Meltzer’s memorandum

The press office of House Minority Leader John Boehner observes that one of President Obama’s prominent economic advisers (Paul Volcker) has said the United States should impose a European-style value-added tax (VAT). The press office forward this memo from economist and professor Allan Meltzer on Volcker’s tax hike recommendation:

To: Republican Leader John Boehner
From: Professor Allan H. Meltzer, Carnegie Mellon University
Date: April 15, 2010
RE: The Value Added Tax
The Obama administration is planning to introduce a Value Added Tax (VAT) probably after the November election. Rumors about the tax have circulated for months. The president’s adviser, Paul Volcker, remarked in an interview that the administration is considering a VAT.
The VAT tax is levied on all economic activity that adds value; that is, it taxes the difference between the revenue that a firm receives for its output and the costs that it pays for inputs. This difference between receipts and costs is the value added by the firm.
For example, when coal and iron ore are sold to a steel mill, the mill pays tax on the value of the steel it sells but deducts the amounts paid for coal and iron ore. The auto company that buys the steel charges tax on the car it sells to a consumer but deducts the cost of the steel and other inputs. The consumer pays the tax on the auto it buys and thus on all the inputs that went into its production.
The collection costs are borne by the sellers, and the full tax is paid by the consumer. The tax is costly to collect and to monitor. To avoid the tax, people pay for services in cash. The service provider does not report the sale and also avoids paying income or other taxes. The so-called underground economy grows. Because the VAT raises the price faced by the consumer, spending declines.
VAT is a common form of taxation in many countries. It raises large amounts of revenue. Estimates are that each 1 percent VAT tax in the United States yields $ 50 billion in revenue. A 5 percent VAT would add $250 billion to Federal tax receipts. To close the projected budget deficits, the tax rate would have to be substantially higher than 5 percent.
The VAT is a regressive tax; it takes a larger share of low incomes because it taxes spending and average spending declines as income rises. To compensate, many countries rebate income tax to low income earners. In the United States, low income earners pay little or no income tax.
Passing a VAT not only locks in place the current welfare state in place by financing the increased current and future share of government spending and transfers. The VAT would pay for part of the unfunded liability for health care including the large costs added by Obamacare. Passing a VAT would mean that the unfunded Federal liability would be paid mainly by tax increases with few or no reductions in spending.
European experience suggests that the VAT is a largely hidden tax that can increase with less political opposition than increases in the income tax. The European welfare state is a main reason that since about 1980 Europe’s growth rate has fallen below the U.S. growth rate, and reported European unemployment rates have been well above U.S. rates on average. The United States should avoid locking the country into a low growth future.
The VAT violates fiscal federalism, the tacit arrangement that leaves some sources of revenue to state and local governments. Traditionally, sales taxes have been reserved for the states. VAT, like a sales tax, falls on consumer spending. State governments are a likely source of opposition to a Federal VAT. States and local governments have large unfunded liabiliies for pensions and health care, so they will need their sources of revenue.
In the coming election, all Republican candidates for Congress should pledge to vote against a VAT.


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