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Le Tax: Do the French have it right?
France first set up a dual tax system that the rest of the developed world adopted, except the U.S.
March 24, 2005: 12:26 PM EST
By Krysten Crawford, CNN/Money staff writer
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NEW YORK (CNN/Money) - Ever since President Bush began pushing tax reform, policy experts have been wondering if he'd go euro.

With reform recommendations from a presidential panel due by July 31, the betting is that at least one of the proposals would move the United States closer to a model that started in France decades ago, spread across Europe and is now used by more than 120 countries, including Singapore, Canada, Japan and Australia.

The model? A hybrid tax code with two key components: a tax on income and a type of sales tax commonly known as a value-added tax.

"My guess is the panel is playing with a couple of different ideas," said Clint Stretch, the director of tax policy at Deloitte Tax, a unit of the accounting giant Deloitte & Touche. "One is some...reform of the current income tax system and the second is a value-added tax."

Simply put, a value-added tax is a sales tax. But unlike a retail sales tax that is levied at the moment a new Hummer or some other good is sold, a value-added tax is charged at various stages of the manufacturing process.

Governments love value-added taxes for a few reasons.

One is that they still produce plenty of tax revenue. In addition, they limit cheating because the tax is imposed -- and documented -- at so many levels. Evading a retail sales or income tax takes two parties, the buyer and the seller or the employer and employee. With a value-added tax, hoodwinking the government requires many participants.

A value-added tax, considered a type of consumption tax, also encourages savings. People who buy more would be taxed more and, hence, have an incentive to save.

Alan Schenk, a tax professor at Wayne State University Law School, says a value-added tax has been proposed in just about every Congress since 1979. The legislation has never gone anywhere, says Schenk, because it lacked White House support.

But Bush has made it clear that he wants a tax code that promotes savings and economic growth. He has also asked for ideas that don't unfairly shift the tax burden around and still bring in some $2 trillion in taxes every year.

Federal Reserve chairman Alan Greenspan has also noted the virtues of consumption taxes for boosting national savings.

Sales or income tax....or both?

So how would a value-added tax work in the United States? One proposal getting a lot of attention comes from Michael Graetz, a Yale Law School professor who was the chief tax policy adviser under Bush's father and is said to have turned down an offer to serve the same role in the current Bush administration.

Graetz's idea, in its simplest form, is to exempt all households with less than $100,000 a year from paying income taxes. Income over $100,000 would be taxed at 25 percent.

To replace the revenue lost by the large exemption and lower tax rate, Graetz would institute a value-added tax on most goods and services at a rate of 10 percent to 14 percent.

Take, for instance, an SUV with a sticker price of $30,000 and a value-added rate of 10 percent.

Ford might buy its steel and other materials for $8,000 plus $800 in sales tax. Then, for the finished SUV, a dealer might pay $25,000 plus $2,500 in tax. Ford would take an $800 credit for tax already paid and send $1,700 to the government.

A buyer then pays $30,000 for the SUV and $3,000 in taxes. The dealer collects the $3,000, takes a credit for the $2,500 worth of taxes already paid, and sends $500 to tax authorities.

The government takes in a total of $3,000 in tax -- the same amount, by the way, it would under a 10 percent retail sales tax. One big difference is that every step of the manufacturing process has been documented.

Graetz, whose plan has similar provisions for businesses, says his system essentially creates a hybrid system similar to what the United States had before World War II, when only high earners paid income taxes while the masses only paid consumption taxes.

"I'm trying to come up with an idea that meets the (president's) criteria, but which is sufficiently dramatic that it moves people off tax rolls and makes it very difficult for Congress to bring them back in," said Graetz.

A tough sell

Enacting Graetz's proposal wouldn't be easy. The concept of a value-added tax has plenty of critics in the United States, including liberals who argue that sales taxes hurt lower-income workers and conservatives who argue that they just lead to bloated government, according to Schenk of Wayne State University.

Indeed, Daniel Mitchell, the chief tax expert at the conservative Heritage Foundation, calls Graetz's proposal a "terrible idea." He points to Europe, where value-added tax rates started off low but have since jumped. Rates vary but they now hover around 20 percent.

"It's a hidden tax that's very easy to raise and it's frighteningly efficient," said Mitchell. "Even a 1 percent increase in value-added tax rates gives the government a whole lot more money to spend. In Europe they can't resist that."

Mitchell says the European experience points to another problem: critics view sales taxes as inherently unfair because poor people consume more than rich people as a percent of their total income. In order to keep the overall tax system fair, Mitchell says, governments have boosted income tax rates as well. As a result, Europe has one of the highest tax burdens in the world.

Mitchell thinks the same would happen with Graetz's proposal or any other hybrid scheme like it.

"If you have a value-added tax you will have bigger government," said Mitchell. "When the dust settled 10 years in the future, we would have the same income tax as we do now and a giant money machine called (a value-added tax)."

More on tax reform: Imagine -- no IRS.

Click here for more on taxes.

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