NCPA - National Center for Policy Analysis

Why The VAT Is A Bad Idea

October 30, 2002

The Treasury Department is considering the idea of a value-added tax (VAT) to replace the corporate income tax and finance other tax reforms. This is a dangerous road for the Bush Administration to travel, both politically and economically.

On a technical economic level, it has much to recommend it. The corporate tax is a bad tax because it is a double tax on corporate profits since dividends are also taxed. The result is a higher cost of capital that lowers investment, productivity and wages. Most economists think it should be abolished.

  • The problem is that the corporate tax raises a significant amount of revenue.
  • A VAT, sometimes called a business transfer tax, could easily make up the revenue from abolishing the corporate income tax -- perhaps raising $50 billion per year for each percentage point.

Thus a 3 percent VAT could replace the corporate tax.

Advantages of the VAT: it's rebatable at the border on exports; it doesn't fall on saving or investment; and it would lead to a sharp drop in the cost of capital.

Against these advantages, however, are some powerful disadvantages.

  • The rate would probably have to be at least 5 percent just to justify the cost of imposing it.
  • A comprehensive VAT would be very regressive -- taking proportionally more out of the pockets of the poor than the rich.
  • Although over one's lifetime the tax would be proportional to income, there is no question that the poor would pay more taxes than they do now under a VAT.

There's another problem: It has proven too easy for governments to piggyback on inflation and raise VAT rates as prices were rising anyway. People did not notice the tax increases because they were hidden in the prices of goods and services. Consequently, the VAT proved to be a massive money machine that fueled a vast increase in taxation in every country that has adopted it.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, October 30, 2002.


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