Will a VAT Turn America into a Greek-style Welfare State?

Many Washington insiders are claiming that America needs a value-added tax (VAT) to get rid of red ink. Proponents even claim that this European-style national sales tax is good for growth. Some of them say the imposition of a VAT would modernize our tax system, whatever that means. Others argue a VAT could be used to finance pro-growth tax reforms. And President Obama says that a VAT is “something that has worked for other countries.”

Every single one of these assertions is demonstrably false.

But one thing that everyone acknowledges is that the VAT is capable of raising enormous amounts of tax revenue. The tax is imposed on consumption, which accounts for about two-thirds of America’s nearly $15-trillion gross domestic product. So even a low tax rate of five percent theoretically would generate as much as $500 billion for the politicians to spend. In practice, though, politicians usually insert loopholes in exchange for campaign cash, so the actual amount of revenue would be lower.

We should be reducing the size and scope of Washington, not making it more of a burden.”

It does not matter, however, how much revenue a VAT generates with a five-percent rate. One of the many problems with a VAT is that it is a hidden levy. Unlike a regular sales tax, which is imposed at the cash register, VATs are imposed at each stage of the production process and thus get embedded in the price of goods. And because the VAT is hidden from consumers, politicians find they are an easy source of new revenue — which is one reason why the average VAT rate in Europe is now more than 20 percent!

You probably won’t be surprised to learn, though, that all the additional tax revenue from a VAT has not resulted in deficit reduction. Western European nations first began imposing VATs about 40 years ago, and the result has been bigger government, permanent deficits and more debt. According to the Economist Intelligence Unit, public debt is equal to 74 percent of GDP in Western Europe, compared to 64 percent of GDP in the United States (and the gap was much bigger before the Bush-Obama spending spree doubled America’s debt burden).

The most important comparison is not debt, but rather the burden of government spending. If you go back to the mid-1960s, before the imposition of VATs, Western European nations had relatively modest-sized government, only slightly larger than in the United States. Adopting a VAT, however, gave politicians a giant new source of tax revenue. And just like you don’t cure an alcoholic by giving him keys to a liquor store, you don’t promote fiscal responsibility by giving government a new source of revenue.

Thanks in large part to the VAT, government spending in Western European now consumes 50 percent of GDP. This stifles growth by diverting a huge share of output from the productive sector of the economy, which helps explain why living standards are 30 percent to 40 percent below American levels. Not that Americans should get cocky. Thanks to reckless fiscal policy by Presidents Bush and Obama, the burden of government spending has now climbed above 40 percent of GDP in the United States.

What about the hypothesis that a VAT is good for growth? To be blunt, this is a silly assertion. As just noted, adding a big new tax on top of the already destructive internal revenue code is nothing but a recipe for bigger government.

To be sure, we would have a better tax system if proponents got rid of the income tax and replaced it with a VAT. But that’s not what’s being discussed. At best, some proponents claim we could reduce other taxes in exchange for a VAT. Once again, though, the evidence from Europe shows this is a naive hope. The tax burden on personal and corporate income is much higher today than it was in the pre-VAT era.

Last but not least, let’s deal with the claim that a VAT is a modern tax system. When you ask people to explain what this means, they usually fall back on the assertion that America should have a VAT because almost all other nations have adopted this punitive tax. But almost all other nations are less free and less prosperous, so that’s not a compelling argument.

Some of them then say that a VAT is better for a modern economy with lots of trade. And when you ask them to elaborate, they provide a protectionist argument that the VAT is imposed on imports and rebated on exports. But even for those who think the trade balance is important, this is an absurd argument.

Let’s use a simple example. Under current law, there is no VAT imposed on cars sold in America, regardless of whether they are produced in America or produced in Germany. This means there is a level playing field. So what happens if politicians impose a VAT? Under that new system, there is a VAT imposed on all cars sold in America, regardless of whether they are produced in America or produced in Germany. The playing field is still level. But one thing has changed. Politicians now have a lot more of our money.

When President Obama said the VAT is “something that has worked for other countries,” he should have specified that the tax is good for the politicians of those nations, but not for the people. The political elite got more money that they use to buy votes, and they got a new tax code, enabling them to auction off loopholes to special interest groups.

That’s not something we want in America. We should be reducing the size and scope of Washington, not making it more of a burden.

Daniel J. Mitchell is an expert on tax reform and supply-side tax policy. He is a senior fellow at the Cato Institute.