Mankiw on the VAT

Greg Mankiw, Harvard economist and CEA Chairman under Bush, has a very good and neutral article on the Value Added Tax. In theory, many of the major tax changes that you hear about are actually all the same, but they vary in execution and compliance. For instance, Huckabee's consumption tax and Steve Forbes' flat tax are essentially the same. Under Huckabee's system, we would use tax free money to buy more expensive taxed products. Under Forbes' our wages are taxed, but the products we buy aren't. In both tax systems, savings aren't taxed. As Mankiw, explained in the article, a VAT is just a consumption tax that is spread out along the value chain.

So, how is "in theory" different than in reality:
1. Compliance - One key way is policing the compliance of those in the tax system. For instance, a large sales tax encourages black markets more than a VAT. In the former, there is a buyer and a seller that have a lot to gain by avoiding the tax and splitting the gains. In a VAT, the gain is small from avoiding tax and spread over every part of the value chain. Think of a car, who is more likely to cut an off-books deal, you and your shady dealer or you and every producer of every part in that car.

2. Change-over - The often overlooked by commentators part to this equation is that economists often show equivalence as if two systems were already in place and would remain in place. Imagine changing from our system to a Huckabee system. If your want of my contemporaries, it probably sounds fine, but if you are one of my parents', it probably doesn't. Let's say you turned 65 and retired the day the change took place. Over your whole career, your labor was taxed, and now that you are living off your savings, your labor is being taxed again! this time by taxing your future consumption. I never heard it mentioned, but Huckabee's plan was a huge one-time tax increase on older people.

3. Affect on Size of Gov't - This seems to be one of the most contentious parts of tax debates and also the part that has the least and most ambiguous evidence. Some argue that when people don't see a tax directly like the VAT, they don't fight against them as hard, so government gets bigger. In reality, government growth appears pretty unrelated to the way taxes are collected.

One final point: These tax plans are generally identified with Republicans, but as a moderate lefty, it's still quite easy for me to find an acceptable version. For a consumption or VAT tax, you'd just have a standard deduction that everyone would get back. The tax rate compared to the deduction determines how progressive the tax is. If the standard deduction is 0, and the tax rate was 20%, it wouldn't be progressive at all. If the standard deduction was $5,000 and the rate was 30%, the very poor would pay almost no taxes with some paying negative taxes. In terms of Forbes' flat tax, it just requires adding a large expemption (no income up to say $25,000 is taxed) and possibly an Earned Income Tax Credit (if you worked but made less than $15,000, the gov't pays you).