The Value-Added Tax: Key to Deficit Reduction?

Interest in the value-added tax (VAT), a form of sales tax on consumption, will increase as the Gramm-Rudman-Hollings targets for deficit reduction become increasingly difficult to achieve through budget cuts. This monograph describes the implementation and economic effects of the VAT.

The VAT would clearly be superior to various alternative sources of revenue that have recently been proposed (such as taxes on energy and increased excise taxes), especially if a substantial amount of additional revenue is needed. It would be preferable to the simpler and more familiar retail sales tax if the combined federal, state, and local sales tax rate were to exceed about 10 percent; at lower rates the retail tax might be preferable. The choice is complicated by the need to coordinate state and federal actions in the sales tax area, since such coordination might imply substantial loss of state fiscal sovereignty.

Several recent proposals for a VAT—most notably the business transfer tax (BTT) proposed by Senator William Roth (Republican, Delaware)—are based on a highly defective means of implementing the VAT, rather than the method employed in virtually all VAT countries. If the VAT were chosen, it should employ the standard method used in Europe, rather than that of the BTT.

For administrative and political reasons, the VAT would probably not apply to more than about 80 percent of consumption. Thus the tax base at 1988 levels would be about $2,500 billion, at most. More liberal exemptions (for example, for food) could reduce the tax base to less than 50 percent of consumption, or $1,500 billion.

The VAT would interfere relatively little with economic decision making and would not discriminate against saving; in both these

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