Value-Added Tax and the Federal Deficit

Tax Foundation President Scott Hodge discusses the Value-Added Tax (VAT) rate that would be needed to erase the budget deficit created by rampant government spending:

Over the past weekend, the Office of Management and Budget released its annual Mid-Session Review of the Budget which projects the administration’s policies over the next ten years. The big news is that OMB is projecting a $1.4 trillion deficit for 2011 (the third year in a row at this level), a $911 billion deficit in 2012, and deficits between $698 billion and $900 billion for the remainder of the decade.

These deficit estimates assume the extension of the Bush tax cuts for families under $250,000 but $639 billion in new tax revenue from repealing the tax cuts for upper-income families. These estimates also assume $702 billion in “other revenue changes and loophole closers” along with some $711 billion in spending cuts, mostly in defense.

Because a Value Added Tax (VAT) has been floated as a solution to the government’s budget problems, we did a back of the envelope estimate of the VAT rates that would be needed to raise enough money to cut Obama’s deficits to zero. Assuming a VAT base of 41 percent of GDP (the average of European-style VATs) , we would need a 22 percent VAT in 2011 to close the $1.4 trillion deficit.

In future years, as the deficit is expected to fall, we would still need a VAT rate of 8 to 14 percent to raise enough revenues to close the budget gap. Of course, these VAT rates would assure that federal revenues stayed above 22 percent of GDP for the next 10 years. Something that has never happened before in U.S. history.

Legislators suffer from a twisted doctrine regarding government deficits: the government’s budgetary “needs” are held as the priority – if citizens want or need lower taxes, they must wait until spending is under control. It is not only liberal legislators who ascribe to this doctrine. For example, Senator John McCain opposed the Bush tax cuts on the grounds that they were not coupled with restraints on spending. So here we have a “conservative” essentially stating that Americans must continue to pay excessive taxes until the government gets around to reigning in spending (and let’s be honest, when has that promise ever been kept?) But it is not the government’s money, it is ours. The individual American citizen should be the primary concern – government works within the boundaries its citizens set, not vice versa. And as the late, great Milton Friedman once remarked:

I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible. The reason I am is because I believe the big problem is not taxes, the big problem is spending. The question is, “How do you hold down government spending?” Government spending now amounts to close to 40% of national income not counting indirect spending through regulation and the like. If you include that, you get up to roughly half. The real danger we face is that number will creep up and up and up. The only effective way I think to hold it down, is to hold down the amount of income the government has. The way to do that is to cut taxes.