When I look at the huge deficits the US has amassed and continues to run up, I see very few magic bullets. The Congressional Budget Office currently estimates that we will generate nearly $10 trillion in cumulative budget deficits over the next 10 years. This is an enormous amount of money and in order to balance our budget (or at least close the gap) it will take more than spending cuts…it will take tax increases. The question that everyone wants to know is how much additional tax will I have to pay?
Our President made many promises during his campaign regarding tax increases and his desire to “only tax the rich.” Well, I am not sure that is a solution for increasing long term tax receipts. Check out this chart below. It shows the actual tax receipts as a percentage of GDP (Gross Domestic Product). Notice how over the past 70 years we collect approximately 18% of GDP regardless of the tax rates in place.
What does this mean? Some may suggest we should just have a flat tax, but that would be a future blog post. More importantly, it means that ultimately, the size of the economy is an absolute limit on the amount of taxes that we can collect. Growth in tax collections cannot exceed growth in the economy for very long. Therefore, it should suggest we need a tax structure that incents growth.
However, I doubt that happens. In fact, I think this administration will do just the opposite. They have this same chart and information and know that raising income tax on the rich will not generate enough tax to cover these huge long term deficits. They know we need to find other sources and will need to tax the middle class (where the bulk of taxpayers are), but will not want to do so with income tax. So enter a VAT or National Sales Tax.
As the Wall Street Journal recently pointed out, VATs were sold in Europe as a way to tax consumption, which in principle does less economic harm than taxing income, savings or investment. This sounds good, but in practice the VAT has rarely replaced the income tax, or even resulted in a lower income tax rate. The top individual income tax rate remains very high in Europe despite the VAT, with an average on the continent of about 46%.
In the U.S., VAT proponents aren't calling for a repeal of the 16th Amendment that allowed the income tax—and, in fact, they want income tax rates to rise. The White House has promised to let the top individual rate increase in January to 39.6% from 35% as the Bush tax cuts expire, while the dividend rate will go to 39.6% from 15% and the capital gains rate to 20% next year and 23.8% in 2013 under the health bill, from 15% today. Even with these higher rates or because of them, revenues won't come close to paying for the Obama Administration's new spending—which is why it is also eyeing a VAT.
One trait of European VAT’s is that while their rates often start low, they rarely stay that way. Of the 10 major OECD nations with VAT’s or national sales taxes, only Canada has lowered its rate. Denmark has gone to 25% from 9%, Germany to 19% from 10%, and Italy to 20% from 12%. The nonpartisan Tax Foundation recently calculated that to balance the U.S. federal budget with a VAT would require a rate of at least 18%. See chart below:
I fear once we go down this path of a VAT, there will be no turning back. Our politicians will find increasing the national rate to be a very easy way to find extra resources to support their every expanding appetite for spending. I would love to hear your thoughts on this. Please comment or contact me and let me know.