David Frum

11.29.12

The Case for a VAT

Bruce Bartlett's newest policy paper calls for a Value Added Tax, which, considering that his latest book includes a VAT among its policy suggestions, is quite unsurprising. Bartlett devotes a substantial portion of this paper to prebutting conservative rejoinders against such tax reform. I've quoted my favorites, and added a few thoughts.

First, Bartlett addresses the "starve-the-best" debate:

A common conservative argument is that holding down taxes will somehow starve the beast and automatically lead to lower spending. Not only is there no evidence supporting this belief, recent research argues that it is perverse. By reducing the tax-cost of spending, starve-the-beast theory has actually caused spending to rise.

Those who oppose big government would do better to concentrate their efforts on actually cutting spending. Holding down taxes or insisting that we keep a ridiculously inefficient tax system because that will give us small government is juvenile and bad for the country.

If people want small government, there are no shortcuts. Spending has to be cut. But if spending isn't cut, then I believe that we must pay our bills. I think it's better to do so as painlessly and efficiently as possible. Those who complain most about the VAT generally oppose all tax increases no matter how large the budget deficit is. They imagine that the fiscal crisis their opposition to higher taxes will help to create will lead to massive spending cuts that would be politically impossible otherwise. This cannot happen, however, because Congress is never going to enact a large deficit reduction package that has no tax increases; historically, such packages have aimed for a 50-50 split between spending cuts and revenue increases.

There's also the inevitable question: "Why do conservatives, who generally should prefer consumption to income taxes, despise a VAT so much?" (Hint: they hate the idea of a tax that can see rates increased with little notice from taxpayers.)

[I]t is often implied that the trend of the VAT is continuously upward. This is factually wrong. According to the OECD, 7 of the 33 countries with a VAT have cut VAT rates: Canada, Chile, the Czech Republic, France, Ireland, Israel, and the Slovak Republic. And some countries, such as Australia and Korea, have never increased their VAT rates. The average VAT rate in OECD countries is barely above what it was in 1984: 17.75 percent then versus 18.5 in 2011. ...

As Bartlett smartly notes, the trick is to distinguish between countries of high inflation and those who instituted a VAT in our modern era of relatively stable pricing and inflation.

Another problem with the money-machine argument is that it fails to note the critical impact of inflation on fueling higher VAT rates in the 1970s. At that time it was absurdly easy for governments to raise VAT rates because they were hardly noticed – what was another one percent rise in the tax rate when the general price level was rising at double-digit rates? Furthermore, to the extent that inflation was a function of budget deficits, higher taxes were a plausible means of reducing it. In the Keynesian model, higher taxes are inherently anti-inflationary because they reduce purchasing power.

Therefore, I think it is essential that any money-machine analysis distinguish between those countries that adopted VATs before
the great inflation of the 1970s and those adopting VATs in the era of relative price stability that we have seen since that time. I
have done so in Tables 3 and 4. They show that to the extent that there is a valid money-machine argument it is only in the countries that were able to piggyback on inflation to ratchet up their rates in the 1970s. VAT rates show little evidence of a ratchet effect during the era of price stability.

(I've embedded the relevant charts below).

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Finally, Bartlett addresses the real elephant in the room: much of the conservative opposition to a VAT is ideologically based.

[I]t is my observation that ideological dogmatism, rather than serious analysis, underlies the vast bulk of opposition to a VAT among conservatives. When, eventually, economic conditions force them to live in the real world, instead of a fantasy world where the budget can be balanced by abolishing Medicare, I think they will support a VAT just as European conservatives did.

The longer they wait to do so, the greater the economic pain we will have to go through before conservatives bow to reality and support a VAT. Even though I think we should enact a VAT as soon as possible, I am under no illusion that it is remotely feasible under current political and economic conditions. But those conditions will inevitably change if projections of future federal deficits are even close to correct and if economists’ beliefs about the impact of deficits are remotely true. They mean that sometime in the nottoo-distant future we are going to see significantly higher inflation and interest rates than we have today. At some point – I don't know when – they will pass a political threshold and politicians can start to talk honestly about the sorts of fiscal actions that will be necessary to bring inflation and interest rates down to tolerable levels.

Bartlett goes on to note, and I must concur, that the odds of a VAT in the near future are quite slim. What might be more feasible would be the introduction of a small VAT (perhaps to supplant part of the payroll tax?) with the understanding that the income tax will gradually be replaced with one based on consumption. But I won't get ahead of myself here.