There has been considerable discussion in Washington over the past several months about tax reform and deficit reduction. In late 2010, two bipartisan commissions offered their plans for reforming the Internal Revenue Code and bringing the federal budget into a more sustainable position. The congressionally created National Commission on Fiscal Responsibility and Reform proposed the elimination of nearly all individual and corporate tax expenditures, along with significant expenditure reductions, as a means of repairing the budget imbalance, bringing greater neutrality to the Code, and substantially reducing personal and corporate tax rates.
The Debt Reduction Task Force of the Bipartisan Policy Center—cochaired by former senator Pete Domenici and Alice Rivlin, a former director of both the Congressional Budget Office (CBO) and the Office of Management and Budget—made a number of similar proposals, but also recommended that the federal government adopt a 6.5% value-added tax (VAT), which it termed a debt reduction sales tax, to address the longer-term fiscal picture, including the need to reduce the federal debt and deal with the health and retirement obligations of an aging population (Bipartisan Policy Center Debt Reduction Task Force, Restoring America’s Future, p. 39 (November 2010)).
Concerns about the near- and long-term fiscal prospects for the federal budget have led a number of other observers to suggest that the United States adopt a VAT at the federal level. The general position of the VAT proponents is that the long-term costs of meeting the Medicare and Social Security obligations of a rapidly aging population, coupled with the need to reduce the federal debt and reform the income tax, require an additional federal revenue source. Given that the United States is the only major developed country in the world without a broad-based national consumption tax, proponents believe that a VAT similar to that used by over 150 countries around the globe should be adopted.
If the federal government were to adopt a VAT, it would need to address a number of issues regarding the structure and operation of the tax as well as how it might be integrated with existing state and local retail sales taxes. This item provides a brief overview of some of those issues, without taking a position either for or against the need or desirability of the federal government adopting a VAT. To provide some context for the VAT discussion, it begins with a brief overview of the near-term and long-term fiscal position of the federal government and then discusses the considerations involved in structuring a hypothetical U.S. federal VAT.
The Federal Fiscal Outlook
The CBO released its most recent examination of the outlook for the federal budget in January 2011 (CBO, The Budget and Economic Outlook: Fiscal Years 2011 to 2021 (January 2011)). The report reflects the impact of the December 2010 enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011, P.L. 111-312, which reduced the payroll tax for 2011, increased the alternative minimum tax exemption amount for tax years 2010 and 2011, and extended for 2011 and 2012 the tax rate reductions and other cuts that had been scheduled to expire in 2011. According to CBO estimates, if the tax provisions scheduled to expire in 2011 and 2012 are extended through 2021 and certain expenditure assumptions are made, deficits would exceed $1 trillion annually through 2021 and beyond, the volume of accumulated debt over the next decade would soar, and annual deficits would exceed 6% of GDP. Under this scenario, the debt held by the general public would approach 100% of GDP by 2020, its highest level since 1946.
The CBO has also examined the long-term fiscal outlook and concludes that with the aging U.S. population and the rate of growth in health care costs generally, the “federal budget is on an unsustainable path. . . . Keeping deficits and debt from reaching levels that would cause substantial harm to the economy would require increasing revenue significantly as a percentage of [GDP], decreasing projected spending sharply, or some combination of the two” (CBO, The Long-Term Budget Outlook (Summary), p. 1 (June 2009)).
The Debt Reduction Task Force used more graphic terms to describe the country’s long-term fiscal fortunes. Using CBO data, the task force found that without changes in current policies, the combination of spending on Social Security, Medicare, Medicaid, and interest on the debt will consume all available federal revenues by 2025, leaving all other services, including defense and homeland security, to be eliminated or financed through additional borrowing. It also noted that CBO data indicated that without substantial changes in financial policies, the total level of debt held by the public would be roughly four times its historical average by 2040 and would reach 200% of GDP, a situation the task force said could lead to a “death spiral” of “rising debt and interest costs . . . feeding off one another in an ever-more vicious cycle.”
Structuring a VAT
Under a typical VAT regime, tax is imposed on consumption of goods and services at every stage of the production and supply chain, offset by credits for previously paid tax.
Tax base: An ideal VAT would tax all individual or household consumption of goods and services and through the crediting mechanism leave no tax embedded on intermediate business purchases. Of course, there is a substantial gap between the ideal and the actual manner in which a VAT is deployed around the world. Most countries, particularly those in the European Union (EU), have a variety of exclusions or preferences in their VAT base. In some cases, the exclusion is due to difficulty in applying the VAT to particular sectors in which it is hard to determine the price of a particular transaction (e.g., financial services, insurance, and government), while in other areas, the intent seems to be to provide preferential treatment because the good or service at issue is considered a necessity or merit good (e.g., food for home consumption, children’s clothing, health care, and education).
Generally speaking, most VATs exclude those items identified above and include about 55% to 65% of final household consumption of goods and services. This is, of course, considerably broader coverage for individual consumption than that provided by retail sales taxes, which for the most part are not imposed on service transactions. Some countries, notably Australia, Canada, and New Zealand (which have adopted VATs in the last 25 years), have a broader tax base than the EU; they impose the VAT on a broader range of financial services, charities, and government functions (in New Zealand) and also impose the tax more widely on various necessities.
Tax rate: The tax rate chosen for a federal VAT of course depends on how much revenue one desires to raise from the VAT and the breadth of the tax base to which the rate is applied. In the EU, where the tax base reaches about 60% of individual consumption and VAT revenues constitute about 25% to 30% of total government revenues, VAT rates fall in the 15%–25% range; this is also quite consistent with the range of rates in the rest of the world. The EU has a larger public sector than the United States, and there is not a system of subnational (state and local) consumption taxes in the EU, two factors suggesting that U.S. VAT rates would likely not be as high, unless the VAT were to replace a significant part of current income tax revenues.
The Bipartisan Policy Center suggested that the debt reduction sales tax would reach 75% of personal consumption expenditures, meaning that at their recommended 6.5% rate, it would generate roughly $500 billion annually when fully phased in—based on 2010 personal consumption expenditures of $10.3 trillion. If the U.S. VAT base were more like the “average” EU base, reaching about 60% of final consumption, each percentage point would generate about $62 billion in receipts, compared with about $78 billion per percentage point if the base covered 75% of personal consumption.
Regressivity: A VAT is regressive with respect to income, meaning that as income rises, the proportion of income that goes to payment of VAT declines. This should not be surprising, since lower-income households consume a greater proportion of their income than upper-income households. The degree of regressivity depends on the nature of the VAT base and any measures that might be included to offset the regressivity. In attempting to offset the regressive nature of the VAT, policymakers will have a variety of options, including some that operate “within the tax”—as in excluding some household necessities that represent a greater proportion of low-income household budgets from the tax—and some measures that operate “outside the tax”—as in taxing the household necessities, but providing a rebate to specified households or adjusting income tax rates to offset the impact of the VAT.
The conventional wisdom among public finance economists is that measures that operate outside the tax are preferable (Ebrill, Keen, Bodin, and Summers, eds., “The Modern VAT,” pp. 80–82 (International Monetary Fund 2001)). Excluding necessities from the tax base narrows the base and requires a higher tax rate to yield any given level of revenue. The exclusion also has the effect of relieving tax on purchases by upper-income households, which are presumably not the intended beneficiaries of the measure. Canada utilizes an extensive array of rebates and grants to offset the impact of VAT on low-income households and other preferred groups.
Coordination with state and local sales taxes: If the federal government adopts a VAT, it would raise the issue of whether and in what manner the federal VAT could be coordinated with the subnational (state and local) taxes. Without some coordination, the compliance burden borne by sellers in the United States could increase substantially as they would need to comply with the already complex state-local tax regime plus the federal VAT. Other countries with a federal system that have adopted a VAT have dealt with this issue in a variety of ways, including:
- Levying a combined national-subnational VAT at a single rate throughout the country and rebating a portion of the receipts to the subnational governments on either a formula basis or according to where the sale actually took place;
- “Harmonizing” the national-subnational taxes so that the base of each is uniform, collection can be done by the national government, and the subnational government establishes the rate to be applied to transactions within its jurisdiction; and
- Doing nothing and maintaining the VAT and the sales tax as separate levies that are administered separately.
States are likely to resist federal adoption of a VAT because they will presumably view it as an intrusion on a revenue source that to this point has been the province of states and localities. If, however, states were to harmonize their sales taxes with a well-designed federal VAT, it could substantially improve the design and operation of sales taxes as consumption taxes. In particular, harmonizing the sales tax with a well-designed VAT would improve the ability of sales taxes to reach transactions involving services, which are for the most part excluded from most state sales taxes. In addition, conforming sales taxes to a VAT would serve to eliminate the extent to which sales taxes are imposed on intermediate purchases. Such harmonization could also reduce significantly the compliance burdens associated with the current sales tax system.
Based on the experience of other countries such as Canada, the ability to harmonize federal and state consumption taxes depends on uniformity between the federal and state tax bases in order to facilitate interstate transactions, treat the national and subnational taxes as a single levy, and reduce the compliance burden. States could retain the ability to establish their own tax rates and to administer the state tax if they so chose, but the tax base uniformity is considered critical to successful integration. The requirement for uniformity is likely to mean many states will want to simply preserve their current sales taxes, at least at the outset. That is the pattern that occurred in Canada, where when the national goods and services tax (GST) was first enacted, nearly every province retained its provincial sales tax. As of July 2010, all but three provinces have adopted a provincial tax that is harmonized with the federal GST.
The fiscal position of the federal government is under considerable stress from both short-term economic pressures and long-term demographic trends. This has led many observers to suggest that the United States adopt a VAT to aid in dealing with the issues. If it does adopt a VAT, the federal government will confront a number of significant design issues, not the least of which will be determining how the VAT can be coordinated with existing state and local sales taxes.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.