The Wilder View

So the Senate Rebukes the VAT for What Exactly?

I don’t normally do politics – and Congress should be worrying about the fragile recovery rather than the public deficit – but this is just ludicrous. Senator McCain drafted bill H.R.4851 that was actually voted on – in favor of, no less – to do the following:

It is the sense of the Senate that the Value Added Tax is a massive tax increase that will cripple families on fixed income and only further push back America’s economic recovery.

Call me crazy, but by rebuking the Value-Added Tax, isn’t the Senate effectively confirming support of higher personal income or corporate income taxes? I’m not a professional bill-sifter; but since taxes will (eventually) rise – the merits of which will not be discussed here – this is the only conclusion I draw. The mix of taxes does matter, something about which Stephen Gordon has written many times, so I will cite him directly:

So a stated preference for a small(er) government sector can only be justified on ideological grounds. A political party may campaign for a larger or smaller public sector, but the justification cannot be that this choice will have a material effect on national income or on economic growth rates.

What does matter is how those government revenues are generated. The subject of the optimal ‘tax mix’ of taxes on labour income, capital income and consumption has been the subject of an enormous amount of theoretical and empirical inquiry. The theoretical literature has reached certain broad conclusions:

1. Taxes on capital income generate the most distortions. In a small open economy, the elasticity of supply is very large (in principle, infinite), so small changes in the rate of return on capital can have large effects on investment. 2. Taxes on consumption generate the least distortions. Since they don’t affect post-tax rates of return, they don’t affect savings and investment decisions.

Interestingly, I completely disagree with the first part of the citation, as the size of the government can be too small and affects the level of aggregate activity. Bill Mitchell argued this quite eloquently just last week.

I digress; back to taxes. Stephen Gordon focuses on Canada, a small-open economy; but in glancing through the literature (two papers here and here, for example), these results seem to hold for larger economies as well. Furthermore, this literature looks a little “old” – I suspect that it will get renewed interest now.

As such, here is the case for McCain’s bill against the VAT tax.


The chart illustrates the VAT tax rates across the OECD – of which the U.S. is the only member country without a VAT, so it is not included in this graph – plotted against economic growth. I know that there are just two variables estimated here, but the scatter is quite clear: there is no correlation. (The data are 2005-2007 averages, and you can download the data from the OECD Tax Database.)

Now here’s an illustration in support of higher corporate income taxes?


The chart illustrates the Corporate income tax rates across the OECD plotted against economic growth. (The data here are from the same OECD database.) There is a very clear and negative correlation amongst the two variables. This supports a recent OECD study, of which I’ll again cite Stephen Gordon:

An interesting recent OECD study on the optimal tax mix finds that a strategy of shifting away from income taxes – and especially corporate income taxes – in favour of consumption and property taxes has a positive effect on national income. (Shifting away from consumption taxes to income taxes has the opposite effect.)

Eventually, economic growth will warrant a transfer of excess private saving back to the government via rising taxes. But wouldn’t you (McCain) want to at least consider the tax that doesn’t adversely affect economic growth? Like a consumption tax?


Update: this discussion is going to move in the direction of the regressive nature of a VAT and income inequality in the U.S. I should note that Canada also has an interesting model. The government transfers benefits in the form of GST tax credits to low- and middle- income households to address the regressive GST. The credits totaled roughly 12% of all GST revenues in the 2008-2009 fiscal year.

Originally published at News N Economics and reproduced here with the author’s permission.   

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