Tax Analysts Blog

Why a VAT Is a Poor Substitute for a Corporate Tax

Posted on Apr 17, 2017

As the House Republican blueprint's destination-based cash flow tax comes under increasing attack from retailers and opponents, the GOP and other would-be tax reformers are looking at other options. And it probably shouldn't be shocking that a federal VAT is among the choices to potentially replace the corporate tax in any major tax reform effort.

European revenue agencies and politicians are probably wondering what took so long. After all, many EU nations have been slowly but steadily cutting their corporate rates and slashing their corporate tax base while at the same time raising their VATs. Heavy consumption taxation has long been a hallmark of tax regimes overseas, and even longtime holdouts such as Japan and the United Kingdom have gotten on board in the last decade or so. 

The United States has always been reluctant to adopt this aspect of European tax systems. Republicans have long objected because they blame the VAT for the high tax rates across the Atlantic, while Democrats are skeptical of the regressive nature of the VAT. In 2010 the Senate famously voted 85 to 13 to condemn VATs when one was suggested by Paul Volcker's tax reform commission. 

 However, a VAT has been gaining steam lately. Maryland Democratic Sen. Ben Cardin proposed one in 2015, and Republican taxwriter Jim Renacci of Ohio followed suit in 2016. Renacci's plan would replace the corporate tax with a 7 percent VAT. Cardin would lower individual and corporate rates and replace the lost revenues with a VAT, but wouldn't end the corporate tax.

 Republicans want to basically do away with the corporate tax. That is the goal of the House GOP blueprint and the destination-based cash flow tax. The corporate rate would drop precipitously, the United States would change from a worldwide to a territorial system, and businesses would be allowed full expensing. The cost of these changes would be offset by the 20 percent rate on imports, which has been projected to raise about $1 trillion over 10 years.

The Republicans need that revenue to deliver the tax cut they (and President Trump) have been promising. So as support for the cash flow tax falls apart, some GOP taxwriters have revived discussions of alternatives. And that has included Renacci's VAT. But replacing the corporate tax with a VAT, or even partially offsetting lost corporate tax revenues with any kind of consumption tax (including the cash flow tax on imports), is a very bad idea.

Regardless of where you stand on the debate over how much of the corporate tax falls on labor, it's hard to argue that some (likely most all) falls on capital. The corporate tax affects stockholders in the form of higher taxes on dividends. A functional corporate tax, in fact, is second only to capital gains taxes as a means to raise revenue from the investor class and capital holders. That makes it quite progressive.

 A VAT, no matter how you look at it, is extremely regressive. It falls on consumption -- meaning that it hits workers and consumers much harder than the corporate tax. There are ways to design an overall tax and spending system that ameliorates this regressivity (most European nations have elaborate social safety nets), but it is extremely unlikely that Trump and GOP lawmakers would pair a consumption tax with higher social spending. In fact, that's probably the least likely outcome of any legislation from a Republican Congress. 

That means that if Republicans used a VAT to cut corporate tax rates, they would be replacing taxes on capital with taxes on consumption. In other words, this kind of tax reform would exacerbate income inequality and be a massive giveaway to multinationals and other large corporations. 

Taxpayers who are skeptical of  higher prices under a destination-based cash flow tax should be angrier about the effects of a VAT. Simply put, a VAT is an even worse idea than the House blueprint, barring a massive change in how the government chooses to spend its money.

Read Comments (5)

Mike55Apr 18, 2017

Thought provoking article to be sure. I've got to ask you though: if your primary goal is to reduce income inequality, then wouldn't trading the corporate income tax for a VAT be a classic "lose the battle, but win the war" scenario from your perspective?

There are two ways the U.S. could meaningfully reduce income inequality, assuming for the sake of argument that's a logical goal: (1) convert a large chunk of the existing age tested federal spending into means tested federal spending; or (2) significantly increase the total amount of federal tax collected using a VAT.* That's the whole universe: all other purported solutions are either misleading rhetoric or unproven/wishful thinking.

Given that option (1) isn't happening anytime soon, I'd have thought that a concrete step towards option (2) would be viewed as a welcome development (or at the very least the best of several bad options currently faced). When the pendulum eventually swings back the other way -- as it always does in U.S. politics -- all that would be left to do is start increasing the VAT rate. Seems like a long-term win, albeit with a short-term price.

*Increasing the total size of a transfer system more than swamps any negative inequality impact associated with implementing a VAT.

Bob GoulderApr 21, 2017

Well said, Jeremy, although I'm much more sympathetic to a VAT than you are.

As you've noted, VAT is regressive. For many people that's a valid reason to oppose it. Yet, as a society we collectively tolerate many other forms of regressive taxation without strenuous objection. 45 of the 50 states impose retail sales taxes, and they're regressive. Presumably RSTs are equally regressive as VAT because both tax consumption. (RSTs have a narrower base because they typically exclude services, but I don't believe that renders them less regressive than VAT.) The typical sin tax is also regressive (e.g., tobacco taxes and booze taxes). It seems municipalities across the country are quick to hike up sin taxes whenever they're forced to squeeze more tax revenue from the local economy - notwithstanding that less regressive options are widely available. Gasoline taxes are regressive. If we were truly serious about stamping out regressive things the first item to go would be the lottery ... (although voluntary, it economically resembles a tax on people who are extremely bad a math). For that matter, payroll taxes are regressive. Some of them we even phase out for rich folks. Yet, they've proven politically durable over many decades - mostly because taxpayers are aware they're get something back in return (e.g., social security benefits). There's a direct linkage between one's payroll tax contribution and the promise of future entitlement - assuming one lives long enough to qualify for those programs.

In fairness, it could be argued that taxpayers also get something back any time they pay a tax, but for things other than payroll taxes the linkage to benefits is far less obvious. The linkage might well be completely overlooked because the things our taxes "purchase" are of such a general nature we lose awareness of the connection. I'd argue that just because we often fail to perceive the linkage between taxes and benefits doesn't mean it's not there. If we accept this application of the benefits principle, then all the same arguments you've raised against VAT might also apply to these other regressive taxes I've mentioned above.

I will leave you with this hypothetical scenario, below, and await your reply when time permits:

Let's assume the Ben Cardin VAT plan is passed by Congress and signed into law by the President. For those unfamiliar with the Cardin bill, it's basically the Michael Graetz plan with a few minor tweaks. But let's add one caveat.

All the proceeds from the newly imposed VAT would be dedicated exclusively to two spending programs: (1) A universal-coverage health care revision. For purposes of argument, lets say Medicare for all, cradle to grave, without age limits. This implies you could repeal ACA and all it's related taxes, and also repeal the current payroll tax for Medicare, as they'd all become unnecessary; and (2) Free tuition for all qualifying students (high school, college, or grad school) who can pass the applicable entrance exam. No restrictions based on the parent's income.

In short, a regressive tax coupled with progressive spending programs. Would that address your objections to VAT? And if so, does it follow that your opposition to VAT is less about taxing consumption and more about how the revenue gets spent?

Cheers

williegApr 25, 2017

A VAT increases taxes on importers and decreases taxes on exporters in a way that is constitutionally and WTO sound (unlike a BAT). Our current system puts all US companies at a major trade disadvantage with their competitors in almost every other country. US export companies pay their VAT, while non-US companies exporting to the US don't pay the higher US income taxes. A VAT increases the corporate tax base by reaching importers who do not pay corporate income tax and lowers rates, making the US more competitive. A VAT and lower rates will instantly make the US more competitive and lift our economy. I agree we should fix the regressive nature of the tax to the extent we can, but the fact is every major country in the world has a VAT, and we are shooting ourselves in the foot by not having one.

Travis RechApr 26, 2017

What indication do we have that US companies aren't competitive? Margins and profits are at record highs. I'm not sure where the idea that American companies are being taxed out of competitiveness. If the current corporate profits are what uncompetitive businesses look like, the rest of the world is doomed should we make them more competitive!

lawrence e stirtzApr 26, 2017

Do not be so quick to assume away the income tax as a capital tax. First the argument is stronger for corporate income taxes but those are a minor portion of the income tax today. It is hard to argue that the income tax is a tax on capital for an individual. I suppose you could reach back for some of the basics in the philosophical discussion of freedom by extension to labor being a form of capital but I think it is far less abstract than that.

If the two taxes are balanced to arrive at the right mix of consumption and income for whatever times you are in it may serve to better balance equality at any given time.

Finally you have what is a very strong reason in my opinion that we are out of step with the rest of the world.

Lets get serious and unstuck from our fear of th Nash Equilibrium.

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