Wednesday, October 4, 2017

VAT -- full text

Now that 30 days have passed, the full text of the WSJ oped advocating a VAT instead of all other federal taxes. Previous post with extra comments.



By John H. Cochrane
Sept. 4, 2017 2:38 p.m. ET

Soon the Trump administration and congressional leaders will unveil their tax-reform proposal. Reports indicate the proposal will include some reductions in corporate and personal rates and the end of some tax deductions. But true reform is likely to be stymied by the usual interests, by those who see the tax code primarily as a way to transfer income to or from favored or disfavored groups, and by politicians who dole out deductions, exemptions and subsidies to supporters.

So if the process stays its normal course, don’t expect the complex and dysfunctional U.S. tax code to change much. But if our leaders were to attempt a really fundamental reform, they could break the political logjam. Changes must be simple, understandable and attractive to voters. And only fundamental reform paired with deregulation can hope to raise economic growth to 3% or more.

The best way to do this is to eliminate entirely the personal and corporate income tax, estate tax and all other federal taxes, and to implement instead a national value-added tax—essentially a national sales tax.


Much of the current tax mess results from taxing income. Once the government taxes income, it must tax corporate income or people would incorporate to avoid paying taxes. Yet the right corporate tax rate is zero. Every cent of corporate tax comes from people via higher prices, lower wages, or lower payments to shareholders. And a corporate tax produces an army of lawyers and lobbyists demanding exemptions.

An income tax also leads to taxes on capital income. Capital income taxes discourage saving and investment. But the government is forced to tax capital income because otherwise people can hide wages by getting paid in stock options or “carried interest.”

The estate tax can take close to half a marginal dollar of wealth. This creates a strong incentive to blow the family money on a round-the-world cruise, to spend lavishly on lawyers, or to invest inefficiently to avoid the tax.

Today’s tax code tries to limit this damage with a welter of complex shelters: 401(k), 526(b), IRA, HSA, deductions for corporate investment, and complex real-estate and estate-tax shelters. Taxing something and then offering complex shelters is a sure sign of pathology. But by taxing cars, houses and boats when people or companies buy them, all this complexity can be thrown out. With a VAT, money coming from every source—wages, dividends, capital gains, inheritances, stock options and carried interest—is taxed when it’s spent.

A reformed tax code should involve no deductions—including the holy trinity of mortgage interest, employer-provided health insurance, and charitable deductions. The interest groups for each of these deductions are strong. But if the government doesn’t tax income in the first place, these deductions vanish without a fight.

In these and other ways, if Congress and the president drop the income tax in favor of a VAT, or another simple consumption tax, they can break the political logjam and achieve a dramatic pro-growth reform.

It is essential that the VAT be uniform, and it is best to carve that in stone at the outset. Trying to transfer income or subsidize people and businesses by charging different rates for different goods or organizations will again muck up the tax system. And it is essential that the VAT replace rather than add to the current tax system, as it does in Europe.

What about progressivity? It is easy to make a value-added tax progressive: In place of current exemptions, send everyone a $10,000 check. Or people could receive a refund according to how much they spend, similar to income-tax refunds. Taxpayers could get a full refund for the first $10,000, half for the next $10,000, and so forth. Electronic record-keeping makes this straightforward—it’s just a big debit or credit card reward—and everyone would have an incentive to report purchases rather than to hide income.

But the chaos in U.S. income redistribution is as great as the anarchy in the tax code. Tax discussions fall apart because the redistributive influence of each change is assessed in isolation. By measuring how the tax and transfer system work together, politicians could get better taxes and more effective redistribution.

The U.S. also needs an integrated social-insurance program: Send checks to needy people, yes, but also monitor the amount they get from all government sources, including college financial aid, health insurance, energy assistance, Medicare, Medicaid, Social Security, unemployment insurance, food stamps, farm programs, housing and so on. Even without reforming the programs, it is necessary at least to measure their total effect to calibrate accurately any tax-based redistribution.

What about the tax rate? Well, if the federal government is going to spend 20% of gross domestic product, the VAT will sooner or later have to be about 20%. Tax reform is stymied because politicians mix arguments over the rates with arguments over the structure of taxes. This is a mistake. They should first agree to fix the structure of the tax code, and later argue about rates—and the spending those rates must support.

Is all of this unrealistic? No. Sometimes when little steps are impossible, big jumps are feasible. It is unrealistic to think that tweaks to the current system will produce a big change from the status quo.

Now is the time. If American democracy cannot fix this tax code, economic stagnation and debt crisis or massive spending cuts await.

Mr. Cochrane is a senior fellow at Stanford University’s Hoover Institution and an adjunct scholar at the Cato Institute.

Update:  I learned of a precedent for the progressive VAT idea, Yaacobi Nir, "Progressive V.A.T. as a Substitute for Income Tax" December 2008

21 comments:

  1. How about Friedman's income tax plan?

    "…the abolition of the corporate income tax, and with the requirement that corporations be required to attribute their income to stockholders, and that stockholders be required to include such sums on their tax returns."

    This seems very agreeable to me. The only caveat being the situation where a stockholder does not have enough cash to pay for the taxes his share's profits have produced. He has earned income, yet no dividends are paid... ?

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    1. He can sell some stock if needed. But you see the weakness in even Friedman's view. By taxing income, we have to measure corporate income (A mess with lots of deductions) and then just who is a stockholder (harder than you think. Sell on April 14, buy back on April 16. Get a rate of return swap or buy call options rather than actual ownership. Tax exempt institutions own stock then sell options to you and me... ). It's easier to just tax the dividends and capital gains. After all, all corporate income is eventually paid out. It's easier still to tax your consumption at the end of all that... the VAT.

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  2. Recently, an IRS solicited request for advice - essentially, on process trivia - reached me by e-mail. One was to make a suggestion, with the promise that a random selection of submits would receive a $100 prize. Well this is the first lottery I've won in my life, receiving an Amazon gift card! I had written: Replace all taxes with a VAT!

    I'm quite sure no will ever read it.

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  3. A major problem with all taxes, both on income and consumption, is unmeasured household production/consumption. The current income tax marriage penalty encourages high-human-capital spouses to substitute away from external production towards (inefficient) unmeasured household production. Is there a way to construct a tax system which doesn't encourage this inefficient allocation of human capital?

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    1. Shri: You are right. If you tax anything you get less of it. The art of taxation is to reduce this effect; tax things people can't so easily substitute away from. A uniform VAT is pretty good on this score -- it's hard to substitute away from buying anything! But as you note, it does encourage substitution away from market to home production. We are such a specialized economy that people growing their own wheat isn't a huge problem. But I acknowledge even a uniform VAT isn't perfect on this score. It is a whole lot better than what we have now though!

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  4. Brad DeLong lit into this piece (and you) today. He says you need to pay for your $10K handout taking your tax rate from from 20 to 40 percent (also accounting for consumption's share of income).

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  5. Brad DeLong has a post criticizing your math. He notes that a 20% VAT wouldn't be nearly enough if you also include the $10,000 universal payment to make the tax more progressive. That alone would account for 16.5% of GDP. Perhaps you don't mean that everyone gets the $10,000, and perhaps you assume this replaces the myriad welfare programs that we have in place. If both these points are true, would 20% be sufficient and who would get the $10,000? Or have I (and Brad) missed something else?

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    1. Indeed, if there is a $10,000 carve out, if we also get rid of all payroll taxes, and if Federal spending remains 20% of GDP, then the rate will be substantially more than 20%.

      When the government starts exempting things from the VAT -- government services, health care, food, electric cars -- the rate will climb higher. If states and local governments also adopt a VAT, well, overall government spending is about 43% of GDP, so the rate starts at 43% and goes up with the carve-outs.

      If we get rid of all other taxes, and make the VAT highly progressive, and the government carves out things like health care (20% of GDP), you could see rates of 70% or even 100%. (100% is possible with a VAT. A 100% VAT generates 50% of GDP as revenue, a further effect on calculating rates that I deliberately ignored in the interest of simplicity.)

      It is not my point that the rate will be low. The rate will be high. This is good. If government is spending 43% of GDP, then somewhere somehow the average taxpayer is paying a 43% rate. It would be very healthy for us all to see this in one place.

      So a high rate is fine with my argument.

      My bigger point is that unlike the current partisan debate, there is no point in talking about tax rates in isolation. Tax rates must be what they must be to finance government spending. If you want lower rates, you need less spending. If we have high spending, we will have high rates. The discussion of the tax code needs to separate discussion of the structure of the tax code from discussion of the rate -- precisely to avoid the sort of foaming-at-the-mouth personal-venom partisanship that Brad so sadly represents.

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    2. John,

      "It is not my point that the rate will be low. The rate will be high."

      So much for lower marginal tax rates = higher growth or Laffer Curve effects too high a tax rate will result in lower tax revenue?

      "This is good."

      Lower tax revenue and lower growth resulting from a high tax rate is good?

      "If government is spending 43% of GDP, then somewhere somehow the average taxpayer is paying a 43% rate."

      Uh no. Here is why. Gross domestic product is limited to the sale of new domestically produced finished goods. GDP does not include:

      1. Sale of previously owned goods (houses, cars, etc.)
      2. Sale of imported goods
      3. Sale of goods produced in previous years (inventories)

      All of these goods would be exposed to a VAT and yet these goods are not counted in current year GDP measures.

      https://fred.stlouisfed.org/series/GDP

      Nominal GDP in 2nd quarter 2017 was about $19.25 Trillion.

      https://www.nar.realtor/sites/default/files/documents/ehs-08-2017-overview-2017-09-20.pdf

      Total sales of previously owned homes in the same quarter (Apr, May, June) was $250,000 x 16.6 million (Seasonally Adjusted) = $4.15 trillion.

      https://static.ed.edmunds-media.com/unversioned/img/car-news/data-center/2017/aug/used-car-report/used-car-report-q2.pdf

      Total sales of used vehicles in 2nd quarter 2017 was $19,227 x 10.05 million = $193 billion.

      You need to play around with the data on the St. Louis FRED website to get this number but U. S. imports totaled about $2.7 Trillion last quarter (compared to $2.2 Trillion of exports).

      Just with those three items added back into the VAT calculation (assuming no progressiveness), your tax base is:

      $19.25 Trillion (Nominal GDP) + $4.34 Trillion (Sale of existing homes + vehicles) + $2.7 Trillion (Imports) = $26.29 Trillion.

      There is still a lot of stuff missing. Existing homes and used motor vehicles are not the only items that are sold and resold. And I didn't even try to take a stab at inventory adjustments.

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    3. > Tax rates must be what they must be to finance government spending.

      A big problem we have right now in this country is that the major parties refuse to own up to this. The typical voter wants low taxes and lots of benefits and transfers ("keep your hands off my Medicare") and is easily whipsawed by exaggerated stories of "wasteful" spending from the right or "inhumane" cuts to essential programs from the left. We've also got the political class preying on voter ignorance to hide the true size of government with regs (the progressive favorite), tax expenditures (the conservative one), trade policy and credit subsidies (everyone's boondoggle), and a crazy budget process that allows both sides off the hook on doing anything about the budget imbalance caused by unfunded entitlement commitments.

      So I think the issue with choosing 20 percent is that it could easily be interpreted as affirming the conservative fiction that the government can continue to do what it does now with much lower tax rates.

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  6. John,

    "In these and other ways, if Congress and the president drop the income tax in favor of a VAT, or another simple consumption tax, they can break the political logjam and achieve a dramatic pro-growth reform."

    It takes more than just the President and Congress to drop the income tax. The 16th Amendment to the Constitution (granting Congress the ability to tax incomes) would either need modified or repealed in it's entirety.

    "It is essential that the VAT be uniform, and it is best to carve that in stone at the outset."

    While the Constitution under Section 1, Article 8 indicates that all excise taxes must be "uniform throughout the United States", that is a geographical distinction only.

    See Knowlton v. Moore (Supreme Court Case, 1900)
    https://supreme.justia.com/cases/federal/us/178/41/case.html

    "Trying to transfer income or subsidize people and businesses by charging different rates for different goods or organizations will again muck up the tax system."

    Again, the Constitution would need amended to keep lobbyist groups (and their Congressional cohorts) from mucking up the system.

    "And it is essential that the VAT replace rather than add to the current tax system, as it does in Europe."

    See 16th Amendment to the U. S. Constitution.

    "Is all of this unrealistic? No. Sometimes when little steps are impossible, big jumps are feasible."

    Do those big jumps include amending the Constitution twice (repeal 16th Amendment & modify language in Article 1, Section 8 regarding "uniform excise taxes")?

    https://www.lexisnexis.com/constitution/amendments_howitsdone.asp

    "Article V of the Constitution prescribes how an amendment can become a part of the Constitution. While there are two ways, only one has ever been used. All 27 Amendments have been ratified after two-thirds of the House and Senate approve of the proposal and send it to the states for a vote. Then, three-fourths of the states must affirm the proposed Amendment."

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  7. John,

    "They should first agree to fix the structure of the tax code, and later argue about rates—and the spending those rates must support."

    Okay, regarding structure - which VAT system should the U. S. use and why - invoice based method, accounts based method, or some other method?

    https://en.wikipedia.org/wiki/Value-added_tax

    "There are two main methods of calculating VAT: the credit-invoice or invoice-based method, and the subtraction or accounts-based method. Using the credit-invoice method, sales transactions are taxed, with the customer informed of the VAT on the transaction, and businesses may receive a credit for VAT paid on input materials and services. The credit-invoice method is the most widely employed method, used by all national VATs except for Japan. Using the subtraction method, at the end of a reporting period, a business calculates the value of all taxable sales then subtracts the sum of all taxable purchases and the VAT rate is applied to the difference. The subtraction method VAT is currently only used by Japan, although subtraction method VATs, often using the name flat tax, have been part of many recent tax reform proposals by US politicians."

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  8. The 16th Amendment says the government MAY tax income, not MUST tax income

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    1. Unknown,

      See John's statement above:

      "The best way to do this is to eliminate entirely the personal and corporate income tax, estate tax and all other federal taxes, and to implement instead a national value-added tax—essentially a national sales tax."

      The only way to eliminate entirely the income tax is to repeal or modify the 16th Amendment. Sure the 115th Congress and President could trim all income tax rates to 0% and the 116th Congress and President could raise them back to current levels.

      I presume that John's "eliminate the income tax" plan has the backing of 2/3 of the House and Senate and 3/4 of the states?

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    2. Frank, I think the job of an economist is not to get the bills passed in the legislature -- he may assist politician toward that endeavor. But he sets out what make economic sense, what should work for the country

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    3. medi77,

      "Frank, I think the job of an economist is not to get the bills passed in the legislature -- he may assist politician toward that endeavor. But he sets out what make economic sense, what should work for the country."

      As they say, there is more than one way to skin a cat, and so an economist should not limit himself / herself to any one policy prescription in addressing a particular issue / problem.

      The economist should be aware of the various political / legal hurdles in the path of any policy proposals. Our federal legal system is modified in a variety of ways - direct legislation, federal court rulings, executive orders / actions, Constitutional amendments and so on. Where as pursuing one policy may require going the more difficult political route (Constitutional amendment), pursing a different policy to achieve a similar result may be more expedient (Executive action).



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    4. medi77,

      And really, in any other applied science, obstacles in the path of success should never be overlooked.

      Does the highway engineer fail to notice the large mountain that he will have to either tunnel through or route his new road around?

      Or is economics strictly an ivory tower science, all kinds of great theories that should never be put into practice?

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  9. John, the most recent VAT implemented has been in India. It should be a great case study. Implementation is key. They had promised lower prices, but prices seem to be rising -- retailers are slapping on the total VAT on consumers since they are not sure they will be able to claim credit for the VAT they have paid. how should a VAT or GST as India calls it be implemented ideally (they have exempted food and other "essentials") in a country where the poor exceed the entire population of the US? Most people in India do not pay income tax (less than 1% i think). Business men almost never do. and thee are a lot of small unincorporated businesses. One advantage of GST is that businessmen who buy luxury goods will be paying taxes for the first time ever? It should raise revenue, but i read that it has been much lower then expected (what kind of cheating occurs, and what can be done to stop it). In the context of India, could you suggest how it should be implemented so as to benefit the country. Perhaps list the benefits of GST and how to ensure that those benefits are actually obtained by"correct" implementation.

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    1. medi77,

      I think the key to success is "How strong is the Indian Court System in relation to it's other governing bodies?".

      From your above:

      "They had promised lower prices, but prices seem to be rising -- retailers are slapping on the total VAT on consumers since they are not sure they will be able to claim credit for the VAT they have paid."

      If the Indian government is contractually obligated to acknowledge credit for VAT that has been paid, then any retailer that is denied that credit should be able to sue the Indian government in court.

      However, reading this article:

      https://en.wikipedia.org/wiki/Supreme_Court_of_India

      "As per the latest pendency data made available by the Supreme Court, the total number of pending cases in the Supreme Court as on 1 April 2014 is 64,330, which includes 34,144 Admission matters (miscellaneous) and 30,186 Regular Hearing matters."

      It is apparent that the Indian Court System has corruption / performance issues. Also, without doing too much research, I am also given to wonder whether the Indian Supreme Court has ever successfully challenged / overruled the Indian government's legislative / executive bodies.

      It is often the case in corrupt political organizations that the rules are not applied to the rulers.

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  10. John, while my comment awaits approval, want to add (please add this to my comment):
    Another reason India is an ideal case study is that effectively there is no personal and perhaps not even much of a corporate income tax (they find ways to avoid taxes)...so it fits your point that "The best way to do this is to eliminate entirely the personal and corporate income tax, estate tax and all other federal taxes, and to implement instead a national value-added tax—essentially a national sales tax."

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  11. and what are pros and cons of exampting food and other essentials to protect the poor vs sending them a check (practical possibility of corruption wherein middlemen take the money or dead people keep receiving checks etc)

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