United States

Value-added tax: A primer for the middle market


As outlined in our latest edition of The Real Economy, policymakers have a little less than a decade to put into place a mix of tax and entitlement reforms to avoid demographically-induced long-term fiscal challenges. If policymakers fail to reach a plan to put the economy on a sounder fiscal path, global investors will increase the risk premium placed on U.S. debt and demand a higher rate of return on U.S. Treasury borrowings. Under such conditions, the most likely “solution” to a combination of an increase in the price of federal borrowing and depreciation in the U.S. dollar would be the implementation of a value-added tax (VAT).

A value-added tax is a consumption tax placed on a good or service wherever value is added at each stage of production, and again at the final sale. For example, when an Apple iPhone is built, Apple would be charged a value-added tax on all raw goods used at earlier stages of production, such as rare earth minerals, software, glass etc.

As a matter of economics, a VAT is a highly efficient revenue producer that would be an optimal substitute for the current inefficient system of taxation. A broad-based VAT necessary to cover two-thirds of current consumption would require a taxed level of 8 percent. Exemptions for low-income families, or a narrower tax regime that exempted food, health care and housing, would drive the VAT above 10 percent.

While Apple is an example of how a large company would be affected, middle market firms should take a special interest in the scope, shape and distributional impact of any VAT as they may face a disproportionate burden. There are distributional effects that would advantage large firms that have economies of scale while placing middle market firms that have to source their supplies from a diverse set of producers at a decisive disadvantage.

Moreover, a VAT placed on top of the current tax system is no panacea. It would result in slower growth, a reduced pace of job creation and cause the Federal Reserve to be far more hawkish than is prudent given the coming demographic challenges.

The implications of a potential VAT on the real economy, and middle market firms specifically, cannot be understated given the critical role the middle market plays in driving growth and job creation. Forward-looking policymakers in both parties should move sooner rather than later to put into place basic tax and entitlement reforms that enhance growth, savings and investment rather than waiting for a crisis to force a new tax regime into place that would carry negative implications for the real economy.

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