Monday, November 8, 2010

Political Promises and the Value Added Tax

The election is over and democracy did its job. Whether you agree with the outcome or not, there is new leadership in Congress. History shows that President's can do a better job when forced to work with the opposition party in Congress. President Reagan and President Clinton both saw the economy improve after the opposite party took control of one house of Congress. Things work best when ideas from both sides of the isle are employed.

The high voter turnout for the midterm elections show how polarized the electorate is over issues of taxes, government spending, and social programs. What got lost in the coterie of attack ads and promises is a cold hard truth: taxes will go up. I hate to say it because I hate taxes as much as the next guy, but the numbers do not lie.

Taxes have declined on a nearly steady pace for thirty years. With the exception of a few years in the nineties, the federal government has run a sizable budget deficit. And more tax cuts are on the way. The promise of fiscal restraint will die now that the votes have been cast. The deficit is here to stay for a very long time.

Raising taxes is difficult at any time and the tax increase required to balance the federal budget deficit will make a balanced budget impossible. Taxes would need to increase nearly 100% to stop the red ink flowing. That kind of shock to the economy makes it unlikely the deficit would be erased under such a scenario.

Cutting spending is always popular. Cut waste and balance the books is a recurring political promise. There are only three programs large enough to make a difference: Social Security, Medicare, and the military. The cuts required from these programs would have to be massive to stop the red ink. It is political suicide to even suggest cuts of the size needed.

Another option is raising taxes and cutting spending. Again, the size of the tax increase and spending cuts would shock the economy and would be impossible for any politician to swallow. So what options remain?

Everyone knows that President Reagan orchestrated the largest tax cut in history up until that time. What most do not remember is that Reagan also increased taxes. While income tax rates were reduced, the payroll tax was increased to the level we still have today. The payroll tax is the Social Security and Medicare taxes, referred to as FICA, that is paid on all wages and self employed income. Everyone pays regardless of income level at a flat rate. The demise of Social Security and Medicare were pushed out decades. The problem is now rearing its ugly head again.

Politicians today will take a page from President Reagan's playbook. Income taxes are a difficult sell, but increasing other taxes is very doable. So in comes the Value Added Tax (VAT). You only pay the VAT when you buy stuff. Don't spend and you don't pay. It encourages saving and makes cheap goods from China more expensive. The VAT works in a similar way to state sales taxes. The concept is different, but consumers will see it as a sales tax.

The VAT will be sold in the following manner: Income taxes will be cut in half or more, the Alternative Minimum Tax will be eliminated, the standard deduction will increase significantly so fewer people pay income tax, and the estate tax will have a higher exemption or will be eliminated. In exchange for massive income tax cuts a VAT of 12-15% will be instituted and could rise to around 20%. Food, shelter, and medical will enjoy exemption from the tax.

There is good news and bad news with the Value Added Tax. The good news is that a VAT reduces the amount of fraud so the government collects more of what it expects; VAT tax collections produce massive additional revenue to balance the budget; and foreigners traveling here also pay the tax.

The bad news is that it is a tax increase; if it were not the budget will not get balanced. More people will pay, especially lower incomers. The added revenue will provide a temptation for politicians. Consider President George W. Bush. He entered the White House with a large budget surplus and spent the entire thing for 10 years at the stroke of a pen. Then reality (terrorist attack) set in and the only way to defend ourselves was with borrowed money.

Right or wrong is not my point. I think we have a VAT in the United States within 10 years. Handled correctly it should be no problem. Still, history is not encouraging when it comes to government management of money.


  1. Hi - good article. VAT does not make non-US goods more expensive though. It is neutral for all domestic sales. Imports are VAT taxed, but the importer gets a VAT refund. Thanks, Mark

  2. All purchases are charged a VAT including imports. By making goods more expensive it discourages spending if only because you have less money after paying the tax. Do not think a widget made in China will Be VAT-free when U.S. made goods are charged. I hope I am clear on this.

    A VAT is added all along the production chain with refunds due to businesses that paid a VAT. I know it is complicated. The goal of Congress on a VAT is increased revenues and reduced tax cheating. Google the subject for a deeper understanding of the VAT. My short blog post does it little service.

  3. Very intelligent writing you have, sir.