The Coming VAT

In fiscal year 2008, the Federal Budget Deficit increased to $455 Billion, which helped drive the total US National Debt to $10.6 Trillion (as of 11/16). The unfolding financial bailout will potentially add another $7.5 Trillionon that (including the likely auto bailout of $25BN is basically a rounding error to the total bailout number). You can also assume that President Obama and his strong Democratic Congressional majority will also enact some type of universal healthcare reform, costing an estimated $75BN per yearthat the Treasury Dept. doesn’t currently have.

But as steep as the bill will be for the bailout and Obamacare, it actually pales in comparison to the unfunded obligations that the Federal Government has related to Social Security, Medicaid and especially Medicare. Current projections for the next 75 years estimate that the cost of these entitlement programs will exceed Government income by $40 Trillion– lets call that $500 Billion per year just to use round numbers.

So clearly, Federal Government’s looming expenditures- even if you don’t count the bailout and the costs of new universal healthcare- are unsustainable. Either the Government is going to have to dial back these spending obligations (not likely) or try to come up with new sources of tax revenue to pay for them (more likely).

There is an interesting article in Fortune Magazine where the author acknowledges these facts and hypothesizes what the “solution” will be.

Here’s the key take on the funding need, assuming continued reliance on the income tax:

Let’s examine the numbers. Under our current tax system, receipts are projected to remain pretty flat, at about 18% to 20% of GDP, far into the future. But spending is slated to rise to 24% of GDP in 2030 and 28% in 2050, excluding interest on the federal debt. If taxes aren’t increased enormously, future deficits, and the enormous borrowing they require, will swamp the budget with ruinous interest costs.

Today, the income tax raises around $1.1 trillion, or around 9% of GDP, with payroll and corporate taxes contributing the balance. The deficit now stands at around $580 billion, including the Social Security surplus that’s helping to pay the bills. But that surplus is also rapidly disappearing. So to balance the budget, America would need to raise income taxes by 53%, assuming the other taxes remained at current rates.

The gap gets far larger in the future, chiefly due to rapidly rising costs of Medicare and Medicaid. To pay for those costs, we’d need to raise taxes by an extra 2% of GDP. That would require an additional $270 billion in income taxes.

All told, that’s a total tax increase of $870 billion, or almost 80%. That’s not including the estimated $240 billion cost of President-elect Barack Obama’s healthcare plan through 2018.

Clearly its not possible to raise income taxes by 80%- I haven’t heard any credible economist suggest that, I don’t believe that even someone as far to the left as Paul Krugman would seriously call for a near doubling of the income tax. Without wanting to inadvertently create a Laffer curve debate here, I think it is universally agreed that massive income tax increases at some point start to drive a reduction in the extent to which Americans work, save and invest- and therefore reduces whatever income there is to be taxed at hypothetical exorbitant rates, ultimately leading to lower tax revenue and negating the benefit of raising those income taxes in the first place.
So what is the government likely to do (again, assuming that it is not capable of making meaningful cuts in entitlement spending)?

The Fortune article surmises that as we approach “European” levels of government spending, we will have to embrace a “European” source of government funding- the Value Added Tax, or VAT.

I’ve never particularly understood how the VAT works, but the article does provide a good thumbnail sketch of how it works:

The VAT is essentially a sales tax, except that it’s charged at each stage in the development of a product instead of at the moment when the product is sold.

Take, for instance, a car with a sticker price of $30,000 and a value-added rate of 10%. Ford might buy its steel and other materials for $8,000 plus $800 in a VAT tax. A dealer then pays $25,000 plus a $2,500 tax for the finished vehicle. Ford takes an $800 credit for the tax it already paid and sends $1,700 to the government. A buyer then pays $30,000 for the SUV and $3,000 in taxes. The dealer collects the $3,000, takes a credit for the $2,500 worth of taxes already paid, and sends $500 to tax authorities. Ultimately, the government pockets $3,000, or 10% of the retail price of the car, in taxes.
The genius of the VAT is that, while the consumer pays it, the actual cash is mostly collected from producers before it reaches the retailer. Since the VAT is essentially a hidden charge embedded in the price of goods and services, raising the VAT doesn’t arouse nearly the uproar caused by increasing income taxes.

The VAT becomes necessary because our current tax system is so progressive that the top 10% of households are now paying about 2/3rds of total income taxpayments. For the reasons noted above, squeezing those top 10% households to make up the looming spending shortfall simply isn’t realistic. And expanding income tax rates to the 90% “non-rich” in the country is political anathema for the Democrats, who hate the rich, and the Republicans, who hate raising taxes.

But the VAT is a way to start eliciting some more tax dollars from that lower 90% without causing those folks the brain damage of filing a 1040. And the VAT has a discretionary element to it- you don’t want to pay it? Fine, just don’t buy so much. And while putting this fancy sales tax into place will no doubt have a negative effect on economic growth, the Euro-socialists have apparently found that it is less detrimental to economic growth than taxing the top 10% wage earners into oblivion. The VAT is also popular with the Euro crowd because purchases don’t fall as sharply in a recession as incomes might (especially incomes for the top 10%). Also, its easier to raise the VAT because the individual payments are small- a 1% increase on a $50 purchase translates to just $0.50. Certainly those $0.50s add up over the course of the year, but the assumption is that most people don’t pay enough attention to notice.

I’m not writing this as a proponent of the VAT. My preference would be to see massive spending cuts and entitlement reforms. But I don’t think that is likely. Unfortunately our spending outlays were already unsustainable relative to our income tax base and will probably be made more so by the unfolding financial bailout and the likely Obama-Universal Healthcare plan. When something is clearly unsustainable, you have to ask yourself how it will be resolved. I am a pessimist about curtailing government spending. No doubt there will be some cutbacks, but nothing close to what’s necessary to offset the massive tax increase that will be needed. If I had to guess, I expect that we’ll have a worst of both worlds by keeping the current progressive income tax system that sticks it to the top 10% and adding in some sort of phased-in VAT to shake extra money out of the lower 90% to plug the difference.

But regardless, keep an eye out for “tax reform” proposals that reference the VAT. Odds are we are going to wind up paying it in some form before the dust settles with the current mess.