In the ongoing discussion on how best to address the nation’s out-of-control deficit spending, one proposal would increase taxes by adding a value-added tax (VAT) on top of the current tax system. Proponents argue that a new tax on consumption would raise the needed revenues to close the deficit gap without the negative economic effects of raising the income tax.
However, rather than putting Washington’s fiscal house back in order, a VAT is more likely to grow the size of government and encourage growth in spending—effects that would be counterproductive to its intended purpose.
Recent analysis by Douglas Holtz-Eakin and Cameron Smith finds that in addition to the existence of a “strong, indisputable, positive relationship between use of a VAT and government spending as a fraction of GDP,” evidence points to a causal relationship between the creation of a VAT and growth in government.
Existing evidence already supports a correlation between the VAT and growth in spending in countries around the world. Holtz-Eakin and Smith sought to uncover whether it was the significant revenues a VAT raises that cause spending to increase or whether “the adoption of a VAT is evidence of the desire for a larger government so that the causal arrow runs from a taste for Leviathan to a VAT, and not the reverse.”
Their findings show that it’s the former: a VAT enables bigger government and fuels “increases in the size of the public sector.”
The VAT is currently discussed within the context of deficit reduction. But a VAT encourages increases in spending and growth in government; thus, far from achieving its goal of heightened fiscal responsibility, using this mechanism to increase taxes for Americans could instead have the opposite effect. In Politico, Holtz-Eakin and Smith discuss the feasibility of using a VAT to replace the current tax system as sweeping tax reform. Though the VAT could be an improvement over the current tax code—so long as it replaced it entirely—when pursued as a means to close the deficit as an add-on to the current tax system, it would create a new and dangerous set of issues.
Instead, to reduce the deficit, Congress should focus on the real problem at hand: spending. As Holtz-Eakin and Smith write, “The deficit problem is excessive spending—not inadequate revenues. In 2010, outlays are projected to be 25.2 percent of gross domestic product—about $1.2 trillion higher than the typical 20 percent of GDP in the postwar era. Coincidentally, that’s about the size of the projected deficit in 2020.”
Entitlement spending—especially on Medicare, Medicaid, and Social Security—is growing on autopilot at an alarming rate. These three programs alone, excluding net interest, comprise 56 percent of all federal expenditures. A reduction in spending, especially within these programs, is the right course to take to reduce federal deficits.