Vat tu, Barack?

monopoly empty pocketsYesterday’s Washington Post featured an article proclaiming “Once Considered Unthinkable, U.S. Sales Tax Gets Fresh Look”.

With budget deficits soaring and President Obama pushing a trillion-dollar-plus expansion of health coverage, some Washington policymakers are taking a fresh look at a money-making idea long considered politically taboo: a national sales tax.

Common around the world, including in Europe, such a tax — called a value-added tax, or VAT — has not been seriously considered in the United States. But advocates say few other options can generate the kind of money the nation will need to avert fiscal calamity.

At a White House conference earlier this year on the government’s budget problems, a roomful of tax experts pleaded with Treasury Secretary Timothy F. Geithner to consider a VAT. A recent flurry of books and papers on the subject is attracting genuine, if furtive, interest in Congress. And last month, after wrestling with the White House over the massive deficits projected under Obama’s policies, the chairman of the Senate Budget Committee declared that a VAT should be part of the debate.

“There is a growing awareness of the need for fundamental tax reform,” Sen. Kent Conrad (D-N.D.) said in an interview. “I think a VAT and a high-end income tax have got to be on the table.”

A VAT is a tax on the transfer of goods and services that ultimately is borne by the consumer. Highly visible, it would increase the cost of just about everything, from a carton of eggs to a visit with a lawyer. It is also hugely regressive, falling heavily on the poor. But VAT advocates say those negatives could be offset by using the proceeds to pay for health care for every American — a tangible benefit that would be highly valuable to low-income families.

Liberals dispute that notion. “You could pay for it regressively and have people at the bottom come out better off — maybe. Or you could pay for it progressively and they’d come out a lot better off,” said Bob McIntyre, director of the nonprofit Citizens for Tax Justice, which has a health financing plan that targets corporations and the rich.

A White House official said a VAT is “unlikely to be in the mix” as a means to pay for health-care reform. “While we do not want to rule any credible idea in or out as we discuss the way forward with Congress, the VAT tax, in particular, is popular with academics but highly controversial with policymakers,” said Kenneth Baer, a spokesman for White House Budget Director Peter Orszag.

monopoly smoke ringsOur Canandian Cousins already have some experience with this (GST) as well as many European Countries.  There is actually a big difference between a Value Added Tax (VAT) and a National Sales Taxes.  The difference is based on if the tax is levied at the point of sale (a tax on final goods and services) or a tax on goods and service in process.  A VAT is a consumption tax that is levied on what is called a “value added” portion of the final price of the good and service.  Take for example an automobile.  It has many component parts, raw materials, and steps in the production and sales process.  It starts out as the raw materials underlying steel, plastics, and rubber.  Those raw materials go into a process that makes them fit to be turned into components.  Those components are then assembled into a car.  The car then is sent to a dealer network where it is sold at a retail price.  The end retail price reflects each of the incremental steps that ‘add value’ to the car.   So, when you buy a new car, the price reflects the production of the tires, the panels, the battery, and all those things and processes that have put it together.  A  basic sales taxes taxes the entire set of processes because it’s focused on the end price of the car.  A VAT may actually leave some of the components or intermediate steps untaxed.  So, it’s completely possible to leave a tax off of the steel industry’s component while hitting the dealer’s value added harder than say the assembly step.

One of the most important things that we teach in basic economics classes is that there is more that meets the eye on who pays the tax.  There is the entity that has the legal responsibility to pay the tax.  In most cases, sales taxes are paid to governments by the retailer.  A VAT can be a nightmare to administer and track because of which step is taxed and which may not be taxed.  An equally important issue is who gets the burden of the tax.  However, the burden of WHO pays the tax depends on how sensitive the buyer and the seller of that good or service is to price changes in that good or service.  This is the dread concept of price elasticity and is the bane of almost every first year economic student because it involves math, graphs, slopes, and elasticity coefficients.

Price elasticity of demand and supply are actually very useful things.  They tell retailers what the impact of increasing the prices of their products will have on their sales and revenues.  If a good is very price elastic, a very small change in price will cause a huge change in quantity demanded.  If a good isn’t very price elastic or it is price inelastic, then you can change the price a lot, and the quantity demanded for your service  is likely to remain relatively unchanged. I tell me students to think of sensitivity as a synonym for elasticity.  As you might think, goods and services that are very necessary tend to be less sensitive to price changes.  If you think of a diabetic, who needs insulin to live, they will not be price sensitive or elastic at all to changes in the price of insulin because they need it to live.

Equally important in any discussion of new taxes is the idea of progressivity of the tax.  Sales taxes are notoriously regressive because they take a higher percentage of income from poor people than from rich people.  My teaching example for this is to think of a family that buys $100 of groceries each week and pays 10% sales tax.   That basically means each family pays $520 annually in food taxes.  Now think of one of those families earning $10,000 a year and the other family earns $100,000 a year.  Everything else basically is the same for each family.  The poorer family pays a huge percent of its income to the sales tax than the richer family.  This makes a sales tax quite regressive.   This is also why many states (like Minnesota) try not to tax either food or clothing since when necessities are taxed, the poor are hit with the biggest burden of the tax.  They pay greater percentages of their incomes than richer people.

It is also possible to shift your burden to some one else.  In some cases, very price sensitive goods wind up placing the monopoly baby carriageburden of the tax back on the seller who must roll back the price of the product in order to sell the product with the tax in place.  The same thing goes for the good with very price insensitive demand.  The seller can frequently pass the entire tax onto the buyer. This may not be a bad thing when you’re talking about booze or cigarettes, but think back again to necessary medicines.  If you study taxes, you find that the only efficient tax is a property tax.   I’ve noticed a tendency for property taxes to be nonexistent in states with a lot of powerful rich people.  They work to decrease the progressiveness of income taxes also.  Rich people LOVE sales taxes.  A lot of them can even avoid them by traveling other places to buy things.  The Wiki entry on VATs is actually worth a read because it shows the variety of countries that have these taxes in place.  It discusses both the difficulty they frequently have with collecting the tax as well as information on the various levels each country has imposed on its consumer.

There are many things that make general sales taxes or even VATs bad ideas.  I covered the regressivity of the tax which is probably my main bone of contention.  Another one however, is that it is a lazy politician’s policy tool.  It doesn’t consider the people who pay the tax and what the tax will do to individual goods and services.  It’s one thing to put a tax on a $500 pair of athletic shoes, it’s completely another thing to place a tax on someone’s much needed medicine or the pants they need to do their job.  It is a much better thing to examine individual goods and services and individual tax payers and decide tax policy based on taxing luxuries (yachts, jets designer clothing) and goods that have extreme social costs (like booze and alcoholism or cigarettes and lung diseases) and not taking milk from the mouths of poor infants.