Consumption Tax: The Next Big Test – VAT, NST or None of the Above?

Like Spring, VAT is in the air.  Uncle Sam needs more revenue.  A consumption tax, either a value added tax (VAT) or a national sales tax (NST) could bring in that revenue.  A “low” level consumption tax (think under 10%) might supplement the existing income tax structure.  A higher level tax might replace income tax, at least for those making less than, say $200,000/year.

Does any consumption tax make sense?  It will be regressive.  On average, the poorer you are the more of your income you spend on goods and services – the rich buy goods and services, but they also save,  The result, the poor man pays VAT or NST on every penny he makes, while the rich woman (this example is not only gender neutral, it's demographically accurate) spends only a fraction of her income on goods and services and banks the rest, free of consumption tax.  The current income tax system uses a progressive rate structure to achieve the opposite result.  To the extent income tax is preserved alongside a new consumption tax, it will mitigate the regressive effect, but an income tax that starts at $200,000 leaves an awful lot of room for the regressive impact of any new consumption tax.

Like any major shift in tax policy, it upsets the best laid plans of ... lots of us.  If you saved your whole life, struggling to put a few bucks away each year after taxes, looking forward to spending in retirement, guess what. You will now pay tax on the way out, just like you did on the way in.  The shift from income tax to consumption tax caught you at the wrong time, leaving you double whammied.  If you just bought a home, counting the value of the deductions for mortgage interest and real estate taxes in your rent v buy equation – better recalculate.  The deductions won't mean much if you aren't paying income tax.  By the way, if you own a home, watch what happens to its value if the effective value of the deductions for mortgage interest and real estate taxes disappears because the income tax is replaced.  This kind of dislocation can be mitigated.  A low level consumption tax that supplements the existing income tax causes less dislocation (of course it also means we will be running two expensive tax collection systems instead of one.)  A higher level, replacement consumption tax could be phased in over several years as the income tax (or at least the lower brackets) are phased out.  Any new tax change could drop the tax on distributions from IRAs and 401Ks to offset the double whammy on lifetime savers.

A consumption tax that replaces income tax, or at least much of the current income tax, could encourage a shift away from consumerism.  Those who believe that a sustainable economy shalt not be built on recreational shopping will cheer.  The Obama administration and the Federal Reserve may be worried.  They were counting on at least one more round of consumer fever to pull us out of recession, whatever higher aspirations they have for the long term future of the US economy.

Before finalizing your answer to the title quiz, consider which tax you prefer.  The following table, a slightly edited lift from Wikipedia, will help.

Without any Consumption Tax

* A widget manufacturer spends $1 on raw materials to make a widget.
* The widget is sold wholesale to a widget retailer for $1.20, making a profit of $0.20.
* The widget retailer then sells the widget to a widget consumer for $1.50, making a profit of $0.30.

With a VAT

Adding on a 10% VAT:

* The manufacturer pays $1.10 for the raw materials, and the seller of the raw materials pays the government $0.10.
* The manufacturer charges the retailer $1.32 and pays the government $0.02 ($0.12 minus $0.10), leaving the same profit of $0.20.
* The retailer charges the consumer $1.65 and pays the government $0.03 ($0.15 minus $0.12), leaving the same profit of $0.30.

So the consumer has paid 10% ($0.15) extra. The businesses have not lost anything directly to the tax, but they do have the extra paperwork to do so that they correctly pass on to the government the difference between what they collect in VAT (output VAT, an 11th of their income) and what they spend in VAT (input VAT, an 11th of their expenditure).

With a U.S.-style sales tax

With a 10% sales tax:

* The manufacturer pays $1.00 for the raw materials.
* The manufacturer charges the retailer $1.20, leaving the same profit of $0.20.
* The retailer charges the consumer $1.65 and pays the government $0.15, leaving the same profit of $0.30.

So the consumer has paid 10% ($0.15) extra. The retailers have not lost anything directly to the tax, but they do have the extra paperwork to do so that they correctly pass on to the government. Supplier and manufacturers are unaffected by the tax.
In real life the supplier-manufacturer-retailer chain is often ten steps long and there are tax collections, payments, and records each step of the way, creating a tax bureaucracy in both the private companies and the government.  Every purchase in Latin America seems to require a degree in VATology.  For this reason, I concede my bias toward the NST, which, with one simple tax collected on sale to the end user,  produces the same revenue for the government with the same macroeconomic effect as the VAT.

VAT proponents point to the cascading effect of the sales tax.  The theory is that supplier charges sales tax to manufacturer, manufacturer then charges tax on the sale tax in the resale to consumer.  This is a non-issue in the real world.  As in the table, purchasers for resale get a sales tax exemption, hence no cascade.

VAT proponents do have at least one truly powerful argument – tax evasion is easier to prevent with VAT than with NST, because the collection process is embedded throughout the supply chain.   Apparently tax evasion becomes an extremely serious problem when sales tax rates hit 10%.

So, how should Uncle Sam raise more revenue. A) Keep the income tax and raise the rates; B) Add a “low” rate NST to supplement the income tax – note that at the lower tax rates required for a supplemental consumption tax, NST beats VAT hands down; C) Replace income tax with VAT (possibly preserving  an income tax on the well to do, say those making $300,000 plus/year) and use a phase-in period and other patchwork fixes to mitigate the dislocation caused by this major change in tax policy.

Although the question is rigged to reflect my own views, you won't get an answer from me today.  You will be hearing some variant of this question almost constantly for the next year, so you might want to start getting your answer ready now.