A VAT Should Only Fund Essential Government Services

The United States, famously, is one of very few countries without a national consumption tax, or VAT (value added tax). It is an interesting question why this is the case. One reason is that it could easily impose a greater burden on some people than others, making it a hard sell politically. For instance, fully replacing income taxes with consumption taxes would increase taxes quite dramatically for some groups, like seniors who consume quite a bit but have relatively little labor income.

Another suggested reason is that it is a very efficient tax; most economists agree that consumption taxes are less distortionary than taxes on labor and capital. Moreover, VAT systems have proven to be very resilient to fraud. These would normally be considered strengths, however it has been argued that they are actually weaknesses, as a VAT would induce ever greater government spending. This makes a VAT unappealing especially to fiscal conservatives.

Nevertheless a VAT remains an important policy option, especially as the US faces enormous fiscal challenges.

How might we make a VAT politically palatable then?

I propose the following: introduce a VAT, but ensure that the revenues can only be used to fund “essential”, or “core” government services. In other words, VAT proceeds are earmarked, and not swallowed into the greater pool of federal revenues.

What are the main benefits of this proposal?

To begin, when someone pays the VAT, they know exactly what they are getting in return. Given that these are essential services, few people will feel they are paying for something they don’t want the government to be doing.

Second, there is a compelling case that almost everyone should contribute something to core government services, preferably in a simple and transparent way. A VAT achieves this: everyone contributes, with high-level consumers contributing the most.

Of course, opinions differ as to which spending is (and isn’t) essential. It is therefore important to single out categories that almost everyone agrees upon. What are the main contenders?

Of the 15 federal executive departments, I would argue that Defense, Energy, Homeland Security, and Justice should certainly qualify. One could make a case that State, Transportation, and Treasury also represent essential government services. I would argue that most other departments should not qualify.

How high would a VAT need to be to cover all spending by the departments of Defense, Energy, Homeland Security, and Justice? A simple calculation suggests just over 6%. While this is not insignificant, it is a lot lower than VAT rates in many other countries. In Europe, for instance, rates are typically on the order of 20%. The US rate could be set lower than 6%, but then essential services would have to be funded also by other sources, primarily income taxes (as they are today).

To make such a dedicated VAT politically feasible would require measures to compensate those whose tax burdens would otherwise increase. Two key reforms would be to 1) lower income taxes, especially for lower- and middle-income households, and 2) reduce taxes on savings (e.g. capital gains) for senior citizens.

The US faces massive fiscal challenges in the years ahead and a wide variety of policy options should be on the table, including a VAT dedicated to essential government services.