Value-Added Tax: A New U.S. Revenue Source?

Publication Date: August 2006

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

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Abstract:

President George W. Bush has stated that tax reform is one of his Administration's top priorities. Some form of a value-added tax (VAT), a broadbased consumption tax, has been frequently discussed as a full or partial replacement for the U.S. income tax system. In the 109th Congress, five bills have been introduced that would levy some type of a VAT in order to reform the tax system: H.R. 1040, H.R. 4707, S. 812, S. 1099, and S. 1921. In addition, H.R. 15 would levy a VAT to finance national health insurance.

A VAT is imposed at all levels of production on the differences between firms' sales and their purchases from all other firms. For calendar year 2005, a broad-based VAT in the United States would have raised net revenue of approximately $50 billion for each 1% levied. Most other developed nations rely more on broad-based consumption taxes for revenue than does the United States. A VAT is shifted onto consumers; consequently, it is regressive because lower-income households spend a greater proportion of their incomes on consumption than higher-income households. This regression, however, could be reduced or even eliminated by any of three methods: a refundable credit against income tax liability for VAT paid, allocation of some of VAT revenue for increased welfare spending, or selective exclusion of some goods from taxation.

From an economic perspective, a major revenue source is better the greater its neutrality -- that is, the less the tax alters economic decisions. Conceptually, a VAT on all consumption expenditures, with a single rate that is constant over time, would be relatively neutral compared to other major revenue sources. A VAT would not alter choices among goods, and it would not affect the relative prices of present and future consumption. But a VAT cannot be levied on leisure; consequently, a VAT would affect households' decisions concerning work versus leisure.

The imposition of a VAT would cause a one-time increase in this country's price level. But a VAT would not necessarily affect this country's future rate of inflation if the Federal Reserve offset the contractionary effects of a VAT with a more expansionary monetary policy. If the United States continued its policy of flexible exchange rates, then the imposition of a VAT would not significantly affect the U.S. balance-of-trade. There is no conclusive evidence that a VAT would change the rate of national saving more than another type of major tax increase.

The high revenue yield from a VAT would cause administrative costs to be low, measured as a percentage of revenue yield. In comparison to other broad-based consumption taxes, VATs have produced relatively good compliance rates. Whether or not a federal VAT would encroach on the primary source of state revenue, the sales tax, is subject to debate. A federal-state VAT could be collected jointly, but a state would lose some of its fiscal discretion.

This report will be updated as issues develop, new legislation is introduced, or as otherwise warranted.