Here's why we need it: If you think the deficit looks bad now, wait a few years. Rising health care costs for retired baby boomers will push U.S. debt levels past their World War II-levels. But whereas WWII ended and we owed that debt to ourselves, our entitlement system is woven into American life and we owe half the resulting debt to foreign countries. Approaching this challenge will require some combination of robust growth, spending cuts, entitlement reform and more tax revenue.
Where should this tax revenue come from? There are three reasonable sources. First, some revenue should come from cleaning out the underbrush of special interest deductions and exemptions that hide hundreds of billions of dollars from taxes. But every tax code in the world molds to the interests of the public, and dramatically reducing these carve-outs is unlikely. Second, some revenue should come from higher income taxes on the rich, whose total tax rates have fallen consistently over the last 40 years -- while spending grew. But higher taxes on the rich alone won't close the deficit. That brings us to revenue-source number three: we will have to raise taxes on lower- and middle-class families, and the VAT is probably the most efficient, most equitable, and most non-distortionary way to do it.
So what is a value-added tax, anyway? What it sounds like: a consumption tax on the "value added" at each stage of production. Here's how that works: Imagine a $1 loaf of bread you buy from the supermarket with a VAT of 10%. You've got a farmer, a baker, and a supermarket in the production chain. The farmer grows the wheat and sells it to the baker. The baker makes a loaf, sells it to the supermarket. The supermarket sells the loaf to me. Each link on the production chain pays the government 10% of the price of its product minus 10% of the price it paid for the goods to make that product. Ultimately, the government collects a total of 10 cents on the $1 loaf. At the supermarket, I pay the bread price plus the VAT: $1.10.
Maybe that sounds complicated. But it's actually much easier to collect VAT than a national retail sales tax because there is a counterparty to every transaction. The baker can try to avoid paying her share of VAT. But the government will see that the supermarket reported the purchase of her bread, and it can go to the baker and say "you forgot to report your sales." With the individual income tax, we ask the IRS to police tax evaders. With a VAT, the production chain helps to police itself.
For most Americans, this is all happening under the hood. All we would see are higher prices and less overall consumption. Who could want such a thing?
Maybe all of us. Remember that debt crisis? A VAT could reduce the deficit and its announcement would signal to foreign investors that we're serious about deficit reduction, reducing our long-term interest rates and making it easier to borrow. What's more, if a tax on consumption discourages some consumption, it might encourage Americans to save more, which might not be such a bad thing considering an avalanche of consumer debt added to the last recession.