VAT and the federal debt

The idea of a value-added tax is gaining traction among some economists and policy makers, as a possible tool to reduce the projected chronic federal budget deficits and avert fiscal crisis.  A VAT is similar to a retail sales tax except that the tax is levied and passed on as part of the4 mark up at each step in the supply chain.  The tax is ultimately still passed on to the consumer.  VATs are common in most of the developed world outside the US.

Two points on a VAT:

1) A major argument used in favor of a VAT is that it discourages economic growth less than the current system of income taxation because it is a tax on consumer behavior rather than productive activity that generates income, so instead of discouraging saving and investment it discourages over consumption.  This argument falls flat however, because the fact that value-added by the consumer inevitably avoids the tax, which leads to one of the most well know unintended consequences of a VAT: vertical integration at the consumer level. 

Consumers can significantly reduce their VAT burden by buying unfinished or wholesale goods and doing final assembly, maintenance, and services for themselves rather than hiring or purchasing from someone who specializes.  This reduces the productivity of the overall economy by eroding the division of labor; the average Joe consumer is simply not going to do as good a job assembling a car stereo or plumbing a house as a trained professional would.  There’s no reason to believe that the improved incentives that result from a move away from income taxation would necessarily out weigh this effect. 

 2) The idea that significantly raising taxes to boost federal revenue by either introducing a VAT or just raising current taxes will be an especially effective means of reducing budget deficits and the federal debt flies in the face of historical precedent.  

Federal debt reduction is always associated with military demobilization following the end of a major war, not with an increase in federal revenue.  If anything, the chart demonstrates that episodes of significant increase in federal revenue are associated with a steeply growing debt.  While sustained higher revenues do appear to lead some debt reduction over a few decades, like an ideal gas spending then expands to fill the available volume of revenue.  The cycle repeats and with each stage revenue, spending, and the total debt all grow.