Tax Analysts Blog

Tax Reform on Steroids: A Progressive VAT to Appease Conservatives?

Posted on Dec 19, 2014

You've heard it a thousand times: The United States has the highest statutory corporate tax rate in the world. No surprise, then, that everybody wants to lower it.

President Obama's framework for business tax reform would reduce the corporate rate from 35 percent to 28 percent. Departing House Ways & Means Committee Chair Dave Camp, R-Michigan, does Obama one better, offering a plan that cuts the rate to 25 percent.

Both Obama and Camp cite "global competitiveness" as the principal justification for their reforms. Yet neither proposal is especially competitive by international standards. The average corporate rate among OECD nations is 24 percent. If tax reform is worth doing, why not aim high?

Earlier this month Sen. Ben Cardin, D-Maryland, introduced tax reform legislation that is decidedly different -- and sure to provoke strong reactions from stakeholders. His bill, the Progressive Consumption Tax (PCT) Act of 2014, attempts the unthinkable. It would slash the corporate rate to 17 percent without adding to the deficit or altering the distributional profile of our current tax system. Spoiler alert: Cardin pays for the impressive rate reduction with a broad-based federal consumption tax. Make no mistake -- this is a VAT.

The details of the PCT Act sound vaguely familiar. That's because the bill bears a strong resemblance to ideas proposed by professor Michael Graetz in his book, 100 Million Unnecessary Returns: A Simple, Fair, Competitive Tax Plan for the United States. The crux of both the PCT Act and the Graetz plan is that a VAT would generate enough revenue to sharply reduce the corporate rate and radically alter the individual income tax by exempting most American households. The change would be dramatic and transformative. This is big-picture stuff.

Here are a few salient discussion points.

Corporations: As mentioned, the PCT Act would reduce the corporate rate by more than half, from 35 percent to 17 percent, and America would enjoy one of the most competitive tax environments in the world. Our corporate tax rate would be well below that of trade partners like Japan (35 percent), Germany (29 percent), and the United Kingdom (21 percent), and it would match the rates in Singapore and Taiwan.

Given the rate differentials, the PCT Act would have major implications for transfer pricing and earnings stripping. Since it would be considered a low-tax country, the United States might become a favorite destination for foreign profits shifted away from high-tax source countries. This would be a bizarre reversal of the prevailing behavioral incentives. We could become the poacher rather than being preyed upon. Our tax code would attract, not repel.

Single Rate: The PCT would apply at a single rate. Unlike European VATs, there would be no reduced rate for necessities (e.g., medicines, children's clothing, unprepared food). That makes sense. A bifurcated rate structure is not optimal for addressing the regressive aspects of taxing consumption. The existence of multiple rates also greatly complicates compliance. Merchants would face endless confusion about which goods and services qualify for which rates. Roughly half of all VAT litigation in other countries concerns eligibility for reduced rates. A single rate avoids these headaches.

Goods and Services: Like other VAT regimes around the world, the PCT would apply to both goods and services. This is preferable to our retail sales taxes that generally focus on goods. Let's face it -- retail sales taxes are not terribly helpful in the modern service economy. The concept here is that broader is better.

Financial Services: One notable exclusion from the PCT would be the financial sector. This isn’t because Cardin is yielding to pressure from Wall Street. Applying a VAT to banks necessarily involves technical difficulties. European VATs similarly exempt the financial sector. That's because the business model of banks intertwines savings and investment (exempt activities) with the provision of services (taxable activities). For VAT purposes, financial institutions generally prefer inclusion -- with zero rating -- to exemption. This enables them to claim valuable input credits. Interestingly, an explanatory statement from Cardin's office hints at flexibility on this issue and points to the systems in Australia and New Zealand as possible alternatives.

Setting the Rate: As drafted, the PCT rate would preliminarily be set at 10 percent. Cardin acknowledges that it could change depending on how the legislation is scored. The Joint Committee on Taxation has not yet estimated its budgetary effects. A revenue scoring of the Graetz plan by the Tax Policy Center found that a 12.9 percent VAT achieved revenue neutrality. These rates seem high compared with retail sales taxes, but they're low by international VAT standards. The average VAT rate among EU nations is around 20 percent.

Business Inputs: Like most VAT systems around the world, the PCT would operate on a transactional basis. No surprise there. Given the almost universal adoption of the credit invoice method, it would have been highly unusual to opt for the subtraction method. The PCT allows a full credit for business inputs. As many readers know, my biggest gripe with retail sales taxes is that they fail to exclude business inputs and result in cascading. It's been estimated that something like one-third of all retail sales tax charges in the United States relate to business inputs. That's outrageous. Any consumption tax that doesn’t address cascading is deeply flawed. The PCT avoids that problem.

Border Adjustment: The PCT is destination based, rather than origin based. That means the applicable rate is determined by the location of sale rather than the location of production. No remote vender problem here. (That means you, Alibaba.) As a result, U.S. exports would be eligible for a border adjustment. If you think that sounds like an export-contingent tax incentive, you are correct. It's also an export subsidy that's expressly authorized by the WTO. The WTO has rejected Congress's attempts to apply export subsidies through the corporate income tax on many occasions. (Longtime readers may recall the domestic international sales corporation, foreign sales corporation, and extraterritorial income fiascos.) Because the PCT is an indirect tax, the border adjustment is WTO-compliant. Other nations with VATs already benefit from these export subsidies. A decade ago the U.S. trade representative estimated the value of the subsidy, just for the European Union, at $4 trillion per year. An export subsidy of roughly comparable size is implicit in the PCT, leveling the playing field (finally) between domestic firms and foreign rivals.

Progressivity: Everyone knows a VAT is regressive. Consumption taxes, by definition, do not reach personal savings. Because the poor save much less of their earnings, they will inevitably pay more VAT (proportionally) than the wealthy. This is true even though affluent households outspend poorer households and pay more VAT on a gross basis.

The PCT mitigates the regressive nature of a VAT in two ways. First, it includes a "family allowance" that exempts the first $100,000 of income for joint filers ($50,000 for single filers and $75,000 for head of household filers). This would relieve about 90 percent of the American public from any federal income tax liability whatsoever. Second, the PCT offers a rebate to compensate poor families for the loss of income tax benefits (such as the earned income tax credit and the child tax credit) that would be functionally eliminated for households no longer subject to income tax.

Income Tax: What about the remaining 10 percent of Americans with annual earnings in excess of $100,000? They would continue to pay income tax, but only on amounts exceeding the threshold. The PCT proposes three brackets with marginal rates of 15, 25, and 28 percent. That's a significant rate cut for the wealthiest taxpayers, who are now taxed at 39.6 percent. The current tax code is rife with tax expenditures, many of dubious merit. The PCT jettisons all but five : (1) charitable contributions, (2) state and local taxes, (3) home mortgage interest expense, (4) employer-provided healthcare, and (5) retirement benefits.

The Circuit-Breaker: Many conservatives favor the concept of a consumption tax, but oppose it for fear it will lead to an uncontrollable expansion of government. These are reasonable concerns. The PCT addresses them with a "revenue circuit-breaker." If revenues grow too large (as gauged by a numerical target), the surplus cash must be returned to taxpayers. This could take the form of direct refunds mailed out by the IRS, or credits to be applied against the following year's income tax. Several state governments already do something similar. The circuit-breaker is untested at the federal level but would seem to address GOP fears.

The VAT Haters Club: I have no doubt that many in Washington will oppose Cardin's bill. The Ralph Nader crowd surely will, because the PCT, like any VAT system, is regressive. These folks are unlikely to be swayed by measures that preserve our system's overall progressivity. This group also sees little value in reducing the corporate tax rate so dramatically. They don't lose any sleep over the loss of global competitiveness. At the opposite end of the political spectrum, staunch conservatives are just as certain to object to the PCT because they wish to starve the beast. These folks generally buy the sloganeering pitch that "VAT is French for big government." True, they're keenly aware of the international trend to reduce corporate rates. In fact, they frequently trumpet this fact. But they selectively ignore that those same rate reductions are almost uniformly paid for with a broad-based consumption tax. I suspect they will not be calmed by Cardin's revenue circuit breaker.

At the end of the day, a VAT isn't going anywhere in Congress. We understand that. But Cardin's PCT legislation nevertheless makes for some compelling discussion.

Read Comments (9)

david brunoriDec 18, 2014

Robert, the VAT Bastard could not have said it better. I share both liberal and
conservative concerns with a VAT. It is regressive and it is a spigot of
revenue that never shuts off. Neither out come is good.

Cardin tries to address both of these issues. He removes the poor from the
income tax rolls and he offers a rebate. He also taxes services -- a problem
long plaguing the states. Of course, by exempting financial services, the plan
will allow the rich to buy stocks, bonds, etc., and escape tax on such
consumption. He then has a circuit breaker that will return excess revenue to
the people. That would be great. Of course, politicians will try to find ways
to retain all revenue.

You are most correct though. Cardin's plan deserves much discussion. The idea
of exempting the first $100,000 of income from tax is alone compelling.

edmund dantesDec 19, 2014

Pardon my ignorance, but how does VAT apply to home sales? What about private
sales? What about commercial leases? If it applies to services, I take it
that's an immediate 10% increase in health care costs? How does that ripple
through the Obamacare subsidies?

You may think 10% seems like a low rate, but when you add a 6% state sales tax
on top of it, it's not low any more. BTW, would a state sales tax be imposed
on the gross sales price, so there's a 6% sales tax on the 10% VAT?

Just wondering.

Max SawickyDec 19, 2014

Since this thing has not been run through a tax model, how does anyone know
whether it is progressive, distributionally neutral, or what?

Stuart LevineDec 19, 2014

What does the following statement mean: "These folks [identified as the Ralph
Nader crowd]are unlikely to be swayed by measures that preserve our system's
overall progressivity." Is the Cardin bill (i) less progressive, (ii) more
progressive, or (iii) has the same progressivity/regressivity as the current
system? In other words, what are these "measures" and to what extent do they
offset the structural regressivity presented by a VAT?

robert goulderDec 19, 2014

David. Thanks for comments.

On the issue of VAT being a "spigot of revenue." Hear that a lot. Legitimate
concern. VAT Bastard responds as follows:

(1) Taxes are supposed to raise revenue. That's what they do. Like fish swim,
and birds fly. Shouldn't be a criticism that VAT accomplishes what it's
designed to do with efficiency and ease. Inefficiency and dead weight loss are
no virtues -- even w/r/t a tax system.

(2) See Cardin's circuit breaker. Idea could have real traction, even if PCT
doesn't. The more $$$ VAT absorbs from the national flow of commerce, the
greater your refund check. Everyone I know loves receiving a nice big check
from the IRS every spring.

(3) Yes, the political class will always crave more of our $$$ to spend on
self-serving nonsense. But it seems politicians at every level of govt are
under constant pressure not to raise taxes. I don't see how that situation
changes just because we swap revenue source. Plenty of Howard Jarvis' and
Grover's out there to hold people's feet to the fire. We currently have RST in
most (45?) US states. Aren't state legislators under steady pressure to not
raise RST? How that different if federal VAT?

(4) Didn't mention this in the post, but I suspect the real reason US
politicians don't like VAT is because it denies them opportunity to trade
generous tax expenditures for fund raising dollars. There would be no goodies
to dole out. A well designed VAT (single rate) would be essentially devoid of
tax expenditures. Note: I'm not counting the border adjustment as a tax
expenditure because its a fundamental design element of a destination-based
VAT.

(5) I predict you will become a zealous VAT supporter when they design one that
eliminates all forms of excise taxes.

:)

robert goulderDec 19, 2014

Edmund: Thank you for the comments. Outstanding questions.

re: Private Sales
The obligation to charge VAT applies only to registered vendors. A de-minimus
threshold excludes the vast majority of private sales (e.g., you bake a cake
and sell it at a community fundraiser). But if you set up a bakery and sell
lots of cakes, then you look like a commercial merchant and must register as a
vendor for VAT purposes (because your sales volume is no longer de-minimus). In
most countries the de minimus standard is fairly generous.

re: Used Items
The core concept of VAT is that buyer pays it when seller "adds value." If no
value added by seller, then no VAT due from buyer. Accordingly, selling used
items (e.g., you sell your old lawnmower to your neighbor) shouldn't trigger
VAT because it's doubtful the seller added value by using the lawnmower. Quite
the opposite, usage caused depreciation. The item is worth less than when new.
Value was lost, not gained. So sales of used consumer goods won't trigger VAT.

re: Real Estate
Tricky area. Strong case for exemption because raw land is never truly
'consumed' in the economic sense. Somewhat different for improvements to real
estate. Best option to allow (1) annual property tax, and (2) stamp tax/deed
conveyance tax, function as sloppy surrogates for VAT. Thus home re-sales VAT
exempt. New home sales zero-rated because developers entitled to claim input
credits. (Note: zero-rating not same as exemption.)

Also, say you do absolutely nothing to enhance your home's value (no major
renovations) but the price appreciates wildly due to a local housing bubble.
Has the seller truly added anything of value? No, the price escalated due to
market conditions completely unrelated to the holding of the asset. [Note:
Price not necessarily a proxy for value added by vendor.] Strong argument that
owning real estate more closely resembles a type of investment than a form of
consumption. And investments are by definition VAT-exempt. The catch is that
it's an investment you happen to reside in.

re: Retail Sales Taxes
This issue is key. Cardin's bill is silent on the point -- I'm guessing
intentionally so -- but a well designed federal VAT should completely override
and abolish all state & local RST. The two should never co-exist. That said,
states would be perfectly free to tax consumption via piggy-back VAT. They
could add-on their own tax, provided they never deviate from the VAT base.
Bottom line: your concerns are legit. I could see most states tacking on at
least 3% or 4% to a federal VAT to make up for loss of RST. Who knows how much
CA, NY, and MA would tack on? Presumably states heavily reliant on RST funds
would tack on a lot.

Canada: Piggy-backing works reasonably well in Canada. Retailers like the
simplicity of having one set of rules to comply with -- as tax base is uniform
from province to province. Federal VAT (they call it "GST") is 5%; Ontario
tacks on 8% (for net HST of 13%); Nova Scotia tacks on 10% (for net HST of
15%). Oddity of Canadian system is that provincial tack-on far exceeds the
federal component.

re: VAT & Obamacare
Gosh, who knows? I'm pretending to live in a parallel universe where it doesn't
exist. Wish me luck.

robert goulderDec 19, 2014

Stuart: Thanks for the comment. I should clarify.

Cardin intends his VAT to be distributionally neutral. Because the precise
distributional effects are not yet known, he's purposely flexible about various
aspects of the bill. The Senator (to whom I have no connection) introduced PCT
in this Congress simply to stimulate debate and discussion. He will
re-introduce it in the next Congress, perhaps with a few tweaks aimed at
keeping it neutral w/r/t the current system. He's viewed as being fairly
progressive in his mindset, so it's not like he wants to throw the poor under
the bus.

The problem is this. Mathematically it's not enough to simply exempt the poor
from the income taxes (via the "family allowance"). Once you do that, you've
striped away all the benefits the poor were receiving from the Earned Income
Tax Credit (EITC), the Child Tax Credit (CTC), and the Additional Child Tax
Credit (ACTC).

Those are popular anti-poverty measures embedded in the tax code. As I recall,
they were created under Prez Clinton and expanded under Prez Bush.

Removing the poor off the income tax sounds good, but in doing so you've just
set them back economically. That point is counter-intuitive to most people.
Cardin knows it, and had to come up with a VAT mechanism to replicate benefits
for the poor. Thus the PCT rebate, which is specifically designed to mimic the
EITC, CTC, and ACTC.

Despite the PCT family allowance and the PCT rebate, my Nader friends (and I
have plenty of them) refuse to support a VAT. They're seemingly unimpressed by
claims of distributional neutrality. They ain't buying it. When we discuss the
topic, they focus heavily on the fact that VAT is regressive (which it is) but
won't assign any significance to the protections Cardin puts in the bill.

Or perhaps I just lack basic debating skills. Take your pick.

Funny thing. Liberals in Europe adore the VAT, but liberals in the USA hate it.
The contrast is remarkable. Places like Sweden and Denmark (self-described
social welfare states) ... they have the highest VAT rates in the world. They
brag about their VATS, and point out all the public services it pays for. Oh
well. Different cultures, different outlooks.

Thanks much for reading.

robert goulderDec 19, 2014

Max. We don't know yet. The state goal is distributional neutrality. To get
there Cardin might need to tweak a few things. Will know more once it's scored,
etc.

Thanks for your comment, and thanks for reading.

edmund dantesDec 21, 2014

thanks very much for the excellent clarifications!

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