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Military spending by the top military spenders, from the Economist.

What if we replace military spending with  official development assistance for these same countries?
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Congress is, no surprise, talking budget and tax reform again.  The 2001 and 2003 tax cuts are set to expire at the end of the year, and the federal debt is now equal to about 60% of GDP, the highest level since just after WWII.  (These figures come from Donald Marron’s very well-balanced testimony on the topic, which you can find here.)

In discussion of tax reform, the idea of instituting a value-added tax (VAT) seems to be a perennial favorite of economists.  Here is a quick overview of the difference between a VAT and a sales tax, and the reasons economists tend prefer the former:

A sales tax is based on a percent of the price of a product sold to a consumer.  In contrast, a VAT is levied on the extra value that is added to a product at each stage in its development.  For example, under a sales tax, an ice cream shop would collect and pay tax based on the final price of an ice cream sundae it sells.  Under a VAT, the ice cream shop would only collect and pay tax on the difference between the final price of the sundae and the costs of the inputs required to make the sundae: cream, sugar, bananas, peanuts, etc.  Both systems result in a tax burden that is eventually paid by the end consumer, but the VAT has several advantages:

  • VAT doesn’t double-tax.  Double-taxation is broadly considered to be a bad thing in economics, because it means that some people have to pay a tax twice (or more times) on one economic activity.  This creates extra distortions, in the form of disincentives to engage in these activities.  In the case of VAT vs. sales tax, the sales tax would tax the cream based on its price, and then tax the ice cream based on its price—but the price of the ice cream includes the price of the cream, which was already taxed once.   This means that goods that have gone through more stages of production—that are higher up the value-added chain-- are taxed more heavily than goods that have only one stage of production before being sold to the final consumer.   While it is generally undesirable to have taxes that discriminate against certain types of products, this might be especially concerning if we want our economy to make high tech, high value products, which often go through many stages of manufacturing. 
  • VAT doesn’t favor monopolies.  Since sales tax must be paid each time something is sold, there is an advantage to being a large, vertically integrated firm that engages in all stages of production of a product.  It is more expensive to be a small, specialized firm.  VAT does not create this distortion, so it puts smaller firms on more even footing with large ones. 
  • VAT has inherent checks on fraud.  In a sales tax system, consumers have no incentive to make sure that producers are submitting the correct taxes for the good they purchase.  However, in a VAT system, the consumers in the middle of the value-added chain have an incentive to make sure their suppliers are submitting the correct taxes.   VATs are collected for each sale based on the price(like the sales tax), but each person paying the tax can deduct the price they paid for inputs from the total they owe.  As a result, they will check that the person they bought the inputs from submitted the correct tax, because otherwise the tax they pay will be inconsistent with what their supplier submitted, and it would be obvious that one of them engaged in fraud.
  • VAT is easy to scale up or down to meet revenue needs.  When sales taxes get too high—generally above 10%-- consumers start finding ways to circumvent it, such as buying online, etc.  VAT is harder to circumvent, and harder to see, since it doesn’t hit all at once, so it is easier to raise the VAT rate without losing revenue to tax avoidance.  (Note: Some conservatives, who one might think would support VAT, don’t like it for this reason—it makes it too easy for governments to raise taxes.)

VAT is not without problems: like the sales tax, VAT is regressive, falling most heavily on those whose consumption is the largest share of their income: the poor.  One option for addressing this problem is providing off-setting  payments from the government to low income individuals.