Can a Value-Added Tax Put Our Debt in Order?

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The projected deficits for the next 25 years raise concern about how long we can continue deficit spending. But is the country ready for a serious debate about an overhaul of our tax system?

Congress is reluctant to curb spending and cannot agree on whose income tax to raise or by how much. Perhaps some other solution must be considered. The United States is the only country in the Organisation for Economic Co-operation and Development (OECD) that does not levy a consumption tax.1 With the 2016 election of a Republican-controlled White House and Congress, and an existing House blueprint for tax reform that includes a version of a consumption-based approach for taxing business income, it appears likely that some version of a value-added tax (VAT) will become part of the debate.

It Starts with the Federal Debt

According to the U.S. Treasury, the total national debt is over $19 trillion.2 Recent annual deficits have been about $600 billion and are projected to be $1 trillion per year starting in 2023. The Congressional Budget Office (CBO) projects the 10-year cumulative deficits through 2026 to be $9 trillion, bringing the total federal debt close to $30 trillion.3

To put this in perspective, by 2026, the portion of the federal debt held by the public is projected to be about 86 percent of our gross domestic product (GDP), and the total gross debt would be about 110 percent of GDP.4 Historically, when countries reach over 100 percent debt-to-GDP ratios they generally face a fiscal crisis of some form: substantial reductions in economic growth, crowding out of private investment, higher Treasury bond interest rates and debt service burden on the federal government, higher consumer borrowing rates which would dampen economic growth causing a recession, currency devaluation, eroding purchasing power of wages and savings arising from inflation, and economic stagnation. This results in substantial cuts in government services and an overall reduced standard of living, especially to the poor, elderly, and middle class.

The CBO included the following language in its most recent annual long-term budget outlook:
Other factors, such as an economic depression, a major war, or unexpected changes in fertility, immigration, or mortality rates, could also affect the trajectory of debt. Taking all factors into account, CBO concludes that despite the considerable uncertainty of long-term projections, debt as a percentage of GDP would probably be greater – in all likelihood, much greater – than it is today if current laws remained generally unchanged. What might the consequences be if current laws remained unchanged? Large and growing federal debt over the coming decades would hurt the economy and constrain future budget policy. The amount of debt that is projected in the extended baseline would reduce national saving and income in the long term; increase the government’s interest costs, putting more pressure on the rest of the budget; limit lawmakers’ ability to respond to unforeseen events; and increase the likelihood of a fiscal crisis, an occurrence in which investors become unwilling to finance a government’s borrowing needs unless they are compensated with very high interest rates.5

The Congressional Research Service recently informed Congress that “addressing the potential consequences ... will likely involve policy adjustments that reduce the occurrences and intensity of budget deficits, either through tax increases, further reductions in spending, or a combination of the two.”6

According to the Treasury, personal income taxes in 2015 accounted for $1.5 trillion, or 47 percent, of $3.2 trillion in total tax receipts.7 To raise about $600 billion more to cover the annual deficit, the government would need to either broaden the taxable income base or raise rates by 40 percent more. Additionally, rates would need to be even higher when you consider the projected greater annual deficits.8

The idea of raising individual tax rates ignores the likely impact that tax rate increases of that magnitude would have on growth and spending and the political reality that the wealthiest Americans will not support a rate increase of that magnitude.

Demanding uncompromising cuts is not any easier. The Budget Control Act (BCA) of 2011 was intended to cut spending by about $1.2 trillion over 10 years by requiring Congress to find areas to cut. When Congress could not, the BCA required mandated cuts, known as “sequestration.” These cuts were scheduled to affect defense, Medicare, and all discretionary programs. Because of political and societal pressures, and emergency funding measures, these planned cuts were postponed, limited, or eliminated by subsequent legislation, especially through the Bipartisan Budget Acts (BBA) of 2013 and 2015.

Specifically, the BBA of 2015 canceled automatic spending reductions set to take effect in 2016 by at least $80 billion, and cancelled reductions for a few more years.9 Also in 2015, Congress permanently repealed a mandated 21 percent cut in Medicare reimbursements to physicians, which added another $140 billion to the debt over the next 10 years, passed a largely unfunded Highway Trust Fund appropriation, which will add another $50 billion over the next 10 years, and made most extenders permanent.

Total tax receipts are $3.2 trillion, roughly 18 percent of the annual GDP of $18 trillion.10 Assuming tax receipts come in at the same rate of GDP, the federal government would generate $180 billion for every $1 trillion of additional GDP growth. Therefore, to fund annual deficits of $600 billion going forward, the economy would have to immediately grow another $3.3 trillion – an impossible additional 18 percent all in one year.

What if we spread the additional needed growth over several years, using a GDP real growth rate of 5 percent per year? Although this would appear to eventually cure the $600 billion annual deficits, it wouldn’t be sufficient for several years. Not only would we be adding to the debt until then, it does not cover $1 trillion in additional deficits starting in 2023. Achieving a 5 percent GDP growth rate also is unrealistic, considering we didn’t achieve that growth rate in the booming 1990s. Bottom line: it is unrealistic to think that we can just grow the economy out of the deficit problem.

To stimulate economic growth, many in Congress have pointed to corporate tax reform. There are proposals to lower the U.S. rate to make it more competitive globally, encourage repatriation of foreign earnings, minimize base erosion, and attract and retain businesses. Republicans and Democrats have substantial common ground here, but they cannot agree on important details. There is tremendous pressure from lobbying groups to preserve the status quo for a multitude of corporate preferences, most of which would have to be eliminated to fund any meaningful reduction in the rate.

The United States has one of the most complex corporate tax codes in the world, and one of the highest statutory rates. Global earnings essentially are trapped offshore because U.S. tax rules provide a disincentive to repatriate.

For fiscal year 2015, the corporate income tax raised about $350 billion out of about $3.2 trillion in total receipts, or about 11 percent of total tax receipts despite its complexity and high costs of compliance. There have been serious policy discussions centered on abolishing it and replacing it with an integrated system, whereby corporate profits and stock appreciation are taxed at the individual level.11 Most observers, though, don’t see a complete abolishment of corporate income tax as politically possible for the foreseeable future. This brings us to another possibility: a national consumption tax.

A national consumption tax would be applied at a much higher rate at the national level than what we are familiar with at the Pennsylvania level. The Fair Tax Act of 2015, for example, would impose a rate of about 20 percent to 23 percent, but it would replace all other federal taxes.12 Proponents argue that such a system would capture taxes from illegal activity, would assess taxes on every person consuming at the retail level in the United States, and would eliminate the complexity of our current income-based systems. Critics argue that it would be regressive, in that a flat rate for all essentially becomes a larger percentage of disposable income on poorer families than it would be on middle income or wealthy families. This is because all families need a minimum amount of food, clothing, shelter, and medicine. However, that burden could be offset by rebates for those near poverty level with low-income subsidies and exemptions for basic necessities.

A national sales tax, however, would have a major noncompliance disadvantage compared with our existing tax system. Specifically, since there is no cross reporting by prior or successor stages of a retail sale, the government would have no corroborating record or know who is the end retailer responsible for tax collection.13 For these reasons – plus the radical nature of such a high national rate and the pressures to maintain the status quo – the public does not appear ready for something this dramatic. However, perhaps something like a VAT might be more acceptable.

The VAT system differs from a national sales tax because a VAT is assessed at each stage of the supply chain, through to the end consumer, on the difference between the seller’s purchase price and the resale price of most products and services in our economy. It would also apply to rentals, sales of business assets, and commissions. How this would be accomplished depends on the type of VAT system implemented.
The most common method, used by most VAT countries, is the “credit-invoice” method.14 Under this method, at the end of a reporting period the business calculates its VAT liability by subtracting the cumulative amount of VAT stated on its purchase invoices from the cumulative amount of VAT stated on its sales invoices. If done accurately, this ensures that the VAT will be neutral, except for the value-added portion, regardless of how many transactions are involved.

All serious U.S. consumption tax proposals would either eliminate or lower rates, and simplify many of our existing federal taxes to varying degrees, depending on the consumption tax rate. The VAT itself is thought to be a much simpler system than an income taxation system in that it involves assessing a tax on a value-added calculation, which intuitively and theoretically is not as complex as defining taxable income. Additionally, it is thought that a consumption-based tax would be more neutral to decision-making regarding what to invest in and how to finance it, as well as being economically more efficient to administer.15

To help U.S. goods and services be more competitive around the world, a VAT could be “border adjustable,” in that it would not apply to the export price, and allow a refund for the earlier production-related VAT. Imports, on the other hand, would not be exempt since its earlier stage production had not been subject to the U.S. VAT.

Proponents argue that moving away from an income-based tax system would lead to significantly more tax revenues. This is because a consumption-based tax removes earnings disincentives and would encourage investing. New revenue could be directed to deficit reduction, and substantial simplification of one or more of our existing tax systems.16

A combination seems more viable. For example, if the corporate income tax could be reformed and rates lowered, the anti-competitive drivers would disappear, foreign earnings could be repatriated, U.S. businesses would have greater incentive to remain here, more foreign capital would be attracted to the United States, and compliance and planning costs would greatly diminish. In effect, the revenue cost of corporate tax reform could be augmented by introducing a VAT.

Revenues that could be raised from a VAT depend on the rate, the types of exemptions, and the subsidies granted to alleviate regressivity on the poor. VAT rates in the OECD range from a high of 27 percent to as low as 5 percent, with the average rate around 17 percent. A recent Tax Policy Center analysis referred to a study that estimated that a 5 percent U.S. VAT rate could raise $200 billion to $350 billion annually (about as much as the corporate income tax), depending on how broad the taxable base would be.17

The Tax Foundation looked at how much of the long-term gap in tax receipts could be neutralized by instituting a VAT. Assuming a VAT base of about 40 percent of GDP (the average of European-style VATs), it concluded that the government would need a 12 percent VAT each year to close the 25-year gap, a 17 percent VAT to close the 50-year gap, and a 21 percent VAT to close the 75-year gap.18

If structured properly, a U.S. VAT could be implemented in a manner that reflects European lessons learned, provides for substantial income tax reduction and tax simplification, and provides additional funds for deficit reduction.

This debate will take years, but Congress may eventually see this as a viable option. 

 

1 Consumption Tax Trends 2014: VAT/GST and Excise Rates, Tax, and Policy Issues, OECD Publishing, Paris (2014).
2 Including $5 trillion owed to various federal agencies, which also includes real obligations under current law.
3 Congressional Budget Office, An Update to the Budget and Economic Outlook: 2016 to 2026, p. 27 (August 2016).
4 Ibid, p. 4, note 4.
5 The 2016 Long-Term Budget Outlook, Congressional Budget Office, p. 4.
6 Deficits and Debt: Economic Effects and Other Issues, Congressional Research Service (Feb.17, 2016).
7 Monthly Treasury Statement (September 2015).
8 Congressional Budget Office, August 2016 Update, note 4, p. 27.
9 Final Sequestration Report for Fiscal Year 2016, Congressional Budget Office, p. 1 (December 2015).
10 Monthly Treasury Statement, note 9 (September 2015).
11 Eric Toder and Alan Viard, “Major Surgery Needed: A Call for Structural Reform of the U.S. Corporate Income Tax,” American Enterprise Institute and Tax Policy Center (April 2014).
12 Tax Reform in the 114th Congress: An Overview of Proposals, Congressional Research Service (March 2016).
13 How Could We Improve the Federal Tax System?, The Tax Policy Center, 2015, The Tax Policy Briefing Book.
14 An Introduction to the Value Added Tax (VAT), U.S. Chamber of Commerce (2010).
15 U.S. Chamber of Commerce, note 20.
16 “Should the U.S. Adopt a Value-Added Tax?”, The Wall Street Journal (Feb. 28, 2016).
17 How Could We Improve the Federal Tax System?, The Tax Policy Center, note 20.
18 “What VAT Rate Could Solve CBO's Long-Term Budget Outlook?”, Tax Foundation, July 2010.

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Robert E. Duquette, CPA, is professor of practice at Lehigh University College of Business in Bethlehem, and of counsel to William G. Koch & Associates, having retired as director of M&A tax at Ernst & Young in Philadelphia. He can be reached at bobduquette@gmail.com.

Andrew M. Bernard Jr., CPA, is managing director of Andersen Tax in Philadelphia and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at andrew.bernard@andersentax.com.

Florian Hanslik is senior manager, indirect taxes, at PrimeTax AG in Zurich, Switzerland. He can be reached at florian.hanslik@primetax.ch.