The Macroeconomic Effects of an Add-on Value Added Tax
Prepared for the National Retail Federation by:
Drs. Robert Carroll, Robert Cline, and Tom Neubig Ernst & Young LLP and Drs. John Diamond and George Zodrow Tax Policy Advisers LLC and Baker Institute for Public Policy and Economics Department, Rice University
As U.S. policymakers consider ways to address unsustainably high projected future federal government deficits and debt, significant policy changes to both spending and revenues will be debated. The President’s National Commission on Fiscal Responsibility and Reform is charged with making recommendations by December 1, 2010 on how to address near-term as well as long-term projected deficits. The Commission is expected to consider significant changes to federal entitlement programs, defense and non-defense discretionary spending, and the tax system, including the possibility of a new federal value-added tax (VAT).
The National Retail Federation (NRF) engaged Ernst & Young LLP and Tax Policy Advisers LLC to analyze the macroeconomic effects of implementing a VAT to reduce projected federal deficits. Although there have been economic analyses of various policies to reform the existing tax system, a macroeconomic analysis of an "add-on" VAT as a means of reducing the deficit and government debt has not been undertaken.
This report examines the macroeconomic effects of reducing future deficits by two percent of GDP. The report focuses on a narrow-based VAT that is similar to VATs in most other countries. To achieve deficit reduction of two percent of GDP with a narrow-based VAT, a 10.3 percent tax rate would be needed. The report also analyzes the effects of a broad-based VAT with a rebate for tax paid by low-income households, as well as a narrow-based VAT with a rebate. All of the add-on VATs analyzed in this report are similar to those used in other countries or recommended in various proposals currently under discussion. For purposes of the analysis, it is assumed that the VAT is effective January 1, 2012.
The three principal findings of the report are:
1. An add-on VAT would reduce retail spending by $2.5 trillion over the next decade. Retail spending would decline by almost $260 billion or 5.0 percent in the first year after enactment of the VAT.
2. An add-on VAT would cause GDP to fall for several years. The economy would lose 850,000 jobs in the first year, and there would be 700,000 fewer jobs ten years later. By comparison, a comparable reduction in the deficit through reduced government spending would have less adverse effects on the economy, and could have positive effects for economic growth.
3. Although lower deficits and debt would have positive long-run effects for the economy, most Americans over 21 years of age when the VAT is enacted would be worse off due to enactment of an add-on VAT. A VAT would have significant redistributional effects across generations, reducing real incomes and employment for current workers.
In the face of an economy that continues to struggle, immediate enactment of an add-on VAT would pose serious risks. The drop in retail spending, jobs, and GDP under an add-on VAT has the potential to further weaken the economy in the near term, rather than strengthen it. Other countries have reduced, not increased, their VATs in the face of the recent economic downturn. Reducing the deficit through lower government spending would have much more favorable economic effects – more jobs, higher GDP, a better standard of living for Americans, and a less depressing effect on retail spending – in both the near term and in the longer term.
Retail Spending Would Fall Significantly Under a VAT
A VAT would lower household consumption in the short- and long-runs, and would reduce GDP for the next several years followed by several years of negligible change.
Retail spending subject to the VAT would initially fall by 5.0 percent or almost $260 billion.
Retail spending would fall by $2.5 trillion over the next decade.
An Add-on VAT Would Have More Adverse Macroeconomic Effects than a Comparable Deficit Reduction through a Reduction in Government Spending
An add-on VAT would result in less economic growth as compared to a reduction in government spending, when addressing the nation’s long-term fiscal imbalance.
The level of GDP initially falls when future deficits are financed with a VAT, but would rise almost immediately when reduced through lower government spending on income transfers.
A VAT has more adverse effects after ten years as well – reducing the deficit through a VAT cuts the growth of GDP by more than half as much as a reduction in government spending after ten years.
The drop in taxable retail spending and services is initially 7.5 times as large under a VAT (-5.0 percent) than after a reduction in government spending (-0.7 percent). After ten years it remains 6 times as large.
A deficit-reducing VAT would result in an initial loss of about 850,000 jobs and a loss of 700,000 jobs for more than a decade. In contrast, reducing the deficit through lower government spending could add 250,000 jobs to the economy.
The two policies would have different distributional effects, depending on the distribution of the reduction in transfer payments.
Most Americans Alive Today Would Be Worse Off Under an Add-on VAT
Most Americans over 21 years of age when the VAT is enacted would be worse off due to a decline in their real wages and their inability to consume as much. Households with incomes above $40,000 and over the age of 21 at the time of enactment would be worse off.
These losses reflect the costs current generations would bear from using a VAT to reduce the current unsustainable level of deficits and the debt in the United States.
An Add-on VAT Would Result in a Large Tax Increase for Middle-Income Families
The required tax rate for a narrow-based VAT would initially need to be at least 10.3 percent to reduce federal government debt by two percent of GDP. An add-on VAT would be in addition to all existing taxes, such as individual income taxes, corporate income taxes, and the payroll tax.
Under a narrow base 10.3 percent VAT, a middle income family-of-four with the U.S. median income of roughly $70,000 would pay $2,400 a year in value added taxes. This would be a 100 percent increase over the federal income taxes currently paid by this family.
A family earning $40,000 would pay an additional $1,800 in VAT. A family at this income level has no federal income tax liability.
A family earning $100,000 would pay $2,800 in value added taxes – a tax increase equal to more than 40 percent of their current Federal income tax liability.
Moreover, the VAT rate would likely increase over time due to continued political pressure to further narrow the VAT base and/or add some type of rebate to offset VAT paid by lower-income households. This is in addition to the possible increase in rates that would be needed to finance any increase in government spending due to the availability of the VAT; such increased spending would be consistent with international experience.
International Experience with VATs
The report examines the experience of ten of the largest countries that have adopted a VAT. All of these countries replaced existing, national consumption-type taxes, such as turnover taxes and manufacturing and wholesale sales taxes, with a VAT.
To address the distributional concerns that VATs are borne disproportionately by lower income households, these VATs have been designed with exemptions and multiple rates. Exemptions and multiple rates increase the administrative and compliance costs of these VATs. Of the ten VATs examined, only Japan imposes a VAT with a single tax rate.
VAT rates in these countries have also increased substantially over time. The average VAT rate has risen from 10.7 percent at the inception of the VATs across all ten countries to 16.0 percent today – a nearly 50 percent increase. The average VAT rate among the 30 member nations of the Organisation for Co-operation and Economic Development (OECD) is 18.0 percent. The United Kingdom will be the first of the ten largest countries analyzed to double its initial VAT rate with its scheduled increase from 17.5 percent to 20 percent in January 2011. Japan briefly considered raising its VAT rate from 5 percent to 10 percent earlier this year, but has not done so in the face of significant political opposition.
The narrow taxable base for VATs in other countries has resulted in some goods and services being favored relative to other goods and services. This has led to important and sizable sectoral effects favoring tax-preferred sectors. In addition, the enactment of a VAT can have temporary effects on consumption patterns. For example, Australia reduced its excise tax on automobiles and replaced its wholesale sales tax when it enacted its VAT in 2000. Before the effective date, automobile sales fell, but then rose sharply after their excise tax was reduced, while retail spending increased just before the VAT effective date, but fell sharply afterwards.
Modeling the Macroeconomic Effects of an Add-on VAT
In practice, the VATs that have been enacted in other countries are typically not uniform broadbased consumption taxes, but rather “narrow-based” VATs.” Within the OECD, VATs only cover a portion of total consumption due to various exemptions and lower rates for spending on goods such as health care, education, financial services, housing and various “necessities,” and it seems likely that a VAT in the United States would also be less than fully comprehensive.
Accordingly, the analysis considers three different VAT scenarios, where each raises revenue equal to two percent of GDP:
A narrow-based VAT covering 41 percent of total consumption, which excludes a wide variety of items due to administrative concerns or because they account for a larger share of low-income families’ budgets. This would require a VAT rate of 10.3 percent.
A broader-based VAT covering 67 percent of total consumption that replaces some of the exemptions under the narrow-based VAT with a cash grant to low-income families to fully offset VAT on families below the federal poverty level. This would require a VAT rate of 8.0 percent.
A narrow-based VAT that also includes a cash grant to low-income families. This would require a VAT rate of 12.4 percent.
The report relies on the Tax Policy Advisers’ (TPA) dynamic general equilibrium model of theU.S. economy, which is designed to analyze major tax policy changes. The TPA model and similar economic models have been widely used by the U.S. Department of the Treasury, the Joint Committee on Taxation, and the Congressional Budget Office to analyze the macroeconomic effects of broad changes to the tax system. The TPA model captures the macroeconomic effects of a new federal add-on VAT tax; the resulting reduction in the federal deficit and the national debt; the associated changes in prices, wages, and interest rates; the effects on economic growth, aggregate consumption and investment; and the resulting effects on households, categorized by age and income groups. Thus, the model estimates the macroeconomic effects of a VAT as well as its age and income distributional effects. The report does not analyze the effects of alternative ways of reducing federal deficits and the debt, other than differentiating the macroeconomic effects of deficit reduction using a VAT from the effects of a reduction in government spending on income transfers
As a consumption-based tax, an add-on VAT would be shifted forward to consumers through higher consumer prices. As a result, private consumption would fall. By increasing consumer prices, the VAT also reduces real or inflation-adjusted wages, which would cause labor supply to fall as well.
An add-on VAT would have particularly adverse effects on the retail industry. There would be an especially pronounced reduction in retail spending because nearly all retail goods would be subject to double-digit VAT rates, while many other consumer purchases would be exempt under a narrow-based VAT. In addition, some consumers would evade the tax – experience in other countries suggests 12 percent non-compliance with the VAT – driving up the VAT rate.
Moreover, an add-on VAT leaves the economy considerably worse off than a similarly-sized reduction in government spending on income transfers. With an add-on VAT, GDP would initially be lower and the economy would lose jobs; by comparison, GDP and employment would increase with a reduction in spending. Although lower deficits and debt would have positive long-run economic effects for the economy, most middle income Americans who are working age or older at the time of enactment of the VAT would be worse off.
Perhaps the most troubling aspect of a deficit-reducing VAT is that, if enacted in the near future, its negative effects on GDP, consumer spending, and employment would occur in the face of the current economic climate of weak economic growth, high unemployment, and low consumer confidence. The near-term drop in output, loss of jobs, and sharp decline in consumer spending described by this report would raise additional economic worries, rather than shoring up the weak economy. With the CBO projecting unemployment to not fall below 7 percent until 2013, the initial reduction in employment from a VAT, estimated to be roughly equivalent to 850,000 jobs, would make full economic recovery much more difficult.