The global economic crisis has two diametrically opposed aspects, as things stand today. The first of these has created the current focus on economic stimulus; of getting consumers to consume; of encouraging lenders to lend; and of reenergizing the banking, manufacturing, wholesaling and retailing sectors. In other words, the emphasis is on getting markets back to a reasonable level of their former functionality. These strategies, in common with virtually all government initiatives, are ultimately being funded by the taxpayer, which brings us on to the flip side of the issue, which is now being addressed in a more serious way.
The situation has never been so dire for the national debt. Additionally, it has been estimated that the US will issue somewhere between $2.7 trillion and $4.2 trillion of debt over the next two years. With the federal deficit already racing towards $2 trillion and with many more billions likely to be paid out in funding to U.S. businesses and in stimulus packages before the crisis is over, how will we ever extract ourselves from the deepening debt hole that threatens to drain the economy for generations to come? Even before the current set of circumstances evolved, it was being forecast that spending on Social Security, Medicare and Medicaid alone would overwhelm the entire federal budget within the next 35 to 40 years.
To address these problems, the limited options open to government include drastically cutting forecast spending, raising taxes, or a mixture of both approaches. The Obama administration has already undertaken to review entitlement provisions, and has set a goal of halving the federal deficit before the end of the current administration but, in the absence of an unlikely root and branch cutting of benefits for baby boomers and beyond, this is unlikely to come close to solving the long term problem.
Looking at the tax side of the equation, what could be done to raise revenues following on from the current climate of tax cuts? It is important to note that increasing corporate income tax rates and Social Security contributions levels could be a retrograde step, in that the U.S. is already viewed as a somewhat uncompetitive environment from a tax perspective. A joint World Bank and PricewaterhouseCoopers report published in 2008 looked at the total tax burden (including income taxes, employers’ Social Security contributions and other non-creditable taxes) imposed on businesses. The report ranked the U.S. 92nd out of a field of 179 countries, with an overall tax burden of 42.3%. The inference is that, in this respect, the U.S. is not an especially attractive country for inward (or even internal) investment in what has become an increasingly competitive and international environment over the last decade or more. Put in perspective, the tax burdens of some of the countries that have been more successful at attracting inward investment include the United Arab Emirates (14.4%); Singapore (27.9%); Ireland (28.8%); and Switzerland (28.9%). This indicates that the tax “gap” between the US and some of its global competitors is not even close. To exacerbate that situation by raising corporate income and Social Security taxes could well do more harm than good.
It is also worth mentioning here that there is a clearly identifiable trend around the world for governments to move away from direct taxes, which effectively penalize employment, savings and earnings, in favor of certain indirect taxes that impact spending, consumption and the environment. Although such taxes are sometimes referred to as “regressive” (in that they can impact the poorer segments of society more severely than the wealthier ones), the degree of regression can largely be controlled by governments targeting particular types of expenditure. There is also a perception of innate fairness about indirect taxes, in that individual citizens are not compelled to pay them – after all, it is to some extent their own choice whether they buy certain goods and services and thereby incur the tax.
For governments, the benefits of moving towards indirect taxes have been highlighted in the current economic environment. Direct taxes such as Income Tax are intrinsically unstable sources of revenue, as they rely on taxpayers making profits in the first instance. As we are seeing in the present crisis, the profitability of American companies this year is likely to be marginal, and the result of that will be a sharp decrease in Income Tax revenues. As an example, in June 2009 California announced that its tax revenues had decreased by 39% for personal income tax and 52% for corporate income tax. In contrast, state sales tax yields had only fallen by 7.5%. This illustrates that, although sales taxes are adversely affected by economic downturns as consumers tighten the purse strings, they are far more stable than direct taxes because people still have to purchase goods and services, even during a recession.
If increasing corporate direct taxes are not a viable option, then what other tax types could raise sufficient revenue to make a meaningful dent in the deficit? Realistically, a National Sales Tax (NST), similar to the Value Added Tax (VAT) that prevails in almost every other country, is one of the few tax systems that could make a real difference over a relatively short period of time. Although raising taxes is never a popular move, it may be useful to add some broader global context here.
The average rate of state sales tax in the U.S. is around 8%, which compares very favorably with most other developed countries in the world. Comparable rates of VAT (or local equivalents) include 15% in Canada, Mexico and the UK, 19.6% in France, 19% in Germany, and 17% in China. The average European Union rate hovers around 20%, and global rates average out at about 16%. So there is a significant gap between the consumption taxes paid in the U.S. and those paid in most other parts of the world and it is this gap that could be narrowed through the introduction of NST and justified on the dual bases of the U.S. being so far out of line with the rest of the world and the critical need to fund the country’s long term economic health. The added benefits of introducing an NST would include the ability to reduce income tax rates (so making the U.S. more competitive on the world stage) and to potentially completely eliminate some other taxes, thereby streamlining the entire tax system. It is this “trade-off” between increasing indirect taxes and reducing direct taxes that could make such a proposal salable to an otherwise financially stressed American public.
So, if NST was to be introduced in the U.S., what would it look like and what impacts would it hold for businesses? The most likely picture would be that this tax would sit on top of the existing Sales and Use Tax structure that operates today at a state level. There is little reason initially to combine Sales Tax and NST from an operational point of view, and any attempt to do so would almost certainly run into fervent opposition from certain states. On balance, it would be better to leave the present Sales Tax system undisturbed. If this was the case, it would seem logical for the new tax to be administered as an offshoot of the IRS, which would need to increase its auditor and administrative numbers to cope with the additional work. That said, a more streamlined structure could be to add NST collections to the existing State Sales Tax process with a compensatory payment being made to the states for providing this service to the federal government. Clearly, separate arrangements would be required for states that do not levy a sales tax. As a point of reference, the European Commission estimates that collection costs for VAT are between 0.5% and 1% of revenue collected. There is no reason to believe that this cost level would be significantly different in the U.S., making NST a relatively cheap tax to administer. Of course, that does not take into account the costs that would be incurred in setting up the new tax. Extensive internal and taxpayer education programs would be required, new computer systems would have to be built, new staff recruited and additional office space found. Realistically, if a decision was taken today to introduce NST, it is likely to take at least two to three years before it could be fully implemented nationally.
The responsibility for charging and remitting NST would rest with all businesses that are registered for the tax, as one of the key differences between sales tax and VAT is that VAT is charged at all stages of the supply chain and exemption certificates are rarely used. This would mean that all companies charge tax on their sales and they all pay tax on their purchases, regardless of their reseller status. Of course, this will increase the administrative costs associated with doing business. There would be initial costs of reconfiguring or upgrading accounting systems and of investing in staff training related to the new tax. There would also be ongoing costs associated with reporting and filing of NST return forms, periodic auditing from the tax authorities, and, especially for some larger concerns, consulting services to ensure that compliance positions are optimized. For most businesses, NST would be unlikely to create an additional tax burden, as any NST incurred on purchases would be offset against the NST charged on sales, creating an effective wash-through. That is not to say that there would be no cash flow impact involved, as NST declarable in respect of sales would typically run ahead of reclaimable NST appearing on purchase invoices.
For consumers, an NST would likely lead to an increase in the cost of many of the goods and services they purchase, but probably not by much. While it might be expected that a 7% NST would increase retail prices by 7%, the true effect is dictated by the markets. If consumers start reducing the numbers of products they buy, producers and those in their supply chains are likely to absorb at least some of the price increases by discounting, so limiting the impact on the consumer. In this way, the consumer might only see a very slight retail price increase. As for the regressive aspects of NST, they could be largely addressed by targeting certain categories of consumer goods such as foodstuffs and clothing with reduced tax rates or even exemptions from NST. Additionally, rental of domestic properties and provision of financial services could be exempted on the grounds of their regressive effects. The message here is that the regressive nature of VAT is often wildly overstated, and it should be viewed in terms of how controllable it is rather than it being an immovable object.
When estimating the value of an NST to the U.S., there are many factors that need to be taken into account, but the key ones are rates, scope and exemptions. A Congressional Research Service report issued in October 2009 and based on 2008 figures, identified that the taxable base for a U.S. NST would be $8.8 trillion (if a broad based tax was introduced) or $5.1 trillion (if NST with various exemptions was implemented). Using these numbers and assuming a 7% rate, which would bring the country in line with the bottom end of global consumption tax rates (roughly in line with Canada and Mexico), and assuming a limited range of exemptions in the finance, food, healthcare and charity sectors, it is estimated that the net tax yield would be in the range $400 billion to $600 billion per year. However, the positive cash flow impact that the government would experience from NST would be considerably greater. This is an often overlooked benefit of such a system but, with far greater amounts of money circulating in the tax system and the significant balance of that cash flow favoring the government, a massive one-off but permanent cash flow benefit could boost tax income significantly.
This all sounds positive in terms of attacking the federal deficit and national debt. But is it likely that some version of NST will see the light of day in the U.S.? After all, the idea of introducing a form of VAT has been on the table for more than 20 years at one level or another and it has not happened yet. Even today, there are three bills before Congress related to aspects of a National Sales Tax concept. The plain answer is that it depends on whether this or any future administration has the political will try to convince the American people that they should be paying higher taxes on their consumption of goods and services. It would be possible to sweeten this pill with the simultaneous repeal of other taxes or providing some form of tax credit for certain groups who would find the new system a serious hardship. However, both sides of the political divide have shown a marked reluctance to head down this path. But, then again, the country has arguably never been in such dire economic straits, so history may not be a good indicator of future policy in this area.
The Obama administration has recognized that it is time to start making serious progress on a tax reform package that will, over time, address the real, long term needs of the country and, most particularly, reduce the very real threat that generations to come will be left to shoulder the burden of a massive debt mountain and huge, unfunded entitlement obligations that have been of this generation’s making. In conjunction with widespread entitlement reform, an NST is one serious option that could be considered.
The content of this article advances the outlook and opinions of the author, Chris Walsh. The author does not advance this article's content to represent in any way the views of Vertex, Inc.