Economist Greg Mankiw wrote a clear-eyed primer on the value-added tax in the Sunday New York Times. If you're still fuzzy on the details of the VAT, read it -- or check out our own policy explainer here.
Here's where Mankiw's ideas get really interesting:
Imagine that we started with a VAT. Then we add a wrinkle: We allow businesses to deduct wages, in addition to the cost of goods and services. We also require households to pay a tax on their wage income.
Other than shifting the responsibility for the tax on wages from the business to the household, it might seem that we haven't done anything significant. Indeed, we haven't. But the new tax system would no longer be a VAT. It would be the flat tax that Robert E. Hall and Alvin Rabushka first proposed back in 1981.
So why, if these two tax systems are really the same, are conservatives attracted to the flat tax and repelled by the VAT? It is because the flat tax is usually proposed as a substitute for our current tax system, whereas the VAT is often suggested as an addition to it.
It's important to see that the VAT is almost never being proposed as a 100% addition to the tax code. Most efforts to introduce a VAT have suggested significant off-sets to keep it close to revenue neutral in its early stages: by slashing top marginal income tax rates, or eliminating FIT for households making under $100,000, or shaving the employer's portion of payroll taxes, or slashing corporate tax rates, or offering credits to low-income houses.
One thing policymakers -- and framers of the policy debate -- have to decide is: What is the question for which VAT is the answer? If the question is, How do we reduce our long-term deficit dramatically by 2020? then you're talking about the value-added tax as an immediate cash cow. If the question is, How do we make revenue-neutral tax reform that lowers existing tax rates on individuals and businesses? then you're talking about VAT as conduit for larger reform. Ultimately, we'll want both: broad-based tax reform soon and a long-term revenue machine later. That's why we should introduce VAT as a piece of revenue-neutral tax reform in the next few years and schedule slow rate increases in a healthy economy.
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