Tax Analysts Blog

Renacci’s VAT: The Shape of Things to Come

Posted on Aug 2, 2016

People often ask me the same question: When will Congress get serious about fundamental tax reform? My response is predictable You’ll know that we’re making genuine progress when lawmakers get over their knee-jerk opposition to discussing a broad-based federal consumption tax. 

There are a few signs from Washington that attitudes toward VAT are evolving, albeit at a glacial pace. In July Rep. James B. Renacci, R-Ohio, introduced a tax reform proposal that might be a harbinger of things to come. He calls it the "Simplify America’s Tax System" plan, or SATS. You can read the press release here and the accompanying white paper here

Renacci’s stated goal is to develop a federal tax system that would be “the most competitive in the world” and to do so without adding to the deficit. That’s no simple task. He was also mindful not to step on the toes of his fellow Republicans, especially House Speaker Paul D. Ryan, R-Wis., who recently unveiled a GOP blueprint for pro-growth tax reform. You can read that document here.

The GOP blueprint is useful in documenting the problems of the current tax code, but it suffers from one glaring conceptual oddity. It proclaims the virtues of consumption taxation but flatly declines to consider a VAT. 

The blueprint proposes converting the corporate tax into a border-adjusted cash flow tax, under which U.S. exports would be tax exempt. That’s a blatant export subsidy that violates our WTO obligations. Everyone knows this. Did Ryan and company learn nothing from our nation’s failed experiments with the DISC, FSC, and ETI tax regimes? It’s as if every decade or so Congress feels compelled to replicate the border adjustment available under VAT, but without the VAT. It never works, and it won’t work this time. (Note to the drafters of the blueprint: The apocryphal tale has Einstein once remarking that the definition of insanity is trying the same thing over and over again and expecting a different outcome.)

That’s where the GOP now finds itself -- trying to sell the American public on the virtues of a consumption tax base while refusing to actually talk about VAT. Renacci suffers from no such hesitation. Bravo for that. We appreciate intellectual honesty where we can find it. He openly describes his plan as a VAT -- and not some half-baked variation on a subtraction-method VAT. No, this is full-bodied credit-invoice VAT.

Does this mean Renacci has gone lefty on us? Hardly.  His plan is vigorously pro-growth. He uses the VAT to repeal the corporate income tax in its entirety. He also lowers individual income tax rates for all segments of the population. And yes, the VAT includes a border adjustment. Remember, this is the same kind of VAT used in more than 150 nations around the world. WTO compliance is not a concern here. That should be music to corporate America’s ears.

If you’re keeping score, all this means that there are now two tax proposals in Congress premised on a credit-invoice VAT. Perhaps that's not a groundswell of support, but it’s a start. The other VAT proposal is offered by Sen. Benjamin L. Cardin, D-Md. The details of Cardin’s and Renacci’s plans are different, but what unifies them is an understanding that traditional 1986-style tax reform is so thoroughly impractical that we should stop wasting people’s time by continuing to talk about it as a thing that could happen in 2016. 

The Details: What VAT Buys You  

The key features of Renacci’s tax proposal are summarized below, interspersed with my personal commentary.

• SATS would repeal the corporate income tax in full. 

This is big-picture stuff. Cardin’s VAT would lower the corporate rate to 17 percent, but Renacci goes Full Monty. The economic incentives to invert would be reversed. Earnings stripping and transfer pricing, as we know them, would cease to exist. The U.S. economy would become poacher instead of prey. We’d observe some loss shifting as multinationals seek to push offsets to other jurisdictions that still impose a corporate tax, but who cares -- there would be no cost to the fisc. That type of transfer pricing we can live with.   

• Passthrough entities could elect to be treated as C corporations.

Could partnerships, LLCs, and S corporations benefit from the elimination of the corporate tax? You betcha. This turns the check-the-box election on its head. Under SATS, a business would likely want to be a C corp in order to avail itself of nontaxation -- and to avoid the partnership tax regime, which would remain on the books. Either way, you don’t have taxation at the entity level. 

• In place of the corporate tax, SATS would impose a single-rate VAT of 7 percent. 

Most countries have a dual-rate VAT, in which a steeply discounted rate applies to necessities like clothing, books, and food. In theory this is done to help the poor. Never mind that affluent families also feed and clothe their offspring. Although well intended, the dual rates lead to practical difficulties. I prefer a single-rate VAT because it would significantly simplify the enforcement burden that falls on the business sector. Merchants would not need to guess which rate applies to a particular purchase. There would be less pressure to game the system by fudging what constitutes a necessity, and there are better means of addressing the regressive nature of a VAT.

• The VAT would be destination based. 

This is a key design element of any modern VAT. We’d have border adjustments. Our exports would be relieved of domestic VAT -- in the form of a rebate -- because they’d pick up the VAT of the country where consumption occurs. Likewise, imports from other countries would pick up the domestic VAT charge. This would eliminate the perceived competitive advantage enjoyed by manufacturers located in jurisdictions that already impose VAT. Three cheers for neutrality.

• The VAT would include an automatic revenue “circuit breaker.” 

This would guard against unintended increases in VAT receipts in the future. It would respond to fears – mostly among conservatives -- that VAT is too good at raising revenue and inevitably leads to unrestricted growth of the public sector. This is how we would derive the benefits from a broad-based consumption tax without becoming a European social welfare state. If Democrats object, remind them the idea came from Cardin and features prominently in his tax reform bill. Note to my progressive friends: VAT legislation will never go anywhere in America without this circuit breaker or something else that serves the same purpose.

• Individual income taxes would be reduced for all taxpayers. 

This would be accomplished by expanding exemptions and reducing marginal rates. SATS provides for a $5,000 personal exemption and a $15,000 standard deduction per filer. As a result, a family of four would see no tax liability on their first $50,000 of income. In other words, a larger segment of the population would pay no income tax. That might bother those who want everyone to have “skin in the game.” Those people need to chill out. Under SATS, everyone in the country would pay VAT so there would be an abundance of skin in the game.

• The seven income brackets would be condensed into three, with rates of 10, 25, and 35 percent. 

I’m not hung up on the number of income brackets. Yes, the tax code is appallingly complex, but I don’t believe the existence of multiple brackets is the source of that complexity. That said, many conservatives want to collapse the current structure. SATS does just that. The 10 percent bracket would cover taxable income up to $50,000 for single filers ($100,000 for joint filers). The 25 percent bracket would extend to taxable incomes of $750,000 ($1.5 million for joint filers). The 35 percent bracket would kick in for higher incomes. Roughly 99 percent of the country would be covered by the 10 and 25 percent brackets -- not exactly a flat tax, but decidedly flatter than what we have now.

• There would be no change in the current preferences for retirement savings, education, and employer-provided health insurance.

Don’t mess with sacred cows if you don’t have to.

• All itemized deductions would be eliminated, except for charitable donations and mortgage interest expense. The latter would be restricted to $500,000 of acquisition indebtedness. 

Ditto above regarding sacred cows. It's interesting that Renacci doesn’t include the itemized deduction for state and local taxes. That’s a significant base broadener and one sure to raise objections from Democrats. As a general matter, we can expect fewer households to itemize because of the expanded standard deduction.

• The child tax credit would be retained in its current form. The earned income tax credit would be expanded 100 percent for childless workers and 40 percent for all others. 

Yes, these are social benefit programs administered through the tax code, but they generally enjoy bipartisan support. The EITC is not welfare; one must have a job to realize any benefit from it. Expanding these programs would help mitigate the regressive aspects of VAT. It will be difficult to get buy-in from Democrats without such an expansion.

• Capital gains and dividends would be treated as ordinary income. 

The case for preferential treatment of dividends and capital gains goes away with the elimination of the corporate income tax. Besides, having a single category of income is a good thing. There would be much less gaming the system by disguising ordinary income as something that it’s not. This is the ideal way to eliminate the carried interest problem. 

• The Alternate Minimum Tax would be repealed. 

The AMT work sheet is an affront to human dignity. I don’t like the concept of giving everyone a tax break and then clawing it right back. The fewer "work sheets" in the tax code, the better off we are.

The Ultimate Pay-For

Let’s back up. Why do I think "serious" tax reform necessarily involves a broad-based consumption tax? Look no further than the unfortunate fate of the proposal from then-House Ways and Means Committee Chair Dave Camp. 
Readers may recall that I was a fan of Camp’s tax plan when it was launched a few years ago. There was much to admire. It adhered to the time-tested formula for tax reform: (i) broaden the tax base, and (ii) reduce marginal tax rates. The plan was also fiscally responsible. It was revenue neutral and distributionally neutral. By lowering the corporate rate from 35 percent to 25 percent, it attempted to bolster U.S. competitiveness (that 25 percent rate being roughly the average among OECD member states).

However, Camp’s tax reform plan suffered from one fatal flaw. It relied on base broadeners from within the income tax to finance the rate reductions, and they proved toxic among key stakeholders. 
Camp could have selected different revenue raisers, and nothing would have changed. The point is that powerful political forces will fight like hell to protect those tax expenditures that favor their interests. Mind you, Camp’s rate reductions weren’t that ambitious. He was merely trying to squeeze the statutory rate down to the OECD average. Just imagine how painful the pay-fors would have been if he’d tried to cut the rate down to the lower tiers of the OECD range? 

The lesson for future tax reformers was crystal clear. You can’t get there from here. There’s simply no way to get the corporate rate down to an internationally competitive level by relying exclusively on pay-fors from within the income tax. The revenue raisers must come from outside the income tax, thus the critical need for an alternate revenue source. 

This might be a novel concept for Americans, but other governments figured it out a long time ago. Globally speaking, the dominant fiscal trend of the last 35 years has been the gradual shift of the collective tax burden away from capital income in favor of consumption. Sure, there are consequences when a government undertakes this transition. But this is what tax reform in the 21st century will look like.

 

Read Comments (4)

Martin SullivanAug 2, 2016

It took Republicans five years to figure out Reagan style tax reform was not for them. It will take them a couple of more years at figure out a destination based business cash-flow tax will not be to their liking either. What they want is exactly what a VAT provides, but they don't know it yet. It will take a few more years. (Members DO need to spend less time fund raising and more time education themselves about these very tough issues.) Cardin's proposals is a good first step. Being a Republican Renacci proves favoring a VAT does not have to be a partisan issue. (Fun Fact: Ryan proposed a VAT in 2010.) I think the usual skeptical "not-in-my-lifetime" predictions about a U.S. VAT may be wearing thin, especially since 2016 will shake up the border between country-club pro-business Republicans (who will tell you privately they favor a VAT) and more social conservative Republicans (whose objections to a VAT seem to have little to do with good tax policy). If after the election moderate in both parties can assert themselves we could be on our way. That, of course, is a big "if".

Bob GoulderAug 3, 2016

Full confession: I get goosebumps when someone as brilliant as Marty Sullivan comments on my humble blog posts.

Here's a hypothetical for us to ponder: What would happen if both the US Chamber of Commerce and the Club for Growth came out tomorrow and threw their full support behind Renacci's replacement VAT? Here's what I think would happen ... the level of policy discourse in Washington (and hopefully across the nation) would be greatly elevated. And we'd have a thorough debate about who actually bears the burden of the corporate income tax.

As a side note, imagine what the Renacci plan would do for the IRS in terms of resource management. They might actually be able to answer taxpayers' phone calls.

Martin SullivanAug 3, 2016

Allow me to quote from two great tax expert who like you Bob are in engaged in the thankless task of advocating value-added taxation:
Hank Gutman (forthcoming): "Educated members of the business community know that their ultimate reform goals cannot be achieved without a new revenue source and that the VAT is the answer . . . .It is time for them to speak up."
Michael Graetz (2008): " .. . . any successful effort to implement a [VAT]. . . must include as part of its effort the education of Congress and the business community to the overall advantages of eliminating the income tax for most Americans, lowering both individual and corporate taxes, and instituting a tax on goods and services."

Mike55Aug 4, 2016

The lesson to be taken from the Camp fiasco is that there is no free lunch in revenue neutral corporate tax reform. You've got to pick winners and losers, then hope the winners have better lobbyists. Camp mistakenly believed he could make everyone happy by using temporary cash tax increases to pay for permanent tax decreases. He quickly discovered companies aren't willing to wait 10 years to break-even on the cash tax side no matter how large the carrot being offered in years 11 forward.

As for the VAT: I personally like the idea proposed here, but don't view it as realistic. As the well-worn saying goes, "in politics, if you're explaining you're losing." A credit invoice style VAT would require an awful lot of explaining. If you can't effectively counter the inevitable "you're selling out individuals to help Fat Cat corporations" accusation in under 10 words, your VAT is DOA. Despite the hopes of Gutman, Graetz and the like, businesses are in no better position to meet this challenge than anyone else.

Republicans are focused on a more complicated approach to consumption based tax, because they hope to flip the explanation burden to the opposing side (who would first need to explain the proposal is actually a VAT in 10 words or less before diving into their anti-VAT rhetoric). Remember Rubio's unsuccessful attempts to explain the Cruz plan was actually a VAT during the debates? If so, you'll understand what it is the Republicans are hoping to achieve here. It might not be perfect, but a decent plan that you can sell is superior to the perfect plan that you can't.

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