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Health Alert | Is a VAT the Answer? — The Commission, Part III

All over the developed world, countries are facing an extremely unpleasant budgetary reality: Per capita health care spending is growing at twice the rate of growth of per capita income.

Couple the fact that government promises of health care for the elderly are almost everywhere unfunded with the fact that pension promises are mostly unfunded and that aging populations mean an ever-increasing number of retirees per worker, and just about every first world country is projecting a fiscal nightmare.

So what's the answer? The Obama administration has made it about as clear as it is going to get that after the fall election its solution to trillion dollar deficits is going to be a value-added tax (VAT). But is that a good idea?

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Are you reelin' in the years,
stowin' away the time

Expected Tax Rates. In a previous Alert, I presented estimates from Larry Kotlikoff and his colleagues of what the tax rates will have to be if we stay on the present course and try to fund excess government spending with a VAT, a payroll tax or some other form of a consumption tax. As the graphs below show:

  • In the United States, the average tax on wage income will rise from 40.6% today (that's a 15.3% payroll tax plus a 15% income tax plus state and local taxes) to 55% by 2030 and 62.1% by midcentury.
  • If Europe follows the same path, the average tax on wage income will rise from 60.1% today to 72.5% in 2030 and 79.3% by 2050.

 

effective-wage-tax-rate-United-States

 

effective-wage-tax-rate-United-States

 

 

And note that these are average tax rates. Marginal rates will have to be even higher.

Theory vs. Reality. But given that revenue has to be raised some way, isn't a VAT the best way to do it? Economists tend to like the VAT because it ultimately taxes consumption rather than production and by collecting the tax at every stage of production, it's harder to evade than a sales tax, which puts the full burden on the final transaction. But, as it turns out, no country really has a pure VAT. All kinds of goods and services are exempted or taxed at lower rates. Randall Holcombe reports that Belgium, with a standard rate of 21%, also has rates of 12%, 6%, and 0%. France, with a standard rate of 19.6%, has 5.5% and 2% rates. Overall, if the United States followed the European model, in order to collect 5% of value added we would need a tax rate of almost 10%.

The Static Cost of a VAT. It turns out that a VAT also has high compliance and administrative costs, and these costs are largely independent of the rate. Holcombe has calculated that the cost to society (welfare loss) from a VAT rate of 2% is 56 cents for every dollar raised. For a 7% VAT rate, the cost is 33 cents for each dollar raised. This implies that it makes no sense to have a small VAT rate, but even a large one has heavy costs.

The Dynamic Cost of a VAT. Every tax discourages economic activity and the VAT is no exception. Based on a review of the literature, Holcombe calculates that a 10% VAT lowers the rate of economic growth by 10%. Based on this relationship, he finds that:

  • After a 20-year period (by 2030), the loss of annual GDP for the United States from a VAT would be more than twice as much as the revenue collected.
  • Moreover, at a lower than otherwise GDP, all revenue from all taxes would be lower, including state and local taxes.
  • Considering all these effects, the net revenue to the government from a 3% VAT would be about 1/10th the loss of output for the economy as a whole in 2030.
  • A 7% VAT, designed to bring in $915 billion in 2030, would in fact net less than one-third of that amount.

Holcombe concludes that higher taxes don't really bring in that much additional revenue. Instead of growing the government, they shrink the private sector. As the following table shows:

  • The French government doesn't really spend much more per person than government in the United States does. But because of its higher tax burden, France's per capita income is about $13,000 lower.
  • Government spending per person in Sweden is only 12.6% higher than in the United States. But Sweden's income is almost $10,000 lower.

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John_GoodmanJohn C. Goodman is president and CEO of the National Center for Policy Analysis. The Wall Street Journal and the National Journal, among other publications, have called him the "Father of Health Savings Accounts," and the Media Research Center credits him, along with former Sen. Phil Gramm and columnist Bill Kristol with playing the pivotal role in the defeat of the Clinton Administration's plan to overhaul the U.S. health care system. He is also the Kellye Wright Fellow in health care. The mission of the Wright Fellowship is to promote a more patient-centered, consumer-driven health care system.

Dr. Goodman's health policy blog is the only right-of-center health care blog on the Internet. It is the only place where pro-free enterprise, private sector solutions to health care problems are routinely examined and debated by top health policy experts throughout the country-conservative, moderate and liberal.  

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