The Macroeconomic Effects of a Value Added Tax Rachelle Bernstein National Retail Federation June 3, 2011

VAT – Why is it on the table? Deficit projection 2011: $1.4 trillion (9.8% of GDP) Deficit projection 2021: $7 trillion Debt to GDP ratio 2021: 98.1% Solutions will require some combination of –Discretionary spending cuts –Mandatory spending cuts –Revenue increases

I. How a VAT works Primary features of VATs –Consumption-type taxes that are similar to retail sales taxes, but spread the remittance of tax across businesses based on their value-added. –Both relieve the tax on the return to saving and investment, but do so in different ways. –Generally are destination based with border adjustments (tax imports, but exempt exports). Virtually all 150 countries with a VAT use the credit method. Subtraction method has received some interest in the U.S. because its structure is similar to the corporate income tax.

How credit and subtraction method VATs work Both tax business receipts, but remove the tax on intermediate production. This helps avoid tax cascading. Accomplished in somewhat different ways. –Credit method: Firms claim a credit for taxes previously paid. –Subtraction method: Firms claim a deduction for business purchases. The two methods generate the identical amount of tax for each taxpayer (if comprehensive and single rate)

An illustration...

II. Key Findings EY/Tax Policy Advisors Study – An add-on VAT poses substantial risks to the economy Lower retail spending –Initially 5 percent lower. –$2.5 trillion lower over the next decade. –Over the longer term, 3.7 percent lower. Initially, lower economic activity –GDP falls for the first three years, then flat for several years. –Rises by only 0.3 percent ten years after enactment. Reduces employment –850,000 fewer jobs in first year. –700,000 fewer jobs over the longer-term. Most working Americans alive today are worse off. Enacting an add-on VAT is particularly troubling during period of economic weakness.

III. VATs Analyzed Three VAT Policy Scenarios Analyzed % Narrow-based VAT with exemptions % Broader-based VAT with a rebate % Narrow-based VAT with a rebate Report also considered a reduction in government spending to reduce the deficit by 2% of GDP. –Helps disentangle the benefits of deficit reduction from the effects of the VAT. –Focuses on the relative benefit of reducing the deficit through spending reductions rather than a tax increase.

Defining the tax base Major items excluded from VAT base (2010):

VATS Are Highly Regressive VATs hit lower and middle income taxpayers much harder than wealthier individuals. Consumption taxes will hurt senior citizens more than working-aged citizens.

Distributional Effects of Narrow-based VAT (no rebate)

Impact on State and Local Governments A VAT would greatly hurt the states, 45 of which rely on sales taxes as a major source of revenue. A VAT would also hurt all of the local governments that impose their own sales taxes. The enactment of a federal consumption tax would crowd out the ability of state and local governments to raise their own sales taxes at times when they are desperately in need of revenue. Because a VAT would cause retail spending to decline by $2.5 trillion over the next decade, state and local governments that rely on sales tax revenues would have significant revenue shortfalls.

Experience with VATs Abroad

CONCLUSION NRF study found that an add-on VAT would result in less economic growth as compared to a reduction in government spending. NRF study found that an add-on VAT would lose 850,000 jobs in the first year, as compared to a reduction in government spending, which would add 250,000 jobs in the first year.