Wednesday, January 4, 2012

The VAT, a libertarian dilemma

Dan Mitchell wrote an interesting op-ed in the Wall Street Journal (Cato link for those without WSJ access), highlighting a great libertarian dilemma: is a consumption tax (VAT or similar) a good thing?

Every bit of economic analysis says yes. Economists hate distortions, taxes that lead to bad economic behavior. Our tax system is full of them.  Broaden the base, lower the rate, tax consumption not savings, dramatically simplify the code, and you can get the same revenue with much less economic damage.

A political argument disagrees: An efficient  tax code can also raise a lot more revenue. Dan opposes the VAT (and similar consumption taxes) on that grounds. Yes it looks good to start, but politicians will soon raise the rate to the sky and spend the results. (Becker and Posner have also tackled this one several times.) 

It's a strking dilemma: should we keep an atrocious tax system to limit the size of government?  Is there no way to get an efficient tax system and a limited government?

Implicit in Dan's argument is a deeply pessimistic view of our Government: sooner or later, Congress will get to the top of the Laffer curve of a given tax structure. (The top of the Laffer curve is the point where the government is getting the most possible tax revenue. If the government raises tax rates any more, people work less, hire lawyers and lobbyists to evade taxes, businesses move offshore or just don't get started, and so on. The government can end up with less total money even though tax rates are higher.)

Most economists seem to disagree that we are at the top of the Laffer curve. They think Congress has not squeezed every drop out of the current tax code, so they would place more hope in future Congressional restraint. In their view, Europe first decided on a welfare state and then decided how to fund it, not the other way around.

I'm almost as pessimistic as Dan. Sure, raising tax rates can generate more revenue for a few years.  But most economic analyses don't look at the long-run, growth effects of tax distortions. The full disincentive effects don't show up for years. If taxes just lower growth a few fractions of a percent, that soon compounds to drastic reductions in income and tax revenue.

The U.S. Federal income tax seems to take in about 18% of GDP with top rates anywhere from 35% to 90%. And the disincentives are bigger than you think. They result from the full sum of federal, state, local, estate, sales, etc. taxes. Greg Mankiw figured his marginal tax rate at 93% -- and he forgot sales taxes.  (A bit more on long-run Laffer curves on p. 20 here)

But I'm not not quite that pessimistic. Perhaps I'm just being soft hearted, but I surely hope our political system is not quite so broken. On the other hand, it seems naive to simply count on self-restraint to keep spending under control if the Laffer curve all of a sudden is less painful.

This whole question begs for a lot more serious thought:

What is the long-run Laffer curve tradeoff, really? How much do distorting taxes affect growth, and hence long-run revenues? Is our government really close to the top of the long-run Laffer curve?

Economic distortions are not exactly the same as revenue reductions. If we accept the dark view of Government, how do we design a tax system that minimizes economic distortions, yet keeps the top of the long-run Laffer curve at, say, 20% of GDP?  That is a fun optimal-taxation optimization problem. Surely the current abomination is not the answer to that question!

In one sense the top-of-the-Laffer curve view is demonstrably wrong. Dan argues that the government grabs as much revenue as it can given the current tax system, but it can't easily change the tax system. If so, it would have already enacted a VAT!  Is there hope for similar hard-to-change constraints on overall tax revenue within a better system? Can we pass an effective law that says revenue may be no more than 20% of GDP? 

What are the relative welfare effects of a government that is too large vs. a distorting tax system? Maybe firing all the tax lawyers accountants and lobbyists is worth putting up with a slightly bigger welfare state?

Any PhD students out there looking for thesis topics?


  1. I don't think it's merely a question of percentage of government spending as a measure of its size, it's rather a question of government efficiency. Who is to say that 20% in particular is an efficient level of revenue (and spending), enough to satisfy the government's main functions (rule of law, enforcement of contracts, private property ownership etc.)?
    I fail to see how, even if we pass a law that limits government spending under a certain threshold, would that be enough to call it an efficient policy.
    Perhaps a better system would be to introduce a flat rate tax system. It would at least call for simplification thus eliminating some of the distortive effects of the current tax system.

    btw, your blog design is the exactly the same as mine:

  2. On a practical note, I believe a constitutional change would be required to authorize a Federal VAT. Also, government is far above 20% of GDP in the US, since the highly-populated states tend to extract significant taxes also. It drives me crazy when people compare Federal tax rates and Federal spending to total tax rates and total government spending in other countries.

    On your question about limiting revenue, it's usually difficult to pass laws restricting Congress from spending money, but once a law does require the expenditure, it can be hard to reverse. Thus, the way for Congress to make a binding commitment (such as to limit spending as a % of GDP) is to have Congress fund its borrowing with bonds whose coupon payments depend on the size of the government. Spending above the limit could then cost 2 or 3 times as much as it should, because of the automatic payout on the bonds. This would give Congress pause when contemplating further spending bloat. Of course, over time Congress could stop issuing such bonds, but this would give clear notice that it intended to expand the government, reducing its ability to pass huge entitlements quickly (before opposition can properly muster) that we then have to live with forever.

    Of course, tying Congressional pensions to the bond coupons (in a reversed way) would also be a good idea - and, since Congress is making a commitment, should not be objectionable to Congress.

  3. P.S. The natural investors in the bonds I propose would be taxpayers, who would use them as a hedge against higher future taxes.

  4. Blog War III - A summary of recent economic debate Krugman+DeLong etc vs. Fama+Cochrane etc.

  5. Hi John
    Is god to see you in the blogosphere.

    I want to make my two cents contribution to the “devaluation/inflation/debt exchange” problem, from the perspective of a small open economy: Argentina

    In our type of countries devaluation is always contractive: as we export commodities to (almost) competitive markets, devaluation only cut purchase power in term of national workers: this is the way we restore balance to our deeply negative balance of payments: a dramatic cut in consumption.
    BUT, regarding devaluation/inflation causalities, I must said that previous situation also counts: as we had been in recession ex-ante devaluation (the “market” was waiting for that…), we also have got unemployment and empty capacity, so, the path through from devaluation to inflation took almost ten years: we devaluated our currency 400% and today IPC accumulate a 400% increase.
    But it took ten years!. It pays for opportunistic politician like we used to have.

    AND the term of trade booster in 2003! so our populist government enjoyed an impressive export boom while introduce distortion in every national market in order to delay import boom.

    Perhaps our problems are more related to politician’s incentives and institution´s qualities, than good economic theory.

    I also want to share two lessons from our debt renegotiation
    (It’s based in two well-known Argentinean economists linked at the end)

    The first lesson has to do with the timing and size of the debt exchange. In this regard, Argentina’s lessons are clear: Delaying the unavoidable and then defaulting belatedly, unilaterally and in a disorderly fashion, imposes significant costs in real activity, with no visible benefits: by the time Argentina defaulted in 2001, it had experienced four years of recession and its gross domestic product had declined by about 22 percent.
    The key to restoring access to capital markets is to rebuild solvency based on debt sustainability after the restructuring. Returning to the financial market doesn’t depend on hard feelings about the size of the haircut: Argentina was initially regarded as a financial pariah because it refused to negotiate with bondholders. However, it regained access to credit markets relatively fast after the 2005 debt exchange, which entailed a very large haircut -- large enough to make the country solvent.
    The claim that Argentina’s sovereign risk premium remained large throughout the 2000s is often posed as proof that the size of the haircut matters. But this overlooks the fact that by the end of 2006, a little more than a year after the completion of the exchange, Argentine bond spreads were almost equal to those of Brazil. They widened later for reasons unrelated to the default.
    The second lesson, equally critical, relates to the role of liquidity in a solvency crisis -- or who takes care of the casualties the day after default? Judging from Argentinean crisis, one would expect the ongoing deposit run on Greek banks to intensify to the point of threatening the economic recovery.
    Bank Solvency: Ten years ago, when the run on Argentine banks deepened and the default was declared, both the need to ensure bank solvency through recapitalization and the provision of liquidity to the banks became critical elements to restore credibility. Back then, the bank-solvency problem was dealt with through “pesification,” a mandatory conversion into pesos of dollar deposits and loans that avoided huge bankruptcies. Most crucially, the central bank didn’t hesitate to print all the pesos needed to meet bank withdrawals. The run ended within six months.

    PD I also teach Finance in a Business school and enjoyed a lot your Asset Valuation book

  6. I don't get your point. I mean, it seems clear that the crisis is getting deeper in Europe once it is spreading toward more central economies like Italy (German negative interest rates shows no more than deep concern over the Euro as whole). The problem is that the financial system is deeply interconnected, a deeper crisis should affect the US economy.
    So what?
    So market will look for safety, and even in a crisis inside US, the safer financial aplication in the world are FED bonds. Which means the FED, want it or not, will be the lander of last resource. Correct?
    That is where I don't get your point: Why shouldn't the FED finance the government current debt by printing money if it will increase agregate demand (desirable), invrease inflation (desirable) and end up being sterilized by and increase on bonds demand due increments is risk aversion as the crisis goes deeper?
    I mean, I agree with you when you say that in the end of the day they will have to sterilize the moeny injected in the economy. But right now, observing the economy, my question is so what?

  7. Why not just allow taxpayers to directly allocate their taxes...aka pragmatarianism? It's not a revenue's a spending problem.

    For the life of me I haven't found any evidence that supports the idea that resources can be efficiently allocated by proxy. Yet...economists never argue that taxpayers should be allowed to directly allocate their taxes.

    Don't we want taxpayers to consider the opportunity costs of their tax allocation decisions?


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