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He was an economic advisor in the Reagan administration. This is his op-ed piece in the NY Times
The Best Kind of Tax
Categories: Congress, Taxes, Federal Budget
In my previous post, I tried to show that the magnitude of growth in government spending already in the pipeline is so great that it cannot be contained just by cutting. Those who think otherwise usually fall into two camps: utopians who think Congress will someday slash programs like Medicare, even though tens of millions of voters depend on them, and those who don’t know the nature of federal spending.
On radio shows, callers routinely tell me that national defense eats up 50 percent or more of the budget and so we can just cut that. Actually, defense takes up less than 19 percent of spending and would have to be completely abolished to pay for the near-term growth in Medicare alone.
Others point to “pork” or “earmarks” in the budget—public works projects inserted into spending bills that principally benefit an individual congressman’s district or a senator’s state. But last year, all such projects taken together added only $27.3 billion to the federal budget, according to Citizens Against Government Waste, a watchdog group. In a $2.5 trillion budget, this is a trivial sum.
Those who still believe that spending cuts can solve our budget problem should consult a document called “Budget Options,” published last year by the Congressional Budget Office. It contains hundreds of spending and revenue proposals that could save large sums. But finding the votes for even the small proposals is extremely difficult. Earlier this year, Congress had extraordinary difficulty passing the Deficit Reduction Act of 2005, which cut the budget by only $40 billion over five years. To keep the deficit from rising down the road, Congress will need to pass budget reductions 100 times larger.
It is far more realistic to assume that the bulk of deficit reduction will come from higher revenues. I say this because every major deficit reduction effort of the last 25 years has relied mainly on higher revenues. Most of the savings included in these efforts have not been real spending cuts but merely promises to hold down future appropriations—in other words, smoke and mirrors. Only the tax increases have been real. As I note in my book, Ronald Reagan signed into law tax increases of $132.7 billion per year by 1988—equal to 2.6 percent of gross domestic product, or $340 billion in today’s economy.
To reduce the deficit, we will need to increase revenue by about 10 percent of G.D.P. per year over the course of the next generation, raising revenues to 28 percent of G.D.P., from about 18 percent. The individual income tax now raises 7.7 percent of G.D.P., and the corporate income tax raises 2.3 percent. So individual and corporate income tax rates would have to double to get the needed revenue—and that assumes that there would be no falloff in growth from such a rate increase.
But such massive income tax increases are not going to happen. Our tax system is creaking and groaning as it is. We already have a large and growing “tax gap,” according to the Internal Revenue Service, as people evade paying the existing rates. Increased enforcement could raise more revenue, but that would require more resources for the I.R.S. and the imposition of draconian collection methods that are unlikely to be sanctioned by Congress.
Many people believe that simply allowing the Bush tax cuts to expire on schedule at the end of 2010 would be enough to avoid more onerous spending or revenue adjustments. But according to the Congressional Budget Office, elimination of the tax cuts would raise revenue by only a little over 1 percent of G.D.P. By 2016, revenues would rise only to 19.7 percent of G.D.P.—even taking into account the revenue increase that would result from real growth (which pushes people into higher tax brackets) and the increasing reach of the Alternative Minimum Tax. That is not even close to how much will be required.
So we are left with the need for a new revenue source. When confronted by the need to pay for health and other spending programs, every other major country has turned to the value-added tax, or V.A.T. This is the best strategy tax economists have ever devised for raising revenue without investing a lot in enforcement and economic incentives.
The V.A.T. is a kind of sales tax embedded in the price of goods. A farmer who grows wheat, for example, pays, say, 10 percent on the sale. The miller buys the wheat (with the tax indicated on the invoice), makes flour, and when that is sold, he also pays 10 percent, but gets a credit for the taxes the farmer paid. The baker who makes bread from the flour also pays 10 percent when he sells to the food store, but gets credit for the taxes paid by the farmer and the miller. Since taxes must be paid in order to claim credits for the taxes embedded in the bread at earlier stages of production, the tax is largely self-enforcing.
And because the tax is applied only to consumption, its impact on incentives is minimal. It can also be rebated at the border on exports, because when exporters sell goods, they can claim credit for taxes they have paid without themselves collecting any taxes on the sale. Many manufacturers believe this aids their international competitiveness, because under world trade law, other forms of taxation may not be rebated in this way.
According to the International Monetary Fund, the tax base for the V.A. T. is about 37 percent of G.D.P. in industrialized countries. With our G.D.P. close to $13 trillion, that means about $5 trillion would be available for taxation. A 10-percent V.A.T. would raise $500 billion in new annual revenue (10 percent of $5 trillion). The average V.A.T. rate is 18 percent, according to the Organization for Economic Cooperation and Development, ranging from a low of 5 percent in Japan to a high of 25 percent in Sweden, Denmark and Hungary.
We should bite the bullet and put in a V.A.T. For now, the revenue could be used to fix glaring problems in the tax code, such as the Alternative Minimum Tax. In the longer run, it could be raised gradually to pay for Medicare and other programs. The burden is on those who oppose a V.A.T. to spell out how spending could otherwise be cut or taxes raised by the order of magnitude I have outlined.
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