Impose a 5 Percent Value-Added Tax
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
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Source: Staff of the Joint Committee on Taxation.
This option would take effect in January 2018.
A value-added tax (VAT) is a type of consumption tax that is levied on the incremental increase in value of a good or service. The tax is collected at each stage of the production process and passed on until the full tax is paid by the final consumer. Although the United States does not have a broad, consumption-based tax, federal excise taxes are imposed on the purchase of several goods (gasoline, alcohol, and cigarettes, for example). In addition, most states impose sales taxes, which, unlike a VAT, are levied on the total value of goods and services purchased.
More than 140 countries—including all members of the Organisation for Economic Cooperation and Development (OECD), except for the United States—have adopted VATs. The tax bases and rate structures of VATs differ greatly among countries. Most European countries have implemented VATs that have a narrow tax base, with certain categories of goods and services—such as food, education, and health care—excluded from the tax base. In Australia and New Zealand, the VAT has a much broader tax base, with exclusions generally limited only to those goods and services for which it is difficult to determine a value. In 2016, the average national VAT rate for OECD countries was 19.2 percent, ranging from 5 percent in Canada to 27 percent in Hungary. All OECD countries that impose a VAT also collect revenues from taxes on individual and corporate income.
This option includes two different approaches that would impose a 5 percent VAT. Each of the approaches would become effective on January 1, 2018—a year later than most of the revenue options presented in this volume—to provide the Internal Revenue Service time to set up and administer the tax.
- The first approach would apply the VAT to a broad base that would include most goods and services. Certain goods and services would be excluded from the base, because their value is difficult to measure. Those include financial services without explicit fees, existing housing services, primary and secondary education, and other services provided by government agencies and nonprofit organizations for little or no fee. (Existing housing services encompass the monetary rents paid by tenants and rents imputed to owners who reside in their own homes. Although existing housing services would be excluded under this alternative, the broad base would include all future consumption of housing services by taxing the purchase of new residential housing.) In addition, government-reimbursed expenditures for health care—primarily costs paid by Medicare and Medicaid—would also be excluded from the tax base under this approach. With those exclusions taken into account, the tax base would encompass approximately 65 percent of household consumption in 2018. This approach would increase revenues by $2.7 trillion over the 2018–2026 period, the staff of the Joint Committee on Taxation (JCT) estimates. (Because a VAT, like excise taxes, reduces the tax base of income and payroll taxes, implementing such a tax would lead to reductions in revenues from those sources. The estimates shown here reflect those reductions.)
- Under the second approach, the VAT would apply to a narrower base. In addition to those items excluded under the broad base, the narrow base would exclude certain goods and services that are considered necessary for subsistence or that provide broad social benefits. Specifically, purchases of new residential housing, food purchased for home consumption, health care, and postsecondary education would be excluded from the tax base.With those exclusions taken into account, the tax base would include about 46 percent of household consumption in 2018. This approach would increase revenues by $1.8 trillion over the 2018–2026 period, according to JCT’s estimates.
Both approaches would employ the “credit-invoice method,” which is the most common method used by other countries to administer a VAT. That method would tax the total value of a business’s sales of a particular product or service, and the business would claim a credit for the taxes paid on the purchased inputs—such as materials and equipment—it used to make the product or provide the service. With a credit-invoice method, goods and services could be either “zero-rated” or “exempt” from the VAT; in both cases, the VAT would not apply to purchased items. If the purchased item was zero-rated, however, the seller would be able to claim a credit for the VAT that had been paid on the production inputs. In contrast, if the purchased item was exempted, the seller would not be able to claim a credit for the VAT paid on the production inputs.
Under both variants, primary and secondary education and other noncommercial services provided by government or nonprofit organizations for little or no fee would be zero-rated, and financial services and existing housing services would be exempt from the VAT. In addition, under the option with the narrow base, food purchased for home consumption, new housing services, health care, and postsecondary education would be zero-rated.
One argument in favor of the option is that it would raise revenues without discouraging saving and investment by taxpayers. In any given period, income can be either consumed or saved. Through exclusions, deductions, and credits, the individual tax system provides incentives that encourage saving, but those types of preferences do not apply to all methods of saving and increase the complexity of the tax system. In contrast to a tax levied on income, a VAT applies only to the amount of income consumed and therefore would not discourage private saving and investment in the economy.
A drawback of the option is that it would require the federal government to establish a new system to monitor compliance and collect the tax. As with any new tax, a VAT would impose additional administrative costs on the federal government and additional compliance costs on businesses. A study conducted by the Government Accountability Office in 2008 showed that all of the countries evaluated in the study—Australia, Canada, France, New Zealand, and the United Kingdom—devoted significant resources to addressing and enforcing compliance. Because such compliance costs are typically more burdensome for smaller businesses, many countries exempt some small businesses from the VAT.
Another argument against implementing a VAT is that, as specified under both alternatives in this option, it would probably be regressive—that is, it would be more burdensome for individuals and families with fewer economic resources than it would be for individuals and families with more economic resources. The regressivity of a VAT, however, depends significantly on how its effects are measured. Furthermore, there are ways to design a VAT—or implement complementary policies—that could ameliorate distributional concerns.
If the burden of a VAT was measured as a share of annual income, the tax would be regressive, primarily because lower-income families generally consume a greater share of their income than higher-income families do. If, however, the burden of a VAT was measured over a much longer period, the tax would appear to be less regressive than if the burden was measured in a single year. For example, the burden of a VAT relative to a measure of lifetime income—which would account for both life-cycle income patterns and temporary fluctuations in annual income—would be less regressive than the burden of a VAT relative to a measure of annual income that does not account for those patterns and anomalies. Furthermore, in the initial year, the distributional effects of a VAT would depend on its impact on consumer prices. Adopting a VAT would probably cause an initial jump in the consumer price index, which would be based on prices that would reflect the new consumption tax. That initial price increase would be equivalent to a onetime implicit tax on existing wealth because of the immediate reduction in purchasing power. To the extent that wealth and annual income are positively correlated, the distributional effects of a VAT in the initial year—if measured relative to annual income—would be less regressive than in subsequent years because of the onetime increase in price levels.
One way to make a VAT less regressive would be to exclude from the tax base certain basic goods and services—just as the narrow-base alternative of this option does. Applying a VAT to that narrower tax base would be less regressive because low-income individuals and families spend a relatively larger share of their budgets on those basic goods and services than higher-income individuals and families do. (Alternatively, lower rates could be applied to such items.) Those preferences, however, generally would make the VAT more complex and would reduce revenues from the new tax. In addition, a VAT with a narrow base would distort economic decisions to a greater degree than would a VAT with a broader base. An alternative approach to offset the regressive impact of a VAT would be to increase or create additional exemptions or refundable credits under the federal income tax for low-income individuals and families. That approach, however, would add to the complexity of the individual income tax and reduce individual income tax revenues, offsetting some of the revenue gains from a VAT.
There are alternative forms of a broad-based consumption that would potentially be easier to implement or be less regressive. A national retail sales tax, for example, would initially be easier to implement than a VAT. However, it would require the federal government to coordinate tax collection and administration with state and local governments. In addition, there are more incentives to underreport national retail sales taxes because they are collected only when the final user of the product makes a purchase, whereas a VAT is collected throughout the entire production chain. A cash-flow tax would be an alternative to a VAT that would be less regressive. A cash-flow tax applies to the difference between a business’s cash receipts and cash payments, which would be equivalent to a consumption tax on income sources other than wages and salaries. Because consumption from wages and salaries would not be included in the tax base, a cash-flow tax would generally have a narrower base than a VAT and would be substantially less regressive than a VAT—and potentially progressive depending on how it was measured. Implementing a cash-flow tax would probably require modifications to the current corporate income tax system but would more easily incorporate the value of financial services in the tax base than a VAT.