7) New Brunswick, Nova Scotia, and Newfoundland & Labrador
(8) “Many OECD governments and state government offer preferential or zero rates on certain items like health care or food to increase progressivity. This approach is largely ineffective because the products in question are consumed in greater quantities by middle-income and wealthy taxpayers than by low-income households. Furthermore, this approach creates complexity and invites tax avoidance as consumers try to substitute between tax-preferred and fully taxable goods and policymakers struggle to characterize goods. For example, if clothing were exempt from the VAT, Halloween costumes classified as clothing would be exempt, while costumes classified as toys would not.” Gale, William and Harris, Benjamin. “Reforming Taxes and Raising Revenue: Part of the Fiscal Solution.” Revised May 2011. Prepared for the Oxford Economic Review on “Economic Borders of the State”
(9) The VAT yield ratio is the ratio of VAT revenues as a share of GDP divided by the VAT rate. For example, a yield ratio of 0.50 for a VAT rate of 7% would raise 3.5% of GDP as revenue. The yield ratio is largely determined by how broad or narrow the tax base is. (Gale and Harris)
(10) OECD. 2008.
(11) Model by Common Sense and available upon request. Data on GDP, national debt, historic growth rates, economic cycles taken from the Congressional Budget Office and the Bureau of Economic Analysis. Average Treasury yields taken from Bloomberg. Effective VAT rates and yields taken from OECD 2008 comparative data. Federal budget deficits are estimates used for the purpose of determining outcomes.