This article first appeared in the January 13, 2015 edition of Tax NotesToday.
The reason the United States doesn't have a consumption tax is that "conservatives view it as a money machine and liberals see it as a tax on the poor," Lawrence Summers once said, before his days as Treasury secretary in the Clinton administration. "We will have a VAT," he predicted, "when liberals figure out that it is a money machine and conservatives see that it is a tax on the poor."
The latest attempt at a consumption tax in the U.S. is a bill introduced by Senate Finance Committee member Benjamin L. Cardin, D-Md., in the waning days of the 113th Congress: the Progressive Consumption Tax Act of 2014 (S. 3005), a proposal designed to address both parties' concerns by reducing income tax rates in a revenue-neutral manner by means of a federal consumption tax.
And while many dismiss the prospects for a consumption tax anytime soon, others consider it inevitable that the U.S. will catch up with the rest of the world in introducing a VAT, and what's more, they see such a tax's potential as a pay-for for budget issues such as the federal deficit, federal debt, or underfunding of Social Security and Medicaid. And since Cardin's effort is the first in many years to put a proposal in legislative language, it is worth a closer look.
"The whole VAT here is relatively well thought out; it is my impression that this is a serious attempt to get a VAT in place," Reuven S. Avi-Yonah of the University of Michigan Law School said of Cardin's bill. "The problem of course is this is before anybody starts lobbying the bill and putting exemptions into it, so it's kind of like opening up shop."
At its core, the Progressive Consumption Tax Act of 2014 proposes a 10 percent VAT while lowering corporate tax rates to 17 percent and decreasing the top personal rate to 28 percent. In an attempt to make the tax progressive, Cardin included a "prebate" that replaces the current earned income tax credit and child tax credit. It also includes an income tax exemption of $100,000 for joint filers and $50,000 for single filers.
The bill would tax capital gains and ordinary income at the same rate. It would replace the current individual income structure with three rate brackets of 15, 25, and 28 percent. The bill would also repeal the 3.8 percent net investment income tax under section 1411.
Not forgetting about Republican concerns that a VAT is a money machine leading to big government, Cardin included a "circuit breaker" that will provide eligible filers a refund if total VAT collected is greater than 10 percent of GDP per year.
"The 10 percent VAT rate will in the best cases get about 4 or 5 percent of GDP, so there is a question if 10 percent is the right number or not, but it at least puts on the table the idea that this would not be an unlimited money machine," said Peter Merrill of PricewaterhouseCoopers LLP. "I think it's a very clever idea."
Economists widely regard the consumption tax, if implemented in place of an income tax, as good for economic growth because it doesn't place a tax on capital, leading to higher investment.
Robert Carroll of EY said that he thinks Cardin's plan is an interesting contribution to the tax reform debate because he goes in a different direction than others working on tax reform, who mostly intend to work within the current system.
Others, such as John Buckley, former Joint Committee on Taxation chief of staff and a Tax Analysts board member, question whether the bill will actually be progressive, as the name suggests.
According to recent Congressional Budget Office data on household income and tax rates, households in the lowest two quintiles of income pay less than a 10 percent effective tax rate. In 2011, the bottom quintile -- those making less than $24,600 -- paid an effective tax of 1.9 percent, and the second lowest quintile -- those making less than $45,300 -- paid an effective tax rate of 7 percent, according to the CBO. Buckley said he is concerned that low- to middle-income individuals who don't have access to the prebate, such as retirees, will experience an increase in their tax liability.
The bill would also cut the corporate tax rate to 17 percent. Avi-Yonah said he thinks the 17 percent corporate tax rate would be too low because it would place the U.S. much lower than other OECD countries, and inversions -- often cited as an effect of the U.S.'s high statutory rate -- would decrease at around 25 or 28 percent. He also wondered how owners of passthrough entities, like private equity funds, would view the tax cut and the elimination of preferential treatment for capital gains.
However, Michael Graetz of Columbia Law School said that by getting the corporate rate to 17 percent, Cardin is eliminating many of the international tax problems that the global tax system is facing. "The issues become trivial," he said.
Avi-Yonah speculated that while the bill might be revenue-neutral overall, there are shifts within it in terms of who is paying what. He questions the effort it would take to get it passed because it doesn't address the largest problems, like the debt, deficit, or inequality. "It preserves, at best, the same level of progressivity that we currently have both on the tax side and the spending side; it doesn't do anything."
Any Chance It Will Pass?
Despite Cardin's attempts to mollify Republicans with the circuit-breaker provision and to maintain progressivity, many commentators said that there is not enough support for a consumption tax generally from either party to lead them to believe that one would pass anytime soon.
But the point of introducing the bill at the close of the previous Congress was largely to inspire reform debate in the current one, Cardin told Tax Analysts at the time of the bill's introduction in December. He said he has incorporated the suggestions of several members of Congress into the bill and received bipartisan "encouragement to go forward" with the legislation, even as he expects many lawmakers to have questions about it.
But Buckley said that Democrats generally view consumption taxes as regressive, "and they are correct -- unless [it were] supported by a robust rebate structure, in which [case] it has the distortive elements that economists don't like." He added, "For Republicans, they see it as a ticket to financing big government, and let me say, both parties are right."
For recent clues into the Republican mindset on consumption taxes, one source is the tax reform report released December 11 by current Finance Committee Chair Orrin G. Hatch, R-Utah. Hatch, along with his then-minority committee staff, was ambivalent on the tax, saying it has advantages over the income tax in terms of the latter's bias against savings and investment, while also arguing that adjustments required to reduce the burden for the elderly and low-income taxpayers would eliminate most positive growth effects.
Graetz, meanwhile, is one who thinks it's only a matter of time before the U.S. has a VAT. "I think it's inevitable," he said. Cardin has "come to a conclusion that this is the right approach and [that] the '86 style tax reform is inadequate to meet the challenges of a 21st century economy; and he's right," Graetz said, adding, "At some point, others are going to have to think about this seriously."
"But we are at the point where we need an overhaul, not an oil change," Graetz said.
According to OECD reports, the U.S. tax on goods and services is 4.3 percent of GDP, compared with the OECD average of 10.8 percent. U.S. tax on income and profits is slightly above the OECD average, with 12.1 percent compared with 11.4 percent. Overall, the U.S. receives revenue of 25.4 percent of GDP, compared with 33.7 percent.
Thirty-eight percent of U.S. tax revenue comes from personal income, profits, and gains, compared with the OECD average of 25 percent. Only 18 percent of U.S. revenue comes from goods and services tax, compared with the 33 percent OECD average.
Graetz said that the U.S. is in a position where it needs to modernize its tax system to keep it in line with the international economy. "We can only keep our head in the sand for so long," he said.
Of Cardin's bill specifically, Avi-Yonah said, "I'm not sure this will have an impact on the tax reform conversation before the 2016 presidential election, but after that, it is conceivable that one or more of the candidates will run on something like this." He added, "But I somehow don't see a Democrat running on a bill with a 28 percent tax rate."
Avi-Yonah said that he sees potential for reform because the public conversation has changed to income inequality. He said Cardin's bill is a good beginning because it is a serious attempt to fix the broken pieces of the income tax, but he isn't sure it focuses on the right parts. "I think some people don't like the current structure because they feel like [wealthy taxpayers] are the only ones not paying taxes -- the rich don't get taxed -- and that is what I like about this proposal; it appears to attempt to equalize, particularly with taxing capital gains and ordinary income at the same rates."
U.S. Consumption Tax History
Much of the pessimism surrounding Cardin's bill comes from the consumption tax's history in the U.S. The story begins with Rep. Al Ullman's consumption tax bill from the late 1970s and the subsequent loss of his seat in the 1980 election. Ullman's efforts, however, were not the end of political attempts to drive the consumption tax debate, as Democrats and Republicans alike have since attempted to enact one.
In the 1990s, Republican Rep. Bill Archer, former House Ways and Means Committee chair, supported tax reform that would replace the income tax with a consumption tax. And in 1996, a group of Republican Congress members introduced the National Retail Sales Tax Act of 1996, which would have scrapped the income tax and replaced it with a 15 percent sales tax. Rep. W.J. "Billy" Tauzin, one of the bill's cosponsors, called on tax reform advocates to start "a second Boston Tea Party to protest our sovereign who unfairly taxes its citizens," while dismissing the notion of a flat tax.
An alternative plan, the Revenue Restructuring Act of 1996, was offered by Democratic Rep. Sam Gibbons, also a former Ways and Means chair. The plan would retain the rudiments of an income tax system to give refunds to the poor and impose a surtax on the rich. His plan was very broad, like Cardin's.
On January 7, 2005, President Bush announced the establishment of a bipartisan panel to advise on options to reform the tax code, and after considering a VAT, the panel did not recommend it. It did, however, recommend a plan to move toward a consumption tax base, dubbed the Growth and Investment Tax option.
And in yet another blow to establishing a VAT in the U.S., the Senate in 2010 approved an attached amendment to the Continuing Extension Act of 2010 that said "it is the sense of the Senate that the Value Added Tax is a massive tax increase that will cripple families on fixed income and only further push back America's economic recovery." The amendment, introduced by Sen. John McCain, R-Ariz., received support from then-Senate Finance Committee Chair Max Baucus on the Senate floor.
Good for Growth? Economists Think So
According to Merrill, the potential growth effects of a revenue-neutral swap of income taxes for consumption taxes are huge. In contrast, the growth effects of revenue-neutral income tax reform are quite modest, he said.
Merrill explained that the growth potential of a consumption tax is significant because taxes on capital, like in an income tax system, reduce investment. If more is invested today, the economy will be larger down the road, leading to greater income and consumption, he said.
"It's about taxing what you take out of the economy versus what you put into it," Merrill said.
An additional benefit is that a consumption tax works better in a global economy than does an income tax because income shifting and transfer pricing among related companies are not issues, Merrill said, adding that a consumption tax system is intended to tax consumption, which occurs where the customers are. "The consumption tax works better in a global economy because the base isn't mobile," he said.
In the U.S. economy, which relies heavily on income from intangibles and the service sector, it is becoming much more difficult to tax income because it is mobile, and that is what the OECD's base erosion and profit-shifting project is trying to address, Merrill said.
Because the U.S. system relies more heavily on income taxes, capital-intensive industries have a harder time competing in the global markets as exporters, Merrill said, which in turn makes the U.S.'s manufacturing sectors less competitive.
Ultimately, the fatal flaw of the corporate income tax in a global economy is the difficulty of determining the taxpayer's residence and the source of income -- two concepts that are not important with the VAT, Merrill said.
The JCT has not yet scored the bill, so questions remain about the real revenue and distributional impact Cardin's bill will have.
Merrill said he hopes that the JCT provides a dynamic score for the bill so that people can understand the growth potential and that by shifting the tax mix to consumption and away from income, the U.S. could promote economic growth more than through a revenue-neutral reform within the income tax system.
When evaluating a major change to a tax system, Carroll explained, it is important to think about certain central issues: Does it result in a system that is simpler? What are its distributional effects? And how does it affect economic growth?
"Generally consumption tax proposals score very high for economic growth but do not score as high on distributional impacts and sometimes not as high on their simplicity effects," Carroll said.
A complete replacement of the income tax tends to score much higher on the economic growth side than an add-on or partial replacement of the income tax, Carroll said. A VAT tends not to tax the economically important portion of a return of capital relative to an income tax, and because of that feature, it tends to result in higher long-term growth than an income tax.
"But when you are talking about a partial replacement, the details matter quite a lot," Carroll said.
"Another important point is that economists' general interest is really focused on broad-based value-added taxes," Carroll said, adding that most global economies that have narrow VATs have less desirable economic efficiencies.
In 2010 Graetz drafted a VAT proposal similar to Cardin's, including the prebate system and the same family allowances. In 2012 the Pew Charitable Trusts conducted a distributional analysis of Graetz's plan for the 2015 tax year. In its analysis, Pew found that the tax burdens remained relatively unchanged under Graetz's proposal. Also, Graetz's plan, which had a 12.3 percent VAT, would lower revenue for state and local governments while slightly raising revenue for the federal government.
The analysis also showed that Graetz's proposal would decrease the number of income tax filers to 36 million, a reduction of 111 million from CBO estimates of filers under the current system for the 2015 tax year.
"So it does two things, it puts the IRS back in a position where it is able to do its job, which it can't do now, and it frees most Americans from ever having to think about taxes -- it's out of their lives," Graetz said of his proposal.
Cardin's bill would tax healthcare, education, and government purchases, which is a tax on states by the federal government and the federal government on itself. "If it is revenue neutral, the thought is that you can tax yourself to finance yourself," Buckley said, adding, "I'm not sure any country would have one that broad."
Buckley explained that a problem with proposals such as Cardin's is that to make it progressive, the rebate system will need to be more significant, if not broader than, the current income tax system.
Financial Supplies Exemption System
The Cardin bill would exempt from consumption tax any financial supplies, which it defines as "the provision, acquisition, or disposal of any of the following: a bank account, a debit or credit arrangement, a mortgage, a superannuation fund, an annuity, insurance, a financial guarantee, an indemnity, currency, securities, or derivatives."
According to a Cardin aide, the definition of financial supplies generally follows Australia's regulations. Goods and services taxes vary regarding how broad their definitions of financial supplies are, and Cardin wanted to take the narrower route until he was able to get feedback from the U.S. financial services industry, the aide said.
Cardin had considered adding other financial supplies rules, such as a reduced input tax credit and a financial acquisition threshold, the aide said.
"The bill doesn't have much of a definition of financial supplies," Merrill said. "This is an area that needs more work and they know it needs more work."
Merrill explained that many financial services companies prefer to be taxable under a VAT because to the extent they are dealing with business customers, they could pay more tax under an exemption system -- due to unrecoverable input taxes -- than if they were fully taxable under a VAT. In an exemption system, the financial services company won't charge its customers, but it isn't getting an input credit, so there is more tax in the system when they are exempt.
The exemption system is widely used, not necessarily because it is popular with financial services companies, but because it is difficult to figure out how to include financial services in a consumption tax system, Merrill said.
"No country has figured out how to tax financial products and there is no reason to believe ours would be more successful," Buckley said.
Zero rating solves the problem of the noncreditable income tax, and there are several countries that have a partial input credit.
Merrill explained that the logic for the partial VAT input credit is that if a taxpayer doesn't get a credit on the supplies, then it may self-supply. For example, instead of going to a law firm, a VAT-exempt taxpayer might use an in-house attorney so it isn't losing the input credits. So to reduce the incentive for vertical integration, or self-supplying, a few countries have put in a partial input VAT credit, he said.
Graetz explained that Europe has been concerned with its taxation of financial institutions. A system that exempts financial institutions, he said, is not the ideal method because it overtaxes financial institutions whose business is mostly with other businesses and undertaxes financial institutions whose business is mostly with consumers.
In a joint PwC report on global tax compliance, the firm found that businesses spend the most resources complying with the consumption tax compared with other forms of taxation.
Credit invoice method VATs, like the one Cardin proposes, are usually viewed as having reasonable compliance, but it depends on the details of the VAT, Carroll said. A broad-based VAT with a single rate and few exemptions will tend to have better administrative and compliance attributes than a VAT with a narrow base, multiple rates, and many exemptions, he said.
While compliance can be reasonably high with a VAT, the U.S. income tax has some elements, including rigorous information reporting, that contribute to extraordinarily high compliance rates.
One compliance concern with a VAT, Merrill explained, is carousel fraud, which the EU is facing. Carousel fraud occurs when businesses collect VAT on sales, don't remit it to the government, and then go out of business. Merrill said that the problem is exacerbated in the EU because between member states, businesses can import inputs without incurring VAT, so they don't need to file for a credit.
In the Cardin proposal, however, the use of credit invoices should raise compliance, Merrill said. The invoices provide a paper trail for VAT received and paid, as opposed to businesses calculating the tax as a percentage of the difference between their income and money spent.
What About the Aging Population?
Buckley warned that although Cardin doesn't add anyone to the tax system, many -- including a growing elderly population -- are left out to their own disadvantage.
Low- and middle-income elderly people who pay little to no income tax will not likely get a rebate in the new system. This problem would be exacerbated because older individuals are likely to be living off their savings -- their consumption is greater than their income.
"The exemption from the income tax is worth something only if you are subject to the income tax," Buckley said.
Cardin has focused his rebate on those with wage income or children, and if a taxpayer has $5,000 of investment income, she is ineligible for the rebate completely. Cardin chose the $5,000 figure based on AARP data compiled in 2012 that showed the median interest, dividend, and rental income for Americans over 65 in the highest income quintile at $3,454.
"You have a really difficult job when you construct something like this," Buckley said. "You either really address the regressive nature of a consumption tax and give everybody rebates -- that means there is no simplification, there would be more people in the tax system than there would normally be. Or you do what Cardin did and have a narrow rebate system; those in the system are already in it."
For a large group of Americans -- low- and middle-income retired people -- this would be an enormous tax increase, Buckley said. Working families with children, however, will likely stay where they are, he said.
The Social Security and Medicare Boards of Trustees, in a summary of their 2014 annual reports, said that Social Security costs in 2007 equaled 4.1 percent of GDP and projected that those costs will increase to 6.2 percent of GDP by 2037. (Reports: http://www.ssa.gov/oact/trsum/.)
The trustees also predicted that the annual cash flow deficit of the program will average about $77 billion for each year from 2014 to 2018. After 2019, Treasury will redeem trust fund asset reserves to the extent that program cost exceeds tax revenue and interest earnings until the depletion of combined trust fund reserves in 2033, the same year projected in last year's trustees report. Thereafter, tax income would be sufficient to pay about 75 percent of the scheduled benefits through the end of the projection period in 2088.
Medicare faces a similar fate.
Merrill said that he thinks that by using the current income tax system, fixing the entitlement shortfall will make the U.S. system even more uncompetitive and that putting in a more competitive tax structure today will allow the U.S. in the long term to address the fiscal imbalances in a way that is less harmful to growth.
"I think it's great we are putting it in now and having a dialogue now and it's something we will need to talk about as a country for quite a few years before [a VAT bill] gets over the finish line," Merrill said.
Avi-Yonah said he thinks the U.S. needs a system that uses the VAT as an add-on and that "the important question is 'what do we use the money for if we have one?'"
Avi-Yonah suggested using it for something that makes a difference in people's lives, like healthcare or education. He said that placing the money toward a program could move the discussion beyond focusing on things like rate structures and tax bases.
"We have long-term budget structure problems, and in my perspective inequality problems, and I think taxes can do something to address it if they are structured in the right way," Avi-Yonah said.
"I think ultimately we are going to have a consumption tax to finance our Social Security and Medicare systems," Buckley said. "We are going to need more revenues; it could be a carbon tax, but it will be a tax on consumption."
Whether Cardin's proposal is a first step toward what some are calling the inevitable remains to be seen.