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Department of theTREASURY
WASHINGTON, D.C. 20220
TELEPHONE 566-2041
FOR RELEASE UPON DELIVERY
EXPECTED AT 10:00 A.M. EST
THURSDAY, NOVEMBER 8, 1979
TESTIMONY OF THE HONORABLE G. WILLIAM MILLER
SECRETARY OF THE TREASURY
BEFORE THE
HOUSE COMMITTEE ON WAYS AND MEANS
Mr. Chairman and Members of this distinguished Committee:
It is a pleasure to appear before this Committee to discuss
the important issues raised by H.R. 5665, the "Tax Restructuring
Act of 1979 ."
This bill would result in fundamental changes in
our Federal tax structure.
Income taxes on corporations and
individuals, as well as social security taxes, would be cut by
$130 billion in 1981.
A Federal value added tax would offset
this revenue loss.
This testimony will not concentrate on the
specifics of H.R. 5665 , but on the basic issue which the bill
raises: whether the United States should replace some of its
income taxes with a consumption tax.
That is, whether the
Federal tax system should weigh more heavily on consumption and
less heavily on saving and investment.
Many believe that such a
change would contribute significantly to improved capital for
mation, higher productivity, and a more competitive position for
American business in world markets.
Others express concern that
a consumption tax would have only small effects on investment and
would place an unfair
burden on lower
income families already
plagued by high prices for energy, food, housing, and other basic
necessities of life.
Higher consumption taxes, they believe,
would mean still higher prices.
These hearings will serve the
valuable function of focusing the discussion on these significant
economic and social issues.
An important element in this discussion is the role of a
value added tax in the Federal tax structure.
A value added tax
is a multistage tax on consumer goods and services.
Unlike a
retail sales tax, it is collected at each stage in the production
and distribution process.
But since it is levied only on the
amount of value added (the difference between sales and pur
chases) at each stage, rather than on the full selling price, it
avoids the cascade, tax-on-tax, effects of a turnover sales tax.
A value added tax is similar to a retail sales tax in that the
total tax paid by the consumer is equal to the final price of the
product multiplied by the tax rate.
M-186
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Many European countries have value added taxes.
Typically,
they are imposed at a rate of about 15 to 20 percent and generate
about 15 percent of a country's total national and local tax
revenue.
In contrast, state and local retail sales taxes raise
about 7 percent of the total Federal, state, and local tax
revenue in the United States.
The $130 billion in value added
tax revenue estimated to be raised by H.R. 5665 would be about 14
percent of total -Federal, state, and local 1981 tax liabilities,
assuming it is accompanied by the proposed income and social
security tax cuts.
In nearly all cases, the European value added taxes replaced
sales taxes, frequently of the cascade turnover type which,
unlike the value added tax, taxed the full sales price at each
stage, without allowing a credit for tax on previous transac
tions.
The Europeans found the cascade tax objectionable because
it discriminated against nonintegrated firms and because the
export rebate and import tax could not be accurately estimated
for border adjustment purposes.
Thus, in the European case, the
adoption of a value added tax was regarded as a reform of an
unwieldy and distortionary system of indirect taxation.
This
characterization does not apply to the present indirect tax
system in the United States.
Only the United Kingdom has used
the value added tax to reduce income taxes, as Chairman Ullman is
suggesting for the United States.
The popularity of the value added tax is not universal.
The
voters of Switzerland have twice rejected it by referendum.
The
latest rejection was based in part on a perceived threat to local
autonomy since a Federal value added tax would have replaced some
of the local Swiss taxes.
Most recently, Japan, largely as a
result of its parliamentary elections, appears to have postponed
the planned introduction of a value added tax.
For the United States, a value added tax raises a number of
important questions.
Would it encourage capital formation? What
impact would it have on the price level?
Would it improve the
trade balance?
Would it be regressive?
No one is seriously
suggesting the value added tax solely as an additional Federal
tax.
Consequently, the answers to these questions, as well as
others, depend upon which taxes the value added tax replaces.
By
way of illustration, two of the proposals made by Chairman Ullman
call
for
reducing the corporate income tax and the social
security taxes.
Capital Formation
Taxes on capital income, such as the corporate income tax and
the individual income tax on interest and dividends, reduce the
after-tax return on savings.
Put another way, an income tax
encourages present, as compared to future, consumption.
With no
taxes, a person with $100 of income could choose between buying
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-3-
$100 of consumption goods this year or saving now and buying $110
of consumption goods next year, assuming the interest rate is 10
percent.
Thus, a person can consume 10 percent more next year by
saving now.
Similarly, with a consumption tax, which exempts the
earnings from capital, a person with $100 of income could consume
$50 this year and pay $50 in tax or, by saving the income this
Thus, a
year, could consume $55 next year and pay $55 in tax.
by
saving
more
next
year
person could still consume 10 percent
now.
If a 50 percent income tax, rather than a consumption tax, is
imposed, however, the individual, after paying the tax, can buy
$50 of consumption goods this year or can save the $50 and, after
paying the tax on the interest earnings, buy $52.50 of consumpBecause of the income tax, a person can
tion goods next year.
percent,
rather
than 10 percent, more consumpt ion
buy only 5
year.
Because
of
this lower return, the individual
goods next
rather
than save for future consumpmay decide to consume now
recognize,
however, that the respontion.
It is important to
taxation is an unsettled
more
favorable
siveness of saving to
will
rise in response to
issue.
If one concludes that savings
value
added tax for the
reduced taxation, then substituting a
saving
.
corporate income tax should encourage
There are other considerations in assessing the mechanism
First, an increase in
that leads to an increase in investment.
be
channeled
into
domestic
financial markets in
savings must
interest
rates
and
therefore
the cost of capital,
order to lower
to
the
lower
cost of capital by
Second, producers must respond
There
methods
of
production.
more
capital
intensive
using
response,
but
its
magnitude
is
open
to
probably will be some
mix
of
new
investment
must
be
considered;
discussion. Third, the
it may be concentrated in housing, consumer durables, or fixed
business capital.
Thus, the substitution of a value added tax
for the corporate income tax will increase capital formation only
if savings increase, the cost of capital falls, and business
responds by investing in the United States.
Finally, it bears noting that the potential of the value
added tax for promoting capital formation may be exaggerated by
an analysis that compares a "pure" consumption tax with a "pure"
The current income
income tax levied on all returns to capital.
tax does not apply with full force to all types of saving and
investment.
For example, home ownership, pension reserves, and
assets eligible for the investment tax credit or the asset
depreciation range receive relatively favorable tax treatment,
Similarly, not all forms of consumption would be taxed the same
under any likely value added tax.
In contrast to an income tax, neither the social security tax
ior a value added tax applies directly to the return from saving,
lonsequently, substituting a value added tax for the social
security tax would be unlikely to affect savings decisions.
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-4-
Price Level Impact
A value added tax, by itself, will probably increase prices,
since the tendency for business to pass the tax on to consumers
is unlikely to be offset by an unduly restrictive monetary
policy.
The result would be a "one-shot" increase, not a
recurrent increase, in the price level, although the subsequent
price effects of adjustments in wage contracts, social security
payments, and other indexed items may occur over time.
Tn this
regard, it is noteworthy that the Thatcher government’s program
of increased value added taxation and reduced individual income
taxation has been accompanied by a significant increase in the
consumer price index in the United Kingdom.
The important question, then, is whether the inflationary
impact of the value added tax would be offset by reductions in
other taxes.
Tn the short run, the corporate income tax reduces
the after-tax rate of return to capital, rather than increases
product prices.
Accordingly, prices will probably not fall as
corporate income taxes are cut.
Thus, substituting a value added
tax for the corporate income tax is likely to increase prices.
This is a serious drawback to the value added tax.
Substituting a value added tax for the social security tax
may be less inflationary.
Reducing the employer portion of the
social security tax would tend to reduce business labor costs and
possibly prices.
Reducing the employee portion of the social
security tax, however, would probably have no effect on the price
level.
Thus a value added tax, accompanied by an equivalent
reduction in employer and employee social security taxes, would
result in some increase in the price level.
This would be
particularly distressing to individuals least able to protect
themselves from rising prices.
The impact of a value added tax on prices is largely inde
pendent of whether it is hidden in the price of the product or
whether it is quoted separately to consumers.
While it is not
customary in Europe to quote the value added tax separately, this
need not be the case in the United States.
State retail sales
taxes are quoted separately because the merchants persuaded
legislators to require it, and the same could occur in the case
of a United States value added tax.
Furthermore, nonseparate
quotation of the value added tax might be viewed as an attempt to
hide the tax from public scrutiny.
Balance of Trade
Many have expressed the view that a value added tax would
improve our trade balance.
This is based on the observation that
current international rules allow indirect taxes, such as sales
or value added taxes, to be imposed on imports and rebated on
exports.
These adjustments are not allowed for direct taxes,
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-5such as the corporate income or social security taxes.
It is
doubtful, however, that the U.S. trade balance would improve
significantly from substituting a value added tax for the
corporate income tax.
The impact of the value added tax on trade is closely related
to what happens to prices.
Quite simply, one must ask the
question: will the substitution of the value added tax for some
other tax increase prices?
It seems likely that the immediate
impact of substituting a general value added tax of 5 percent for
part of the corporate income tax would be to increase prices by
about 5 percent.
Since the new tax would be rebated on exports,
just like our state retail sales and Federal excise taxes,
exports would leave the country tax free.
While domestic prices
would be 5 percent higher, export prices would remain unchanged.
Foreign consumers, therefore, would find U.S. products no more
attractive than before? there would be no increase in demand for
U.S. exports.
Since imports would be subject to the value added tax their
prices also would increase by about 5 percent, the same as for
domestic goods and services.
As a consequence, domestic con
sumers would find imports just as attractive as before; there
would be no incentive to reduce the demand for imports. Thus, on
both the export and import side, there would be little immediate
impact on the U.S. trade balance if a value added tax were sub
stituted for the corporate income tax.
There might, of course,
be a positive trade impact in the long run if the substitution
led to an improved investment climate, enhanced capital forma
tion, and a more productive and competitive U.S. economy.
A modest trade balance improvement might result from
replacing the social security tax with a value added tax, if tha
price level increased by less than the value added tax.
Because
of the price-dampening effect of reducing the employer portion of
the social security tax, this is a possibility.
Regardless of which tax it replaces, many believe that a
value added tax rebate, in itself, will expand exports and that a
value added tax levy will retard imports.
This belief might have
a positive effect on trade if it encourages businesses to compete
more vigorously in international markets.
This result would
depend upon the importance of nonprice considerations in
explaining export activity.
It is also important to recognize that other countries could
restructure their own tax systems if they felt the United States
was gaining an unfair trade advantage.
Relative to other coun
tries, the United States has a moderately high corporate income
tax, but a low social security tax.
(See Annex A.)
Thus, the
possibility exists that other countries might maintain their
competitive position by increasing their existing value added
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Federal Reserve Bank of St. Louis
-6taxes and reducing their corporate income or, especially, their
social security taxes.
This outcome is by no means certain.
After all, a country's tax structure is not determined solely by
international considerations.
Moreover, except for Japan, U.S.
indirect taxes, as a share of gross domestic product, are the
lowest of the major developed countries.
(See Chart 1 and Annex
A.)
Other countries may believe that the United States should be
allowed to "tilt" its tax struct’ure to reach some "reasonable" or
"average" level of indirect taxation.
1.
This issue has been studied before.
Both the President’s
Task Force on Business Taxation, in its 1970 review of tax
policy,
and the Advisory Commission on Intergovernmental
Relations, in its 1973 value hdded tax study, considered the
trade issue.
Both expressed’ doubt over any trade benefits
resulting from substituting a value added tax for the corporate
income tax and both noted the possibility of foreign retaliation.
Distribution of Tax Burden
Lower income taxpayers, who must spend all their income on
consumption, may find a value added tax burdensome because of its
regressivity. While a value addled tax, by itself, is regressive,
one must consider which tax it replaces.
The immediate impact of
the corporate income tax is probably progressive since it falls
on income from capital.
Therefore, substituting a value added
tax for the corporate income t!ax would make the tax structure
less progressive.
The social security tax, on the other hand,
also is regressive because it is limited to the first $22,900 of
wages and applies only to labor income.
Accordingly, substi
tuting a value added tax for t^e social security tax would not
make the tax system noticeably less progressive.
One regressive
tax would be substituted for another.
Retired individuals, how
ever, who do not pay social security tax, would be distressed by
having to pay value added tax. * They could justifiably say that
they already had paid for their retirement during their working
years and that higher prices and- taxes in retirement were unfair.
Their distress might be partially assuaged by the fact that
social security payments are indexed.
One way to illustrate possible distributional effects is to
ask what would happen to tax burdens if a value added tax
completely replaced the individual income and social security
(employee portion) taxes.
(See jChart 2.)
The combination of the
current income and social security taxes is progressive while a
value added tax, even with necessities excluded, is regressive.
As a share of income, the present individual income and social
security taxes are only 2 percent for families with less than
$5,000 in income, but increase throughout the income range to 33
percent for families with over $100,000 in income.
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1
•• i ’
I ;
I
1-•
j
CHART 1
DIRECT AND INDIRECT TAXES AS A
PERCENT OF TOTAL TAX REVENUE
Canada
France
Germany
Japan
{Indirect
I Direct
United Kingdom United States
TAX REVENUESAS A PERCENT
OF GROSS DOMESTIC PRODUCT
30-
20-
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Canada
France
Germany
Japan
United Kingdom United States
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CHART 2
TAXES AS PERCENT OF INCOME
-9This may be contrasted with a value added tax with no exclu
sions at a 23.2 percent rate, sufficient to equal the revenue
raised by the individual
income and employee
social security
taxes in 1978.
As a share of income, such a value added tax
would be 35 percent for families with less than $5,000 in income,
but fall to 6 percent for families with over $100,000 in income.
No one, of course, is proposing the complete substitution of
the value added tax for the income and social security taxes.
A
more realistic alternative would be to substitute a value added
tax for part of the combined individual income and social secur
ity taxes.
One possibility would be to reduce income and
employee social security taxes by $100 billion, keeping the same
degree of progressivity for these taxes as under present law, and
offset the revenue loss with a $100 billion value added tax with
no exclusions.
The resulting distribution of tax burdens would
be regressive at the lowest income levels and mildly progressive
elsewhere.
As a share of income, families with less than $5,000
in income would pay 17 percent in taxes, families with between
$5,000 and $10,000 in income would pay 14 percent, and taxes
would then increase throughout the income range so that families
with over $100,000 of income would pay 21 percent of their income
in taxes.
The overall distribution is significantly less
progressive than the present combination of income and employee
social security taxes.
The regressivity of the value added tax can be moderated, but
not eliminated, by special measures.
One possibility is the use
of exemptions and reduced rates for necessities, as in Chairman
Gilman's proposal and in some European countries.
These reduce
the tax burden of the value added tax at the lowest income
levels, but the tax remains regressive.
Exemptions and reduced
rates, moreover, create administrative problems.
A tax with two,
three, or four rates is more complex than a tax with one rate.
The specially-taxed items must be identified.
Does a lower rate
for food, for example, apply to such items as chewing gum, soda
pop, candy, or caviar? Experience with the income tax shows that
even medical services and drugs are not easy to define.
Beyond
the definitional problems, total or partial exclusions erode the
value added tax base and its revenue potential.
(See Chart 3.)
The regressivity of a value added tax also can be reduced by
a refundable income tax credit for tax paid on a necessary amount
of consumption. This avoids the need to define exempt commodities
and can be implemented at a lower revenue cost than a complete
exemption for certain "essential" commodities.
It can, for
example, be phased out at increased income levels.
In effect,
middle and upper income groups would still pay tax on purchases
of food and other necessary items.
On the other hand, a refund
able credit is effective only if it reaches the roughly 25
million individuals who do not appear on an income tax return.
These tend to be individuals most in need of the credit, mainly
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CHART 3
SUBTRACTIONS
FROM VALUE ADDED
TAX BASE
(Percent)
Housing
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Medical Care
I
I
o
52 9
Other Expenditures
-11-
recipients of social security benefits and of transfer payments
under social and welfare programs.
Unlike lower rates and
exemptions, if the credit was not paid until the end of the year,
the consumer would have to finance the tax during the year.
Administrative and Design Considerations
Both the European value added taxes and the tax suggested by
Chairman Ullman have certain basic similarities:
they are broad based, applying to services as well as
goods;
tax liability is determined by the credit method with
tax paid on purchases deductible from tax due on
sales?
-
they are consumption
capital
equipment
deductible: and
type taxes,
purchases
any
is
tax paid on
immediately
they extend through the retail stage.
A value added tax of this type for the United States would
involve about 15 million taxpayers.
This number might be reduced
by 5 million if exemptions were provided for very small propri
etorships and farming.
But under a value added tax, nearly all
transactions are taxed.
Even a firm that is tax exempt on its
sales will have paid tax on its purchases.
If it is to receive
credit for tax paid on its purchases, it either would have to
file a return or the credit would have to be made available to
its customers.
Even 10 million taxpayers would add about 30 percent to the
number of returns filed with the Internal Revenue Service,
assuming quarterly returns are required.
Since the value added
tax would not totally replace any other tax and would be a new
tax, requiring new returns, new regulations, and a new body of
case law, this would be a net addition to the work of taxpayers,
the Internal Revenue Service, and the courts.
This differs
sharply from the typical European case where the value added tax
completely replaced another sales tax.
Reporting and payment requirements for a value added tax
would be similar to those for Federal excises, which require
liability to be computed on a semimonthly basis with payment due
9 days later.
The actual excise tax return is filed quarterly
and is accompanied by the payment of any remaining balance.
Liquor and tobacco excises, however, have slightly different
rules.
A value added tax payment system which would fit more
neatly with ordinary bookkeeping would be a monthly liability
period with payment due at the end of the next month.
This would
be similar to that proposed by Chairman Ullman.
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Federal Reserve Bank of St. Louis
-12Other Considerations
A Federal value added tax would raise a number of other
issues.
Forty five states and the District of Columbia impose
general sales taxes, a revenue source which they tend to view as
belonging exclusively to them.
Sales and gross receipts taxes
account for about 30 percent of state tax revenue.
In contrast,
excise taxes generate less than 4 percent of Federal tax collec
tions.
Nevertheless, while a Federal value added tax may make it
more difficult for the states to raise their sales taxes, it
should not prevent such increases. All levels of government, for
example, impose income taxes.
Moreover, total Federal, state,
and local sales tax collections are lower in the United States
than in most developed countries.
Because of likely differences in the tax bases, it is doubt
ful that a Federal value added tax could be coordinated with the
state sales taxes.
Separate taxes, admittedly, would mean higher
administrative and compliance costs.
Each level of government
would require a collection and audit capability.
Taxpayers would
have to become familiar with separate tax bases and separate
returns.
Revenue departments and taxpayers, however, already
face this problem with Federal and state income taxes.
Efforts
aimed at Federal-state cooperation and coordination have not been
successful.
As shown by Chairman Ullman’s proposal, even a broad-based
value added tax may not apply to all forms of final consumption.
Practical considerations may require special treatment for many
items.
In the area of housing, for example, homeowners and
tenants should be treated equally.
But if rental payments are
taxed, how should homeowners be taxed?
It may be difficult to
value the so-called "imputed rent" on owner occupied housing.
Taxing the purchase price of a home is one alternative, but this
may aggravate the problems of many families already hard pressed
to cope with high housing prices.
The treatment of interest in
the housing area also is troublesome.
If it is exempt, what part
of a cental payment should a landlord be allowed to exclude from
the tax base?
These and other problems will require careful
study.
The value added tax is a very potent revenue source.
At 1979
levels of consumption, a value added tax would raise roughly $10
billion in revenue for each percentage point.
Thus, a 7 percent
value added tax would raise about as much revenue as the corpor
ate income tax and a 12 percent value added tax would raise as
much revenue as the social security taxes.
With such a powerful
instrument for raising revenue, many are concerned that the value
added tax eventually will be used to add to the total Federal tax
burden.
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-13Conclus ion
Mr. Chairman, you are to be commended for initiating an
examination of the very important, but complex, issues of how the
Federal tax structure affects our national well being.
This is a
time of great change.
It is also a time of troublesome and
unfamiliar economic conditions.
The combination of high infla
tion, slow growth, and persistent trade deficits must make us
wonder if the traditional economic remedies still work.
In this
sense, your decision to study a broad range of new initiatives
could not come at a better time.
But changes of such major
consequences require careful and deliberate study.
We welcome
the opportunity to participate with you in that study.
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ANNEX A
Federal, State and Local Tax Revenues for Selected Countries as Percent of Cross Domestic Product, by Type of Tax, 1976
(Country Rankings In Parentheses)
:
Indirect :
:___ Iaxej_____1_______________________________________________
Diract Taxes
Social Security 2/
Country
i
Belgium
Canada
Denmark
France
Germany (Fed Rep)
Italy
Japan
Luxembourg
Netherlands
Sweden
Switzerland
United Kingdom
United States
Total
41.43(5)
33-98(9)
43.05(4)
36.90(6)
36.22(8)
32.34( 10)
20.23(13)
16.7K2)
16.90(1)
16.96(3)
29.»9(12)
36.77(7)
3O.3KH)
: Sales and
: Excise 1/
10.87(6)
10.9KD
11.7KD
12.14(2)
9.37(8)
9.34(9)
3.67(13)
9.72(7)
10.9K6)
11.18(3)
5.90(11)
9.21(10)
5.19(12)
Total
: Emo lover
13.1K5)
3.22(12)
0.18(13)
11.72(3)
12.03(6)
11.83(2)
5.09(11)
11.05(1)
17.99(1)
8.89(7)
8.49(8)
6.71(10)
7.42(9)
8.44(4)
n.a.
0.3K12)
10.61(2)
6.60(7)
11.92(1)
2.63(11)
7.80(6)
8.40(5)
8.47(3)
3.05(10)
3-75(9)
4.18(8)
Employee and
: Self Emoloved
4.70(5)
n.a.
0.17(12)
4.11(6)
5.43(D
2.9K9)
2.46(10)
6.25(2)
9.59(1)
0.42(11)
5.44(3)
2.96(8)
3.24(7)
Corporate
Income
3.07(6)
4.67(2)
1.37(13)
2.00(9)
1.56(12)
2.01(8)
3.43(4)
7.22(1)
3.61(3)
1.99(10)
2.46(7)
1.92(11)
3.29(5)
Noncorporate
Other 5/ :
13.2K4)
11.32(7)
23.86(1)
4.58(13)
10.60(8)
4.95(12)
5.07(11)
12.78(5)
12.66(6)
21.17(2)
10.5K9)
14.29(3)
9.98(10)
1.01(12)
3.13(3)
2.57(4)
1.46(9)
1.09(11)
1.17(10)
1.94(7)
2.34(5)
1.48(8)
0.51(13)
2.13(6)
4.64(1)
4.13(2)
0.10(8)
0.70(4)
0.06(10)
1.70(2)
0.57(6)
0.01(11)
1.03(3)
0.63(5)
0.25(7)
1.92(1)
—
0.07(9)
Total Direct
Taxes 6/
30.56(4)
23.04(11)
28.34(5)
24.46(9)
25.85(7)
23.00(12)
16.56(13)
37.02(1)
35.99(2)
34.48(3)
23.59(10)
27.53(6)
24.82(8)
Office of the Secretary of the Treasury
Office of Tax Analysis
Source:
(—i
aeycaua SiaLlaLUa of QECD Heatrcr Cauntrlga. 1965-1975•
±/
Includes general sales, value added, and specific excise taxes.
2J
Includes contributions of employers, employees, and self employed.
Category Is broadly defined to Include all tax payments to Institutions of general
government providing social welfare benefits, provided they are levied as a function of pay or a fixed amount per person. Thus, for the United States
this category Includes contributions to the railroad retirement fund, unemployment Insurance
fund, workman’s compensation fund, and civilservice retire
ment program In addition, of course, to the more familiar social security-type payments made pursuant to the FederalInsuranceContributionsAct (FICA).
3/
Includes Income taxes on Individual and ixilncorporated enterprise, such as proprietorships and partnerships.
3/
Includes taxes on net wealth, immovable property, estates, and gifts.
5/
Includes taxes on employers based on payroll or manpower and miscellaneous taxes which oannot be classified within a specific direct tax category.
kJ
Computed by subtracting sales and excises from total.
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Federal Reserve Bank of St. Louis
z
Department of theTREASURY
WASHINGTON, D.C. 20220
TELEPHONE 566-2041
FOR RELEASE UPON DELIVERY
EXPECTED AT 10:00 A.M. EST
THURSDAY, NOVEMBER 8, 1979
TESTIMONY OF THE HONORABLE G. WILLIAM MILLER
SECRETARY OF THE TREASURY
BEFORE THE
HOUSE COMMITTEE ON WAYS AND MEANS
Mr. Chairman and Members of this distinguished Committee:
It is a pleasure to appear before this Committee to discuss
the important issues raised by H.R. 5665, the "Tax Restructuring
Act of 1979 ."
This bill would result in fundamental changes in
our Federal tax structure.
Income taxes on corporations and
individuals, as well as social security taxes, would be cut by
$130 billion in 1981.
A Federal value added tax would offset
this revenue loss.
This testimony will not concentrate on the
specifics of H.R. 5665 , but on the basic issue which the bill
raises: whether the United States should replace some of its
income taxes with a consumption tax.
That is, whether the
Federal tax system should weigh more heavily on consumption and
less heavily on saving and investment.
Many believe that such a
change would contribute significantly to improved capital for
mation, higher productivity, and a more competitive position for
American business in world markets.
Others express concern that
a consumption tax would have only small effects on investment and
would place an unfair
burden on
lower
income families already
plagued by high prices for energy, food, housing, and other basic
necessities of life.
Higher consumption taxes, they believe,
would mean still higher prices.
These hearings will serve the
valuable function of focusing the discussion on these significant
economic and social issues.
An important element in this discussion is the role of a
value added tax in the Federal tax structure.
A value added tax
is a multistage tax on consumer goods and services.
Unlike a
retail sales tax, it is collected at each stage in the production
and distribution process.
But since it is levied only on the
amount of value added (the difference between sales and pur
chases) at each stage, rather than on the full selling price, it
avoids the cascade, tax-on-tax, effects of a turnover sales tax.
A value added tax is similar to a retail sales tax in that the
total tax paid by the consumer is equal to the final price of the
product multiplied by the tax rate.
M-186
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Federal Reserve Bank of St. Louis
-2-
Many European countries have value added taxes.
Typically,
they are imposed at a rate of about 15 to 20 percent and generate
about 15 percent of a country's total national and local tax
revenue.
In contrast, state and local retail sales taxes raise
about 7 percent of the total Federal, state, and local tax
revenue in the United States.
The $130 billion in value added
tax revenue estimated to be raised by H.R. 5665 would be about 14
percent of total Federal, state, and local 1981 tax liabilities,
assuming it is accompanied by the proposed income and social
security tax cuts.
In nearly all cases, the European value added taxes replaced
sales taxes, frequently of the cascade turnover type which,
unlike the value added tax, taxed the full sales price at each
stage, without allowing a credit for tax on previous transac
tions.
The Europeans found the cascade tax objectionable because
it discriminated against nonintegrated firms and because the
export rebate and import tax could not be accurately estimated
for border adjustment purposes.
Thus, in the European case, the
adoption of a value added tax was regarded as a reform of an
unwieldy and distortionary system of indirect taxation.
This
characterization does not apply to the present indirect tax
system in the United States.
Only the United Kingdom has used
the value added tax to reduce income taxes, as Chairman Ullman is
suggesting for the United States.
The popularity of the value added tax is not universal.
The
voters of Switzerland have twice rejected it by referendum.
The
latest rejection was based in part on a perceived threat to local
autonomy since a Federal value added tax would have replaced some
of the local Swiss taxes.
Most recently, Japan, largely as a
result of its parliamentary elections, appears to have postponed
the planned introduction of a value added tax.
For the United States, a value added tax raises a number of
important questions.
Would it encourage capital formation? What
impact would it have on the price level?
Would it improve the
trade balance?
Would it be regressive?
No one is seriously
suggesting the value added tax solely as an additional Federal
tax.
Consequently, the answers to these questions, as well as
others, depend upon which taxes the value added tax replaces.
By
way of illustration, two of the proposals made by Chairman Ullman
call for
reducing the corporate income tax and the social
security taxes.
Capital Formation
Taxes on capital income, such as the corporate income tax and
the individual income tax on interest and dividends, reduce the
after-tax return on savings.
Put another way, an income tax
encourages present, as compared to future, consumption.
With no
taxes, a person with $100 of income could choose between buying
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Federal Reserve Bank of St. Louis
-3-
$100 of consumption goods this year or saving now and buying $110
of consumption goods next year, assuming the interest rate is 10
percent.
Thus, a person can consume 10 percent more next year by
saving now.
Similarly, with a consumption tax, which exempts the
earnings from capital, a person with $100 of income could consume
$50 this year and pay $50 in tax or, by saving the income this
Thus, a
year, could consume $55 next year and pay $55 in tax.
more
next
year
by
saving
person could still consume 10 percent
now.
If a 50 percent income tax, rather than a consumption tax, is
imposed, however, the individual, after paying the tax, can buy
$50 of consumption goods this year or can save the $50 and, after
paying the tax on the interest earnings, buy $52.50 of consumpBecause of the income tax, a person can
tion goods next year.
percent,
rather
than 10 percent, more consumption
buy only 5
year.
Because
of
this lower return, the individual
goods next
than save for future consumprather
may decide to consume now
recognize,
however, that the respontion.
It is important to
favorable
taxation is an unsettled
siveness of saving to more
will
rise in response to
issue.
If one concludes that savings
value
added tax for the
reduced taxation, then substituting a
saving
.
corporate income tax should encourage
There are other considerations in assessing the mechanism
First, an increase in
that leads to an increase in investment.
be
channeled
into
domestic
financial markets in
savings must
interest
rates
and
therefore
the cost of capital,
order to lower
to
the
lower
cost of capital by
Second, producers must respond
There
methods
of
production,
using more capital intensive
is
open
to
response,
but
its
magnitude
probably will be some
considered
;
mix
of
new
investment
must
be
discussion. Third, the
durables,
or
fixed
in
housing,
consumer
it may be concentrated
business capital.
Thus,, the substitution of a value added tax
for the corporate income tax will increase capital formation only
if savings increase, the cost of capital falls, and business
responds by investing in the United States.
Finally, it bears noting that the potential of the value
added tax for promoting capital formation may be exaggerated by
an analysis that compares a "pure" consumption tax with a "pure"
The current income
income tax levied on all returns to capital.
tax does not apply with full force to all types of saving and
investment.
For example, home ownership, pension reserves, and
assets eligible for the investment tax credit or the asset
depreciation range receive relatively favorable tax treatment,
Similarly, not all forms of consumption would be taxed the same
under any likely value added tax.
In contrast to an income tax, neither the social security tax
lor a value added tax applies directly to the return from saving.
Consequently, substituting a value added tax for the social
security tax would be unlikely to affect savings decisions.
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Federal Reserve Bank of St. Louis
-4Price Level Impact
A value added tax, by itself, will probably increase prices,
since the tendency for business to pass the tax on to consumers
is unlikely to be offset by an unduly restrictive monetary
policy.
The result would be a "one-shot" increase, not a
recurrent increase, in the price level, although the subsequent
price effects of adjustments in wage contracts, social security
payments, and other indexed items may occur over time.
Tn this
regard, it is noteworthy that the Thatcher government’s program
of increased value added taxation and reduced individual income
taxation has been accompanied by a significant increase in the
consumer price index in the United Kingdom.
The important question, then, is whether the inflationary
impact of the value added tax would be offset by reductions in
other taxes.
Tn the short run, the corporate income tax reduces
the after-tax rate of return to capital, rather than increases
product prices.
Accordingly, prices will probably not fall as
corporate income taxes are cut.
Thus, substituting a value added
tax for the corporate income tax is likely to increase prices.
This is a serious drawback to the value added tax.
Substituting a value added tax for the social security tax
may be less inflationary.
Reducing the employer portion of the
social security tax would tend to reduce business labor costs and
possibly prices.
Reducing the employee portion of the social
security tax, however, would probably have no effect on the price
level.
Thus a value added tax, accompanied by an equivalent
reduction in employer and employee social security taxes, would
result in some increase in the price level.
This would be
particularly distressing to individuals least able to protect
themselves from rising prices.
The impact of a value added tax on prices is largely inde
pendent of whether it is hidden in the price of the product or
whether it is quoted separately to consumers.
While it is not
customary in Europe to quote the value added tax separately, this
need not be the case in the United States.
State retail sales
taxes are quoted separately because the merchants persuaded
legislators to require it, and the same could occur in the case
of a United States value added tax.
Furthermore, nonseparate
quotation of the value added tax might be viewed as an attempt to
hide the tax from public scrutiny.
Balance of Trade
Many have expressed the view that a value added tax would
improve our trade balance.
This is based on the observation that
current international rules allow indirect taxes, such as sales
or value added taxes, to be imposed on imports and rebated on
exports.
These adjustments are not allowed for direct taxes,
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Federal Reserve Bank of St. Louis
-5-
such as the corporate income or social security taxes.
It is
doubtful, however, that the U.S. trade balance would improve
significantly from substituting a value added tax for the
corporate income tax.
The impact of the value added tax on trade is closely related
to what happens to prices.
Quite simply, one must ask the
question: will the substitution of the value added tax for some
other tax increase prices?
It seems likely that the immediate
impact of substituting a general value added tax of 5 percent for
part of the corporate income tax would be to increase prices by
about 5 percent.
Since the new tax would be rebated on exports,
just like our state retail sales and Federal excise taxes,
exports would leave the country tax free.
While domestic prices
would be 5 percent higher, export prices would remain unchanged.
Foreign consumers, therefore, would find U.S. products no more
attractive than before; there would be no increase in demand for
U.S. exports.
Since imports would be subject to the value added tax their
prices also would increase by about 5 percent, the same as for
domestic goods and services.
As a consequence, domestic con
sumers would find imports just as attractive as before; there
would be no incentive to reduce the demand for imports. Thus, on
both the export and import side, there would be little immediate
impact on the U.S. trade balance if a value added tax were sub
stituted for the corporate income tax.
There might, of course,
be a positive trade impact in the long run if the substitution
led to an improved investment climate, enhanced capital forma
tion, and a more productive and competitive U.S. economy.
A modest trade balance improvement might result from
replacing the social security tax with a value added tax, if the
price level increased by less than the value added tax.
Because
of the price-dampening effect of reducing the employer portion of
the social security tax, this is a possibility.
Regardless of which tax it replaces, many believe that a
value added tax rebate, in itself, will expand exports and that a
value added tax levy will retard imports.
This belief might have
a positive effect on trade if it encourages businesses to compete
more vigorously in international markets.
This result would
depend upon the importance of nonprice considerations in
explaining export activity.
It is also important to recognize that other countries could
restructure their own tax systems if they felt the United States
was gaining an unfair trade advantage.
Relative to other coun
tries, the United States has a moderately high corporate income
tax, but a low social security tax.
(See Annex A.)
Thus, the
possibility exists that other countries might maintain their
competitive position by increasing their existing value added
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Federal Reserve Bank of St. Louis
-6-
taxes and reducing their corporate income or, especially, their
social security taxes.
This outcome is by no means certain.
After all, a country's tax structure is not determined solely by
international considerations.
^Moreover, except for Japan, U.S.
indirect taxes, as a share of gross domestic product, are the
lowest of the major developed countries.
(See Chart 1 and Annex
A.)
Other countries may believe^ that the United States should be
allowed to "tilt" its tax structure to reach some "reasonable" or
"average" level of indirect taxation.
I
This issue has been studied before.
Both the President's
Task Force on Business Taxation, in its 1970 review of tax
policy, and the Advisory Commission on Intergovernmental
Relations, in its 1973 value added tax study, considered the
trade issue.
Both expressed' doubt over any trade benefits
resulting from substituting a value added tax for the corporate
income tax and both noted the possibility of foreign retaliation.
Distribution of Tax Burden
j
I
Lower income taxpayers, who must spend all their income on
consumption, may find a value added tax burdensome because of its
regressivity. While a value addled tax, by itself, is regressive,
one must consider which tax it replaces.
The immediate impact of
the corporate income tax is probably progressive since it falls
on income from capital.
Therefore, substituting a value added
tax for the corporate income fax would make the tax structure
less progressive.
The social security tax, on the other hand,
also is regressive because it is! limited to the first $22,900 of
wages and applies only to labor income.
Accordingly, substi
tuting a value added tax for tfte social security tax would not
make the tax system noticeably less progressive.
One regressive
tax would be substituted for another.
Retired individuals, how
ever, who do not pay social security tax, would be distressed by
having to pay value added tax. * They could justifiably say that
they already had paid for their retirement during their working
years and that higher prices and' taxes in retirement were unfair.
Their distress might be partially assuaged by the fact that
social security payments are indexed.
One way to illustrate possible distributional effects is to
ask what would happen to tax burdens if a value added tax
completely replaced the individual income and social security
(employee portion) taxes.
(See Chart 2.)
mhe combination of the
current income and social security taxes is progressive while a
value added tax, even with necessities excluded, is regressive.
As a share of income, the present individual income and social
security taxes are only 2 percent for families with less than
$5,000 in income, but increase throughout the income range to 33
percent for families with over $100,000 in income.
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Federal Reserve Bank of St. Louis
;
' '
1
■
> •
I
•
■
1
1
J
1
CHART 1
TAX REVENUESAS A PERCENT
OF GROSS DOMESTIC PRODUCT
40r-
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Federal Reserve Bank of St. Louis
Canada
France
Germany
Japan
United Kingdom United States
CHART 2
TAXES AS PERCENT OF INCOME
(Each line reflects equal total tax liabilities at 1978 levels of income)
ti
30
i
I
00
20
10
0
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Federal Reserve Bank of St. Louis
I
$20,000
___ |
____ L_
$40,000
$60,000
Family Income
$80,000
$ 100,000
and Over
9-
This may be contrasted with a value added tax with no exclu
sions at a 23.2 percent rate, sufficient to equal the revenue
raised by the individual
income and employee social security
taxes in 1978.
As a share of income, such a value added tax
would be 35 percent for families with less than $5,000 in income,
but fall to 6 percent for families with over $100,000 in income.
No one, of course, is proposing the complete substitution of
the value added tax for the income and social security taxes.
A
more realistic alternative would be to substitute a value added
tax for part of the combined individual income and social secur
ity taxes.
One possibility would be to reduce income and
employee social security taxes by $100 billion, keeping the same
degree of progressivity for these taxes as under present law, and
offset the revenue loss with a $100 billion value added tax with
no exclusions.
The resulting distribution of tax burdens would
be regressive at the lowest income levels and mildly progressive
elsewhere.
As a share of income, families with less than $5,000
in income would pay 17 percent in taxes, families with between
$5,000 and $10,000 in income would pay 14 percent, and taxes
would then increase throughout the income range so that families
with over $100,000 of income would pay 21 percent of their income
in taxes.
The overall distribution is significantly less
progressive than the present combination of income and employee
social security taxes.
The regressivity of the value added tax can be moderated, but
not eliminated, by special measures.
One possibility is the use
of exemptions and reduced rates for necessities, as in Chairman
Oilman's proposal and in some European countries.
These reduce
the tax burden of the value added tax at the lowest income
levels, but the tax remains regressive.
Exemptions and reduced
rates, moreover, create administrative problems.
A tax with two,
three, or four rates is more complex than a tax with one rate.
The specially-taxed items must be identified.
Does a lower rate
for food, for example, apply to such items as chewing gum, soda
pop, candy, or caviar? Experience with the income tax shows that
even medical services and drugs are not easy to define.
Beyond
the definitional problems, total or partial exclusions erode the
value added tax base and its revenue potential.
(See Chart 3.)
The regressivity of a value added tax also can be reduced by
a refundable income tax credit for tax paid on a necessary amount
of consumption. This avoids the need to define exempt commodities
and can be implemented at a lower revenue cost than a complete
exemption for certain "essential" commodities.
It can, for
example, be phased out at increased income levels.
In effect,
middle and upper income groups would still pay tax on purchases
of food and other necessary items.
On the other hand, a refund
able credit is effective only if it reaches the roughly 25
million individuals who do not appear on an income tax return.
These tend to be individuals most in need of the credit, mainly
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Federal Reserve Bank of St. Louis
CHART 3
SUBTRACTIONS
FROM VALUE ADDED
TAX BASE
(Percent)
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Federal Reserve Bank of St. Louis
IO
I
Clothing
Other Expenditures
-11recipients of social security benefits and of transfer payments
under social and welfare programs.
Unlike lower rates and
exemptions, if the credit was not paid until the end of the year,
the consumer would have to finance the tax during the year.
Administrative and Design Considerations
Both the European value added taxes and the tax suggested by
Chairman Ullman have certain basic similarities:
they are broad based, applying to services as well as
goods;
tax liability is determined by the credit method with
tax paid on purchases deductible from tax due on
sales;
they are consumption
capital
equ ipmen t
deductible ; and
type taxes,
purchases
any
is
tax paid on
immediately
they extend through the retail stage.
A value added tax of this type for the United States would
involve about 15 million taxpayers.
This number might be reduced
by 5 million if exemptions were provided for very small propri
etorships and farming.
But under a value added tax, nearly all
transactions are taxed.
Even a firm that is tax exempt on its
sales will have paid tax on its purchases.
If it is to receive
credit for tax paid on its purchases, it either would have to
file a return or the credit would have to be made available to
its customers.
Even 10 million taxpayers would add about 30 percent to the
number of returns filed with the Internal Revenue Service,
assuming quarterly returns are required.
Since the value added
tax would not totally replace any other tax and would be a new
tax, requiring new returns, new regulations, and a new body of
case law, this would be a net addition to the work of taxpayers,
the Internal Revenue Service, and the courts.
This differs
sharply from the typical European case where the value added tax
completely replaced another sales tax.
Reporting and payment requirements for a value added tax
would be similar to those for Federal excises, which require
liability to be computed on a semimonthly basis with payment due
9 days later.
The actual excise tax return is filed quarterly
and is accompanied by the payment of any remaining balance.
Liquor and tobacco excises, however, have slightly different
rules.
A value added tax payment system which would fit more
neatly with ordinary bookkeeping would be a monthly liability
period with payment due at the end of the next month.
This would
be similar to that proposed by Chairman Ullman.
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Federal Reserve Bank of St. Louis
-12-
Other Considerations
A Federal value added tax would raise a number of other
issues.
Forty five states and the District of Columbia impose
general sales taxes, a revenue source which they tend to view as
belonging exclusively to them.
Sales and gross receipts taxes
account for about 30 percent of state tax revenue.
In contrast,
excise taxes generate less than 4 percent of Federal tax collec
tions.
Nevertheless, while a Federal value added tax may make it
more difficult for the states to raise their sales taxes, it
should not prevent such increases.
All levels of government, for
example, impose income taxes.
Moreover, total Federal, state,
and local sales tax collections are lower in the United States
than in most developed countries.
Because of likely differences in the tax bases, it is doubt
ful that a Federal value added tax could be coordinated with the
state sales taxes.
Separate taxes, admittedly, would mean higher
administrative and compliance costs.
Each level of government
would require a collection and audit capability.
Taxpayers would
have to become familiar with separate tax bases and separate
returns.
Revenue departments and taxpayers, however, already
face this problem with Federal and state income taxes.
Efforts
aimed at Federal-state cooperation and coordination have not been
successful.
As shown by Chairman Ullman's proposal, even a broad-based
value added tax may not apply to all forms of final consumption.
Practical considerations may require special treatment for many
items.
In the area of housing, for example, homeowners and
tenants should be treated equally.
But if rental payments are
taxed, how should homeowners be taxed?
It may be difficult to
value the so-called "imputed rent" on owner occupied housing.
Taxing the purchase price of a home is one alternative, but this
may aggravate the problems of many families already hard pressed
to cope with high housing prices.
The treatment of interest in
the housing area also is troublesome.
If it is exempt, what part
of a cental payment should a landlord be allowed to exclude from
the tax base?
These and other problems will require careful
study.
The value added tax is a very potent revenue source.
At 1979
levels of consumption, a value added tax would raise roughly $10
billion in revenue for each percentage point.
Thus, a 7 percent
value added tax would raise about as much revenue as the corpor
ate income tax and a 12 percent value added tax would raise as
much revenue as the social security taxes.
With such a powerful
instrument for raising revenue, many are concerned that the value
added tax eventually will be used to add to the total Federal tax
burden.
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Federal Reserve Bank of St. Louis
-13-
Conclusion
Mr. Chairman, you are to be commended for initiating an
^examination of the very important, but complex, issues of how the
Federal tax structure affects our national well being.
This is a
time of great change.
It is also a time of troublesome and
unfamiliar economic conditions.
The combination of high infla
tion, slow growth, and persistent trade deficits must make us
wonder if the traditional economic remedies still work.
In this
sense, your decision to study a broad range of new initiatives
could not come at a better time.
But changes of such major
consequences require careful and deliberate study.
We welcome
the opportunity to participate with you in that study.
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Federal Reserve Bank of St. Louis
ANNEX A
Federal, State and Local Tax Revenues for Selected Countries as Percent of Gross Domestic Product, by Type of Tax,
(Country Rankings In Parentheses)
:
1975
Indirect
:__ Iaasa____
Social Security 2/
Country
l
Belgium
Canada
Denmark
France
Germany (Fed Rep)
Italy
Japan
Luxembourg
Netherlands
Sweden
Switzerland
United Kingdom
United States
Total
*1.*3(5)
33.98(9)
*3.05(1)
36.90(6)
35.22(8)
32.3K1O)
20.23(13)
*6.71(2)
*6.9O(1)
*5.96 ( 3)
29.*9(12)
36.77(7)
3O.3K11)
: Sales and
: Excise 1/
10.87(6)
10.91(1)
11.7K1)
12.11(2)
9.37(8)
9.3K9)
3.67(13)
9.72(7)
10.91(5)
11.18(3)
5.90(11)
9.21(10)
5.19(12)
Total
: Eaolover
13.1K5)
3.22(12)
0.18(13)
11.72(3)
12.03(6)
11.83(2)
5.09(11)
11.05(1)
17.99(1)
8.89(7)
8.19(8)
6.7K10)
7.12(9)
8.11(1)
n.a.
0.31(12)
10.61(2)
6.60(7)
11.92(1)
2.63(11)
7.80(6)
8.10(5)
8.17(3)
3.05(10)
3.75(9)
1.18(8)
Employee and
: Self EmDloved
1.70(5)
n.a.
0.17(12)
1.11(6)
5.13(D
2.9K9)
2.16(10)
6.25(2)
9.59(1)
0.12(11)
5.11(3)
2.96(8)
3.21(7)
Corporate
Incomi
3.07(6)
1.67(2)
1.37(13)
2.00(9)
1.56(12)
2.01(8)
3.*3(D
7.22(1)
3.61(3)
1.99(10)
2.16(7)
1.92(11)
3.29(5)
Noncorporate
Total Direct
: ProDertv 1/
13.21(1)
11.32(7)
23.86(1)
1.58(13)
10.60(8)
1.95(12)
5.07(11)
12.78(5)
12.66(6)
21.17(2)
10.5K9)
11.29(3)
9.98(10)
1.01(12)
3.13(3)
2.57(1)
1.16(9)
1.09(11)
1.17(10)
1.9K7)
2.3K5)
1.18(8)
0.51(13)
2.13(6)
1.51(1)
1.13(2)
Other 5/ :
0.10(8)
0.70(1)
' 0.06(10)
1.70(2)
0.57(6)
0.01(11)
1.03(3)
0.63(5)
0.25(7)
1.92(1)
0.07(9)
30.56(1)
23.01(11)
28.3K5)
21.16(9)
25.85(7)
23.00(12)
16.56(13)
37.02(1)
35.99(2)
3*.18(3)
23.59(10)
27.53(6)
21.82(8)
Office of the Secretary of the Treasury
Office of Tax Analysis
Source:
Beyeoufl Statistics of OECD Member Countries. 1965-1975.
1/
Includes general sales, value added, and specific excise taxes.
U
Includes contributions of employers, employees, and self employed.
Category Is broadly defined to Include all tax payments to Institutions of general
government providing social welfare benefits, provided they are levied as a function of pay or a fixed amount per person. Thus, for the United States
this category Includes contributions to the railroad retirement fund, unemployment Insurance
fund, workman's compensation fund, and civilservice retire
ment program In addition, of course, to the more familiar social security-type payments made pursuant to the FederalInsuranceContributionsAct (FICi).
A/
Includes Income taxes on individual and unincorporated enterprise, such as proprietorships and partnerships.
1/
Includes taxes on net wealth,
5/
Includes taxes on employers based on payroll or manpower and miscellaneous taxes which oannot be classified within a specific direct tax category.
bJ
Computed by subtracting sales and excises from total.
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Immovable property, estates, and gifts.
.U
Department of theTREASURY
WASHINGTON, D.C. 20220
TELEPHONE 566-2041
FOR RELEASE UPON DELIVERY
EXPECTED AT 10:00 A.M. EST
THURSDAY, NOVEMBER 8, .197 9
TESTIMONY OF THE HONORABLE G. WILLIAM MILLER
SECRETARY OF THE TREASURY
BEFORE THE
HOUSE COMMITTEE ON WAYS AND MEANS
Mr. Chairman and Members of this distinguished Committee:
It is a pleasure to appear before this Committee to discuss
the important issues raised by H.R. 5665, the "Tax Restructuring
Act of 1979."
This bill would result in fundamental changes in
our Federal tax structure.
Income taxes on corporations and
individuals, as well as social security taxes, would be cut by
$130 billion in 1981.
A Federal value added tax would offset
this revenue loss.
This testimony will not concentrate on the
specifics of H.R. 5665 , but on the basic issue which the bill
raises: whether the United States should replace some of its
income taxes with a consumption tax.
That is, whether the
Federal tax system should weigh more heavily on consumption and
less heavily on saving and investment.
Many believe that such a
change would contribute significantly to improved capital for
mation, higher productivity, and a more competitive position for
American business in world markets.
Others express concern that
a consumption tax would have only small effects on investment and
would place an unfair
burden on lower
income families already
plagued by high prices for energy, food, housing, and other basic
necessities of life.
Higher consumption taxes, they believe,
would mean still higher prices.
These hearings will serve the
valuable function of focusing the discussion on these significant
economic and social issues.
An important element in this discussion is the role of a
value added tax in the Federal tax structure.
A value added tax
is a multistage tax on consumer goods and services.
Unlike a
retail sales tax, it is collected at each stage in the production
and distribution process.
But since it is levied only on the
amount of value added (the difference between sales and pur
chases) at each stage, rather than on the full selling price, it
avoids the cascade, tax-on-tax, effects of a turnover sales tax.
A value added tax is similar to a retail sales tax in that the
total tax paid by the consumer is equal to the final price of the
product multiplied by the tax rate.
M-186
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-2-
Many European countries have value added taxes.
Typically,
they are imposed at a rate of about 15 to 20 percent and generate
about 15 percent of a country's total national and local tax
revenue.
In contrast, state and local retail sales taxes raise
about 7 percent of the total Federal, state, and local tax
revenue in the United States.
The $130 billion in value added
tax revenue estimated to be raised by H.R. 5665 would be about 14
percent of total Federal, state, and local 1981 tax liabilities,
assuming it is accompanied by the proposed income and social
security tax cuts.
In nearly all cases, the European value added taxes replaced
sales taxes, frequently of the cascade turnover type which,
unlike the value added tax, taxed the full sales price at each
stage, without allowing a credit for tax on previous transac
tions.
The Europeans found the cascade tax objectionable because
it discriminated against nonintegrated firms and because the
export rebate and import tax could not be accurately estimated
for border adjustment purposes.
Thus, in the European case, the
adoption of a value added tax was regarded as a reform of an
unwieldy and distortionary system of indirect taxation.
This
characterization does not apply to the present indirect tax
system in the United States.
Only the United Kingdom has used
the value added tax to reduce income taxes, as Chairman Ullman is
suggesting for the United States.
The popularity of the value added tax is not universal.
The
voters of Switzerland have twice rejected it by referendum.
The
latest rejection was based in part on a perceived threat to local
autonomy since a Federal value added tax would have replaced some
of the local Swiss taxes.
Most recently, Japan, largely as a
result of its parliamentary elections, appears to have postponed
the planned introduction of a value added tax.
For the United States, a value added tax raises a number of
important questions. Would it encourage capital formation? What
impact would it have on the price level?
Would it improve the
trade balance?
Would it be regressive?
No one is seriously
suggesting the value added tax solely as an additional Federal
tax.
Consequently, the answers to these questions, as well as
others, depend upon which taxes the value added tax replaces.
By
way of illustration, two of the proposals made by Chairman Ullman
call for
reducing the corporate income tax and the social
security taxes.
Capital Formation
Taxes on capital income, such as the corporate income tax and
the individual income tax on interest and dividends, reduce the
after-tax return on savings.
Put another way, an income tax
encourages present, as compared to future, consumption.
With no
taxes, a person with $100 of income could choose between buying
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Federal Reserve Bank of St. Louis
-3-
$100 of consumption goods this year or saving now and buying $110
of consumption goods next year, assuming the interest rate is 10
percent.
Thus, a person can consume 10 percent more next year by
saving now.
Similarly, with a consumption tax, which exempts the
earnings from capital, a person with $100 of income could consume
$50 this year and pay $50 in tax or, by saving the income this
yeaY, could consume $55 next year and pay $55 in tax.
Thus, a
person could still consume 10 percent more next year by saving
now.
If a 50 percent income tax, rather than a consumption tax, is
imposed, however, the individual, after paying the tax, can buy
$50 of consumption goods this year or can save the $50 and, after
paying the tax on the interest earnings, buy $52.50 of consump
tion goods next year.
Because of the income tax, a person can
buy only 5 percent, rather than 10 percent, more consumption
goods next year.
Because of this lower return, the individual
may decide to consume now rather than save for future consump
tion.
It is important to recognize, however, that the respon
siveness of saving to more favorable taxation is an unsettled
issue.
If one concludes that savings will rise in response to
reduced taxation, then substituting a value added tax for the
corporate income tax should encourage saving.
There are other considerations in assessing the mechanism
First, an increase in
that leads to an increase in investment.
savings must be channeled into domestic financial markets in
order to lower interest rates and therefore the cost of capital,
Second, producers must respond to the lower cost of capital by
There
using more capital intensive methods of production,
is
open
to
response,
but
its
magnitude
probably will be some
considered
;
mix
of
new
investment
must
be
discussion. Third, the
durables,
or
fixed
it may be concentrated in housing, consumer
business capital.
Thus,, the substitution of a value added tax
for the corporate income tax will increase capital formation only
if savings increase, the cost of capital falls, and business
responds by investing in the United States.
Finally, it bears noting that the potential of the value
added tax for promoting capital formation may be exaggerated by
an analysis that compares a "pure" consumption tax with a "pure"
income tax levied on all returns to capital.
The current income
tax does not apply with full force to all types of saving and
investment.
For example, home ownership, pension reserves, and
assets eligible for the investment tax credit or the asset
depreciation range receive relatively favorable tax treatment,
Similarly, not all forms of consumption would be taxed the same
under any likely value added tax.
In contrast to an income tax, neither the social security tax
nor a value added tax applies directly to the return from saving.
Consequently, substituting a value added tax for the social
security tax would be unlikely to affect savings decisions.
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Federal Reserve Bank of St. Louis
-4Price Level Impact
A value added tax, by itself, will probably increase prices,
since the tendency for business to pass the tax on to consumers
is unlikely to be offset by an unduly restrictive monetary
policy.
The result would be a "one-shot" increase, not a
recurrent increase, in the price level, although the subsequent
price effects of adjustments in wage contracts, social security
payments, and other indexed items may occur over time.
Tn this
regard, it is noteworthy that the Thatcher government's program
of increased value added taxation and reduced individual income
taxation has been accompanied by a significant increase in the
consumer price index in the United Kingdom.
The important question, then, is whether the inflationary
impact of the value added tax would be offset by reductions in
other taxes.
Tn the short run, the corporate income tax reduces
the after-tax rate of return to capital, rather than increases
product prices.
Accordingly, prices will probably not fall as
corporate income taxes are cut.
Thus, substituting a value added
tax for the corporate income tax is likely to increase prices.
This is a serious drawback to the value added tax.
Substituting a value added tax for the social security tax
may be less inflationary.
Reducing the employer portion of the
social security tax would tend to reduce business labor costs 3nd
possibly prices.
Reducing the employee portion of the social
security tax, however, would probably have no effect on the price
level.
Thus a value added tax, accompanied by an equivalent
reduction in employer and employee social security taxes, would
result in some increase in the price level.
This would be
particularly distressing to individuals least able to protect
themselves from rising prices.
The impact of a value added tax on prices is largely inde
pendent of whether it is hidden in the price of the product or
whether it is quoted separately to consumers.
While it is not
customary in Europe to quote the value added tax separately, this
need not be the case in the United States.
State retail sales
taxes are quoted separately because the merchants persuaded
legislators to require it, and the same could occur in the case
of a United States value added tax.
Furthermore, nonseparate
quotation of the value added tax might be viewed as an attempt to
hide the tax from public scrutiny.
Balance of Trade
Many have expressed the view that a value added tax would
improve our trade balance.
This is based on the observation that
current international rules allow indirect taxes, such as sales
or value added taxes, to be imposed on imports and rebated on
exports.
These adjustments are not allowed for direct taxes,
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Federal Reserve Bank of St. Louis
-5-
such as the corporate income or social security taxes.
It is
doubtful, however, that the U.S. trade balance would improve
significantly from substituting a value added tax for the
corporate income tax.
The impact of the value added tax on trade is closely related
to what happens to prices.
Quite simply, one must ask the
question: will the substitution of the value added tax for some
other tax increase prices?
It seems likely that the immediate
impact of substituting a general value added tax of 5 percent for
part of the corporate income tax would be to increase prices by
about 5 percent.
Since the new tax would be rebated on exports,
just like our state retail sales and Federal excise taxes,
exports would leave the country tax free.
While domestic prices
would be 5 percent higher, export prices would remain unchanged.
Foreign consumers, therefore, would find U.S. products no more
attractive than before; there would be no increase in demand for
U.S. exports.
Since imports would be subject to the value added tax their
prices also would increase by about 5 percent, the same as for
domestic goods and services.
As a consequence, domestic con
sumers would find imports just as attractive as before; there
would be no incentive to reduce the demand for imports. Thus, on
both the export and import side, there would be little immediate
impact on the U.S. trade balance if a value added tax were sub
stituted for the corporate income tax.
There might, of course,
be a positive trade impact in the long run if the substitution
led to an improved investment climate, enhanced capital forma
tion, and a more productive and competitive U.S. economy.
A modest trade balance improvement might result from
replacing the social security tax with a value added tax, if the
price level increased by less than the value added tax.
Because
of the price-dampening effect of reducing the employer portion of
the social security tax, this is a possibility.
Regardless of which tax it replaces, many believe that a
value added tax rebate, in itself, will expand exports and that a
value added tax levy will retard imports.
This belief might have
a positive effect on trade if it encourages businesses to compete
more vigorously in international markets.
This result would
depend upon the importance of nonprice considerations in
explaining export activity.
It is also important to recognize that other countries could
restructure their own tax systems if they felt the United States
was gaining an unfair trade advantage.
Relative to other coun
tries, the United States has a moderately high corporate income
tax, but a low social security tax.
(See Annex A.)
Thus, the
possibility exists that other countries might maintain their
competitive position by increasing their existing value added
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Federal Reserve Bank of St. Louis
4
-6-
taxes and reducing their corporate income or, especially, their
social security taxes.
This outcome is by no means certain.
After all, a country's tax structure is not determined solely by
international considerations.
Moreover, except for Japan, U.S.
indirect taxes, as a share of igross domestic product, are the
lowest of the major developed countries.
(See Chart 1 and Annex
A.)
Other countries may believe that the United States should be
allowed to "tilt" its tax structure to reach some "reasonable" or
"average" level of indirect taxation.
This issue has been studied before.
Both the President's
Task Force on Business Taxation, in its 1970 review of tax
policy, and the Advisory Commission on Intergovernmental
Relations, in its 1973 value added tax study, considered the
trade issue.
Both expressed* doubt over any trade benefits
resulting from substituting a value added tax for the corporate
income tax and both noted the possibility of foreign retaliation.
Distribution of Tax Burden
?
Lower income taxpayers, who must spend all their income on
consumption, may find a value added tax burdensome because of its
regressivity. While a value add^d tax, by itself, is regressive,
one must consider which tax it replaces.
The immediate impact of
the corporate income tax is pro,bably progressive since it falls
on income from capital.
Therefore, substituting a value added
tax for the corporate income dax would make the tax structure
less progressive.
The social security tax, on the other hand,
also is regressive because it is limited to the first $22,900 of
wages and applies only to labor income.
Accordingly, substi
tuting a value added tax for the social security tax would not
make the tax system noticeably less progressive.
One regressive
tax would be substituted for another.
Retired individuals, how
ever, who do not pay social security tax, would be distressed by
having to pay value added tax. ’ They could justifiably say that
they already had paid for their retirement during their working
years and that higher prices and} taxes in retirement were unfair.
Their distress might be partially assuaged by the fact that
social security payments are indexed.
One way to illustrate possible distributional effects is to
ask what would happen to tax burdens if a value added tax
completely replaced the individual income and social security
(employee portion) taxes.
(See Chart 2.)
The combination of the
current income and social security taxes is progressive while a
value added tax, even with necessities excluded, is regressive.
As a share of income, the present individual income and social
security taxes are only- 2 percent for families with less than
$5,000 in income, but increase throughout the income range to 33
percent for families with over $400,000 in income.
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CHART 1
SJ Indirect
DIRECT AND INDIRECT TAXES AS A
TAX REVENUES AS A PERCENT
OF GROSS DOMESTIC PRODUCT
40
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Canada
France
Germany
Japan
United Kingdom United States
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Federal Reserve Bank of St. Louis
CHART 2
TAXES AS PERCENT OF INCOME
-9This may be contrasted with a value added tax with no exclu
sions at a 23.2 percent rate, sufficient to equal the revenue
raised by the individual
income and employee social
security
taxes in 1978.
As a share of income, such a value added tax
would be 35 percent for families with less than $5,000 in income,
but fall to 6 percent for families with over $100,000 in income.
No one, of course, is proposing the complete substitution of
the value added tax for the income and social security taxes.
A
more realistic alternative would be to substitute a value added
tax for part of the combined individual income and social secur
ity taxes.
One possibility would be to reduce income and
employee social security taxes by $100 billion, keeping the same
degree of progressivity for these taxes as under present law, and
offset the revenue loss with a $100 billion value added tax with
no exclusions.
The resulting distribution of tax burdens would
be regressive at the lowest income levels and mildly progressive
elsewhere.
As a share of income, families with less than $5,000
in income would pay 17 percent in taxes, families with between
$5,000 and $10,000 in income would pay 14 percent, and taxes
would then increase throughout the income range so that families
with over $100,000 of income would pay 21 percent of th£ir income
in taxes.
The overall distribution is significantly less
progressive than the present combination of income and employee
social security taxes.
The regressivity of the value added tax can be moderated, but
not eliminated, by special measures.
One possibility is the use
of exemptions and reduced rates for necessities, as in Chairman
Ullman's proposal and in some European countries.
These reduce
the tax burden of the value added tax 3t the lowest income
levels, but the tax remains regressive.
Exemptions and reduced
rates, moreover, create administrative problems.
A tax with two,
three, or four rates is more complex than a tax with one rate.
The specially-taxed items must be identified.
Does a lower rate
for food, for example, apply to such items as chewing gum, soda
pop, candy, or caviar? Experience with the income tax shows that
even medical services and drugs are not easy to define.
Beyond
the definitional problems, total or partial exclusions erode the
value added tax base and its revenue potential.
(See Chart 3.)
The regressivity of a value added tax also can be reduced by
a refundable income tax credit for tax paid on a necessary amount
of consumption. This avoids the need to define exempt commodities
and can be implemented at a lower revenue cost than a complete
exemption for certain "essential" commodities.
It can, for
example, be phased out at increased income levels.
In effect,
middle and upper income groups would still pay tax on purchases
of food and other necessary items.
On the other hand, a refund
able credit is effective only if it reaches the roughly 25
million individuals who do not appear on an income tax return.
These tend to be individuals most in need of the credit, mainly
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CHART 3
SUBTRACTIONS
FROM VALUE ADDED
TAX BASE
(Percent)
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Federal Reserve Bank of St. Louis
HOII 1
Other
-11-
recipients of social security benefits and of transfer payments
under social and welfare programs.
Unlike lower rates and
exemptions, if the credit was not paid until the end of the year,
the consumer would have to finance the tax during the year.
Administrative and Design Considerations
Both the European value added taxes and the tax suggested by
Chairman Ullman have certain basic similarities;
they are broad based, applying to services as well as
goods;
-
tax liability is determined by the credit method with
tax paid on purchases deductible from tax due on
sales;
-
they are consumption
capital
equipment
deductible; and
type taxes,
purchases
any
is
tax paid on
immediately
they extend through the retail stage.
A value added tax of this type for the United States would
involve about 15 million taxpayers.
This number might be reduced
by 5 million if exemptions were provided for very small proprietorships and farming.
But under a value added tax, nearly all
transactions are taxed,
Even a firm that is tax exempt on its
sales will have paid tax on its purchases,
If it is to receive
credit for tax paid on its purchases, it either would have to
file a return or the credit would have to be made available to
its customers.
Even 10 million taxpayers would add about 30 percent to the
number of returns filed with the Internal Revenue Service,
assuming quarterly returns are required.
Since the value added
tax would not totally replace any other tax and would be a new
tax, requiring new returns, new regulations, and a new body of
case law, this would be a net addition to the work of taxpayers,
the Internal Revenue Service, and the courts.
This differs
sharply from the typical European case where the value added tax
completely replaced another sales tax.
Reporting and payment requirements for a value added tax
would be similar to those for Federal exci ses, which require
liability to be computed on a semimonthly bas is with payment due
9 days later.
The actual excise tax return is filed quarterly
and is accompanied by the payment of any remaining balance.
Liquor and tobacco excises, however, have siightly d i fferent
rules.
A value added tax payment system wh ich would fit more
neatly with ordinary bookkeeping would be a monthly liability
period with payment due at the end of the next month.
This would
be similar to that proposed by Chairman Ullman
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Federal Reserve Bank of St. Louis
-12-
Other Considerations
A Federal value added tax would raise a number of other
issues.
Forty five states and the District of Columbia impose
general sales taxes, a revenue source which they tend to view as
belonging exclusively to them.
Sales and gross receipts taxes
account for about 30 percent of state tax revenue.
Tn contrast,
excise taxes generate less than 4 percent of Federal tax collec
tions.
Nevertheless, while a Federal value added tax may make it
more difficult for the states to raise their sales taxes, it
should not prevent such increases.
All levels of government, for
example, impose income taxes.
Moreover, total Federal, state,
and local sales tax collections are lower in the United States
than in most developed countries.
Because of likely differences in the tax bases, it is doubt
ful that a Federal value added tax could be coordinated with the
state sales taxes.
Separate taxes, admittedly, would mean higher
administrative and compliance costs.
Each level of government
would require a collection and audit capability.
Taxpayers would
have to become familiar with separate tax bases and separate
returns.
Revenue departments and taxpayers, however, already
face this problem with Federal and state income taxes.
Efforts
aimed at Federal-state cooperation and coordination have not been
successful.
As shown by Chairman Ullman's proposal, even a broad-based
value added tax may not apply to all forms of final consumption.
Practical considerations may require special treatment for many
items.
In the area of housing, for example, homeowners and
tenants should be treated equally.
But if rental payments are
taxed, how should homeowners be taxed?
It may be difficult to
value the so-called "imputed rent" on owner occupied housing.
Taxing the purchase price of a home is one alternative, but this
may aggravate the problems of many families already hard pressed
to cope with high housing prices.
The treatment of interest in
the housing area also is troublesome.
If it is exempt, what part
of a •'ental payment should a landlord be allowed to exclude from
the tax base?
These and other problems will require careful
study.
The value added tax is a very potent revenue source.
At 1979
levels of consumption, a value added tax would raise roughly $10
billion in revenue for each percentage point.
Thus, a 7 percent
value added tax would raise about as much revenue as the corpor
ate income tax and a 12 percent value added tax would raise as
much revenue as the social security taxes.
With such a powerful
instrument for raising revenue, many are concerned that the value
added tax eventually will be used to add to the total Federal tax
burden.
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Federal Reserve Bank of St. Louis
-13Conclus ion
Mr. Chairman, you are to be commended for initiating an
examination of the very important, but complex, issues of how the
Federal tax structure affects our national well being.
This is a
time of great change.
It is also a time of troublesome and
unfamiliar economic conditions.
The combination of high infla
tion, slow growth, and persistent trade deficits must make us
wonder if the traditional economic remedies still work.
In this
sense, your decision to study a broad range of new initiatives
could not come at a better time.
But changes of such major
consequences require careful and deliberate study.
We welcome
the opportunity to participate with you in that study.
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ANNEX A
Federal, State and Local Tax Revenues for Selected Countries as Percent of Gross Doaestlc Product, by Type of Tax,
(Country Rankings In Parentheses)
:
Indirect
Taxes
1975
Direct Taxes
Social Security 2/
Country
i
Belgium
Canada
Denmark
France
Germany (Fed Rep)
Italy
Japan
Luxembourg
Netherlands
Sweden
Switzerland
United Kingdom
United States
ToLal
*1.*3(5)
33.98(9)
93-05(9)
36.90(6)
35.22(8)
32.39(10)
20.23(13)
96.79(2)
96.90(1)
95.96(3)
29.99(12)
36.77(7)
30.31(11)
: Sales and
: Excise 1/
10.87(6)
10.99(9)
19.71(1)
12.99(2)
9.37(8)
9.39(9)
3.67(13)
9.72(7)
10.9K5)
11.98(3)
5.90(11)
9.29(10)
5.99(12)
Total
: Emolover
13.19(5)
3.22(12)
0.98(13)
19.72(3)
12.03(6)
19.83(2)
5.09(11)
19.05(9)
17.99(1)
8.89(7)
8.99(8)
6.7K10)
7.92(9)
8.99(9)
n.a.
0.31(12)
10.61(2)
6.60(7)
11.92(1)
2.63(11)
7.80(6)
8.90(5)
8.97(3)
3.05(10)
3.75(9)
9.18(8)
Employee and
: Self Emoloved
9.70(5)
n.a.
0.17(12)
9.11(6)
5.93(9)
2.9K9)
2.96( ,0)
6.25(2)
9.59(1)
0.92(11)
5.99(3)
2.96(8)
3-29(7)
Corporate
income
3.07(6)
9.67(2)
1.37(13)
2.00(9)
1.56(12)
2.09(8)
3.93(9)
7.22(1)
3.61(3)
1.99(10)
2.96(7)
1.92(11)
3-29(5)
Noncorporate
Income 3/
13.29(9)
11.32(7)
23.86(1)
9.58(13)
10.60(8)
9.95(12)
5.07(11)
12.78(5)
12.66(6)
21.17(2)
10.5K9)
19.29(3)
9.98(10)
: Prooertv 9/
1.01(12)
3.13(3)
2.57(9)
1.96(9)
1.09(11)
1.17(10)
1.99(7)
2.39(5)
1.98(8)
0.51(13)
2.13(6)
9.59(1)
9.13(2)
Other 5/ :
0.10(8)
0.70(9)
' 0.06(10)
1.70(2)
0.57(6)
0.01(11)
1.03(3)
0.63(5)
0.25(7)
1.92(1)
—
0.07(9)
—
Total Direct
Taxes 6/
30.56(9)
23.09(11)
28.39(5)
29.96(9)
25.85(7)
23.00(12)
16.56(13)
37.02(1)
35.99(2)
39.98(3)
23.59(10)
27.53(6)
29.82(8)
Office of the Secretary of the Treasury
Office of Tax Analysis
(—>
I
source:
flgygDua statmisa .ol .QECfl hsatrcr CQuakrlea. 19.to-.im■
1/
Includes general sales, value added, and specific excise taxes.
2J
Includes contributions of employers, employees, and self employed.
Category Is broadly defined to Include all tax payments to Institutions of general
government providing social welfare benefits, provided they are levied as a function of pay or a fixed amount per person. Thus, for the United States
this category Includes contributions to the railroad retirement fund, unemployment Insurance fund, workman's compensation fund, and civil service retire
ment program In addition, of course, to the more familiar social security-type payments made pursuant to the Federal Insurance Contributions Act (FICA).
3/
Includes Income taxes on Individual and unincorporated enterprise, such as proprietorships and partnerships.
Includes taxes on net wealth,
Immovable property, estates, and gifts.
3/
Includes taxes on employers based on payroll or manpower and miscellaneous taxes which cannot be classified within a specific direct tax category.
V
Computed by subtracting sales and excises from total.
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»
>
WASHINGTON, D.C. 20220
TELEPHONE 566-2041
FOR RELEASE UPON DELIVERY
EXPECTED AT 10:00 A.M. EST
THURSDAY, NOVEMBER 8, 1979
TESTIMONY OF THE HONORABLE G. WILLIAM MILLER
SECRETARY OF THE TREASURY
BEFORE THE
HOUSE COMMITTEE ON WAYS AND MEANS
Mr. Chairman and Members of this distinguished Committee:
It is a pleasure to appear before this Committee to discuss
the important issues raised by H.R. 5665, the "Tax Restructuring
Act of 1979."
This bill would result in fundamental changes in
our Federal tax structure.
Income taxes on corporations and
individuals, as well as social security taxes, would be cut by
$130 billion in 1981.
A Federal value added tax would offset
this revenue loss.
This testimony will not concentrate on the
specifics of H.R. 5665 , but on the basic issue which the bill
raises: whether the United States should replace some of its
income taxes with a consumption tax.
That is, whether the
Federal tax system should weigh more heavily on consumption and
less heavily on saving and investment.
Many believe that such a
change would contribute significantly to improved capital for
mation, higher productivity, and a more competitive position for
American business in world markets.
Others express concern that
a consumption tax would have only small effects on investment and
would place an unfair
burden on lower
income families already
plagued by high prices for energy, food, housing, and other basic
necessities of life.
Higher consumption taxes, they believe,
would mean still higher prices.
These hearings will serve the
valuable function of focusing the discussion on these significant
economic and social issues.
An important element in this discussion is the role of a
value added tax in the Federal tax structure.
A value added tax
is a multistage tax on consumer goods and services.
Unlike a
retail sales tax, it is collected at each stage in the production
and distribution process.
But since it is levied only on the
amount of value added (the difference between sales and pur
chases) at each stage, rather than on the full selling price, it
avoids the cascade, tax-on-tax, effects of a turnover sales tax.
A value added tax is similar to a retail sales tax in that the
total tax paid by the consumer is equal to the final price of the
product multiplied by the tax rate.
M-186
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-2-
Many European countries have value added taxes.
Typically,
they are imposed at a rate of about 15 to 20 percent and generate
about 15 percent of a country's total national and local tax
revenue.
In contrast, state and local retail sales taxes raise
about 7 percent of the total Federal, state, and local tax
revenue in the United States.
The $130 billion in value added
tax revenue estimated to be raised by H.R. 5665 would be about 14
percent of total Federal, state, and local 1981 tax liabilities,
assuming it is accompanied by the proposed income and social
security tax cuts.
In nearly all cases, the European value added taxes replaced
sales taxes, frequently of the cascade turnover type which,
unlike the value added tax, taxed the full sales price at each
stage, without allowing a credit for tax on previous transac
tions.
The Europeans found the cascade tax objectionable because
it discriminated against nonintegrated firms and because the
export rebate and import tax could not be accurately estimated
for border adjustment purposes.
Thus, in the European case, the
adoption of a value added tax was regarded as a reform of an
unwieldy and distortionary system of indirect taxation.
This
characterization does not apply to the present indirect tax
system in the United States.
Only the United Kingdom has used
the value added tax to reduce income taxes, as Chairman Ullman is
suggesting for the United States.
The popularity of the value added tax is not universal.
The
voters of Switzerland have twice rejected it by referendum.
The
latest rejection was based in part on a perceived threat to local
autonomy since a Federal value added tax would have replaced some
of the local Swiss taxes.
Most recently, Japan, largely as a
result of its parliamentary elections, appears to have postponed
the planned introduction of a value added tax.
For the United States, a value added tax raises a number of
important questions.
Would it encourage capital formation? What
impact would it have on the price level?
Would it improve the
trade balance?
Would it be regressive?
No one is seriously
suggesting the value added tax solely as an additional Federal
tax.
Consequently, the answers to these questions, as well as
others, depend upon which taxes the value added tax replaces.
By
way of illustration, two of the proposals made by Chairman Ullman
call for
reducing the corporate income tax and the social
security taxes.
Capital Formation
Taxes on capital income, such as the corporate income tax and
the individual income tax on interest and dividends, reduce the
after-tax return on savings.
Put another way, an income tax
encourages present, as compared to future, consumption.
With no
taxes, a person with $100 of income could choose between buying
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Federal Reserve Bank of St. Louis
-3$100 of consumption goods this year or saving now and buying $110
of consumption goods next year, assuming the interest rate is 10
percent.
Thus, a person can consume 10 percent more next year by
saving now.
Similarly, with a consumption tax, which exempts the
earnings from capital, a person with $100 of income could consume
$50 this year and pay $50 in tax or, by saving the income this
yeah, could consume $55 next year and pay $55 in tax.
Thus, a
person could still consume 10 percent more next year by saving
now.
If a 50 percent income tax, rather than a consumption tax, is
imposed, however, the individual, after paying the tax, can buy
$50 of consumption goods this year or can save the $50 and, after
paying the tax on the interest earnings, buy $52.50 of consumpBecause of the income tax, a person can
tion goods next year.
percent,
rather
than 10 percent, more consumption
buy only 5
year.
Because
of
this lower return, the individual
goods next
than save for future consumprather
may decide to consume now
recognize,
however, that the respontion.
It is important to
siveness of saving to more favorable taxation is an unsettled
issue.
If one concludes that savings will rise in response to
reduced taxation, then substituting a value added tax for the
corporate income tax should encourage saving.
There are other considerations in assessing the mechanism
First, an increase m
that leads to an increase in investment.
be
channeled
into
domestic
financial markets in
savings must
interest
rates
and
therefore
the cost of capital,
lower
order to
to
the
lower
cost of capital by
producers
must
respond
Second,
methods
of
production.
There
more
capital
intensive
using
probably will be some response, but its magnitude is open to
discussion.
Third, the mix of new investment must be considered;
it may be concentrated in housing, consumer durables, or fixed
business capital.
Thus, the substitution of a value added tax
for the corporate income tax will increase capital formation only
if savings increase. the cost of capital falls, and business
responds by investing in the United States.
Finally, it bears noting that the potential of the value
added tax for promoting capital formation may be exaggerated by
an analysis that compares a "pure" consumption tax with a "pure"
The current income
income tax levied on all returns to capital.
tax does not apply with full force to all types of saving and
investment.
For example, home ownership, pension reserves, and
assets eligible for the investment tax credit or the asset
depreciation range receive relatively favorable tax treatment,
Similarly, not all forms of consumption v/ould be taxed the same
under any likely value added tax.
In contrast to an income tax, neither the social security tax
nor a value added tax applies directly to the return from saving,
Consequently, substituting a value added tax for the social
security tax would be unlikely to affect savings decisions.
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Federal Reserve Bank of St. Louis
-4Price Level Impact
A value added tax, by itself, will probably increase prices,
since the tendency for business to pass the tax on to consumers
is unlikely to be offset by an unduly restrictive monetary
policy.
The result would be a "one-shot" increase, not a
recurrent increase, in the price level, although the subsequent
price effects of adjustments in wage contracts, social security
payments, and other indexed items may occur over time.
In this
regard, it is noteworthy that the Thatcher government’s program
of increased value added taxation and reduced individual income
taxation has been accompanied by a significant increase in the
consumer price index in the United Kingdom.
The important question, then, is whether the inflationary
impact of the value added tax would be offset by reductions in
other taxes.
In the short run, the corporate income tax reduces
the after-tax rate of return to capital, rather than increases
product prices.
Accordingly, prices will probably not fall as
corporate income taxes are cut.
Thus, substituting a value added
tax for the corporate income tax is likely to increase prices.
This is a serious drawback to the value added tax.
Substituting a value added tax for the social security tax
may be less inflationary. Reducing the employer portion of the
soc i al security tax would tend to reduce business labor costs and
poss ibly prices.
Reducing the employee portion of the social
secu rity tax, however, would probably have no effect on the price
leve 1.
Thus a value added tax, accompanied by an equivalent
redu ction in employer and employee social security taxes, would
resu It in some increase in the price level.
This would be
part icularly distressing to individuals least able to protect
them selves from rising prices.
The impact of a value added tax on prices is largely inde
pendent of whether it is hidden in the price of the product or
whether it is quoted separately to consumers.
While it is not
customary in Europe to quote the value added tax separately, this
need not be the case in the United States,
State retail sales
taxes are quoted separately because the merchants persuaded
legislators to require it, and the same could occur in the case
of a United States value added tax.
Furthermore, nonseparate
quotation of the value added tax might be viewed as an attempt to
hide the tax from public scrutiny.
Balance of Trade
Many have expressed the view that a value added tax would
improve our trade balance.
This is based on the observation that
current international rules allow indirect taxes, such as sales
or value added taxes, to be imposed on imports and rebated on
exports.
These adjustments are not allowed for direct taxes,
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Federal Reserve Bank of St. Louis
-5such as the corporate income or social security taxes.
It is
doubtful, however, that the U.S. trade balance would improve
significantly from substituting a value added tax for the
corporate income tax.
The impact of the value added tax on trade is closely related
to what happens to prices.
Quite simply, one must ask the
question: will the substitution of the value added tax for some
other tax increase prices?
It seems likely that the immediate
impact of substituting a general value added tax of 5 percent for
part of the corporate income tax would be to increase prices by
about 5 percent.
Since the new tax would be rebated on exports,
just like our state retail sales and Federal excise taxes,
exports would leave the country tax free.
While domestic prices
would be 5 percent higher, export prices would remain unchanged.
Foreign consumers, therefore, would find U.S. products no more
attractive than before; there would be no increase in demand for
U.S. exports.
Since imports would be subject to the value added tax their
prices also would increase by about 5 percent, the same as for
domestic goods and services.
As a consequence, domestic con
sumers would find imports just as attractive as before; there
would be no incentive to reduce the demand for imports. Thus, on
both the export and import side, there would be little immediate
impact on the U.S. trade balance if a value added tax were sub
stituted for the corporate income tax.
There might, of course,
be a positive trade impact in the long run if the substitution
led to an improved investment climate, enhanced capital forma
tion, and a more productive and competitive U.S. economy.
A modest trade balance improvement might result from
replacing the social security tax with a value added tax, if the
price level increased by less than the value added tax.
Because
of the price-dampening effect of reducing the employer portion of
the social security tax, this is a possibility.
Regardless of which tax it replaces, many believe that a
value added tax rebate, in itself, will expand exports and that a
value added tax levy will retard imports.
This belief might have
a positive effect on trade if it encourages businesses to compete
more vigorously in international markets.
This result would
depend upon the importance of nonprice considerations in
explaining export activity.
It is also important to recognize that other countries could
restructure their own tax systems if they felt the United States
was gaining an unfair trade advantage.
Relative to other coun
tries, the United States has a moderately high corporate income
tax, but a low social security tax.
(See Annex A.)
Thus, the
possibility exists that other countries might maintain their
competitive position by increasing their existing value added
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Federal Reserve Bank of St. Louis
-6taxes and reducing their corporate income or, especially, their
social security taxes.
This outcome is by no means certain.
After all, a country's tax structure is not determined solely by
international considerations.
Moreover, except for Japan, U.S.
indirect taxes, as a share of (gross domestic product, are the
lowest of the major developed countries.
(See Chart 1 and Annex
A.)
Other countries may believe1 that the United States should be
allowed to "tilt" its tax struct’ure to reach some "reasonable" or
"average" level of indirect taxation.
This issue has been studied before.
Both the President's
Task Force on Business Taxation, in its 1970 review of tax
policy, and the Advisory Cclmmission on Intergovernmental
Relations, in its 1973 value added tax study, considered the
trade issue.
Both expressed’ doubt over any trade benefits
resulting from substituting a value added tax for the corporate
income tax and both noted the possibility of foreign retaliation.
Distribution of Tax Burden
•;
Lower income taxpayers, who must spend all their income on
consumption, may find a value added tax burdensome because of its
regressivity. While a value added tax, by itself, is regressive,
one must consider which tax it replaces.
The immediate impact of
the corporate income tax is probably progressive since it falls
on income from capital.
Therefore, substituting a value added
tax for the corporate income tiax would make the tax structure
less progressive.
The social security tax, on the other hand,
also is regressive because it is* limited to the first $22,900 of
wages and applies only to labor income.
Accordingly, substi
tuting a value added tax for tlje social security tax would not
make the tax system noticeably less progressive.
One regressive
tax would be substituted for another.
Retired individuals, how
ever, who do not pay social security tax, would be distressed by
having to pay value added tax. ■ They could justifiably say that
they already had paid for their retirement during their working
years and that higher prices andi taxes in retirement were unfair.
Their distress might be partially assuaged by the fact that
social security payments are indexed.
One way to illustrate possible distributional effects is to
ask what would happen to tax burdens if a value added tax
completely replaced the individual income and social security
(employee portion) taxes.
(See Chart 2.)
The combination of the
current income and social security taxes is progressive while a
value added tax, even with necessities excluded, is regressive.
As a share of income, the present individual income and social
security taxes are only 2 percent for families with less than
$5,000 in income, but increase throughout the income range to 33
percent for families with over $-100,000 in income.
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J
.J;
i
”, i
;
5
' -»•
i
I .
CHART 1
BE Indirect
DIRECT AND INDIRECT TAXES AS A
TAX REVENUESAS A PERCENT
OF GROSS DOMESTIC PRODUCT
40r-
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Canada
France
Germany
Japan
United Kingdom United States
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CHART 2
TAXES AS PERCENT OF INCOME
-9This may be contrasted with a value added tax with no exclu
sions at a 23.2 percent rate, sufficient to equal the revenue
raised by the individual
income and employee social security
taxes in 1978.
As a share of income, such a value added tax
would be 35 percent for families with less than $5,000 in income,
but fall to 6 percent for families with over $100,000 in income.
No one, of course, is proposing the complete substitution of
the value added tax for the income and social security taxes.
A
more realistic alternative would be to substitute a value added
tax for part of the combined individual income and social secur
ity taxes.
One possibility would be to reduce income and
employee social security taxes by $100 billion, keeping the same
degree of progressivity for these taxes as under present law, and
offset the revenue loss with a $100 billion value added tax with
no exclusions.
The resulting distribution of tax burdens would
be regressive at the lowest income levels and mildly progressive
elsewhere.
As a share of income, families with less than $5,000
in income would pay 17 percent in taxes, families with between
$5,000 and $10,000 in income would pay 14 percent, and taxes
would then increase throughout the income range so that families
with over $100,000 of income would pay 21 percent of their income
in taxes.
The overall distribution is significantly less
progressive than the present combination of income and employee
social security taxes.
The regressivity of the value added tax can be moderated, but
not eliminated, by special measures.
One possibility is the use
of exemptions and reduced rates for necessities, as in Chairman
Ullman’s proposal and in some European countries.
These reduce
the tax burden of the value added tax 3t the lowest income
levels, but the tax remains regressive.
Exemptions and reduced
rates, moreover, create administrative problems.
A tax with two,
three, or four rates is more complex than a tax with one rate.
The specially-taxed items must be identified.
Does a lower rate
for food, for example, apply to such items as chewing gum, soda
pop, candy, or caviar? Experience with the income tax shows that
even medical services and drugs are not easy to define.
Beyond
the definitional problems, total or partial exclusions erode the
value added tax base and its revenue potential.
(See Chart 3.)
The regressivity of a value added tax also can be reduced by
a refundable income tax credit for tax paid on a necessary amount
of consumption. This avoids the need to define exempt commodities
and can be implemented at a lower revenue cost than a complete
exemption for certain "essential” commodities.
It can, for
example, be phased out at increased income levels.
In effect,
middle and upper income groups would still pay tax on purchases
of food and other necessary items.
On the other hand, a refund
able credit is effective only if it reaches the roughly 25
million individuals who do not appear on an income tax return.
These tend to be individuals most in need of the credit, mainly
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Federal Reserve Bank of St. Louis
CHART 3
SUBTRACTIONS
FROM VALUE ADDED
TAX BASE
(Percent)
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Federal Reserve Bank of St. Louis
Medical Care
(-■oI
I
KT
52 9
Clothing
Food
\
Other Expenditures
-11-
recipients of social security benefits and of transfer payments
under social and welfare programs.
Unlike lower rates and
exemptions, if the credit was not paid until the end of the year,
the consumer would have to finance the tax during the year.
Administrative and Design Considerations
Both the European value added taxes and the tax suggested by
Chairman Ullman have certain basic similarities:
they are broad based, applying to services as well as
goods;
tax liability is determined by the credit method with
tax paid on purchases deductible from tax due on
sales;
-
they are consumption
capital
equipment
deductible? and
type taxes,
purchases
any
is
tax paid on
immediately
they extend through the retail stage.
A value added tax of this type for the United States would
involve about 15 million taxpayers.
This number might be reduced
by 5 million if exemptions were provided for very small propri
etorships and farming.
But under a value added tax, nearly all
transactions are taxed.
Even a firm that is tax exempt on its
sales will have paid tax on its purchases.
Tf it is to receive
credit for tax paid on its purchases, it either would have to
file a return or the credit would have to be made available to
its customers.
Even 10 million taxpayers would add about 30 percent to the
number of returns filed with the Internal Revenue Service,
assuming quarterly returns are required.
Since the value added
tax would not totally replace any other tax and would be a new
tax, requiring new returns, new regulations, and a new body of
case law, this would be a net addition to the work of taxpayers,
the Internal Revenue Service, and the courts.
This differs
sharply from the typical European case where the value added tax
completely replaced another sales tax.
Reporting and payment requirements for a value added tax
would be similar to those for Federal excises, which require
liability to be computed on a semimonthly basis with payment due
9 days later.
The actual excise tax return is filed quarterly
and is accompanied by the payment of any remaining balance.
Liquor and tobacco excises, however, have slightly different
rules.
A value added tax payment system which would fit more
neatly with ordinary bookkeeping would be a monthly liability
period with payment due at the end of the next month.
This would
be similar to that proposed by Chairman Ullman.
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Federal Reserve Bank of St. Louis
-12Other Considerations
A Federal value added tax would raise a number of other
issues.
Forty five states and the District of Columbia impose
general sales taxes, a revenue source which they tend to view as
belonging exclusively to them.
Sales and gross receipts taxes
account for about 30 percent of state tax revenue.
Tn contrast,
excise taxes generate less than 4 percent of Federal tax collec
tions.
Nevertheless, while a Federal value added tax may make it
more difficult for the states to raise their sales taxes, it
should not prevent such increases. All levels of government, for
example, impose income taxes.
Moreover, total Federal, state,
and local sales tax collections are lower in the United States
than in most developed countries.
Because of likely differences in the tax bases, it is doubt
ful that a Federal value added tax could be coordinated with the
state sales taxes.
Separate taxes, admittedly, would mean higher
administrative and compliance costs.
Each level of government
would require a collection and audit capability.
Taxpayers would
have to become familiar with separate tax bases and separate
returns.
Revenue departments and taxpayers, however, already
face this problem with Federal and state income taxes.
Efforts
aimed at Federal-state cooperation and coordination have not been
successful.
As shown by Chairman Ullman's proposal, even a broad-based
value added tax may not apply to all forms of final consumption.
Practical considerations may require special treatment for many
items.
In the area of housing, for example, homeowners and
tenants should be treated equally.
But if rental payments are
taxed, how should homeowners be taxed?
It may be difficult to
value the so-called "imputed rent" on owner occupied housing.
Taxing the purchase price of a home is one alternative, but this
may aggravate the problems of many families already hard pressed
to cope with high housing prices.
The treatment of interest in
the housing area also is troublesome.
If it is exempt, what part
of a cental payment should a landlord be allowed to exclude from
the tax base?
These and other problems will require careful
study.
The value added tax is a very potent revenue source.
At 1979
levels of consumption, a value added tax would raise roughly $10
billion in revenue for each percentage point.
Thus, a 7 percentvalue added tax would raise about as much revenue as the corpor
ate income tax and a 12 percent value added tax would raise as
much revenue as the social security taxes.
With such a powerful
instrument for raising revenue, many are concerned that the value
added tax eventually will be used to add to the total Federal tax
burden.
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Federal Reserve Bank of St. Louis
-13Conclusion
Mr. Chairman, you are to be commended for initiating an
examination of the very important, but complex, issues of how the
Federal tax structure affects our national well being.
This is a
time of great change.
It is also a time of troublesome and
unfamiliar economic conditions.
The combination of high infla
tion, slow growth, and persistent trade deficits must make us
wonder if the traditional economic remedies still work.
In this
sense, your decision to study a broad range of new initiatives
could not come at a better time.
But changes of such major
consequences require careful and deliberate study.
We welcome
the opportunity to participate with you in that study.
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Federal Reserve Bank of St. Louis
ANNEX A
Federal, State and Local Tax Revenues for Selected Countries as Percent of Gross Domestic Product, by Type of Tax,
(Country Rankings In Parentheses)
:
Indirect
:___ Taxes
,975
Direct Taxes
Social Security 2/
Country
i
Belgium
Canada
Denmark
France
Germany (Fed Rep)
Italy
Japan
Luxembourg
Netherlands
Sweden
Switzerland
United Kingdom
United States
Total
*1 .*3(5)
33.98(9)
*3.05(4)
36.90(6)
35.22(8)
32.3*(10)
20.23(13)
*6.74(2)
*6.90(1)
*5.96(3)
29.*9(,2)
36.77(7)
30.31(H)
: Sales and
: Excise ,/
10.87(6)
10.9*(*)
1*.71 < 1)
12.**(2)
9.37(8)
9.3*(9)
3.67(13)
9.72(7)
10.91(5)
,1.*8(3)
5.90(11)
9.2*(10)
5.*9(12)
Employee and
Total
: Emnlover
13.14(5)
3.22(12)
0.*8(13)
14.72(3)
12.03(6)
1*.83(2)
5.09(11)
14.05(4)
17.99(1)
8.89(7)
8.*9(8)
6.7K1O)
7.*2(9)
8.44(4)
n.a.
0.3K12)
10.61(2)
6.60(7)
11.92(1)
2.63(H)
7.80(6)
8.*0(5)
8.*7(3)
3.05(10)
3.75(9)
*.l8(8)
:
*.70(5)
n.a.
0.17(12)
*.11(6)
5.*3(*>
2.9K9)
2. *6(,0)
6.25(2)
9.59(1)
0.42(11)
5.*4(3)
2.96(8)
3.24(7)
Corporate
Income
3.07(6)
*.67(2)
1.37(13)
2.00(9)
1.56(12)
2.04(8)
3.*3(*)
7.22(1)
3.61(3)
1.99(10)
2.46(7)
1.92(11)
3.29(5)
Noncorporate
Income 37
13-2*(*)
11.32(7)
23.86(1)
*.58(13)
10.60(8)
4.95(12)
5.07(11)
,2.78(5)
12.66(6)
21.17(2)
,0.51(9)
,4.29(3)
9.98(10)
Total Direct
: Prooertv 4/
1.01(12)
3.13(3)
2.57(4)
1.46(9)
1.09(11)
1.17(10)
1.94(7)
2.3*(5)
1.48(8)
0.51(13)
2.13(6)
*.5*(1)
4.13(2)
Other 57 :
0.10(8)
0.70(4)
0.06(10)
1.70(2)
0.57(6)
0.01(11)
1.03(3)
0.63(5)
0.25(7)
1.92(1)
0.07(9)
—
30.56(4)
23.04(11)
28.3«(5)
2*.*6(9)
25.85(7)
23.00(12)
16.56(13)
37.02(1)
35.99(2)
3*.*8(3)
23.59(10)
27.53(6)
24.82(8)
Office of the Secretary of the Treasury
Office of Tax Analysis
|__i
I
Source:
Heyeaue Statistics of OECD Menbar Countries. 1965-1975.
1/
Includes general sales, value added, and specific excise taxes.
iJ
Includes contributions of employers, employees, and self employed.
Category Is broadly defined to Include all tax payments to Institutions of general
government providing social welfare benefits, provided they are levied as a function of pay or a fixed amount per person. Thus, Tor the United States
this category Includes contributions to the railroad retirement fund, unemployment Insurance fund, workman's compensation fund, and civilservice retire
ment program In addition, of course, to the more familiar social security-type payments made pursuant to the FederalInsuranceContributionsAct (FICA).
2/
Includes Income taxes on Individual and unincorporated enterprise, such as proprietorships and partnerships.
1/
Includes taxes on net wealth,
5/
Includes taxes on employers based on payroll or manpower and miscellaneous taxes which cannot be classified within a specific direct tax category.
6/
Computed by subtracting sales and excises from total.
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Immovable property, estates, and gifts.
a
Department of the TR[flSURY
WASHINGTON, D.C. 20220
TELEPHONE 566-2041
FOR RELEASE UPON DELIVERY
EXPECTED AT 10:00 A.M. EST
THURSDAY, NOVEMBER 8, .1979
TESTIMONY OF THE HONORABLE G. WILLIAM MILLER
SECRETARY OF THE TREASURY
BEFORE THE
HOUSE COMMITTEE ON WAYS AND MEANS
Mr. Chairman and Members of this distinguished Committee:
It is a pleasure to appear before this Committee to discuss
the important issues raised by H.R. 5665, the "Tax Restructuring
Act of 1979 ."
This bill would result in fundamental changes in
our Federal tax structure.
Income taxes on corporations and
individuals, as well as social security taxes, would be cut by
$130 billion in 1981.
A Federal value added tax would offset
this revenue loss.
This testimony will not concentrate on the
specifics of H.R. 5665 , but on the basic issue which the bill
raises: whether the United States should replace some of its
income taxes with a consumption tax.
That is, whether the
Federal tax system should weigh more heavily on consumption and
less heavily on saving and investment.
Many believe that such a
change would contribute significantly to improved capital for
mation, higher productivity, and a more competitive position for
American business in world markets.
Others express concern that
a consumption tax would have only small effects on investment and
would place an unfair
burden on lower
income families already
plagued by high prices for energy, food, housing, and other basic
necessities of life.
Higher consumption taxes, they believe,
would mean still higher prices.
These hearings will serve the
valuable function of focusing the discussion on these significant
economic and social issues.
An important element in this discussion is the role of a
value added tax in the Federal tax structure.
A value added tax
is a multistage tax on consumer goods and services.
Unlike a
retail sales tax, it is collected at each stage in the production
and distribution process.
But since it is levied only on the
amount of value added (the difference between sales and pur
chases) at each stage, rather than on the full selling price, it
avoids the cascade, tax-on-tax, effects of a turnover sales tax.
A value added tax is similar to a retail sales tax in that the
total tax paid by the consumer is equal to the final price of the
product multiplied by the tax rate.
M-186
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-2-
Many European countries have value added taxes.
Typically,
they are imposed at a rate of about 15 to 20 percent and generate
about 15 percent of a country's total national and local tax
revenue.
In contrast, state and local retail sales taxes raise
about 7 percent of the total Federal, state, and local tax
revenue in the United States.
The $130 billion in value added
tax revenue estimated to be raised by H.R. 5665 would be about 14
percent of total Federal, state, and local 1981 tax liabilities,
assuming it is accompanied by the proposed income and social
security tax cuts.
In nearly all cases, the European value added taxes replaced
sales taxes, frequently of the cascade turnover type which,
unlike the value added tax, taxed the full sales price at each
stage, without allowing a credit for tax on previous transac
tions.
The Europeans found the cascade tax objectionable because
it discriminated against nonintegrated firms and because the
export rebate and import tax could not be accurately estimated
for border adjustment purposes.
Thus, in the European case, the
adoption of a value added tax was regarded as a reform of an
unwieldy and distortionary system of indirect taxation.
This
characterization does not apply to the present indirect tax
system in the United States.
Only the United Kingdom has used
the value added tax to reduce income taxes, as Chairman Ullman is
suggesting for the United States.
The popularity of the value added tax is not universal.
The
voters of Switzerland have twice rejected it by referendum.
The
latest rejection was based in part on a perceived threat to local
autonomy since a Federal value added tax would have replaced some
of the local Swiss taxes.
Most recently, Japan, largely as a
result of its parliamentary elections, appears to have postponed
the planned introduction of a value added tax.
For the United States, a value added tax raises a number of
important questions.
Would it encourage capital formation? What
impact would it have on the price level?
Would it improve the
trade balance?
Would it be regressive?
No one is seriously
suggesting the value added tax solely as an additional Federal
tax.
Consequently, the answers to these questions, as well as
others, depend upon which taxes the value added tax replaces.
By
way of illustration, two of the proposals made by Chairman Ullman
call for
reducing the corporate income tax and the social
security taxes.
Capital Formation
Taxes on capital income, such as the corporate income tax and
the individual income tax on interest and dividends, reduce the
after-tax return on savings.
Put another way, an income tax
encourages present, as compared to future, consumption.
With no
taxes, a person with $100 of income could choose between buying
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-3-
$100 of consumption goods this year or saving now and buying $110
of consumption goods next year, assuming the interest rate is 10
percent.
Thus, a person can consume 10 percent more next year by
saving now.
Similarly, with a consumption tax, which exempts the
earnings from capital, a person with $100 of income could consume
$50 this year and pay $50 in tax or, by saving the income this
Thus, a
yeat, could consume $55 next year and pay $55 in tax.
by
saving
more
next
year
person could still consume 10 percent
now.
If a 50 percent income tax, rather than a consumption tax, is
imposed, however, the individual, after paying the tax, can buy
$50 of consumption goods this year or can save the $50 and, after
paying the tax on the interest earnings, buy $52.50 of consumpBecause of the income tax, a person can
tion goods next year.
percent,
rather
than 10 percent, more consumpt ion
buy only 5
Because of this lower return, the individual
goods next year.
may decide to consume now rather than save for future consumption.
It is important to recognize, however, that the responsiveness of saving to more favorable taxation is an unsettled
issue.
If one concludes that savings will rise in response to
reduced taxation, then substituting a value added tax for the
corporate income tax should encourage saving.
There are other considerations in assessing the mechanism
First, an increase m
that leads to an increase in investment.
be
channeled
into
domestic
financial markets in
savings must
interest
rates
and
therefore
the cost of capital,
order to lower
to
the
lower
cost of capital by
Second, producers must respond
methods
of
production.
There
using more capital intensive
but
its
magnitude
is
open
to
probably will be some response,
must
be
considered;
mix
of
new
investment
discussion.
Third, the
it may be concentrated in housing, consumer durables, or fixed
business capital.
Thus, the substitution of a value added tax
for the corporate income tax will increase capital formation only
if savings increase. the cost of capital falls, and business
responds by investing in the United States.
Finally, it bears noting that the potential of the value
added tax for promoting capital formation may be exaggerated by
an analysis that compares a "pure" consumption tax with a "pure"
income tax levied on all returns to capital.
The current income
tax does not apply with full force to all types of saving and
investment.
For example, home ownership, pension reserves, and
assets eligible for the investment tax credit or the asset
depreciation range receive relatively favorable tax treatment,
Similarly, not all forms of consumption vzould be taxed the same
under any likely value added tax.
In contrast to an income tax, neither the social security tax
nor a value added tax applies directly to the return from saving.
Consequently, substituting a value added tax for the social
security tax would be unlikely to affect savings decisions.
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-4-
Price Level Impact
A value added tax, by itself, will probably increase prices,
since the tendency for business to pass the tax on to consumers
is unlikely to be offset by an unduly restrictive monetary
policy.
The result would be a "one-shot" increase, not a
recurrent increase, in the price level, although the subsequent
price effects of adjustments in wage contracts, social security
payments, and other indexed items may occur over time.
Tn this
regard, it is noteworthy that the Thatcher government’s program
of increased value added taxation and reduced individual income
taxation has been accompanied by a significant increase in the
consumer price index in the United Kingdom.
The important question, then, is whether the inflationary
impact of the value added tax would be offset by reductions in
other taxes.
Tn the short run, the corporate income tax reduces
the after-tax rate of return to capital, rather than increases
product prices.
Accordingly, prices will probably not fall as
corporate income taxes are cut.
Thus, substituting a value added
tax for the corporate income tax is likely to increase prices.
This is a serious drawback to the value added tax.
Substituting a value added tax for the social security tax
may be less inflationary.
Reducing the employer portion of the
social security tax would tend to reduce business labor costs and
possibly prices.
Reducing the employee portion of the social
security tax, however, would probably have no effect on the price
level.
Thus a value added tax, accompanied by an equivalent
reduction in employer and employee social security taxes, would
result in some increase in the price level.
This would be
particularly distressing to individuals least able to protect
themselves from rising prices.
The impact of a value added tax on prices is largely inde
pendent of whether it is hidden in the price of the product or
whether it is quoted separately to consumers.
While it is not
customary in Europe to quote the value added tax separately, this
need not be the case in the United States.
State retail sales
taxes are quoted separately because the merchants persuaded
legislators to require it, and the same could occur in the case
of a United States value added tax.
Furthermore, nonseparate
quotation of the value added tax might be viewed as an attempt to
hide the tax from public scrutiny.
Balance of Trade
Many have expressed the view that a value added tax would
improve our trade balance.
This is based on the observation that
current international rules allow indirect taxes, such as sales
or value added taxes, to be imposed on imports and rebated on
exports.
These adjustments are not allowed for direct taxes,
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-5-
such as the corporate income or social security taxes.
It is
doubtful, however, that the U.S. trade balance would improve
significantly from substituting a value added tax for the
corporate income tax.
The impact of the value added tax on trade is closely related
to what happens to prices.
Quite simply, one must ask the
question: will the substitution of the value added tax for some
other tax increase prices?
It seems likely that the immediate
impact of substituting a general value added tax of 5 percent for
part of the corporate income tax would be to increase prices by
about 5 percent.
Since the new tax would be rebated on exports,
just like our state retail sales and Federal excise taxes,
exports would leave the country tax free.
While domestic prices
would be 5 percent higher, export prices would remain unchanged.
Foreign consumers, therefore, would find U.S. products no more
attractive than before; there would be no increase in demand for
U.S. exports.
Since imports would be subject to the value added tax their
prices also would increase by about 5 percent, the same as for
domestic goods and services.
As a consequence, domestic con
sumers would find imports just as attractive as before; there
would be no incentive to reduce the demand for imports.
Thus, on
both the export and import side, there would be little immediate
impact on the U.S. trade balance if a value added tax were sub
stituted for the corporate income tax.
There might, of course,
be a positive trade impact in the long run if the substitution
led to an improved investment climate, enhanced capital forma
tion, and a more productive and competitive U.S. economy.
A modest trade balance improvement might result from
replacing the social security tax with a value added tax, if thj
price level increased by less than the value added tax.
Because
of the price-dampening effect of reducing the employer portion of
the social security tax, this is a possibility.
Regardless of which tax it replaces, many believe that a
value added tax rebate, in itself, will expand exports and that a
value added tax levy will retard imports.
This belief might have
a positive effect on trade if it encourages businesses to compete
more vigorously in international markets.
This result would
depend upon the importance of nonprice considerations in
explaining export activity.
It is also important to recognize that other countries could
restructure their own tax systems if they felt the United States
was gaining an unfair trade advantage.
Relative to other coun
tries, the United States has a moderately high corporate income
tax, but a low social security tax.
(See Annex A.)
Thus, the
possibility exists that other countries might maintain their
competitive position by increasing their existing value added
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1
-6taxes and reducing their corporate income or, especially, their
social security taxes.
This outcome is by no means certain.
After all, a country's tax structure is not determined solely by
international considerations.
Moreover, except for Japan, U.S.
indirect taxes, as a share of }gross domestic product, are the
lowest of the major developed countries.
(See Chart 1 and Annex
A.)
Other countries may believe that the United States should be
allowed to "tilt" its tax structure to reach some "reasonable" or
"average" level of indirect taxation.
i
This issue has been studied before.
Both the President's
Task Force on Business Taxation, in its 1970 review of tax
policy, and the Advisory Cdmmission on Intergovernmental
Relations, in its 1973 value added tax study, considered the
trade issue.
Both expressed- doubt over any trade benefits
resulting from substituting a value added tax for the corporate
income tax and both noted the possibility of foreign retaliation.
Distribution of Tax Burden
i
*
Lower income taxpayers, who must spend all their income on
consumption, may find a value added tax burdensome because of its
regressivity. While a value addpd tax, by itself, is regressive,
one must consider which tax it replaces.
The immediate impact of
the corporate income tax is probably progressive since it falls
on income from capital.
Therefore, substituting a value added
tax for the corporate income t’ax would make the tax structure
less progressive.
The social security tax, on the other hand,
also is regressive because it i^ limited to the first $22,900 of
wages and applies only to labor income.
Accordingly, substi
tuting a value added tax for the social security tax would not
make the tax system noticeably less progressive.
One regressive
tax would be substituted for andther.
Retired individuals, how
ever, who do not pay social security tax, would be distressed by
having to pay value added tax.
They could justifiably say that
they already had paid for their retirement during their working
years and that higher prices and taxes in retirement were unfair.
Their distress might be partially assuaged by the fact that
social security payments are indexed.
I
One way to illustrate possible distributional effects is to
ask what would happen to tax’ burdens if a value added tax
completely replaced the individual income and social security
(employee portion) taxes.
(See ’Chart 2.)
mhe combination of the
current income and social security taxes is progressive while a
value added tax, even with necessities excluded, is regressive.
As a share of income, the pres'ent individual income and social
security taxes are only 2 percent for families with less than
$5,000 in income, but increase throughout the income range to 33
percent for families with over $'100,000 in income.
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j
CHART 1
|§ Indirect
DIRECT AND INDIRECT TAXES AS A
TAX REVENUESAS A PERCENT
OF GROSS DOMESTIC PRODUCT
40
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Canada
France
Germany
Japan
United Kingdom United States
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CHART 2
TAXES AS PERCENT OF INCOME
-9This may be contrasted with a value added tax with no exclu
sions at a 23.2 percent rate, sufficient to equal the revenue
raised by the individual
income and employee social security
taxes in 1978.
As a share of income, such a value added tax
would be 35 percent for families with less than $5,000 in income,
but fall to 6 percent for families with over $100,000 in income.
No one, of course, is proposing the complete substitution of
the value added tax for the income and social security taxes.
A
more realistic alternative would be to substitute a value added
tax for part of the combined individual income and social secur
ity taxes.
One possibility would be to reduce income and
employee social security taxes by $100 billion, keeping the same
degree of progressivity for these taxes as under present law, and
offset the revenue loss with a $100 billion value added tax with
no exclusions.
The resulting distribution of tax burdens would
be regressive at the lowest income levels and mildly progressive
elsewhere.
As a share of income, families with less than $5,000
in income would pay 17 percent in taxes, families with between
$5,000 and $10,000 in income would pay 14 percent, and taxes
would then increase throughout the income range so that families
with over $100,000 of income would pay 21 percent of their income
in taxes.
The overall distribution is significantly less
progressive than the present combination of income and employee
social security taxes.
The regressivity of the value added tax can be moderated, but
not eliminated, by special measures.
One possibility is the use
of exemptions and reduced rates for necessities, as in Chairman
Ullman's proposal and in some European countries.
These reduce
the tax burden of the value added tax at the lowest income
levels, but the tax remains regressive.
Exemptions and reduced
rates, moreover, create administrative problems.
A tax with two,
three, or four rates is more complex than a tax with one rate.
The specially-taxed items must be identified.
Does a lower rate
for food, for example, apply to such items as chewing gum, soda
pop, candy, or caviar? Experience with the income tax shows that
even medical services and drugs are not easy to define.
Beyond
the definitional problems, total or partial exclusions erode the
value added tax base and its revenue potential.
(See Chart 3.)
The regressivity of a value added tax also can be reduced by
a refundable income tax credit for tax paid on a necessary amount
of consumption. This avoids the need to define exempt commodities
and can be implemented at a lower revenue cost than a complete
exemption for certain "essential" commodities.
It can, for
example, be phased out at increased income levels.
In effect,
middle and upper income groups would still pay tax on purchases
of food and other necessary items.
On the other hand, a refund
able credit is effective only if it reaches the roughly 25
million individuals who do not appear on an income tax return.
These tend to be individuals most in need of the credit, mainly
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CHART 3
SUBTRACTIONS
FROM VALUE ADDED
TAX BASE
(Percent)
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Medical Care
\
10
52.9
13 5
Other Expenditures
IO—II 1
-11recipients of social security benefits and of transfer payments
under social and welfare programs.
Unlike lower rates and
exemptions, if the credit was not paid until the end of the year,
the consumer would have to finance the tax during the year.
Administrative and Design Considerations
Both the European value added taxes and the tax suggested by
Chairman Ullman have certain basic similarities:
they are broad based, applying to services as well as
goods;
tax liability is determined by the credit method with
tax paid on purchases deductible from tax due on
sales;
they are consumption
capital
equipment
deductible; and
type taxes,
purchases
any
is
tax paid on
immediately
they extend through the retail stage.
A value added tax of this type for the United States would
involve about 15 million taxpayers.
This number might be reduced
by 5 million if exemptions were provided for very small propri
etorships and farming.
But under a value added tax, nearly all
transactions are taxed.
Even a firm that is tax exempt on its
sales will have paid tax on its purchases.
If it is to receive
credit for tax paid on its purchases, it either would have to
file a return or the credit would have to be made available to
its customers.
Even 10 million taxpayers would add about 30 percent to the
number of returns filed with the Internal Revenue Service,
assuming quarterly returns are required.
Since the value added
tax would not totally replace any other tax and would be a new
tax, requiring new returns, new regulations, and a new body of
case law, this would be a net addition to the work of taxpayers,
the Internal Revenue Service, and the courts.
This differs
sharply from the typical European case where the value added tax
completely replaced another sales tax.
Reporting and payment requirements for a value added tax
would be similar to those for Federal excises, which require
liability to be computed on a semimonthly basis with payment due
9 days later.
The actual excise tax return is filed quarterly
and is accompanied by the payment of any remaining balance.
Liquor and tobacco excises, however, have slightly different
rules.
A value added tax payment system which would fit more
neatly with ordinary bookkeeping would be a monthly liability
period with payment due at the end of the next month.
This would
be similar to that proposed by Chairman Ullman.
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-12-
Qther Considerations
A Federal value added tax would raise a number of other
issues.
Forty five states and the District of Columbia impose
general sales taxes, a revenue source which they tend to view as
belonging exclusively to them.
Sales and gross receipts taxes
account for about 30 percent of state tax revenue.
In contrast,
excise taxes generate less than 4 percent of Federal tax collec
tions.
Nevertheless, while a Federal value added tax may make it
more difficult for the states to raise their sales taxes, it
should not prevent such increases. All levels of government, for
example, impose income taxes.
Moreover, total Federal, state,
and local sales tax collections are lower in the United States
than in most developed countries.
Because of likely differences in the tax bases, it is doubt
ful that a Federal value added tax could be coordinated with the
state sales taxes.
Separate taxes, admittedly, would mean higher
administrative and compliance costs.
Each level of government
would require a collection and audit capability.
Taxpayers would
have to become familiar with separate tax bases and separate
returns.
Revenue departments and taxpayers, however, already
face this problem with Federal and state income taxes.
Efforts
aimed at Federal-state cooperation and coordination have not been
successful.
As shown by Chairman Ullman's proposal, even a broad-based
value added tax may not apply to all forms of final consumption.
Practical considerations may require special treatment for many
items.
In the area of housing, for example, homeowners and
tenants should be treated equally.
But if rental payments are
taxed, how should homeowners be taxed?
It may be difficult to
value the so-called "imputed rent" on owner occupied housing.
Taxing the purchase price of a home is one alternative, but this
may aggravate the problems of many families already hard pressed
to cope with high housing prices.
The treatment of interest in
the housing area also is troublesome.
If it is exempt, what part
of a cental payment should a landlord be allowed to exclude from
the tax base?
These and other problems will require careful
study.
The value added tax is a very potent revenue source.
At 1979
levels of consumption, a value added tax would raise roughly $10
billion in revenue for each percentage point.
Thus, a 7 percent
value added tax would raise about as much revenue as the corpor
ate income tax and a 12 percent value added tax would raise as
much revenue as the social security taxes.
With such a powerful
instrument for raising revenue, many are concerned that the value
added tax eventually will be used to add to the total Federal tax
burden.
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-13-
Conclusion
Mr. Chairman, you are to be commended for initiating an
examination of the very important, but complex, issues of how the
Federal tax structure affects our national well being.
This is a
time of great change.
It is also a time of troublesome and
unfamiliar economic conditions.
The combination of high infla
tion, slow growth, and persistent trade deficits must make us
wonder if the traditional economic remedies still work.
In this
sense, your decision to study a broad range of new initiatives
could not come at a better time.
But changes of such major
consequences require careful and deliberate study.
We welcome
the opportunity to participate with you in that study.
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ANNEX A
Federal, State and Local Tax Revenues for Selected Countries as Percent of Gross Domestic Product, by Type of Tai,
(Country Rankings In Parentheses)
:
Indirect
:
:Taxes;•
1975
Direct Taxes
Social Security 2/
Country :
Belgium
Canada
Denmark
France
Germany (Fed Rep)
Italy
Japan
Luxembourg
Netherlands
Sweden
Switzerland
United Kingdom
United States
Total
Ml .*3(5)
33.98(9)
*3.O5(*)
36.90(6)
35.22(8)
32.3* (10)
20.23(13)
*6.7*(2)
*6.90(1)
*5.96(3)
29.*9(12)
36.77(7)
30.31(11)
: Sales and
: Excise 1/
10.87(6)
10.9*(«)
1*.7K1)
12.**(2)
9.37(8)
9.3*(9)
3.67(13)
9.72(7)
10.9K5)
11.*8(3)
5.90(11)
9.2*(10)
5.*9(12)
Total
: Emo lover
13.1*(5)
3.22(12)
0.*8(13)
14.72(3)
12.03(6)
14.83(2)
5.09(11)
1*.05(*)
17.99(1)
8.89(7)
8.*9(8)
6.71(10)
7.*2(9)
8.**(*)
n.a.
0.3K12)
10.61(2)
6.60(7)
11.92(1)
2.63(11)
7.80(6)
8.*0(5)
8.*7(3)
3.05(10)
3.75(9)
*. 18(8)
Employee and
: Self Emnloved
*.70(5)
n.a.
0.17(12)
*.11(6)
5.*3(* >
2.9K9)
2.*6(10)
6.25(2)
9.59(1)
0.42(11)
5.**(3)
2.96(8)
3-24(7)
Corporate
Income
3.07(6)
*.67(2)
1.37(13)
2.00(9)
1.56(12)
2.04(8)
3.*3(*)
7.22(1)
3.61(3)
1.99(10)
2.*6(7)
1.92(11)
3.29(5)
Noncorporate
Income 3/
13-24(4)
,1.32(7)
23.86(1)
*.58(13)
10.60(8)
*.95(12)
5.07(11)
,2.78(5)
12.66(6)
21.17(2)
10.5K9)
1*.29(3)
9-98(10)
: Prooertv */
1.01(12)
3.13(3)
2.57(«)
1.*6(9)
1.09(11)
1.17(10)
1.9*(7)
2.3*(5)
1.*8(8)
O.5K13)
2.13(6)
*.5*(1)
*.13(2)
Other 5/ :
0.10(8)
0.70(4)
0.06(10)
1.70(2)
0.57(6)
0.01(11)
1.03(3)
0.63(5)
0.25(7)
1.92(1)
__
0.07(9)
—
Total Direct
Taxes 6/
30.56(4)
23.0*(11)
28.3*(5)
2*.*6(9)
25.85(7)
23.00(12)
,6.56(13)
37.02(1)
35.99(2)
3*.*8(3)
23.59(10)
27.53(6)
2«.82(8)
Office of the Secretary of the Treasury
Office of Tax Analysis
Source:
Keygnua
aliaLlca .a£.Q££fl HeaDcr CQuakrlca.. 1965-1375■
1/
Includes general sales, value added, and specific excise taxes.
2/
Includes contributions of employers, employees, and self employed.
Category Is broadly defined to Include all tax payments to Institutions of general
government providing social welfare benefits, provided they are levied as a function of pay or a fixed amount per person. Thus, for the United States
this category Includes contributions to the railroad retirement fund, unemployment Insurance
fund, workman's compensation fund, and civilservice retire
ment program In addition, of course, to the more familiar social security-type payments made
pursuant to the FederalInsuranceContributionsAct (PICA).
3/
Includes Income taxes on Individual and unincorporated enterprise, such as proprietorships and partnerships.
1/
Includes taxes on net wealth,
3/
Includes taxes on employers based on payroll or manpower and miscellaneous taxes which cannot be classified within a specific direct tax category.
6/
Computed by subtracting sales and excises from total.
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Federal Reserve Bank of St. Louis
Immovable property, estates, and gifts.
►—*
I
r/M
ACTION
Date:
MEMORANDUM FOR:
From:
Subject:
23/979
secretary miller
Donald C. Lubick
Assistant Secretary
(Tax Policy)
Outline of Value Added Tax Testimony
Attached is our proposed outline of your value
added tax testimony for November 7 before the Ways
and Means Committee.
A copy is also attached of the
Ullman plan.
It calls for a value added tax, generally
at 10 percent, in exchange for substantial social
security, individual, and corporate rate cuts, along
with reduced taxation of savings.
Because tax reduc
tions of such magnitude would not be possible without
a new substitute tax, I assume you would like your
testimony to concentrate on the desirability of a
sales tax, like VAT, rather than on the tax reduction
elements of the Ullman proposal.
If so, I suggest a comprehensive statement that
would discuss the major economic and administrative
issues associated with a VAT.
It would not conclusively
endorse or reject the VAT, but would aim to shape and
focus the future debate on this tax.
Attachments
Initiator
Surname
Initials J Date
Form OS 3129
Department of Treasury
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Federal Reserve Bank of St. Louis
X-LUBICK
7
Reviewer
Reviewer
/
/
Reviewer
Reviewer
/
Ex. Sec.
A.
OUTLINE OF
SECRETARY MILLER'S TESTIMONY
ON VAT
I.
II.
INTRODUCTION
A.
Brief description of VAT and characterization as
a sales tax.
B.
Statement of issues whether U.S. should replace direct
taxes on income with a sales tax on consumption and,
if so, whether VAT is superior to retail sales tax?
C.
Statement that testimony will review the issues and
argumentation on both sides and welcome hearings to
receive public testimony on issues.
ECONOMIC ISSUES
A.
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PRO
1.
VAT would enhance capital formation.
You would
acknowledge this as the strongest argument for a
VAT, but caution that it depends on what taxes
the VAT replaces and on the response of saving
and investment to lower taxation.
Economists can
give us little assurance whether the rate of
savings responds to tax reduction.
You also
would note that our current income tax treats some
types of saving (home ownership, pension reserves)
and investment (assets eligible for the investment
tax credit or ADR) preferentially.
2.
VAT would improve our trade balance.
You would
contend that, aside from psychologically, this
is an economically dubious argument.
It assumes
a VAT would not be inflationary and that our
trading partners would not retaliate by increasing
their VATs.
Either assumption, you would observe,
is possible, but quite unlikely.
3.
Other advantages.
In lesser detail, you would
note that some feel that our social security
and income taxes are too high and that a VAT
offers relief from them.
2
B.
Ill.
CON
1.
VAT would be inflationary.
You would stress
this as a strong argument against the VAT at
this time.
Although it depends on which taxes
are cut, most observers agree that a VAT would
increase prices.
Although this would be a
"one-shot" increase, rather than a recurrent
annual increase, in the price level, you would
note that this is a bad time for any more
inflation.
2.
VAT would be regressive.
You would characterize
this as a significant,’’but not fatal, criticism.
For one thing, the impact of taxes on various
income groups should be viewed in terms of the
entire tax structure, not one particular tax.
More importantly, the potentially-harsh impact
of a VAT on the poor can be alleviated by tax
credits or different rates.
You would note that
our states do this for sales tax purposes.
You
would note that the Ullman proposal is quite
regressive.
3.
Other objections.
In lesser detail you would
note the concern of the states over a Federal
incursion into the sales or consumption tax
area and of others that the VAT, with its
enormous revenue potential, would ultimately
mean a net Federal tax increase.
You would also
discuss the fact that VAT involves not inconsider
able complexity and compare the use of a retail
sales tax.
You would note that an additional tax
source could lead to an increase in overall tax
levels, and that essentially VAT for the Europeans
is the margin of excess over our rate of taxation.
ADMINISTRATIVE AND DESIGN ISSUES
A.
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General design would be a broad-based consumptiontype VAT.
You would state that European experience
and our own analyses leads us to conclude that the
tax should:
be broad based;
3
be a consumption-type VAT;
provide for tax liability to be calculated
by the credit method; and
—
extend through the retail stage.
B.
Number of taxpayers.
A VAT of this type would encompass
about 15 million taxpayers, but farming and small
proprietorship exemptions could reduce that by about
5 million taxpayers.
In either case, this would be
a net addition to the work of both taxpayers and the
Treasury.
Even 5 million taxpayers filing quarterly
returns would constitute a roughly 15 percent increase
in the number of returns filed with the IRS.
C.
Offset regressivity by tax credits.
You would favor
this method as being cheaper and administratively
preferable to lower rates or exemptions.
To illustrate
the point, you might question what food items would be
eligible for Chairman Ullman’s reduced rate.
Chewing
gum?
Soda pop?
Candy?
Caviar?
You would acknowledge
that if tax credits are used care would have to be taken
to reach the roughly 25 million individuals not covered
by an income tax return.
D.
Reporting and payments requirements would be similar
to excise tax rules.
You would describe briefly the
current excise tax rules and note the VAT rules would
be similar, but perhaps not identical.
If the generous
payment rules proposed by Ullman were adopted, it is
likely that pressure would build to provide similar
rules for other excises and this would involve a
substantial one-time revenue loss.
E.
Special problem areas.
Even if one accepts the concept
of a broad-based VAT, there will be problem areas.
You
would highlight the problems:
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1.
Housing.
Should imputed rent on owner occupied
housing be taxed?
2.
Consumer interest.
Should mortgage interest
be taxed?
Interest paid by tenants?
4
F.
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Federal Reserve Bank of St. Louis
Should the tax be hidden?
Should the tax be separately
stated and disclosed or buried in the price?
Disclosure
would impose fiscal discipline.
Failure to separate
the tax would mean state sales taxes would be imposed
on a larger base than the actual price.
/
INFORMATION
Date:
MEMORANDUM FOR:
From:
secretary
OCT 1 5 1979
miller
4
Donald C. Lubick
Assistant Secretary
Tax Policy)
Subject: Chairman Ullman’s Grand Plan
I understand that Chairman Ullman next Wednesday will
reveal his plan for a major restructuring of the American
tax system.
He plans to begin holding hearings on November 5.
It is anticipated that you will be the leadoff witness for
the Administration and that Chairman Volcker will appear on
Tuesday, November 6.
On a confidential basis, the broad details of the
Ullman plan have been given to us on the understanding that
we will not discuss them with outsiders until the proposal
is actually released.
The elements of the Ullman plan arei as follows:
1981 Revenue Impact
($Billions)
Revenue increases
1.
VAT — a 10% rate except a 5% rate
for food, shelter, and medical
expenses.
Zero rating on 501(c)(3)
organizations, farmers, fishermen,
and mass transit
$130
The impact of the exemptions are as5 follows:
10% rate without exemptions
$19";
less increase in cost of
Federal purchases due to
introduction of VAT
less food exemptions
less housing exemption
Initiator
Surname
Initials j Date
Form OS-3129
Department of Treasury
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
Reviewer
Reviewer
Reviewer
XA-Sunley
!
/
Reviewer
/
Ex. Sec.
------------- <
——
2
less medical expense
deduction
less increased social security
payments due to indexing of
benefits
less zero rating for 501(c)(3)
organizations, farmers,
fishermen, and mass transit
-5
$130
Revenue decreases
1.
2.
Social security — rate reduced 2.15%
for both employers and employees.
1981 rate would be 4.5%.
Individual
—50% maximum rate
—Low income relief — earned income
credit extended to childless couples,
rate increased to 15 percent, and
credit phased out at $12,000; credit
for elderly made refundable; and
increase in AFDC payments
—Rate reductions and higher zero
bracket amount
3.
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Federal Reserve Bank of St. Louis
$52
5
5
37
Savings incentive
—Current limit on IRAs increased to
$2,000 and anyone not qualified for
an IRA can set up one with a $1,000
limit.
Deferral of tax on income of
qualified savings accounts for up to
$1,000 a year of additional savings.
Income will be exempt until withdrawn;
it is assumed that deferred income
withdrawn first, then principal.
Rollover permitted within the account
and taxpayers permitted to switch to
another trustee without triggering
taxation
2
3
—Pickle’s dividend reinvestment plan
with a $1,500 limit per taxpayer
4.
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Business reductions
—Reduce 46% rate to 36% and
increase the brackets at the low
end of the corporate rate schedule
so that the top rate of 36% is
reached at a $160,000 of taxable
income (compared to $100,000 under
current law).
22
—Increase ADR variance from 20 to
40% and permit small business to
elect ADR without all the bells
and whistles.
Investment credit
liberalized to 6% for assets with
useful lives of 3 to 4 years and
10% for assets with useful lives
of 5 years or more.
6
$130
@FedFRASER