Tax advice for Mr. Bush: Consider the VAT
By Bruce Bartlett

(FORTUNE Magazine) – PRESIDENT BUSH HAS PUSHED THROUGH SOME DELIGHTFUL changes in the tax code over the past four years: lower income tax rates, rebates, and increased business depreciation allowances, to name a few. It's been great. Except for one thing: When you consider those measures as a whole, they don't make much sense. Bush's tax policy--although "policy" may be stretching the meaning of the word--is a haphazard mess.

What's scary is that the President has never spelled out anything resembling a guiding philosophy of taxation. Is it more important to the President that we fundamentally restructure the tax system into something coherent and efficient? Or does he simply believe that taxes must be lower, period, and damn the consequences? Who knows? Without a principled view of tax reform the White House and Congress are too easily led astray into ad hoc policies. And that's how we find ourselves with the kind of unholy hairball of a tax code that we so enjoy today.

Meanwhile, all the President's tax cuts are a reason the federal deficit is getting out of control. Political pressure hasn't yet built to the point where the administration might, say, do something about the deficit. But it's building. And there are reasons to believe that financial markets will force Washington to take action, which is what happened in the 1980s. The sharply falling dollar and rapidly rising current-account deficit mean that something will have to be done soon to reduce America's dependence on foreign capital. Reducing the budget deficit is the quickest and easiest way to do that.

But even if financial markets somehow fail to demand action on the deficit, the economy-devouring effects of America's long-term entitlement obligations will. According to the Congressional Budget Office's most likely scenario, Medicare and Medicaid spending alone will rise from 4% of GDP to 11.5% in 2030 and 21.3% in 2050. Today, by contrast, all federal spending consumes just under 20% of GDP. On the revenue side, the federal government is taking in only 16% of GDP, the lowest percentage since the 1950s and well below the postwar average of 18%. Yet Bush has proposed making all expiring tax cuts permanent, and everyone knows that the alternative minimum tax (AMT) will have to be fixed, which will further erode revenue growth.

Putting all that together yields an inescapable conclusion: The government must increase federal revenue as a share of GDP. In other words, raise taxes. The only question is how? Although Bush's position is essentially that the country needs more taxes the way it needs more liberals, the idea that the growing deficit can be ignored or that it can be dealt with solely on the spending side is simply wrong and getting wronger.

One clue to where Bush may end up comes from his days as governor of Texas. He appointed a tax-reform commission that recommended a form of value-added tax, or VAT, for the state. Bush endorsed the proposal and worked to get it passed, although the legislature ultimately voted it down.

Many economists, including this one, believe that the time has come for the U.S. to seriously consider a national VAT. We are the only major industrialized country without one. A broad-based VAT could raise half a percent of GDP in revenue for every percent of tax. A 10% VAT, therefore, could raise revenue equal to 5% of GDP. That would be more than enough to fix glaring problems in the tax code such as the AMT, make Bush's tax cuts permanent, and still leave money for deficit reduction.

There's no doubt that a VAT would be controversial. But it has the enormous virtue of raising large revenues at a low economic cost--discouraging less economic output per $1 raised than any other tax that economists know of. Trying to raise substantial additional federal revenues by increasing income tax rates would be far more costly to the economy.

A VAT has other virtues as well. If it were used to replace the corporate income tax, it would unquestionably improve the competitiveness of American businesses because world trade rules allow a VAT to be rebated on exports, whereas corporate income taxes may not. That is one reason European businesses have remained competitive despite tax burdens sharply higher than those here.

There is no indication that Bush will propose a VAT, either for deficit reduction or tax reform. But the logic for it is compelling and may soon become overwhelming. It's the least bad way out of this morass.

BRUCE BARTLETT is a senior fellow at the National Center for Policy Analysis and was a staffer in the Reagan and George H.W. Bush administrations.