February 24, 2005
By Daniel J. Mitchell, Ph.D.
Tax reform is
high on President Bush's list of second-term priorities.
Considering the mess our tax code has become, this is welcome news.
More than 90 years of social engineering and backdoor industrial
policy have created a tax system that combines punitive class
warfare and special-interest loopholes.
Unfortunately, this silver cloud may have a dark lining. There are
signs that a few people in the Bush administration may be
sympathetic to a European-style value-added tax (VAT), a form of
national sales tax imposed at each stage of the production process.
Enacting such a tax in America, though, would be a tragic mistake.
A VAT might have some theoretically attractive features, but it a
perniciously effective way of raising revenues and inevitably leads
to bigger government.
The best evidence comes from Europe. Back in the mid-1960s, the
burden of government in Europe wasn't that much higher than it was
in the United States. Tax revenues consumed about 30 percent of
gross domestic product in Europe. The United States had a small
advantage: Including state and local governments, the tax burden
was about 27 percent of GDP.
But then European governments started adopting the VAT. In 1967,
Denmark was the first, followed by France and Germany, with many
other European nations imposing the tax within five years.
For politicians, the VAT was great news. Besides being a new source
of revenue, the VAT has been a disturbingly easy tax to increase
since it's built into the price of products and hidden from
consumers. Moreover, even small increases generate a big pile of
revenue because the tax base is so broad. The tax has become so
easy to raise that VAT rates in Europe average more than 20
For taxpayers, though, the news has been disastrous. Thanks to
this levy, the burden of government in Europe today is much higher
than it is in the United States. On average, taxes consume about 41
percent of Europe's economic output. While other taxes also have
climbed, the VAT certainly has helped finance the explosion of
social welfare spending that creates such a drag on European
In the United States, by contrast, the total tax burden as a share
of GDP is about where it was 40 years ago -- 27 percent (which
helps explain why America is growing faster and creating so many
more jobs than European nations).
So if the VAT is a money machine for big government, why would
anybody inside the Bush administration support it? Money is
reportedly the biggest attraction. The president has said that tax
reform must be "revenue-neutral." This means the pro-growth,
revenue-reducing parts of tax reform -- lower tax rates, repeal of
the alternative minimum tax, and a shift from depreciation to
expensing -- must be financed by revenue increases.
Ideally, these pro-growth elements of tax reform would be "paid
for" by eliminating shelters, deductions, exemptions, credits and
other tax breaks. But this would be a daunting task.
Special-interest groups almost surely would fight to protect the
major loopholes, including the deduction for state and local tax
payments and the exclusion for employee fringe benefits.
That's why a VAT is alluring. It is a relatively non-destructive
way to raise tax revenue. Like a flat tax, it is a single-rate
system that doesn't penalize saving and investment. It's
understandable that officials would be tempted to enact a VAT and
use the money to finance much-needed reforms to the income
On paper, this would be a good trade. But in the real world,
America would be taking the first step toward fiscal destruction.
Many European governments used the same argument when enacting the
VAT. They claimed that more destructive taxes would be reduced or
repealed once the VAT was implemented. In the short term, this was
true: As late as 1975, taxes on income and profits were lower in
the EU than they were in the U.S.
But this was a transitory phenomenon. Income-tax rates quickly
began climbing and almost immediately jumped above U.S. levels.
Ironically, the VAT facilitated higher tax rates on income since
politicians often argued that a higher VAT had to be accompanied by
higher income tax burdens to ensure the tax burden wasn't being
shifted to lower-income taxpayers.
There is only one scenario that would make a VAT acceptable. If
U.S. lawmakers were willing to repeal the 16th Amendment and
abolish all taxes on income, a VAT would be an acceptable risk. But
until that happens, taxpayers should vigorously resist the
Europeanization of America.
Mitchell is the McKenna fellow in political economy
at The Heritage Foundation.
Distributed nationally on the Knight-Ridder Tribune wire
Tax reform is high on President Bush's list of second-term priorities. Considering the mess our tax code has become, this is welcome news.
Daniel J. Mitchell, Ph.D.
McKenna Senior Fellow in Political Economy
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