VAT debate: What does Mike Huckabee want?

NEW YORK (Fortune) -- This week, I posted a story on Fortune.com saying that a Value Added Tax is fast becoming the only option America has left to solve the current fiscal crisis. In the piece, I said that former Arkansas Governor and leading Republican presidential contender Mike Huckabee favors a VAT to replace the income tax.

I received numerous angry emails stating that the ex-governor advocates a solution called a "Fair Tax" that's quite different from a VAT.

So what's the difference between the "Fair Tax" and the VAT? If the VAT is coming it's important to understand all of its cousins and relatives.

Under Huckabee's plan, the difference is mainly in the way the money is collected and distributed. Under a VAT, each supplier or manufacturer in the chain of production collects a tax on the markup they charge the next player in the chain, and pays it to the government. Hence, the retailer writes the government a check for just part of the tax. But the producers don't actually pay the tax; they recoup their portion of it from the player they sell to. So the consumer pays the entire levy on the auto or PC at the cash register.

Huckabee's "Fair Tax" is a national sales tax that resembles a classic state sales tax. The retailer tacks the full amount onto the bill, collects the tax, and sends the government a check. In other words, the full amount is charged at the cash register. For the consumer, the expense is the same: a 20% sales tax or a 20% VAT on a $1,000 PC is sill costs them an extra $200.

The Fair Tax advocates claim that the VAT is a "hidden tax" because, in the countries where it's levied, the VAT is frequently not disclosed in the bill, while sales taxes are broken out for all to see. In theory, that could stiffen taxpayer resistance to raising a national sales tax. As we've seen in Europe, it's relatively easy for countries to lift the VAT every time a recession shrinks tax receipts. Huckabee clearly wants to make sure his tax doesn't fuel the growth of government.

So how would the Huckabee tax work? It would impose a 23% levy on all the goods and services Americans consume. It would replace both income taxes and payroll taxes such as Social Security and Medicare. In theory, it would collect just as much revenue as our current tax system now provides.

How does Huckabee pledge to solve the problems that plague either a national sales tax or a VAT? The biggest objection to a pure consumption tax is that it's regressive, since low earners spend a far higher proportion of their pay on goods and services than the wealthy.

Huckabee would overcome that barrier in two ways. First, since the Fair Tax would replace payroll taxes -- which are themselves highly regressive -- it would lighten the burden on lower income Americans. Second, he would send taxpayers monthly payments called "prebates" to compensate for the taxes Americans would pay for such staples as food and clothing. The prebates would ensure that low-earners recoup all or most of the levy on life's essentials. In effect, they'd pay no sales tax at all.

Huckabee's Fair Tax, however, may lack the feature that makes the VAT so powerful and popular outside of the U.S. Because producers pay most of it, cheating is minimal. And the lack of cheating makes the VAT an awesome machine for raising revenue.

When the money is collected at the cash register, retailers are sorely tempted to sell for cash at a discount, move more merchandise, and forget the tax. The cheating, if it's rampant, forces the federal government to raise the rates to collect the needed revenues.

Can Huckabee's tax work? It all depends on whether a national sales tax would avoid the pitfall of the VAT: Providing an irresistible temptation for politicians to keep ratcheting up the rate and growing taxes as a share of GDP. That's clearly just what Huckabee wants to avoid. We've certainly seen the states succumb to that temptation time after time.

And remember, Huckabee wants the Fair Tax to replace our current system, not to add an additional layer. That's conceivably a good idea. Let's hope his opponents don't use his arguments to saddle America with both rising income taxes and a brand new consumption tax as well.