Potential new tax threatens to keep the U.S. economy in a crisis

Commentary by James H. Shott

On April 8, Congressional Budget Office (CBO) chief Douglas Elmendorf said this about the enormous Obama budget deficit: “U.S. fiscal policy is unsustainable, and unsustainable to an extent that it can't be solved through minor changes. It's a matter of arithmetic.” What does that mean?

It means that government spending is so far ahead of its revenue collection that some major change has to occur. In such situations there are three choices: reduce spending; increase taxation; or some combination of the two.

All those who think the administration and the current Congress will reduce spending, please stand up. Those still sitting are correct: there won’t be spending cuts, and everyone – everyone – is going to pay more taxes, despite Barack Obama’s promises to the contrary during the presidential campaign.

Mr. Elmendorf suggested that the CBO has begun to study the impact of adding an entirely new kind of tax to the extensive list of existing federal taxes: the value added tax (VAT). Observers suspect that President Obama’s deficit reduction commission will recommend the VAT to counter the administration’s spending addiction; the only tool many economists believe is capable of raising enough money to make a dent in the gargantuan Obama deficit.

A value added tax is similar to a national retail sales tax but imposes a tax at every stage of business production, and its cumulative effects are paid by the consumer. Unlike earnings-based taxes like the income tax, people are taxed on what they spend: spend a lot, pay a lot of VAT taxes; spend little, pay little VAT taxes.

Value added tax systems are popular in the social democracies of Europe and other nations around the world, and standard rates range from five percent (Japan) to 25 percent (Sweden and Denmark). Most countries with a VAT have lower rates for some items, and no tax at all on a few.

On inexpensive items you won’t really notice a five percent VAT very much. An item that costs $20 will have an additional dollar of VAT added to it. If the VAT rate is 25 percent, however, you’ll pay a $5.00 VAT. That might be enough to get your attention.

On more expensive items, like something that costs $1,000, the five percent VAT will add $50 to the cost, and the 25 percent VAT will add $250. Both of those should get your attention.

The problem the VAT poses for Americans is that where it might be a suitable replacement for income taxes as a means to raise government revenue, the VAT will not replace the income tax or the myriad of federal taxes we pay, it will be added to them, since the only way to counter the Obama spending addiction is to provide additional revenue to the federal government over and above what it is already collecting.

But adding the VAT to existing taxes will have significant negative effects. Since it is based on spending, the more you make, the more you can spend. However, everyone will likely buy less because the price of nearly everything will go up, while salaries and wages will not. Imagine having to pay from five to twenty-five percent more for most things you purchase. And everyone will be affected by the VAT, not just the middle-class Americans Mr. Obama has labeled “rich.”

Since rising prices lead to lower purchasing, demand for products will drop and production levels will decline commensurately, and that will put additional pressure on employers to lay off workers. The only question is how substantial a drain on the economy the VAT will produce?

EconomyWatch notes that a concern in “introducing value-added tax is that the introduction of the tax would set in motion a spiral in which prices and wages would feed on each other – that is, VAT would be inflationary.”

That Black Hole of Economics, otherwise known as the White House, makes one blunder after another. The most serious problem facing the country when Barack Obama took office was unemployment. The most serious problem 15 months later is unemployment followed closely by the deficit.

Instead of taking action to foster job creation, like reducing taxes on business and individuals, Mr. Obama wasted more than a year focusing on a problem a minority of Americans thought was important – health care reform – and paid lip service to unemployment, the issue Americans thought was most important. He helped push through a $787 billion stimulus bill that hasn’t worked, but has doubled the budget deficit to a scary level.

When he took office, Mr. Obama inherited a deficit of about $800 billion: the original $485 billion Bush deficit, plus $100 billion in increased recession-related spending and lost revenues, plus $200 billion in unpaid Troubled Asset Relief Program loans ($500 billion has been repaid). The Obama deficit is more than $1.5 trillion today, double what he inherited, and 10 percent of GDP.

And now he may be considering imposing a new tax on the country that will increase everyone’s taxes and put additional pressure on jobs, when what is clearly needed is cuts in spending and taxes.

Cross-posted from Observations