April 7, 2017 Reading Time: 2 minutes

Ongoing federal budget deficits have contributed to a federal debt near an all-time high. The government could reduce the deficit by reducing spending or raising taxes. Growth in the private sector could also help reduce the deficit.

Some policymakers have proposed switching to a value-added tax (VAT) to raise tax revenue. A VAT would levy a uniform tax on all stages of production. The additional tax revenue would ostensibly be used to reduce the budget deficit. A smaller budget deficit would slow growth in the national debt. Some policymakers also contend that a uniform VAT would reduce market distortions.

The value-added tax is not an answer to the deficit and debt. The VAT would expand the reach of government. There is no guarantee Congress would use the tax revenue to reduce the deficit or retire the debt. The VAT would also raise prices across the economy leading to inflation.

A VAT would tax every stage of production as well as the final consumer. Each stage of production is taxed only on the value added. Firms can deduct the cost of inputs. For example, Johnson Controls in Milwaukee, Wisc., uses copper and plastic to produce electrical components for automobiles made by General Motors. Johnson Controls would be taxed on the difference between the cost of the copper and plastic and the sale price. General Motors would be taxed on the difference between the final sale price of the car and all input costs.

The VAT would be levied regardless of the inputs’ country of origin. Instead of buying from a company from Wisconsin, GM could purchase electrical components from Magna International, located in Canada. General Motors would still deduct the cost of components and only pay tax on their value added. The VAT would not be levied on exports.

Switching to a VAT would expand the reach of government. Firms would have to keep detailed records on every transaction. The detailed record keeping will require firms to hire additional compliance staff. An important goal of tax reform is simplicity.

Compliance adds to the total cost of the tax burden. Higher business taxes are often passed onto the consumer. The VAT is levied on every stage of production and the final retail sale. Because of this, the value-added tax would likely cause prices to rise across the economy.

Theodore Cangero

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