Why Isn’t Obama Considering a Consumption Tax?

Obama’s debt-reduction plan is unlikely to pass Republican-dominated congress because of its focus on higher taxes for the rich, ie. those making over $250,000 a year, as well as higher investment taxes. In total, Obama hopes to take $1.5 trillion more from wealthy Americans. Unfortunately, higher income taxes reduce the incentive to work and higher investment taxes reduce the incentive for businesses to purchase new equipment and ultimately to hire fewer people. It is well documented that consumption taxes (aka value-added taxes or VAT) do not have these effects. In fact, Stephen Gordon at the Globe and Mail Economy Lab noted that few countries support high spending without the use of a VAT. So why haven’t they been suggested?

Interestingly, the IMF recently suggested raising the VAT for Japan to deal with its soaring debt. Japanese government coffers were already strained before the earthquake and tsunami last spring; now they also urgently need to find a way to pay for reconstruction. Based on simulations done by the IMF, Keen et al cite four arguments for increase Japan’s VAT from 5 to 15 per cent.

1. An increase in the VAT rate is likely to be less distortionary than other sources of additional revenue.

2. Japan has one of the lowest VAT rates in the world.

3. Japan’s VAT is relatively efficient and easy to administer.

4. The VAT is a stable and robust source of revenue in an aging society.

The arguments are, for the most part, directly applicable to the U.S. Certainly, for long-run growth, consumption taxes are preferable to income or investment taxes. The U.S. levies no consumption tax at the federal level. The third argument is less applicable to the U.S. case, as there would be setup and continuing adminstrative costs. I dug up this document by Michelle Salvail that estimates the administrative burden of Canada’s GST when it was introduced at about 3 per cent of its tax revenue. And finally, the U.S. population is certainly aging, if not as dramatically as Japan.

How much revenue could be generated with a relatively low consumption tax? Currently, Americans consume over $10.5 trillion dollars annually. An extremely rough estimate would be that a three per cent VAT would likely generate over $200 billion in new revenue, after considering redistribution to reduce the impact to low and middle income housholds, that the tax wouldn’t apply to all goods, and paying for the administration of the new tax.  It would, of course, also grow with GDP in the U.S. Overall, a VAT far smaller than anywhere else in the Western world could generate trillions of dollars in new revenue over a decade.

Now is probably not the best time to cut into American’s spending, given the state of the economy and horrific consumer confidence. Theory indicates that a new consumption tax would immediately hit GDP by reducing consumption. Interestingly, however, the IMF report notes that many countries, such as Sweden, Italy and Denmark have hiked their VATs by as much as 10 per cent, without significantly undermining growth. But in President Obama’s speech introducing his debt plan he said that “[he] will not support any plan that puts all the burden for closing our deficit on ordinary Americans.” So, his plan distorts the incentive to invest and work for people with high income and on top of that slashes $580 billion in spending on benefit programs.

Despite political foot-dragging, in the long-term, introducing a consumption tax, or replacing distortionary taxes with consumption taxes, would certainly go a long way to reducing the U.S. debt. Furthermore, it could be set up so that it is still a progressive tax that does not reduce the incentive to invest or work.