The Value Added Tax and Targeted Budget Cuts as a Means to Reduce the Federal Deficit
Deficit spending is a government action in which the amount of its expenditures exceeds that of its revenues. In other words, the government spends more money than it receives from its citizens through taxation. While such spending is generally considered necessary in turbulent economic times, recent annual trillion dollar deficits are alarming to say the least. To be sure, continued deficit spending threatens the very fiscal solvency of this country. Though it is reasonable to assume that both Democrats and Republicans agree as to its danger, there has been little agreement between them on how to implement a plan to reduce the deficit.
Democrats by and large agree that a deficit reduction plan needs to include increased revenues, i. e. taxes. Republicans insist that the size of government should decrease, i. e. cut taxes. Despite the political volatility these two opposing ideas create, I believe that there is a way in which to do both. The question of deficit reduction then is: What is the most effective way in which to raise revenues and cut taxes? Overview The reasons for the partisan disagreement over how to reduce the federal deficit are beyond the scope of this paper.
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Suffice it to say that the proper mix of budget cuts and increased revenue that Congress needed to implement to start to reduce the deficit resulted, not in legislation, but rather in an arbitrary post-election deadline that blindly slashes discretionary and mandatory spending by trillions of dollars (Kogan, 2011). In effect, lawmakers agreed that cuts needed to be made, but could not determine where and when to make them. In their defense, budget cuts are a conundrum among the electorate as well. Though we are generally opposed to ncrease in taxes and are favorable to reducing spending, there is little agreement among us on which programs should be cut and by how much.
For example, the most obvious cuts would have to go to the federal government’s three main expenditures: Social Security, Medicare, and Medicaid. Yet, in a recent poll conducted by the Program for Public Consultation, Americans roundly rejected cuts to Social Security (78%), Medicare (81%), and Medicaid (70%) (Kull, et. al. , 2011)! Though among the electorate there are misgivings about raising taxes in general, some support can be gained if it is the wealthy whose taxes are raised.
President Obama has made raising taxes on the rich a hallmark of his tax reform plan. Raising taxes on wealthy individuals and married couples from 33% and 35%, respectively, to 35% and 39. 6% would equal nearly a trillion dollars over the next decade in added revenue, according to the President’s proposed budget plan (Anonymous, 2010). This plan makes sense in that America’s tax code is progressive: the wealthy pay more than the poor. I believe in the progressivity of the tax code but I also believe it to be incredibly complex and porous; leaving much revenue uncollected.
A better approach would be to work to “flatten” the tax code so that more revenue could be collected from a larger pot of taxpayers. In order to add more desperately needed revenues, proposals need to be set forth by Congress that change but do not fundamentally alter the tax code. My hypothesis for how this should be done is as follows: The implementation of a value added tax (VAT) and a reduction in corporate taxes will increase federal receipts in the short term and long term and thus reduce the deficit.
The reason for the use of the VAT is simple: it effectively raises receipts through consumption of goods. In fact, the VAT is often called a consumption tax because unlike income tax, it raises revenues by taxing what we purchase, not what we earn. The corporate income tax should be reduced because in addition to being taxed at the world’s highest rate (Hodge, 2012); the dividends that corporations pay to their shareholders are also taxed. Taken together, the corporate tax system that is in place both discourages investment and encourages the repatriation of profits.
The Value Added Tax
The VAT addresses the need for a less complex, more efficient means for which to collect revenue. Though it is not practiced in the U. S. , the variations of the VAT are in place in over 140 countries including all the member countries of the Organization for Economic Cooperation and Development (Shultz, T. D, Sullivan, D. H, and Gould, M. S. , 2011). The particular type of VAT I will be exploring is called the credit-invoice method. The credit-invoice VAT is a way in which to increase revenue, thereby alleviating the deficit and reducing the need for deficit spending.
It is a consumption tax on goods that is present from raw materials through the final retail sale. However, throughout this journey, each buyer only pays his own share of the VAT and receives a credit for the portion of the tax that the seller paid. In this way, each buyer in each phase of a product’s sale is taxed the same amount. This amount of the VAT is usually around 15% to 20%, though even a modest 6. 5% VAT could increase federal receipts by three trillion dollars by 2020 (Shultz, T. D, Sullivan, D. H, and Gould, M.
S. , 2011, pg. 16). Despite its relative simplicity, the VAT is controversial because it is a regressive tax. The amount of money that poorer people spend on goods and services which are subject to the VAT tax is substantially more than that of wealthier individuals. Indeed, if a 20% VAT were implemented, the bottom 20% of wage earners would be effectively taxed at a rate of 77. 9% while the top quintile’s income would only be taxed at an average rate of 11% (Burman, L. E. , Gravelle, J. , Rohaly, J. , 2005, pg. 5).
For all its complexity, the U. S tax code is very progressive. In order to keep this progressivity, an across the board VAT would not work. In light of this, Columbia law professor Michael J. Graetz has proposed an interesting twist on the VAT. Instead of a flat VAT, he would first reform the progressive but porous income and corporate tax, then implement a 12. 3% VAT. The plan would start by taking the majority of Americans–those earning less than 100,000 dollars per year–off of the income tax and replace it with a family allowance.
This group would then be taxed at a flat 16% of income. Those earning more than 100,000 dollars per year would be taxed at a 25% clip. In addition, this group would be allowed certain special deductions, including those for including medical and investment expenses. Capital gains income would be taxed as regular income. A rebate would be offered to low income households as a means to alleviate any undue burden that a VAT tax would impose. Finally, the corporate income tax rate would be lowered to 15% (Toder, E. , Nunns, J. , Rosenberg, J. 2012). The result of this plan is a fairer VAT which both broadens and flattens the tax base that can increase receipts while keeping the tax burdens among the classes essentially the same (pg. 26, table 5). Reduction of Corporate Income Taxes The federal tax code is lengthy and burdensome. Perhaps there is no clearer example of its convoluted nature is that of the corporate income tax. The high rates of corporate taxes are first paid by the company, and then dividends paid to their investors are taxed again in the form of capital gains tax.
Of course, this information should not discount the importance that corporate taxes have in the federal tax code as a revenue generator. It does, however, point to the need for reform because corporations employ a substantial portion of the working population. The Graetz model addresses this need by reducing the corporate tax rate to 15% while also increasing the 15 % capital gains tax to regular taxable income of either 16% or 25% depending on end of year income. However, his model is not the first nor last to address the need for reform.
A special congressionally appointed task force recently offered other options. The variable of corporate tax reduction measured as a means to reduce the deficit, thus alleviating the need for deficit spending was recently tackled by the 2010 Debt Reduction Task Force. The Task Force recommended a reduction of corporate tax income to 27 percent (Domenici, P. V. , Rivlin, A. M, et. al, pg. 33) and increases the maximum capital gains tax from 15 percent to 27 percent (pg. 38). The result of these plans is a flatter, broader, more user friendly tax rate that will increase revenue while also encouraging investment.
Regarding their choice for increasing the capital gains tax, the authors reported that a change was needed “because tax preferences…reduce the economy’s productivity because decisions on earning, spending, and investment are driven by tax considerations rather than the price signals that a free market economy produces” (pg. 29). The same line of thinking also applied to high corporate taxes; the authors found that they encourage companies to make decisions on investments and production based upon how much money could be diverted from paying taxes.
Though the path to deficit reduction policy has proven difficult, there are ways and means to get it done. The two options I have expounded upon here represent the work of concerned scholars across the country that have put forth valid suggestions as to how to adopt conservative and liberal ideas into coherent policy that can increase revenue and simplify the tax code. The VAT is a proven revenue generator that has been implemented in wealthy countries around the world. However, fiscal conservatives keen on keeping government expenditures down hesitate to embrace such an idea.
In his work, Graetz takes great pains to address the temptation that some lawmakers might have for fiscal profligacy by allowing his proposed VAT to be flexible to allow for deficit neutrality. This would leave the window open for a much needed, politically sane, discourse on the need to address the sacred cows of federal expenditures. Liberals will no doubt note that the progressivity of the current tax code that would be kept in the Graetz VAT. They should also, however, extinguish the thought that the high tax rate on corporation is an inherent good.
They are in fact bad for business because they discourage foreign and national investment. Federal outlays have continually been one trillion dollars more than receipts each year since 2009 (treasurydirect. gov, n. d. ). The continued growth of the deficit not only compromises the country’s fiscal integrity, but also our national security as well. By broadening the tax base, decreasing corporate tax liabilities, and implementing a progressive VAT, I think we can be well on our way to turning the deficit into a surplus.