The 10 Percent Solution

How progressives can stop worrying and love a value-added tax.

Among progressives, the revenue-raising promise of the VAT has been overshadowed by aversion toward its regressive nature. A regressive tax is, of course, one that falls more heavily on lower-income households. Progressives view consumption taxes like the VAT as regressive because individuals and families at the bottom end of the income spectrum tend to spend everything they make, with the accompanying tax taking a greater share of their income than it would for the affluent, who spend only a portion of their income and save the rest. American Prospect co-editor Robert Kuttner calls the VAT “especially perverse” since it taxes consumers. In light of recent interest in the VAT, he warns Americans to “keep our hands on our wallets.”

But a VAT need not be regressive. When linked to a set of redistributive programs, a VAT becomes a substantial, steady source of revenue that provides the protections and investments for which Americans yearn. In other words, a properly designed VAT can be a tax program that matches progressives’ ambitions.

Plugging the Shortfall

In recent, non-recession years, federal government spending has been about 20 percent of GDP and receipts around 18 percent, for an annual budget deficit of 2 percent, which is generally regarded as sustainable. That situation is about to change dramatically. By 2035, the Congressional Budget Office (CBO) predicts that primary spending–federal government spending except for interest on the national debt–will reach 24 percent of GDP. The main drivers of increased spending are the three large entitlement programs, Social Security, Medicare, and Medicaid, with the health programs accounting for most of the increase due in part to the aging of the population, but mainly to growth in per capita health-care costs. And revenues will fail to keep up. If we assume that the Bush tax cuts are allowed to expire completely and that more and more households fall under the Alternative Minimum Tax (AMT), revenues would be 23 percent of GDP in 2035. But under the far more realistic assumption that most Bush tax cuts will stay in place, AMT relief continues, and the estate tax is pegged permanently at 2009 levels, then revenue in 2020 and thereafter will be just 19 percent of GDP.

Hence we have a long-term fiscal gap of 5 percent of GDP. Tea Partiers and many conservatives may wish to close this gap solely with spending cuts, but such reductions would have to be truly draconian, and both public opinion research and experience under Democratic and Republican administrations alike show that the public has little stomach for such reductions. For all their small-government talk, federal spending under Republican administrations has been no lower than under Democratic ones, and sometimes higher. The main difference under Republican presidencies has been lower taxes and higher deficits. If we are realistic about the size of government Americans truly desire, and if we wish to end the cycle of inadequate taxation and crippling deficits, it is time to look seriously at new sources of revenue.

To put the United States on a sustainable fiscal course, and to make new investments in much-needed areas, we need perhaps 7 percent of GDP in additional revenues. Part of that amount–2 to 3 percent of GDP–could be realized by increasing the income tax rates for the top two brackets. The rest could be achieved with a VAT. A 10 percent VAT would generate about $570 billion per year, or 4 percent of GDP. Note that while some conservative VAT proponents wish to substitute the tax for all or part of the individual or corporate income tax system, thereby keeping total revenues steady, the whole purpose of a VAT in this plan is to generate the additional revenues we need to put the nation on a sustainable long-term trajectory.

A Better VAT

For a VAT to be truly progressive, it needs to be designed carefully, with its regressive edges smoothed out. There are four major design features that policy- makers should consider in creating a VAT.

First, a progressive VAT could be designed to soften the blow on spending by the poor. This can be accomplished in several ways: a low or zero rate for necessities, such as food and prescription drugs; a reduction in the taxable amount of the item to a fraction of its actual value; or tax credits to the poor to offset the effect of the VAT. Canada introduced a tax credit with the institution of its good-and-services tax, and Canada and Australia implemented a tax credit for first-time home buyers to offset their VAT. Many countries have lower rates for food, medicines, and electricity and heating. For example, Switzerland has a 7.6 percent VAT rate, but reduced rates of 3.6 percent for lodging and 2.4 percent for food, medicine, newspapers, and water supply. The VAT in the Netherlands is 19 percent, but 6 percent for food and certain services. The British VAT of 17.5 percent is not imposed on food, books, and newspapers. Alternatively, all goods could be subject to taxation, but lower-income persons can be issued a debit card that would exempt certain dollar amounts from the VAT, as Michael Graetz of Columbia Law School has suggested. The “smart card” he proposes would be scanned by retailers and would reduce or eliminate the VAT on specific goods and services or on a portion of the cost. For ease of administration, the exemption amount could be based on the person’s income the previous year. Such cards could be given to the unemployed as well, an immediate form of relief to the individual. The advantage of a debit card or a tax credit offset of the VAT is that tax relief would be targeted to lower-income households, whereas under a system of low or zero rates for necessities, the affluent would not be taxed on those goods as well.

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