A 'value-added tax' isn't so hot, one analyst says

Charles E. McLure Jr. an economist who has been studying the "value-added tax" -- now a hot idea in Congress -- since the mid-1960s, concludes: "The more I look at it, the more I am not convinced of it. This 'many splendored' tax has a lot of problems. It comes out a loser in the horse race with any other tax I can think of."

The objections to the value-added tax (VAT) by Mr. McLure, who is vice-president of the National Bureau of Economic Research, and other critics has prompted Rep. Al Ullman (D) of Oregon, chairman of the tax-writing House Ways and Means Committee, to consider some important changes in his proposal for a 10 percent VAT.

The VAT is basically a sales tax, but one not collected in a simple way. Under it, if a farmer sells $80 worth of lettuce to a wholesaler, he would pay $ 8 of tax. When the wholesaler sells this lettuce to the retailer for $100, he is liable to a tax of $10, but gets a credit for the $8 in tax paid by the farmer. So he pays only $2 -- the amount of "value added." When the retailer sells the lettuce for $120, he is liable to a tax of $12 but pays only $2 on the value added.

For many years now VAT has been a major source of government revenue in the European Community. Every so often it has roused some interest in the United States as a possible way to stimulate exports or encourage savings and investment rather than consumption. But the ideas have not gone far in Congress.

Today, however, the VAT has an important champion in Mr. Ullman. In October, he proposed a VAT as part of a sweeping new plan to revamp the basic US tax system. He wanted to use the $130 billion in new revenues from a VAT to trim the federal income tax and the social security tax by about $50 billion each.

Now, according to a report from Washington, he is reworking his plan to ease some of the objections. Mr. McLure looks at the merits and demerits of the VAT under six topics:

1. Effects on capital formation. Both the corporate and personal income taxes penalize savings and encourage consumption. The person who saves and invests pays taxes on the interest or dividends earned. The individual who buys goods is subject to no taxation or low taxation on them, but would face a greater tax bill under VAT. However, replacing part of the social security payroll tax with VAT revenues would not do much to stimulate capital formation, Mr. McLure says. He and Mr. Ullman would agree the nation needs more investment in modern plant and equipment to improve productivity and thereby the US standard of living and international competitiveness.

2. Tax neutrality. Any value-added tax that is likely to be adopted will probably be substantially less neutral (a neutral tax does not favor any one economic activity over another) than its advocates like to believe, Mr. McLure says. In fact, it might be less neutral than the social security tax, if not the personal income tax.But it would be more neutral than the corporate income tax and in this case would result in a net improvement in the allocation of the nation's scarce resources.

In testimony to Congress Nov. 15, Mr. McLure said he assumed the VAT would have to exempt food, housing, and such important services as medical care, legal expenses, public transportation, and so forth. Congressman Ullman's revisions do exempt food, shelter, medical care, and government services entirely.

3. Distribution of tax burdens. If the VAT were imposed at a uniform rate on all consumption, it would be regressive -- hitting low-income taxpayers harder than those with high incomes. That's because spending on goods and services takes a lower fraction of personal income as income rises. The social security tax is also regressive. But the personal income tax is progressive -- hitting the well- to-do harder than those in lower income brackets.

Mr. Ullman's proposed exemptions (instead of a reduced rate of 5 percent for these items in the original proposal) would ease the regressive nature of the tax somewhat. They would also lower revenues from $130 billion to about $90 billion, trimming the size of the offsetting tax cuts.

4. Price effects. Mr. McLure estimates that a 10 percent VAT would shove up consumer prices 5 percent.

5. International effects. The imposition of VAT would do little to stimulate US exports, Mr. McLure figures. In any event, in a floating-exchange-rate regime, the dollar would soon adjust to cancel out any initial advantages.

6. Revenue yield and growth of government. He is concerned that Congress, seeing a new pile of money available from the VAT, would quickly spend it, boosting the government's role in the economy. To counter this fear, Mr. Ullman now proposes to limit government spending to a fixed percentage of the nation's gross national product -- its total output of goods and services. That percentage would indeed be reduced over the years.

Weighing the overall pros and cons, Mr. McLure still comes out thumbs down on the VAT. If the nation did go a sales-tax route, however, he would prefer a simple retail sales tax, because of its administrative ease and the experience of more than 40 states with it. The VAT, he says, "seems a little silly."