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February 24, 2005

A Dangerous "VAT" of New Tax Revenue

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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 percent.

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 economies.

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 tax.

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.

Daniel J. Mitchell is the McKenna fellow in political economy at  The Heritage Foundation.

Distributed nationally on the Knight-Ridder Tribune wire

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