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Meet the value-added tax

debtcbpp.jpgFirst, a simple fact: Tax rates will rise over the next decade. Even with painful spending cuts, tax rates will rise. At some point, taxes have to come further into line with spending, and that means the direction they will travel is "up."

But -- and this isn't a fact -- they won't rise within the current system. People don't trust the current tax system. It feels opaque and unfair, largely because it is. An increase in revenues will have to come alongside a change in the tax system. And the change in the tax system that most economists prefer and that most other countries use is a value-added tax. My guess is you'll be hearing a lot more about the VAT in the coming years, and so it wouldn't be a bad idea to clip and save Catherine Rampell's introduction, which is about the clearest I've read. That's why I'm ripping out such a long quote:

The value-added tax is also the darling of many economists for its bounce-a-quarter-off-its-abs efficiency. Its administrative costs to the government are generally low. It is also considered less of a drag on the economy over the long run than raising income taxes, which discourage people from saving money and thereby making capital available to businesses.

To understand why a value-added tax is considered so efficient, you have to understand how it usually works.

Imagine the production of a new dress, in three steps:

1) A fabric store sells a tailor enough silk to make one dress, at a total price of $10 before taxes;

2) The tailor sews a dress and sells it to Macy’s for $30 before taxes;

3) Macy’s then sells the dress to a shopper for $50, before taxes.

Let’s say the value-added tax is 10 percent. The government will collect some tax revenue in each step of the production process, from roll of fabric to cocktail-party scene-stealer, but each business in the chain gets credit for the tax already paid by other suppliers.

When selling the cloth to the tailor, the fabric store adds a tax of 10 percent, or $1 on the $10 of supplies the tailor purchases. The tailor pays the fabric store $11, and the store remits $1 to the government.

When the tailor sells his dress to Macy’s, he calculates the value-added tax as $3, or 10 percent of his $30 pretax price. Macy’s pays the tailor $33.

But instead of sending the full $3 to the government, the tailor gets to subtract the $1 of taxes he had already paid to the fabric store. So he sends $2 to the government.

When Macy’s sells the dress to a shopper, it adds another 10 percent, so the shopper pays $55, or $50 plus $5 in tax. That would be in addition to any state or local sales taxes consumers have to pay, depending on the locale.

Macy’s checks to see how much the previous companies in the supply chain — the fabric store and the tailor — have already paid the government in value-added taxes, and subtracts that from the $5. Macy’s ends up remitting just $2 to the government.

The government receives $5 total, or 10 percent of the final purchase price, but from three different businesses.

Although more complicated, value-added taxes are considered better than equivalent sales taxes — where the tax is levied only when the consumer buys a product — for two main reasons.

First, if a single business evades the value-added tax, the government does not lose a large portion of money, because it will collect taxes at other stages of production.

Since companies usually get credit for taxes already paid by their suppliers, companies will pressure other businesses in the production chain to prove they paid their taxes. That means the system is somewhat self-policing.

To some foes of big government, though, the efficiency of the tax is also its fatal flaw. Conservatives worry that it enables the government to raise money with such little effort that it will encourage Washington to spend even more.

On the other hand, liberals are wary of value-added taxes because they are regressive. Poor people spend a higher portion of their income buying things than the rich, meaning lower-income people would be disproportionately hurt.

More, including some helpful graphics, here. For a more academic introduction, see this paper from the Tax Policy Center.

By Ezra Klein  |  December 11, 2009; 11:28 AM ET
 
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Comments

My experiences in France with VAT is that it leads to a very healthy black market in goods and services so that people can avoid paying the VAT. People always ask " do you want to pay in cash" a, code word for avoiding the VAT....

Posted by: robinshuster | December 11, 2009 11:34 AM | Report abuse

The point of the VAT, though, is that that doesn't really matter, or at least it doesn't matter that much. The customer pays the the price of the VAT in what they pay to the ultimate seller, but the government got paid the VAT by the producers, so long before the sellers talked to the customer. If Macy's tried to evade the VAT by having you pay in cash, they would just lose money on the sale.

That said, there might be a black market in smuggling stuff or something, but in general, evasion in a VAT is much lower than in other tax schemes. That's why economists like it.

Posted by: Ezra Klein | December 11, 2009 11:40 AM | Report abuse

This will never happen.

Posted by: obrier2 | December 11, 2009 11:50 AM | Report abuse

I've never looked into VAT taxes in detail, so I wonder if used items are taxed at all? If only new items are taxed, people might maintain their possessions better and also be more disposed to buying used items instead of new ones. It could help change our "disposable society" attitude.

Posted by: marvyT | December 11, 2009 12:01 PM | Report abuse

KID, HAVE YOU EVER WORKED IN A RETAIL STORE?


Of course not -- you're so much better than those people. Like Lady Thatcher's family of retailers.

VAT requires the merchants to collect taxes. Ever deal with angry customers? Of course not -- you're better than them.

You and your LIB-BURR-AL pals just never get it. If you think taxes will go up -- they will.

If you decided to fight your AFSCME/SEIU pals and BE ACCOUNTABLE for your budget -- they would not.

But that would require spine, guts, and dedication, wouldn't it?

Posted by: russpoter | December 11, 2009 12:01 PM | Report abuse

It's weird that the idea for a new consumption tax is being talked up at the same time as we are struggling to emerge from an economic depression and consumer spending is deeply depressed. Also there would seem to be a better case for much higher income taxes in response to the increase in income equality in the last 30 years. Implementing a much stronger cap-and-trade system plus other energy taxes also would be more appealing than a new regressive sales tax.

Posted by: redwards95 | December 11, 2009 12:04 PM | Report abuse

That VAT intro didn't tell me anything I didn't already know.

Yep, I still think it sucks, due to its regressiveness. My candidates for tax hikes would be:

1) Have new income tax brackets with higher rates kicking in at $10 million, $30M, $100M, $300M, $1 billion, $3B, $10B, $30B, and $100B. (Sure, some of those brackets are currently out of everyone's reach, but that will eventually change. Might as well be ready.) Maybe have the marginal tax rates for those brackets be 50%, 55%, 60%, ... , 90%.

2) Have a similar hierarchy (with respect to spacing and rates) of new tax brackets in the Federal Estate Tax.

3) Treat capital gains like regular income for tax purposes (with one exception noted in (4) below, but allow the basis of a capital asset to be adjusted for inflation when held for longer than a year.

4) When a capital asset has been held for less than 90 days, tax the gain at the rate of the higher of the taxpayer's marginal regular income tax rate, and (99-d)%, where d = number of days that the asset was held.

So if you buy and sell a stock on the same day, 99% of your gain goes to the taxman. If the next day, 98%. If you hold it for 2 days, 97%. And so forth, until you hit your regular income tax marginal rate.

5) And might as well toss in a transaction tax on sales of capital assets and financial instruments.

Yeah, I want to soak the rich. That's where the money is.

Posted by: rt42 | December 11, 2009 12:04 PM | Report abuse

this one is directed to the last guy, but also to the commenters in general-

why are short term financial transactions viewed so negatively?

Buying a stock and selling it the next day isn't, in and of itself, evil. It adds liquidity to the market and allows everyone to trade more efficiently.

A small stamp tax (10-20 basis points) would be an effective way to make money, but let's not demonize short-term trading. You're searching for a bogeyman that isn't there.

Posted by: Quant | December 11, 2009 12:24 PM | Report abuse

A small VAT in lieu of an income tax rate increase might work, though I really don't see the advantage of it over a more progressive income tax. Might as well just figure out how to enforce one system instead of two.

But a transition away from the income tax to the VAT tax is really problematic for anyone with accumulated savings. That money will have been taxed at a high rate already when earned under the old system and then taxed at a high rate again when spent under the new system. I'm a progressive - and that's inappropriately confiscatory even to me.

Older folks have more accumulated wealth than younger folks. Which of those two groups has more political clout?

You would need to find a way to credit purchases made with this old money somehow. That's hard to see happening, and its impossible to see happening under anything sold as a "simplification".

Posted by: patrickinmaine | December 11, 2009 12:44 PM | Report abuse

"Conservatives worry that it [VAT] enables the government to raise money with such little effort that it will encourage Washington to spend even more.

On the other hand, liberals are wary of value-added taxes because they are regressive."

So, in other words, everyone hates it. Ergo, it should pass, as no matter who's in charge VAT can be agreed on as a sacrifice we all must bear to reduce the debt. And someday we'll have to.

Actually, I'd rather "soak the rich", but what looks like progressive taxation on paper usually ends up in practice ridden with so many loopholes and exclusions that it ends up hitting harder at those with middle incomes who can't afford high priced lobbyists and accountants. And the conservatives' response--cut taxes for all, especially the rich, and we'll just grow our way out of the deficit--is not worthy of being taken seriously.

Posted by: mkarns | December 11, 2009 12:52 PM | Report abuse

J. K. Galbraith, I believe in the reissue of "The Affluent Society", advocated that Democrats should change the tax code. He wanted a simpler tax system, perhaps a VAT, that favored savings and would accept a less progressive, even somewhat regressive system. He argued only Democrats could make such major changes and impliment a less progressive system. A Nixon in China thing.

His biggest argument however, was that removing the sense of grievance over the perceived unfairness of our tax system would take a lot of air ($) out of the Republican balloon. He also, of course, mentioned that VATs are widely accepted in Europe, despite their regressive nature, because they fund good public services and a safety net.

Posted by: gVOR08 | December 11, 2009 12:55 PM | Report abuse

Did you know that we could turn our current income tax into a consumption tax? We would just have to allow unlimited, tax-free savings. In practice that could mean unlimited, non-age-restricted IRA contributions, or you could just stop taxing interest, dividends, and capital gains. Boom! You have the consumption tax you want, with PROGRESSIVE BRACKETS. No new kind of tax laid on top of the existing system!

Then we could get more revenue by raising rates and phasing out the mortgage interest deduction. This is a much better plan than introducing a VAT.

Posted by: Anno3 | December 11, 2009 1:00 PM | Report abuse

*****Yeah, I want to soak the rich. That's where the money is.*****

I think this is doubtful. Every single one of the social democracies with robust safety nets liberals (like me) admire -- every single one -- employs a national consumption tax of some sort. I don't think this is a coincidence. I think a big reason is one mentioned by Ezra -- VAT taxes are simple to administer and collect, and hard to evade. Rich people can find sophisticated means of shifting income to lower income tax localities. But it's pretty hard to avoid the VAT on the new Rolls if, you know, you actually want to drive it where you live.

Now, I would share the objection to a VAT if the money weren't going to be used to make society more equitable. But if the net outcome -- that is, after taxes and TRANSFERS (ie., spending programs) is progressive, what's not to love?

Also, any progressive fan of Keynesian economics should root for a VAT, as well, because consumption tax revenue tends to dip as the economy weakens more quickly than direct taxes like those on income or property. So there's a natural counter-cyclical factor that kicks in, and stimulates the economy.

Finally, the adoption of a VAT doesn't have to be (and shouldn't be) accomplished without looking at the tax code as a whole. In other words, if we're going to introduce a VAT some day, it would make sense to use some of the revenue to cut income or payroll taxes on the less affluent; I'd like to see the rest of the tax code made simpler and more progressive, and make up for the difference with VAT revenue.

Posted by: Jasper99 | December 11, 2009 1:36 PM | Report abuse

Quant asks: "why are short term financial transactions viewed so negatively?"

It isn't so much that they're bad in and of themselves. It's that stock movements in the short term have a lot of randomness that had little to do with their real value. Betting on short-term movements adds no value to the economy, so why not tax the hell out of it?

I think it's worth trying to arrange our taxes so that they generate the necessary revenue while doing the least harm - burdening those least who can afford it least, and minimizing the extent that they discourage productive activity.

Seems to me that taxing short-term financial transactions rarely burdens people who have little to begin with, and don't discourage productive activity.

Posted by: rt42 | December 11, 2009 1:40 PM | Report abuse

*****Actually, I'd rather "soak the rich", but what looks like progressive taxation on paper usually ends up in practice ridden with so many loopholes and exclusions that it ends up hitting harder at those with middle incomes who can't afford high priced lobbyists and accountants.*****

Right. And one of the biggest ways the rich "avoid" paying higher income taxes is via a perfectly legal method that can't even be considered a "loophole" -- they simply build the tax into the price of goods and services. It would appear that the US maintains (believe it or not) on paper one of the rich world's most progressive tax codes (in the sense that the wealthy pay the lion's share of income taxes; and income taxes are by far the biggest source of the government's funds).

http://www.economist.com/businessfinance/displaystory.cfm?story_id=14924473

But if ones takes into account how taxes affect the price of goods and services, it becomes pretty clear that the US tax code is, broadly speaking, relatively flat.

I think it's folly to talk about making the tax code alone more progressive. But it's not folly to talk about making the tax code/transfer system as a whole more progressive. But that means better, more robustly funded programs to help working ordinary people. And that means more money. And that, in turn, means a reliable and efficient revenue source like a VAT.

Posted by: Jasper99 | December 11, 2009 1:50 PM | Report abuse

rt42-

I disagree- in some cases short term trading can be successful (if you're trading around a particular event, say), so it's not always an unsound strategy.

But more importantly- this tax wouldn't do any good! Most of the money in the stock market is from institutions- endowments, pension funds, mutual funds. Your tax wouldn't hit the super rich, nor would it hit the "Wall Street fat cats"- all this tax would do is take profits away from mutual funds (ie large groups of small investors).

Posted by: Quant | December 11, 2009 2:16 PM | Report abuse

Why should anyone be happy about another tax that disproportionately hurts poor people when we could simply go back to doing what we did when we had a more sane social contract (the 1950s): progressively tax rich people? Oh, becaus the rich people own the government?

Posted by: janinsanfran | December 11, 2009 2:21 PM | Report abuse

I fully agree with the recommendations of rt42 except it really isn't soaking the rich. In current conditions wage earners are in a race to the bottom on wages and will be for many decades. So the wage earners are getting soaked all along. Progressive taxes used to reduce taxes on the low end and shore up the middle with things like universal health care just does a little toward correcting that soaking.

Posted by: TomCantlon | December 11, 2009 2:37 PM | Report abuse


The last recommendation by rt42 to tax financial exchanges is the only way a vat can be made a little less regressive.

Posted by: TomCantlon | December 11, 2009 2:40 PM | Report abuse

It is jaw dropping the way any attempt at progressive taxation is just tossed aside as too difficult. Change the term, this is not "regressive taxation", this is "you are going to pay a bigger share and the very richest are going to pay less". You are already paying a bigger percentage of your income than they do. With your local sales taxes and having to spend all or most of your income your total income percentage going to all taxes is much higher than theirs. (They're not evil, just enjoying benefits that fall in their lap from being able to hire lobbyists and clever accountants.) So because the tax code has loop holes and clever accountants build tax shelters and it's just difficult to enforce progressive taxes we'll just throw in the towel like it's a minor policy issue? It's not minor. It's you're already getting the shaft and now you're going to get more of it. The heck with that. Either progressive income tax or a vat made progressive by taxing financial exchanges. Anything else is class warfare, by the top shafting the middle once again.

Posted by: TomCantlon | December 11, 2009 2:48 PM | Report abuse

I fail to see how it is more distorting to tax high levels of income income than to tax the creation of value.
Surely if we must disincentivize something, the former is better than the latter?

I will note that "Conservatives worry that it enables the government to raise money with such little effort that it will encourage Washington to spend even more" is utterly perverse.

Posted by: adamiani | December 11, 2009 2:48 PM | Report abuse

A VAT would be extremely regressive compared to a bending-upward of the upper income tax brackets, and would profoundly depress consumer spending.

As we see with the banks sitting on heavy capital cushions but not lending very much, there isn't really a shortage of savings to invest. There is a shortage of productive things to invest in, in large part because the future earnings of any investment depend on people having jobs and income to buy stuff. It is a mistake to always think that more saving and less consumption is a good thing. What matters is where those savings go. If they're simply loaned out at ever-increasing ratios to people buying houses, for instance, all that happens is an inflationary bubble and considerable malinvestment.

But the most important factor is just that VATs are extremely regressive. Lower-income people spend a much larger percentage of their income than do higher-income people. Introducing a VAT will mean they will be able to afford fewer goods while not particularly affecting the ability of higher-income people to consume. You have to be crazy to think that that's a good progressive policy, and it's probably not a good economic policy either, unless you think a (say) 15% cut in consumption would be good for the economy.

Posted by: Jacob_Davies | December 11, 2009 3:39 PM | Report abuse

Flat.

I'm so sick of regressive taxes. In fact, I'm for making tickets, fines, penalties, et al, progressive:

Fair Fines and Flatulence Taxes for the Half-Glass Empty Class

http://supak.blogspot.com/2009/01/fair-fines-and-flatulence-taxes-for.html

I sure hope this VAT goes the way of other regressive proposals.

Posted by: supak | December 11, 2009 3:58 PM | Report abuse

>First, a simple fact: Tax rates will rise over the next decade.<

Ezra, I don't think this is at all a "simple fact." More likely -- and certainly in the light of your other recent posts -- is that the country will go bankrupt, a la California.

And for the same reasons:

1. The vast majority of citizens oppose the cuts needed to remain solvent at current tax levels.

2. The vast majority of citizens oppose the taxes needed to remain solvent at current government service levels.

3. Right-wing demagogues in Congress, on the airwaves, and among the Tea Party movement will destroy the careers of anyone on their side of the aisle who compromises on taxation.

4. The entire legislative process is structured to prevent effective action.

Posted by: bcamarda2 | December 11, 2009 4:02 PM | Report abuse

Not just regressive. If I follow this argument correctly, Macy's charges $5 tax but only pays $2 tax, pocketing the $3 difference. It is a hidden price increase.

Seems more logical and transparent, to me, to lower the tax rate and make everyone pay all of it it regardless of what happened at earlier stages in the supply chain.

Posted by: member5 | December 11, 2009 5:16 PM | Report abuse

"People don't trust the current tax system. It feels opaque and unfair, largely because it is."

So the solution is a nice clear regressive tax? I thought Ezra Klein was a Democrat.

Posted by: Ulium | December 12, 2009 12:08 AM | Report abuse

@member5 - Macy's collected $5 from the customer, paid $3 to their supplier, and sent the other $2 to the government.

I used to work in VAT enforcement in the UK. The idea that it's simple to administer is a myth. It looks nice and easy when you explain it in a blog post, but any implementation that is sufficiently detailed enough to work is phenomenally complicated unless you plan on taxing every business transaction and at the same rate (which you almost certainly don't)

Posted by: keith28 | December 12, 2009 8:20 AM | Report abuse

I still don't see the difference between VAT and the sales tax we are already paying. There seem to be technical differences but no explanation I have seen so far has convinced me that these are more than arcane technicalities. I don't buy this meme about the US not having a VAT, when it looks, walks and talks like a VAT.

Compared to Germany, what stands out is that the VAT rate is uniform across the country, so you don't have silly competition between local governments for the lowest sales tax and there are no loopholes for internet vendors; and that the price label in the store already includes the VAT so you know what you are going to pay. In the US, you are told how much it will be at the checkout, which again is silly. But in Canada, which does have a VAT, the situation is the same as in US. This VAT/sales tax distinction is artificial.

The fact remains that VAT/sales taxes are highly regressive and have always been opposed by progressives for good reasons.

Posted by: carbonneutral | December 12, 2009 2:16 PM | Report abuse

Why can't we reduce spending and obviate the need for yet more taxes? There's no reasonable excuse to keep making the federal Leviathan larger and larger.

General question, though: Doesn't the Fair Tax proposal favored by some conservatives look and smell like the VAT, or am I missing something?

Posted by: dturnerc | December 12, 2009 6:27 PM | Report abuse

thanks for the info, ezra.

Posted by: schaffermommy | December 13, 2009 3:37 AM | Report abuse

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